MauledAgain

Almost a year ago, Pennsylvania State Representative Jesse White announced plans to introduce legislation “that would provide a tax credit for the adoption of a dog or cat.” Late last week, as reported in this article, the attempt to add the credit to the state income tax law failed by a vote of 97-96.

This effort is a textbook example of why it is so difficult to clean up the tax law. Any sort of objection to this credit will bring howls of protest and derision from many of those who like animals and have pets. I say many and not all because I like animals and have had pets, but I’m no fan of cluttering the income tax law with a provision whose goals can and should be accomplished in other ways.

The goal of the legislation is “to encourage adoption and discourage puppy mills and also ease the burden on shelters.” Those are noble goals. The tax law, and the Department of Revenue, are not appropriate vehicles for accomplishing those goals. I have criticized the use of tax incentives to achieve non-tax purposes at the federal level, as discussed in posts such as The Problem with Income Tax Vehicle Credits, Congressional Mis-delegation Endangers Tax Collections, and More Criticism of Non-Tax Tax Credits, When Tax Credits Aren’t Worth the Trouble, The Disadvantages of Tax Incentives, and
Tax Incentives Gone Wild, and I am no less critical of similar approaches at the state level. For example, would the Department of Revenue be responsible to make certain that taxpayers who claim the credit keep the adopted dogs and cats and don’t abandon them or drop them off at a shelter a few months later after filing their tax returns?

The state of Pennsylvania has a history of providing financial support to animal shelters. This is a classic case of good public spending, no matter what the so-called smaller-government and anti-tax advocates claim. Public health and safety is threatened when animals run wild that ought not be running wild, and the establishment of shelters provides a public service. Thus, the public ought to fund the efforts to take those animals off the street. In recent years, however, the anti-spending forces have succeeded in cutting state funding for shelters in half and have proposed to eliminate the funding altogether.

Representative White’s proposal would limit the credit to $7.5 million. It’s unclear what would happen if 25,001 taxpayers claimed the credit. That issue aside, why not simply provide $7.5 million of funding to animal shelters? Surely that is a more efficient use of $7.5 million than dishing out tax credits to taxpayers who may or may not even need the financial support to adopt a dog or cat. Despite the claims of the cut-taxes, cut-spending crowd, the $7.5 million credit increases the state’s budget deficit by the same amount as would $7.5 million in spending. Once again, I make the point that a tax credit is spending in disguise, and yet anti-spending legislators vote for tax credits without blinking.

The proposed credit has several other flaws. Why is it limited to dogs and cats? Is that not discrimination against those who favor other animals? I have a law school classmate friend who rescues birds and who has successfully advocated on behalf of birds that have been mistreated. Is her work no less noble than the work of those trying to save abused, abandoned, and neglected dogs and cats?

The proposed credit suffers from the same misguided notions as does the federal income tax adoption credit. It is inconceivable that anyone would consider the credit the tipping point between adopting and not adopting. Considering that the cost of raising and caring for a child or pet exceeds the credit or proposed credit by orders of magnitude, no one should rely on the credit as the financial wherewithal to taking on the responsibilities of having a child or pet.

The worse aspect of the credit is a defect that it shares with all other credits. The credit is a reverse tax. Setting aside the increased budget deficits generated by tax credits, if revenue is to be maintained when a tax credit is enacted, taxes must be raised across the board to fund the credit. Thus, those who, for whatever reason, cannot or do not adopt a dog or cat, are being taxed, whereas those who receive the credit, even net of the taxes they pay due to the across-the-board tax increase, are not paying additional tax. Thus, the enactment of a funded tax credit is a tax on those who fail to do whatever it is that those who qualify for the credit are doing. And if taxes are not increased to fund the credit, everyone pays through the economic effect of increased budget deficits. Either way, those who do not adopt pets are being taxed or charged. I wonder, once those who support the anti-tax groups because they don’t want to pay more taxes figure out the reverse tax implicit in the tax credits enacted by the supposed anti-tax, anti-spending legislators, will they shift their support to those who take a more sensible approach to taxation and spending?

Two separate developments that appeared last week provide even more warnings about the dangers of relying on tax incentives to accomplish goals that are far beyond the scope of a rational tax law. This is not the first time that I’ve addressed this concern, as evidenced by posts such as The Problem with Income Tax Vehicle Credits, Congressional Mis-delegation Endangers Tax Collections, and More Criticism of Non-Tax Tax Credits, When Tax Credits Aren’t Worth the Trouble, and The Disadvantages of Tax Incentives, and I doubt it will be the last.

The first development was the introduction in Congress of a proposed “Qualifying Renewable Chemical Production Tax Credit Act of 2012”. This is truly a bi-partisan effort, as the each of the two members of Congress who introduced the bill belong to one of the two major political parties. The legislation would add a section 45S to the Code equal to 15 cents per pound of eligible content of renewable chemical produced by the taxpayer during the taxable year. Each taxpayer’s credit is limited to its share of a $500 million limitation allocated by the IRS among taxpayers claiming the credit. The definition of eligible content is a long, technical, and exception-ridden description that chemical engineers can understand, though few, if any, tax practitioners or IRS employees would appear to be well versed in terms such as biobased content, renewable chemical, biobased content percentage, biological conversion, thermal conversion, and renewable biomass. I daresay that the legislators who introduced this bill did not write it, and if compelled to hazard a guess, I’d put this language in the hands of lobbyists.

Not only would this legislation require the IRS to jettison revenue officers so that it could hire chemical engineers, it also would require the IRS to fire even more revenue agents so that it could hire more economists and scientists. Why? In allocating the $500 million spending increase masquerading as a tax credit, the IRS would be required to determine “the number of jobs created and maintained (directly and indirectly) in the United States” by each taxpayer’s credit allocation, “the degree to which the production of the renewable chemical demonstrates reduced dependence on imported feedstocks, petroleum, non-renewable resources, or other fossil fuels,” “the technological innovation involved in the production method of the renewable chemical,” “the energy efficiency and reduction in lifecycle greenhouse gases of the renewable chemical or of the production method of the renewable chemical,” and “whether there is a reasonable expectation of commercial viability.” It is not the role of the IRS to engage in these sorts of determination. Putting aside the question of increased government spending, why not allocate $500 million to the Department of Energy and tell it to administer this program? The answer, of course, is all sorts of nonsense about how the tax law is the better vehicle for accomplishing the purposes of the spending program, but the true answer is that it’s simply a way to spend money without disclosing the expenditure. That might resonate with people who don’t understand that reduced revenue, whether through credits or otherwise, and increased spending have the same effect on the budget deficit. It doesn’t resonate with those of us who can see through the ploy. But, speaking of ploys, it’s an election year, and the introduction of this bill might be nothing more than a sop to some campaign contributors.

The second development was a GAO report, Energy Conservation and Climate Change: Factors to Consider in the Design of the Nonbusiness Energy Property Credit, that explores the possibility of changing the section 25C nonbusiness energy property credit to one that is calculated using performance-based standards rather than simply the cost of the improvement incurred by the taxpayer. In a sentence set in bold and much larger font, the report declares: “Performance-based credits may have significantly higher compliance and administrative costs than cost-based credits.” And on what agency would these higher costs fall? The IRS, of course, which would need to dismiss even more employees tasked with tending to the agency’s primary revenue collection function. The report also explores the use of floors in the computation of the credit, which would make the tax law even more complicated, adding to the misery of taxpayers and the administrative and compliance burdens placed on the IRS.

Considering that the GAO issued the report in response to requests by the Congress, there is a significant possibility that the tax law will become even more complicated, even as the Congress tosses about the phrase “tax simplification.” Rather than listening to the Congress, Americans ought to be watching what the Congress does. And one of the things that it does is to make the tax law more complicated, for reasons that have nothing to do with sound tax policy.

They are persistent, that much must be conceded. I’m referring to people whose intelligence and cleverness could accomplish much to benefit society, but who choose to use their talents to do evil. The other day I received an email with the subject line “RE: Tax Exemption Notification” from a person using the name Isabella Charlotte. I doubt this person exists, and if she does exist, I doubt she is the sender of the email. I doubt that Charlotte is her surname. In the body of the email was a purported IRS logo, and a letter that began, “Sir/Madam, Our records indicate that you are a Non-resident.” Really? Guess what, Isabella Charlotte or whoever you are, I am not a non-resident. I cannot imagine what IRS records would exist showing me to be a non-resident. Of course, at that point I knew the letter was a scam, a product of a twisted and devious mind, but I kept reading.

The letter continued, “As a result you are exempted from United States of America Tax reporting and withholdings. . .” Even if I had not yet concluded that the letter was a scam, that phraseology would seal the deal. It’s not professional tax terminology. The letter then proceeded to request that I “recertify” my status by filling out “form W-4100B2.” Attached to the email was a concocted Form W-8BEN, not a “form W-4100B2.” The letter asked that the form be sent by fax to 1-815-390-1251, but the attached form requested that it be sent to 1-267-427-1363. The attached form actually asked that it be sent “to fax no- 1-267-427-1363 Via Email TO irs.usa@5acapital.com.” The forms, of course, ask for all sorts of identifying information, including social security number, bank name and account number, and so on.

Perhaps I give this “Isabella Charlotte” too much credit for intelligence and cleverness. Consider the sloppiness of this attempt to steal identities. Inconsistent form numbers. Inconsistent fax numbers. Grammatically confusing sentences. Absurd email address. Perhaps “Isabella Charlotte” doctored up a more sophisticated scam in an effort to avoid being linked to the originator of this particular phishing attempt. The clincher is the claim by “Isabella Charlotte” to represent “IRS Public Relations.”

So who is responsible for ridding the planet of this behavior, and curtailing the activities of those who engage in these counterproductive enterprises? Government? Which ones? The private sector? Who pays? The funneling of resources that could be used for more productive endeavors into the prevention of, and punishment for, fraudulent activity is a sad commentary on the failure of the species to make better progress. Sadder still is the probability that somewhere, someone will provide to this “Isabella Charlotte” and others like her the requested information. Again, it comes down to education, combined with careful monitoring of those who lack or lost the capacity to deal with these sorts of scams. And again, who is responsible? And who pays?

I wonder how much more prosperous the economies of every nation could be if this sort of behavior could be stamped out. Whatever is being done isn’t enough, because the practice continues. It will stop when it becomes a fruitless exercise. That hasn’t happened yet. Why?

Consider the situation in which two homeowners find themselves. Each lives in the same real property tax jurisdiction. Each owns a home worth $300,000. One pays real estate taxes of $1,500. The other pays real estate taxes of $3,500. Why the difference? A variety of factors contribute to the inequity. Appraisals are inconsistent. Appraisals are done at different times. Appraisals are not updated. The tax is computed using an arbitrary fraction of presumed value.

This sort of situation is the poster child for the Philadelphia real property tax system, although similar problems surely afflict localities across the nation. I’ve been writing about the Philadelphia real property tax dilemma since my first post, An Unconstitutional Tax Assessment System, and I have continued with a series of posts, Property Tax Assessments: Really That Difficult?, Real Property Tax Assessment System: Broken and Begging for Repair, Philadelphia Real Property Taxes: Pay Up or Lose It, How to Fix a Broken Tax System: Speed It Up? , Revising the Board of Revision of Taxes, How Can Asking Questions Improve Tax and Spending Policies?, This Just Taxes My Brain, Tax Bureaucrats Lose Work, Keep Pay, Testing Tax Bureaucrats Just Part of the Solution, A Citizen Vote on Taxes, Freezing Real Property Tax Reassessments: A Nice Idea, The Tax Price of a Flawed Tax System, Can Bad Tax Administration Doom the Tax?, Taxes and Priorities, R.I.P., BRT, A Tax Agency Rises from the Dead, and Tax Law as Subterfuge: Best Use Valuation v. Current Market Valuation, How to Kill a Bad Tax System That Will Not Die?, and The Bad Tax System That Will Not Die Might Get Another Lease on Life.

Fixing the problem should be simple. Appraise properties at current market value, and divide current revenue by total valuation to obtain the rate. One difficulty, as noted in The Bad Tax System That Will Not Die Might Get Another Lease on Life, is the temptation to increase revenues in the process of fixing valuations. The two processes should be kept separate. Another major problem, as discussed in a recent Philadelphia Daily News article, is the reaction of property owners who suspect that an appraisal set at market value will cause their real property taxes to increase. Though some property owners who have that worry might be worrying needlessly, there is no doubt that a substantial number of properties in fact are undervalued, and their owners will face higher taxes.

One taxpayer quoted by the article claims that her property taxes will increase to $5,500 a year. How does she know that? Does she have both the new appraisal and the new rate? No, because the new rate continues to be the subject of debate among the city’s leaders. This person also claimed, “I feel like I love the city and it doesn’t love me back.” How is a city supposed to show love? By selecting random individuals for tax breaks in the form of under-market valuations? By giving tax breaks to those who claim to “feel like I love the city?” How does one identify individuals who qualify? If the test were a matter of finding people willing to speak those words, the real property tax base and its revenues would plummet. Should the fact that someone has benefitted from years of inequitably low taxes, in comparison to property owners paying at higher effective rates, matter?

There are in place a variety of arrangements that property owners can use to blunt the impact of real property tax increased caused by the restoration of equity to the system. Some taxpayers qualify for programs designed to assist those who are economically disadvantaged in terms of income and those who qualify for certain benefits for the elderly. There also is a law that permits property owners to defer tax payment if their assessments increase by more than 15 percent. The deferred payments, plus interest, are due when the property is sold. In addition, the city is considering phasing in the tax increase, though no mention is made of phasing in the tax decrease for the taxpayers who have been relatively over-paying during the past several decades. The city also is trying to persuade the state legislature to enact a $15,000 across-the-board homestead exemption.

Coalitions of taxpayers are urging the city to delay switching to assessments based on actual value. One risk of doing so is a $41 million revenue loss triggered by a state tax board decision that opens the door to more appeals by taxpayers whose properties are over-valued. Ultimately, the question is how much longer should some taxpayers in the city, who have been paying disproportionately higher real property taxes, continue to subsidize taxpayers who have been paying disproportionately lower real property taxes? This question, it must be understood, overlooks the tougher question of how to ameliorate the effect of years of this unjustifiable subsidization, because the practical answer to that question is simply that it won’t happen. For that, the subsidized property owners have something for which to be thankful and a reason to appreciate the fact that things could be much worse.

Earlier this month, the Institute of Medicine of the National Academies released the third in a series of reports on the state of public health in this country. In the third report, the Institute turned to the question of funding federal public health efforts to cope with the “large proportions of the U.S. disease burden” that can be prevented. The proposal rests on the belief that the need for medical care and its associate costs can be reduced by preventing disease, illness, and injury, and on the belief that the cost of prevention is less than the cost of treating the disease, illness, or injury. The report mentions the benefits of reducing tobacco use, and increasing immunizations, seat belt use, healthy nutrition, and physical exercise.

The Institute proposes that federal public health funding be doubled, that state and local funding currently directed into clinical care be redirected to public health purposes when the clinical costs become reimbursable under Medicaid or Affordable Care Act state health insurance exchanges, and the enactment of “a national tax on all medical care transactions.” The Institute considered pretty much every sort of tax possibility, including increases in estate taxes, sales taxes, intangibles taxes, life insurance proceeds taxes, property taxes, and value-added taxes.

It may shock some readers of MauledAgain, but I question the wisdom of dealing with these issues in the manner the Institute suggests. The idea of encouraging prevention efforts has my full support. It is logical and makes sense to use seatbelts, to wear helmets when riding motorcycles, to exercise, to eat healthily, and to avoid tobacco use.

The tough question is how to increase prevention efforts and to decrease choices that ultimately contribute to the escalation in health care costs. There are three pathways, not mutually exclusive, to achieving better prevention efforts. The first is to compel people to engage in prevention efforts. The second is to pay people to engage in prevention efforts. The third is to educate people so that they conclude that prevention matters, decide that they want to make better choices, and learn how to make those choices.

The first pathway is blocked by a variety of obstacles. Compelling people to go to the gym, or to eat broccoli, meets public resistance. There’s the matter of the federal Constitution and state Constitutions. There are lessons to be learned from Prohibition, one of which is the realization that alcohol consumption, in moderation, has health benefits, and is not the per se bad practice that some believe. That there are statutes requiring the use of seat belts and prohibiting texting while driving is encouraging, but there’s as much pressure to repeal those laws as there is to expand them to widen the scope of obligatory safe behaviors and prohibited unhealthy activities.

The second pathway is nothing more than a bribe, though many probably prefer the less glaring term incentive. Though money might induce some people to change their health habits, the amount required to do so might consume whatever savings can be obtained through prevention.

The third pathway is the most efficient route to implementing the sort of changes that will reduce long-term medical costs. Education costs money, but does it require the sort of funding that the Institute proposes? Is it not possible to reform elementary and secondary education to include in the curriculum information and instruction in preventative care and common sense health measures? Is it not possible to insert health prevention education into existing social programs that serve adults who are beyond their school years? Even so, even with all the education money could buy, some people are dead-set, pun intended, on living in ways that are unhealthy and that ultimately will lead to increased medical costs. There are some things taxation cannot cure.

A recent case provides good insight into the disadvantages of using the tax law in an effort to encourage or discourage particular economic or other activity. In previous posts, such as The Problem with Income Tax Vehicle Credits, Congressional Mis-delegation Endangers Tax Collections, and More Criticism of Non-Tax Tax Credits, and When Tax Credits Aren’t Worth the Trouble, I have shared a variety of reasons that it makes little or no sense to use the tax law as a substitute for direct funding and oversight by the agencies expertised in the area in question.

In McGuire v. Comr.,, T.C. Summ. Op. 2012-34, the Tax Court held that the taxpayers, a married couple, did not qualify for the section 36 first-time homebuyer credit. The taxpayers failed to qualify because they signed the lease-purchase agreement for the property on March 20, 2008. Although the parties agreed that the agreement constituted a purchase and the property was used as a principal residence, the credit applied to property purchased after April 8, 2008, and before July 1, 2009.

Hindsight suggests that had the taxpayers waited 20 days, they would have obtained a $7,500 credit. The lesson appears to be that if there is any possibility of a tax incentive being enacted with respect to a particular type of transaction or activity, a person should wait, unless the transaction or activity is essential. It’s silly to postpone purchasing groceries for months on end on the off-chance the Congress might enact a food market stimulation credit. But is it so silly to hold off making other sorts of acquisitions? Not at all. According to a recent report from the National Restaurant Association, roughly thirty percent of restaurants are delaying expansion and renovation projects because they don’t know if Congress is going to restore the expired special 15-year recovery period for restaurant property. The projects that are on hold would put $30 billion into the economy through direct expenditures and ancillary economic impacts, and create roughly 200,000 new jobs.

What makes the use of tax law incentives particularly detrimental is the refusal of the Congress to enact a set of rules that have any sort of long-term sustenance that permits long-term business and personal planning. The pattern of letting incentives expire, or come close to expiration, only to re-enact them, sometimes retroactively, is a practice designed to permit members of Congress to solicit funds for their electoral campaigns. There’s much more to sell when dozens of tax law provisions are on their death beds. The well-being of the national economy demands stability, continuity, predictability, and reliability in the tax system. By putting personal electoral goals ahead of the nation’s well-being, Congress is selling the nation short and ultimately risks selling it out.

Perhaps there is another element in the raging debate about taxes. Perhaps the disagreement has less to do with how much a government collects and spends and more with whether the taxpayers trust those who are serving in government positions. This observation surfaces from a story about a town whose citizens voted to oppose tax increases and then, a year later, voted to increase taxes.

In New Jersey, local governments are not permitted to increase taxes by more than 2 percent without voter approval. More than a year ago, the town of Medford found itself with a huge budget deficit. At that time, the mayor and town council requested approval by the voters of a 25 percent increase in property taxes. The proposal was defeated, by a factor of five to one. The town eliminated its recreation department and programs, cut back public works expenditures, chopped salaries for town officials, and laid off police. Next up on the list of expenditures to be cut was municipal trash collection.

In the meantime, the town’s mayor resigned after being caught in a sex scandal, and discovery of financial mismanagement compelled the departure of four members of town council. In January of this year, a new mayor and new members of council, from the same political party as those who had departed, were elected. They brought back the proposal to increase property taxes by 25 percent. The proposal passed, 57 percent to 43 percent.

What happened? Why did so many voters change their minds? There appear to be two major considerations.

First, according to interviews with voters, some of whom were ready to vote “no” in the most recent referendum but who changed their minds, it seems that they wanted to give the newly elected officials a chance, considered them sincere, and went from distrusting the town government to trusting the newly elected slate of officials. One voter noted that she now had a better idea of what was happening with the tax revenues.

Second, according to these interviews, residents concluded that if the town eliminated municipal waste removal, the cost of contracting with private companies for the same services would be costlier than paying taxes to have the town provide the service. As one voter put it, “The logistics would be difficult.” Another voter explained, “I don’t know how I could afford to have them [the items put out for collection] all taken away unless we all pay for it as a community.” Unlike private contractors, municipalities do not operate with a need to build profit into the price, and provided – and this is a big provided – the town operates efficiently, it makes more sense to leave public functions to the public.

These two factors readily combine. The voters deserve to be treated in a manner that justifies trust in public officials, and public officials need to treat that trust as a sacred and fiduciary obligation. As the town’s new mayor put it, “[We were] humbled by the idea the people trust us, and it’s not lost on us.” As New Jersey Governor Christie, who championed the limit-unless-overridden-by-vote plan and who urged the voters to reject the 25 percent increase proposal, put it, “"Good for them. Higher property taxes for Medford. Congratulations. If the people of Medford want to pay higher property taxes, that's their call. . . . I said I would vote no, but . . . this is a democracy." Democracy provides the opportunity to kick out incompetent, corrupt, and manipulative politicians, which the people of Medford did but which too few voters across the country do in local, state, and national elections. Democracy does not exist in the private sector, and the so-called free market is a woeful failure when it comes to purging the planet of incompetent, corrupt, and manipulative business entities and their operatives.

Two years ago, I addressed the question of tax referenda in Tying Tax Revenue to Voter Responsibility, explaining:

The key to balancing government budgets is not a simple matter of limiting tax revenue and triggering a free-for-all among the proponents of particular state services. The key is to price out and advertise the cost of each service that voters tell their representatives that they wish to receive. Pennsylvania has a similar property tax limitation in place, but it can be exceeded if the voters approve a budget that is based on an increase above the cap. By shifting responsibility onto voters, and making it clear that they must pay for what they want, particularly with respect to items that take the form of a user fee, governments can move away from spending decisions that are made by legislatures without any specific directive from voters. The cap ought not be an iron-clad revenue increase restriction that has no bearing to the actual costs of providing government services, but a cap on the spending decisions that are not specifically authorized by voters.

Ultimately, when complaints about high taxes circulate, the response, “You voted for it,” should either dampen the griping or inspire people to reconsider, and cut back, their government services wish list. The debate before each tax referendum, though probably loud, intense, and heated, will be educational, worthwhile, and productive. Imagine how cathartic it will be to listen to the proponents of a tax for a particular service debate those who do not want to pay taxes to provide that service. It will take the issues out of the back rooms and put them on the table Tying ownership of the expenditure process with ownership of the taxing process makes much better sense in the long-run than unworkable and impractical absolute revenue caps.

It seems to have worked that way in Medford. The governor of New Jersey may not agree with the outcome, but to his credit, he pushed through legislation that has moved the politics of government finance closer to the system I advocate.

A recent discussion on the ABA-TAX listserve ultimately revealed a rather disturbing error in an IRS audit guide. The issue involves the computation of section 751(a) ordinary income or loss. Section 751(a) applies when a partner sells a partnership interest, and is designed to characterize as ordinary the portion of the selling partner’s gain or loss that is attributable to the partnership’s ordinary income items.

Until 1999, Regulations section 1.751-1(a)(2) provided the following rules for determining the amount of ordinary income or loss that a selling partner must recognize:

The income or loss realized by a partner upon the sale or exchange of his interest in section 751 property is the difference between (i) the portion of the total amount realized for the partnership interest allocated to section 751 property, and (ii) the portion of the selling partner's basis for his entire interest allocated to such property. Generally, the portion of the total amount realized which the seller and the purchaser allocate to section 751 property in an arm's length agreement will be regarded as correct. The portion of the partner's adjusted basis for his partnership interest to be allocated to section 751 property shall be an amount equal to the basis such property would have had under section 732 (including subsection (d) thereof) if the selling partner had received his share of such properties in a current distribution made immediately before the sale. See §§1.732-1 and 1.732-2. Such basis shall reflect the rules of section 704(c)(3), if applicable, or any agreement under section 704(c)(2). Any gain or loss recognized which is attributable to section 751 property will be ordinary gain or loss. The difference between the remainder, if any, of the partner's adjusted basis for his partnership interest and the balance, if any, of the amount realized is the transferor's capital gain or loss on the sale of his partnership interest.

In 1999, to reflect amendments to section 704(c), and for other reasons, the Treasury amended the regulation. When the regulation was proposed, the preamble (see 63 Fed. Reg. 4408) explained:

B. Section 751.

Section 751(a) provides that to the extent an amount realized on the sale or exchange of a partnership interest is attributable to the transferor's interest in unrealized receivables or inventory items of the partnership, the amount realized is considered to be an amount realized from the sale or exchange of property other than a capital asset. Thus, the transferor partner may recognize ordinary income or loss on the sale or exchange of its partnership interest. Under the current section 751 regulations, the amount of income or loss realized by a partner on the sale or exchange of an interest in section 751 property is equal to the difference between: (i) The portion of the total amount realized for the partnership interest allocated to section 751 property, and (ii) the portion of the transferor partner's basis in its partnership interest allocated to the property. Generally, the portion of the total amount realized allocated to section 751 property is determined by the seller and purchaser in an arm's length agreement. The portion of the partner's adjusted basis in the partnership interest allocated to the section 751 property equals the basis that the property would have had under section 732 if the transferor partner had received its proportionate share of the property in a current distribution immediately before the sale.

The proposed regulations amend these rules for determining the transferor partner's gain or loss from the sale or exchange of its interest in section 751 property. Rather than attempting to allocate a portion of the transferor partner's amount realized and adjusted basis to the section 751 property, the proposed regulations adopt a hypothetical sale approach. Thus, the income or loss realized by a partner from section 751 property upon the sale or exchange of its interest is the amount of income or loss that would have been allocated to the partner from section 751 property (to the extent attributable to the partnership interest sold or exchanged) if the partnership had sold all of its property in a fully taxable transaction for fair market value immediately prior to the partner's transfer of the partnership interest.

The proposed regulation was adopted by T.D. 8847, and reads as follows:

Par. 6. Section 1.751-1 is amended by:

1. Revising paragraphs (a)(2) and (a)(3).

* * *

The addition and revisions read as follows:

§ 1.751-1 -- Unrealized receivables and inventory items.

* * * * *

(a) * * *

(2) Determination of gain or loss. The income or loss realized by a partner upon the sale or exchange of its interest in section 751 property is the amount of income or loss from section 751 property (including any remedial allocations under § 1.704-3(d)) that would have been allocated to the partner (to the extent attributable to the partnership interest sold or exchanged) if the partnership had sold all of its property in a fully taxable transaction for cash in an amount equal to the fair market value of such property (taking into account section 7701(g)) immediately prior to the partner's transfer of the interest in the partnership. Any gain or loss recognized that is attributable to section 751 property will be ordinary gain or loss. The difference between the amount of capital gain or loss that the partner would realize in the absence of section 751 and the amount of ordinary income or loss determined under this paragraph (a)(2) is the transferor's capital gain or loss on the sale of its partnership interest.

During the course of the discussion about section 751(a) on the ABA-TAX listserve, a participant suggested that it would be helpful to look at a section 751 audit guide that the IRS had posted on its website. The IRS document, chapter 7 of the Partnership – Audit Technique Guide, Dispositions of Partnership Interest, states:

The amount of the disposing partner's ordinary gain or loss is the difference between the amount realized attributable to the hot assets less the partnership's adjusted basis associated with these assets.

What appears in the IRS audit guide is a paraphrase of Regulations section 1.751-1(a)(2) as in effect before the 1999 amendment by T.D. 8847. Thinking perhaps that the document was old, I checked its date. According to the website, it was revised in March 2008. At the bottom of the web page is a tag line stating that the page was “last reviewed or updated: January 25, 2012.”

What’s happening here? Are IRS auditors examining sales of partnership interests and applying old law? Are taxpayers, where old law produces a less advantageous outcome than does current law, citing the current version of the Regulations and demonstrating the obsolescence of the audit guide? Is anyone even aware of this discrepancy?

Partnership tax law is complex, conceptually challenging, and daunting. It’s easy to misapply the applicable law. It’s easy to overlook a critical fact. It’s easy, but dangerous, to apply old law, and that’s true for any area of tax law, not just partnership tax law, as well as any area of law, period. It is not unknown for students in my Partnership Taxation course, and in other courses, to apply old law, and almost always it’s a result of using an old outline passed down through the years.

As another ABA-TAX listserve participant noted when I posted a much shorter version of this discovery, “Well, so much for trusting information provided by the ‘Horse's mouth’.” So true, but not surprising, as there are more than a few cases in which taxpayer reliance on erroneous IRS advice was not treated by the court as justifying the erroneous position taken by the taxpayer on the tax return. But it indeed is disturbing that the agency charged with administering tax laws does not understand those laws. Can taxpayers be expected to do any better?

It’s bad enough that federal income tax returns are bloated with multiple forms, and that most forms are crammed with dozens of lines of information and computational entries. Much of what contributes to this aspect of tax complexity is the use of the tax law as a substitute for direct spending programs and use of the IRS as a substitute for other federal agencies that ought to be charged with administering programs in their respective areas. I have explained why using the tax law and the IRS in this manner is inefficient, ineffective, and deceptive, in posts such as The Problem with Income Tax Vehicle Credits, Congressional Mis-delegation Endangers Tax Collections, and More Criticism of Non-Tax Tax Credits, and When Tax Credits Aren’t Worth the Trouble.

The latest proposal to add more clutter to tax returns comes from the president of Muhlenberg College, Peyton R. Helm. With the goal of finding a way to deal with the growing concern over the cost and quality of higher education, Helm, in a Philadelphia Inquirer editorial, suggests “adding three simple questions to the IRS’s 1040 form.” He wants to ask, “What college or university, if any, did you attend?, What degree did you receive?, and Was it worth it?” Helm is motivated by a disdain for any sort of regulatory structure that requires educational institutions to “create massive databases” or to “spend more on data collection and compliance.” Whether the federal government should be regulating higher education is a question that reaches far beyond the specific proposal in question. Perhaps it should. Perhaps it is the federal government, rather than a state government or even a private organization, that takes on the task of protecting consumers against fraudulent reporting, misleading advertising, educational malpractice, unsafe campuses, and other problems faced by students and prospective students. But surely, even assuming that it is the federal government that should take on this role, and I am not at all convinced that it should, using the IRS and tax returns to deal with a Department of Education function is simply unwise, totally impractical, and counterproductive.

First, how does the IRS find the space to add these questions to the various 1040 forms? Does it reduce the font size of the print? Does it jettison other lines that are far more relevant to revenue collection that questions about a person’s educational experience?

Second, how do graduates who do not file tax returns – because they’re yet to be employed – express their opinions? Do they file a zero return simply for the sake of answering these questions?

Third, who audits the answers to these questions? Are the answers taken at face value, or is some method employed to make certain that the taxpayer filing the return in fact did attend the university that the taxpayer claims to have attended? Who ensures that the taxpayer earned the claimed degree, particularly in an age where people falsely claiming academic credentials have proliferated? Who pays to redesign the form? Who pays to have people transcribe the answers into software, considering that, as noted in the next paragraph, automation poses issues? Who pays to accumulate and sort the answers? Who pays to report the results? Which audits and which taxpayer service programs are subjected to further cuts to fund this education satisfaction data collection?

Fourth, who handles the lack of consistency in providing the names of colleges and universities? How does the software know that Penn State, PSU, and Pennsylvania State University are the same school? Which school is “Loyola”? Will we end up with substantially enlarged instructions for the 1040 forms in order to provide a “code” for each college and university in the country?

Fifth, what happens if the taxpayer attended multiple universities? What if the taxpayer transferred after sophomore year from one school to another? What school is reported by the taxpayer who attended an undergraduate institution, a master’s program at another university, and a doctoral program at yet another school? Would the IRS need to insert multiple lines for each of the three proposed questions? Or would taxpayers be asked to fill out yet another schedule to include this information?

Sixth, would colleges and universities in other countries be included? Or would taxpayers who earned their degrees abroad simply be ignored?

Seventh, what, if anything, would be done to gather information from graduates who are not taxpayers because they pursued education in this country and returned home? Do their opinions not count?

Eighth, would the reporting be mandatory? Would there be penalties for failing to answer the questions? Would there be penalties for providing incorrect answers, such as claiming to have earned a degree that was not earned?

Ninth, how is this reporting system protected against the games that could be played by graduates of other institutions? For example, if students and graduates of university #1 are unhappy because they think university #2 defeated university #1’s football team under questionable circumstances, what is to prevent them from claiming, en masse, that they attended university #2 and that their degree was not worth it? Without an extensive system of auditing, coupled with penalties for false reporting, the proposed system fails. Keep in mind that most return penalties are based on tax understatements, and the sort of nonsense that this proposal invites does not generate tax understatements.

Tenth, considering that Helm’s goal is to measure “the real value of their education,” how does his proposal distinguish between the negative reaction of the recent graduate who remains unemployed, and the positive reaction of the graduate who eventually ends up realizing that the education was worth it despite rough going during the first few years after graduation?

In his editorial, Helm refers to alumni surveys that are circulated among his school’s graduates. It’s unclear whether the school does the survey directly or pays an independent survey firm to do the work. Why not simply mandate that schools conduct alumni surveys, that the surveys be conducted by independent organizations, and that the results, including comments, be made available to the public? Well-designed surveys are orders of magnitude more informative, and far less prone to misreporting and gamesmanship, than the “three simple questions” that are proposed by Helm.

The IRS has better things to do than to conduct surveys on behalf of America’s colleges and universities. The IRS should be collecting revenue, period.

The Pew Center on the States has released a report on the effectiveness of state tax incentives. The report, titled “Evidence Counts: Evaluating State Tax Incentives for Jobs and Growth,” concluded that although a few states attempt to determine whether state tax incentives have had the intended effect, half of the states haven’t even tried to measure the outcome of the tax provisions that have been enacted. Even though some states try to evaluate the incentives, most do so every now and then, and none do so with the sort of in-depth analysis required to determine the effectiveness of the incentive. The study concludes that “no state regularly and rigorously tests whether those investments are working.” Every state has at least one tax incentive program, and most states have at least three or four; some states have dozens. Collectively, these incentives cost the states billions of dollars of lost revenue. The question that needs to be asked, that hasn’t been asked often enough, and that rarely is answered even when it is asked, is a simple one. “Are state tax incentives worth the lost revenue?”

One example provided by the report is the New Mexico tax credit for film production. One study determined that for every dollar of lost revenue caused by the incentive, New Mexico’s economy received a 14 cent boost. Another study concluded that every dollar of lost revenue generated 94 cents of economic activity. Though these outcomes suggest that the incentive should be repealed as a waste of taxpayer money, the New Mexico legislature continued the program but with a cap. The same thing happened in Wisconsin, which determined that its film tax credit was ineffective. Louisiana conducted a study that demonstrated its enterprise zone credit produced one-third of the jobs that the incentive’s lobbyists promised it would create. Pennsylvania examined its Keystone tax incentive, initially determined it had created 64,000 jobs, on a re-examination reduced that number to 35,000, and finally concluded that it had no idea what, if anything, the incentive had done for the state’s economy.

The idea of testing the outcome of a change, particularly when the change is hawked as being beneficial, is simple common sense. Decades ago, when I requested and obtained permission to require law students in my courses to turn in graded exercises during the semester, a concept that was alien to legal education and that met resistance and criticism at the time, I not only argued why it made sense but promised to provide reports to the faculty on the impact of the practice. The reporting idea was mine, and I offered it because I wanted to find out if I was correct in my assumptions, and to have evidence to support continuation or discontinuation of the semester-exercise approach. It worked, it’s something I continue to do, and it’s something that within the past several years has caught on with many, though unfortunately far from all, law faculty throughout the country. Innovation and experimentation need to be encouraged but oversight is essential, and outcomes measurements are necessary.

Why do so many states neglect following through with tax incentives? My guess is that there are several reasons. No one thinks of doing so. Perhaps someone requests an outcomes measurement but political constraints jettison the provision. It is not unlikely that legislators simply swallow, hook, line, and sinker, the lobbyists’ “guarantees” of the incentive’s value. It is also plausible that the fear of discovering the incentive’s wastefulness obstructs future evaluation.

It is quite probable that the vast majority of state tax incentives turn out to be boondoggles for the taxpayers who get tax reductions without generating the promised benefits for everyone else, including the state. Almost all state tax incentives are targeted at specific areas of economic activity that would be better regulated and encouraged using programs other than tax law provisions. As I pointed out in posts such as The Problem with Income Tax Vehicle Credits, Congressional Mis-delegation Endangers Tax Collections, and More Criticism of Non-Tax Tax Credits, and When Tax Credits Aren’t Worth the Trouble,

Artificial tax credits, in contrast to true credits arising from payments made to the [revenue department] by or on behalf of a taxpayer, aren’t worth the trouble. They’re not advantageous for taxpayers. They’re not advantageous for government economic policy. They’re not advantageous for the simplification and efficiency of the tax law. They’re not worth it, except to those who find them useful tools for the deceptive process of increasing [government] spending.

I’m still waiting for the opponents of government spending to step up and challenge tax incentives. Their failure to do so is a silence that speaks loudly.

An unfortunate fatal fire in Philadelphia has focused attention on the double whammy of absentee property owners who are derelict both in meeting their tax obligations and complying with safety regulations. These two faces of government, fire and taxes, though a favorite target of anti-tax advocates, come together in this instance in multiple ways. It is unfortunate that it takes the death of two public servants to bring serious issues to the forefront in the public arena.

The tax and safety facts, as reported in a flood of stories, including this one, are rather simple. Two firefighters were killed when a wall of a burning building collapsed on them. The building is owned by a Brooklyn, N.Y., family that owes the city almost $400,000 in real estate taxes on 31 properties, including $60,000 on the building that burned down. Residents who lived in the neighborhood where the building was located complained incessantly to the city about the building’s unsafe condition, particularly the lack of security to keep out vagrants. Though some complain that the city moved too slowly, during the past five months, the city issued three citations to the owners, trying to compel them to secure the building. The owners failed to respond, and the city initiated proceedings to move the matter into the judicial system, with the eventual goal of subjecting the property to sheriff’s sale. According to court records, during the past ten years, the city has issued more than 30 citations to the family and the entities through which it owns the properties. The owners not only have failed to comply with building, fire, and safety code provisions, they also have failed to pay water and sewer bills.

When asked about the city’s alleged failure to seal the building on behalf of the owners, the City Controller explained that the responsible department is overwhelmed by the number of vacant properties with which it has to deal. He noted that the department has a limited budget, limited personnel, and limited resources. Surely there is a connection between funding deficiencies and the unpaid taxes.

The afflictions caused by insufficient revenue attributable to noncompliance are undeniable. No matter how easily some folks think tax noncompliance can be brushed aside as a small matter, there is no doubt that the lack of compliance led directly and indirectly to the deaths of two firefighters. If the city had received the taxes that are owed, it would have had funds to provide the resources necessary to eliminate the dangers posed by vacant and insecure properties.

How bad is noncompliance with the city’s real property tax? According to another article, taxes on almost 20 percent of properties in the city are in arrears. There are more than 100,000 properties in the city on which taxes are not current. The average delinquency is 6.5 years. The city’s attempts to bring these properties to sheriff’s sale is thwarted, yet again, by a lack of funding for the responsible department. Almost half a billion dollars remains unpaid.

Tax delinquency and building code noncompliance seem to go hand-in-hand. That’s not surprising. The same philosophy that causes people to toss aside their civic responsibilities as taxpayers also leads them to disregard building and safety code compliance. Consideration of how the decision to ignore their obligations adversely impacts other people appears to matter not at all. One wonders the extent to which they toss aside their responsibilities because of the continued anti-tax and anti-regulation mentality that infects the public discourse.

Some commentators, officials, and politicians have mentioned the possibility that criminal charges will be brought against the owners of the building in question. Even if those charges are brought, and even if there are convictions, it’s too late to bring back two firefighters. Taking action after the fact is easier than taking action before the fact. How many more people must die before the tax delinquents and the code violators are compelled to do what they are required to do?

The Transactional Records Access Clearinghouse (TRAC) has released a new study of IRS Global High Wealth Group (GHWG) audits. The GHWG was formed to focus on taxpayers with tens of millions of dollars of assets or income. According to the Internal Revenue Service Data Book for 2011, in 2010 there were 291,831 individual tax returns reporting $1 million or more in total positive income, of which 8,274 reported adjusted gross income of $10 million or more.

According to TRAC’s analysis of internal IRS documents obtained under a court order, the IRS targeted for 3 large corporations, 15 S corporations, and 60 partnerships for audits under the GHWG program in fiscal year 2011, and 7 large corporations, 2 large foreign corporations, 26 S corporations, and 70 partnerships in fiscal year 2012. In fact, for FY 2011 the IRS conducted 18 audits, of which 4 cleared the process with no change. The other 14 audits generated more than $20 million in increased taxes. For the first five months of FY 2012, the IRS conducted 18 audits, of which 8 cleared the process with no change. The other 10 audits generated more than $27.5 million in increased taxes.

The writers of the TRAC report express some degree of surprise or alarm at the fact that one-third of the 36 audits generated no change. But I don’t find that very surprising or alarming. It’s not unrealistic to expect that some high-income returns are rather straight-forward, provide fewer opportunities for error, and are filed by taxpayers who are complying with the tax law without attempting to game the system. Consider the tax return of a professional athlete or celebrity whose income is reported on a W-2, who makes simple investments generating interest and dividends reported on Forms 1099, and whose deductions are nothing more than some charitable contributions and perhaps some mortgage interest and real estate taxes. It’s not a surprise that this sort of return passes an audit with flying colors.

On the other hand, the writers of the TRAC report are dead-on when they question the small scale of the GHWG program. The returns that generated tax increases generated an average of more than $2 million per return. Though it’s not clear if the returns that were audited were in the over-$10-million or over-$1-million category, multiplying $2 million times two-thirds times the number of returns that could be audited generates a significant amount of revenue that has not yet been paid.

Not only is the IRS auditing a small fraction of the number of returns it has targeted for audit, it is targeting a woefully small percentage of the total returns available for audit. Auditing 18 returns out of 8,274 over-$10-million returns, or, worse, 18 returns out of 291,831 over-$1-million returns is appalling. It raises the question, where is the IRS directing its audit resources? A clue comes from another batch of information obtained and shared by TRAC. There are a variety of groups within the IRS focusing on different clusters of returns and taxpayers. As of January 31, 2012, the average group, other than the GHWG, consists of 1,012 revenue agents. The GHWG consists of 101 revenue agents. Further, the TRAC report indicates that most audits of millionaire taxpayers, including those not within the GHWG program, are fairly cursory, don’t consume much time, and leave 87.5% of millionaire taxpayer returns unexamined.

Why not shift revenue agents from other programs to the GHWG, considering the rate of return from these audits? Is it possible that the IRS has an insufficient number of auditors trained and expertised in the sorts of tax issues that are involved with the returns of millionaires who are not filing the simple return described several paragraphs ago, but who are engaging in what the IRS explained in 2009 were “sophisticated financial, business, and investment arrangements with complicated legal structures and tax consequences.”? Is it possible that one of the effects of insufficient funding of the IRS is the lack of resources to train a sufficient number of revenue agents to work in the GHWG?

Recently, in Barnes v. Comr.,, T.C. Memo. 2012-80, the Tax Court addressed two interesting questions concerning the basis of stock in an S corporation. Two arguments advanced by the S corporation shareholders were rejected by the IRS and by the Tax Court.

The first argument made by the shareholders was that they were entitled to increase the adjusted basis in their S corporation stock by the amount of S corporation income erroneously reported by them on their individual returns. The IRS and the Tax Court emphasized that section 1367 provides for an increase in basis that reflects an S corporation shareholder’s actual share of the corporation’s income. According to the court, the IRS speculated as to why the shareholders reported income when, in fact, the corporation reported a loss, of which a portion was allocated to the shareholders. On their 1995 return, the shareholders reported a loss of $66,553 from the corporation even though their adjusted basis in the stock was $44,271. The shareholders, according to the IRS speculation, then erroneously calculated an adjusted basis of negative $22,282, and then reported that amount as income in 1996, increasing their adjusted basis to zero, and ignoring their $136,228 distributive share of loss of 1996. On this point, the IRS position and the Tax Court decision affirms the principle that basis cannot be negative. Perhaps the taxpayers, or their tax return preparers, were thinking of the at-risk recapture principle that triggers income when amount-at-risk becomes negative. Interesting, if that indeed was the case, but it’s an analogy that fails to withstand statutory analysis.

The second argument made by the shareholders was that they were not required to reduce adjusted basis in their stock if they chose not to deduct on their return their distributive share of the S corporation’s loss for the year. In a later year, after making contributions that caused their adjusted basis in the stock to be positive, the shareholders decided not to deduct their distributive shares of the corporation’s loss that had been suspended in earlier years and carried forward to the year in question. Accordingly, they did not reduce their adjusted basis in the stock by the amount of these losses. The IRS and the Tax Court determined that section 1367(a)(2)(B) requires S corporation shareholders to reduce adjusted basis by their shares of the corporation’s losses, even if they choose not to deduct those losses on their individual returns. It is unclear why the taxpayers chose not to deduct their losses. Perhaps they, or their tax return preparers, were thinking of the depreciation recapture principle that does not require recapture of depreciation which the taxpayer is entitled to deduct but that the taxpayer, for whatever reason, does not deduct.

Was this simply a case of someone not understanding the tax law? Was something else going on that’s not apparent from the facts set forth in the opinion? Though the answers to those questions probably will never surface, the appropriate impact on adjusted basis of an S corporation shareholder’s share of the corporation’s income and loss is clear. Sometimes, though, it takes litigation to get that point across.

As an aside, it is worth noting that the taxpayers were not challenged in their decision not to claim the losses. In other words, they were not compelled to claim the losses, but simply tagged with the consequences of having those losses, namely, reduction of basis. For a discussion of whether taxpayers are required to claim deductions, losses, and credits to which they are entitled, see James Edward Maule, No Thanks, Uncle Sam, You Can Keep Your Tax Break, 31 Seton Hall Leg. J. 81 (2006), available here.

According to a flurry of recent reports, including, for example, this one, an increasing number of state governments are looking for ways to deal with computer software written expressly for the purpose of assisting business owners in their efforts to hide cash receipts from revenue departments. The software, known as a tax zapper, is installed on a flash drive that is plugged into the register. It generates an accurate report for the benefit of the business owner, and then generates a set of false numbers to be used on the tax return. Reportedly states are losing billions of dollars in revenue thanks to this programming scheme. It also has been estimated that 30 percent of businesses operating primarily on cash receipts are using the software. Some establishments, such as restaurants, are evading so much tax that they are paying their employees in cash under the table, permitting the employees to report income low enough to qualify for welfare assistance from the state.

Legislation passed in several states and proposed in others makes it illegal to possess or install devices designed to generate false records. Would it not make sense to add to the list of illegal activities the acts of designing, programming, marketing, and producing this software? Only if the judicial system would do something less foolish than what was done in Detroit, where a self-employed software salesman who sold a tax zapper program was sentenced to the grand total of one day in jail and two years of probation. What sort of deterrence is that? Spokespersons for a variety of business associations have expressed support for legislation of this sort, because law-abiding entrepreneurs dislike being disadvantaged by the illegal behavior of competitors.

Taxpayers who comply with the tax law but who are concerned about high tax rates ought to think about the impact on the tax system of tax cheaters. When a tax cheat fails to pay tax, one or more of three things can happen. Taxes on honest taxpayers are raised to maintain revenues. Spending is cut, leaving honest citizens with deteriorating roads and bridges, inadequate safety inspections, reduce police patrols, longer waits for fire fighters and EMTs, and all other sorts of deprivations that jeopardize the existence of civilized society. Governments incur deficits as revenues drop and programs are maintained because the impact of spending cuts is so devastating.

For the most part, tax cheats are not acting from a philosophical approach. People who object to taxes and fail to file returns, or who file returns tagged with all sorts of anti-tax or other rebellious messages, aren’t hiding their position or their actions. They’re much easier to identify and may want to be identified so that they can make a statement. There’s a perverse sort of courage in behaving that way. Tax cheats who use tax zapper software do not want to be identified. They simply want to let others bear the burden while they take a free ride. They are probably among the folks who don’t want to pay for health insurance but demand free treatment when they have an emergency and show up at the urgent care clinic. The behavior exhibited by the tax cheats and free riders is about as far from courageous as one can get.

It’s time not only to criminalize ownership, use, design, production, sale, or other activities with respect to tax zappers, it’s time to make the penalties sufficiently harsh that others are deterred from engaging in this sort of dishonest behavior. It’s also time to publicize the names of those who are convicted, the names of their businesses, and the amounts that they have stolen from the public. Lest this be thought too rough, think of the person who dies when their vehicle hits a pothole and goes out of control, a pothole not repaired because of revenue shortfalls and spending cuts triggered by the actions of a group of people who refuse to pitch in and fulfill the obligations of citizenship.

The Philadelphia real property tax system, riddled with flaws, inefficiencies, and injustice, has provided yet another reason that it needs to be terminated, pronto. This news ought not be surprising, given its long troubled history, as I’ve discussed in posts beginning with An Unconstitutional Tax Assessment System, and continuing through Property Tax Assessments: Really That Difficult?, Real Property Tax Assessment System: Broken and Begging for Repair, Philadelphia Real Property Taxes: Pay Up or Lose It, How to Fix a Broken Tax System: Speed It Up? , Revising the Board of Revision of Taxes, How Can Asking Questions Improve Tax and Spending Policies?, This Just Taxes My Brain, Tax Bureaucrats Lose Work, Keep Pay, Testing Tax Bureaucrats Just Part of the Solution, A Citizen Vote on Taxes, Freezing Real Property Tax Reassessments: A Nice Idea, The Tax Price of a Flawed Tax System, Can Bad Tax Administration Doom the Tax?, Taxes and Priorities, R.I.P., BRT, A Tax Agency Rises from the Dead, and Tax Law as Subterfuge: Best Use Valuation v. Current Market Valuation, How to Kill a Bad Tax System That Will Not Die?, and momentarily ending with The Bad Tax System That Will Not Die Might Get Another Lease on Life.

To understand the news reported in this Philadelphia Inquirer article, it is necessary to explore a little bit of how the property tax works. Generally, a property tax equals the fair market value of the property multiplied by a tax rate. That’s a fairly simple approach, although the determination of fair market value is a challenging factual question, and establishment of the tax rate involves the usual political discourse and maneuvering characteristic of taxation generally. What makes Philadelphia’s property tax system more complicated, and more flawed, is something called “common level ratio.” Instead of applying the tax rate against fair market value, the city applies the tax rate against an assessment that is supposed to equal 32 percent of fair market value. It is unclear what advantages this approach provides. From my perspective, none.

To make certain that assessments are fair, an entity known as the State Tax Equalization Board (STEB) examines property sale documents to compare the real property tax imposed on the property with the amount of the tax that would have been computed if the assessment equaled 32 percent of fair market value. The STEB computes a number called the common level ratio, which reflects the assessments actually used compared to fair market value. If the common level ratio is less than 32 percent, then any property owner whose assessment exceeds the common level ratio can appeal the assessment and have it lowered to reflect the common level ratio. To the extent an appeal is successful, the city’s revenue and the school district’s revenue decreases.

In July of 2011, the STEB concluded that the city’s common level ration was 18.1 percent, not 32 percent. The city appealed, giving the STEB more information, and earlier this week the STEB revised the common level ration to 24.8. After the July announcement, more than 2,000 appeals were filed, and most had been put on hold pending the city’s attempt to have the common level ratio revised. Had the common level ratio not been revised, and the appeals successful, the city and school district would have lost $80 million in revenue. With the revised STEB, the city stands to lose $18 million and the school district $23 million. These are not revenue decreases that either the city or the school district can afford.

The city has filed cross appeals in the assessment cases. Its budget director has asked City Council for $1.8 million to hire private assessors to develop evidence supporting the city’s cross appeals. City Council has not yet acted on the request. The Philadelphia Inquirer, Carnegie Mellon University, and the University of Pennsylvania Wharton School have independently computed the common level ratio and have concluded that it is more in the neighborhood of 12.2 percent. Property owners who make good use of these independent studies face favorable prospects in the litigation.

Proposals to base assessments on actual value, along with other reforms, have been floated for years. Several years ago the city adopted an Actual Value Initiative, but the process of assessing each property is taking quite some time. It remains to be seen whether City Council puts a final seal of approval on the initiative. This most recent addition to the string of property tax glitches ought to be the final nail in the property tax coffin, but somehow I get the feeling that the burial isn’t going to be quite so simple.

The debate over the type of tax best for funding public education has been underway for decades. In most jurisdictions, the revenue is generated by local real property taxes. The primary reason for this choice is that when public education took hold, real property taxation was one of the few viable options available. Income taxation had not yet been authorized, and sales taxes were yet to be considered an efficient source of revenue. The difficulty with funding education through real property taxes is two-fold. When property values go down, revenue goes down, and when people’s income flattens out, such was when they retire and begin to live on fixed incomes, ever-increasing real property taxes threaten their financial well-being.

According to Joseph N. DiStefano’s recent article, No More School Property Taxes?, once again a proposal has been floated to alleviate the school funding crisis precipitated in part by the inadequacies and inefficiencies of the real property tax. Two members of the Pennsylvania House, one a Republican and one a Democrat, have joined together to sponsor a bill that would do away with real property taxes and replace the revenue with increases in the state’s personal income tax and its sales tax. The bill also would jettison a variety of other taxes, such as the gross receipts tax, the business privilege tax, local earned income taxes, and a handful of local taxes often characterized as nuisance taxes. The two representatives have gathered more than 50 co-sponsors, almost evenly divided between both parties.

Sounds simple, doesn’t it? Certainly administrative costs would be reduced, by eliminating many existing taxes while retaining the administrative structures already in place for the income and sales taxes. Compliance costs would be reduced, as a variety of forms and other paperwork would be retired. The disadvantages of the real property tax would disappear as that tax disappeared. And there’s even bipartisan support, something not often seen these days in national or local politics.

But perhaps it’s not so simple. In addition to raising the state income tax and sales tax rates, the bill also would expand the scope of the sales tax to include items currently exempt. The shifting of education funding entirely to the state raises issues about how the revenues are allocated among school districts. Schools currently in property-poor districts that suffer from inadequate revenue are not guaranteed improved funding under the proposal. In fact, according to a detailed description of the proposal, school districts would be funded at current per-pupil levels, and school boards would lose their taxing power other than for referenda for local income or earned income taxes to fund school construction or other major projects.

And despite the bipartisan support, the proposal is simply another in a long line of tax reform ideas that have been tossed aside by the Pennsylvania legislature. Several legislators who were on board abandoned the proposal when constituents began to complain about higher sales tax rates. People selling items and services currently exempt from the sales tax are lobbying against the idea of subjecting their products to the sales tax, even though the sales tax is imposed on the purchaser and not the seller.

Another point of disagreement is the issue of economic stability. Although real property taxes are subject to the risk of property devaluation, sales and income taxes also decrease in tough economic times. Joe Bright, an experienced state and local taxation attorney in Philadelphia, pointed out the higher volatility of sales and income taxes compared to real property taxes. There is no tax that guarantees a specific revenue stream, because all taxes are measured in some way by amounts dependent on economic activity.

Individuals and businesses that decide to take a position on the proposal based on how it would affect them need to do a somewhat complicated computation. First, they need to add up what they currently pay in the taxes that would be repealed. Second, they need to compute the additional income tax that they would pay. Third, they need to compute the additional sales tax that they would pay on currently taxable items. Fourth, they need to compute the entire sales tax that they would pay on items currently exempt but taxable under the proposal. Then they need to add up the last three amounts and compare it to the first amount. It is a safe prediction that some people would do better under the proposal and some would do worse. What’s tough to predict is how many are in each category. What’s even tougher to predict is the fate of this proposal in the Pennsylvania legislature.

About a month ago, in Taxes, Citizenship, and Shame, I reflected on the effectiveness of publishing the names of tax scofflaws, noting “We live in an age when shame does not have the effect it once did.” Last week, the Shelton Group released the results of a survey that asked people how embarrassed they would be if someone they admired discovered they were engaging in particular behaviors. Although 57 percent said they would be embarrassed if someone they admired discovered they were cheating on their taxes, that means 43 percent would not be ashamed of cheating on their taxes. Three behaviors generated more embarrassment. Being revealed as having shoplifted would embarrass 73 percent, getting a DUI would similarly affect 65 percent, and throwing trash out the car window would cause 59 percent to be ashamed. On the other hand, only 17 percent would be ashamed at someone discovering they leave the water running while brushing their teeth. Other percentages: being discovered smoking cigarettes, 36 percent; being caught not using their seatbelt, 32 percent; driving a vehicle that gets 13 or 14 MPG, 26 percent, not recycling plastic bottles, 18 percent; using paper plates, towels, and napkins instead of reusable products, 18 percent; and keeping their thermometer set to 73 degrees year-round, 18 percent.

It is disheartening, though not surprising, that significant numbers of Americans think it’s no big deal, so to speak, to engage in some of these behaviors. One cannot be embarrassed being caught doing something that one has no shame in doing. According to the survey, more than one-fourth of Americans are not ashamed to be caught shoplifting by someone they admire. What does that say about the American value system? Almost half of Americans have no shame about cheating on their taxes. Put another way, to the extent that tax cheating imposes greater burdens on compliant taxpayers, almost half of American taxpayers hold their heads high while free riding or inching toward free riding by letting others carry a heavier load. History teaches us that societies permeated by those sorts of values don’t persist very long. What happens when everyone sits back and concludes, erroneously, that someone else will step up?

It’s no secret that I disagree with those who use the tax law to accomplish indirectly what should be handled directly by government agencies other than the IRS and state revenue departments. In posts such as The Problem with Income Tax Vehicle Credits, Congressional Mis-delegation Endangers Tax Collections, and More Criticism of Non-Tax Tax Credits, I have pointed out the disadvantages of having the IRS administer programs designed to achieve national policy goals with respect to energy, environmental protection, employment, health care, education, and other matters that are within the purview of agencies established and operated to deal with those issues. Several weeks ago, in The Futility of Tax Incentives, I noted that a recent survey had corroborated the drawbacks to using tax incentives to influence behavior. I shared the outcome of a survey that indicated about two-thirds of respondents, mostly tax professionals, were “mostly or completely unfamiliar” with the production tax credit for wind projects.

Now comes even more corroboration of why it is bad policy to use the tax law to manage policies in other areas of the law. According to a very recent Philadelphia Inquirer article, the small business health care tax credit, available to businesses with fewer than 25 employees and with average annual wages under $50,000, has turned out to be a tax incentive whose “benefit often outweighs the cost of figuring out whether the business qualifies.” The credit, correctly described as “very complicated” and “burdensome . . . to compute” ended up being claimed on fewer than 10 of the 150 corporate returns filed by one tax practitioner who was interviewed for the article.

The arguments against inserting non-tax provisions into the tax law continue to grow. As a matter of general policy, it is wrong to use a revenue law to do anything other than raise revenue. There are so many tax incentives, especially credits, that taxpayers and tax professionals end up not even knowing they exist. These tax provisions are complicated. They are expensive to compute. Administration of these incentives is put in the hands of an agency that the Congress continually underfunds.

The arguments for overloading the Internal Revenue Code with tax incentives are specious at best. The claim that the IRS is the best agency to administer them flies in the face of reality, for the IRS is an agency expertise in revenue collection and not in the specifics of energy, health, environment, education, and other matters within the purview of agencies tasked with handling those matters. Justification for putting these provisions into the tax law actually opens up yet another reason to oppose this practice. Given the choice between authorizing a department to spend $x on a program, and setting up a tax credit that reduces revenue by $x, the Congress, particularly the members who are opposed to federal spending, find it expedient to hide spending increases in the tax law and treat them as revenue reductions.

Artificial tax credits, in contrast to true credits arising from payments made to the Treasury by or on behalf of a taxpayer, aren’t worth the trouble. They’re not advantageous for taxpayers. They’re not advantageous for government economic policy. They’re not advantageous for the simplification and efficiency of the tax law. They’re not worth it, except to those who find them useful tools for the deceptive process of increasing federal spending.

It is not uncommon for me to use a sports analogy when teaching tax law to illustrate, emphasize, or clarify a point. I’m not the only tax professor who does so, as one learns from this interview with Joseph Darby. I’ve brought a few into this blog, as evidenced by Noncompliant Tax Attorneys Are Dangerous to the Tax System, Getting It Right, and Tax Policy: It's OK for Us But Not For You.

A few mornings ago, while listening to the John Kincade show on ESPN Radio, I discovered the flip side of the analogy. Instead of someone trying to make a point about tax by referencing sports, Kincade tried to make a point about sports by referencing tax. He was discussing the penalties imposed by the NFL on the New Orleans Saints and their coaches for their role in the bounty scandal. Kincade was responding to critics of the penalties, specifically focusing his attention on the fact that the Saints and their coaches had been warned on previous occasions to put an end to the bounty practice. Kincade compared the situation to a person who, according to his formulation, is contacted by the IRS and told that his tax return had problems and ought to be fixed, does nothing, is warned again, and finally is audited. According to Kincade, there’s no grounds for the taxpayer to complain that the audit is a surprise, or undeserved. Perhaps as he was sharing his tax analogy he began to wonder if his audience would appreciate it, so he followed it with an analogy to the traffic world, involving a police officer who stops a speeding motorist, gives a warning, stops the same motorist the following day, gives another warning, and on the third day issues a ticket. Kincade’s point, that receiving a warning for the first offense does not bar a stronger reaction on a later offense, applies to much more than sports, taxes, and traffic enforcement.

One of the reasons some of my analogies in tax class end up in the sports world is that for most people, including students, sports is more interesting than tax. Making an analogy to tax on a sports show may amuse someone like me, but I’m confident I’m in the minority. It was a rare event, one that I had not previously encountered, and one that I doubt I will encounter again.

There is another chapter in the continuing and almost eternal story about Philadelphia’s attempts to fix its broken property tax system. My commentary on the story began in An Unconstitutional Tax Assessment System, and continued through Property Tax Assessments: Really That Difficult?, Real Property Tax Assessment System: Broken and Begging for Repair, Philadelphia Real Property Taxes: Pay Up or Lose It, How to Fix a Broken Tax System: Speed It Up? , Revising the Board of Revision of Taxes, How Can Asking Questions Improve Tax and Spending Policies?, This Just Taxes My Brain, Tax Bureaucrats Lose Work, Keep Pay, Testing Tax Bureaucrats Just Part of the Solution, A Citizen Vote on Taxes, Freezing Real Property Tax Reassessments: A Nice Idea, The Tax Price of a Flawed Tax System, Can Bad Tax Administration Doom the Tax?, Taxes and Priorities, R.I.P., BRT, A Tax Agency Rises from the Dead, and Tax Law as Subterfuge: Best Use Valuation v. Current Market Valuation, to How to Kill a Bad Tax System That Will Not Die?. The most recent chapter establishes that the title of my last post on the topic was unfortunately too good of a prediction.

A recent Philadelphia Inquirer report reveals that a member of City Council has introduced legislation to postpone reform of the property tax system by keeping the current assessment process and tax rates in effect for another year. The issue has become complicated because the mayor has proposed coupling the assessment reform not with rate revisions that would keep property tax revenue the same, but with permanent adoption of two previous rate increases that were characterized as temporary when they were enacted. Apparently some other members of City Council have been voicing concern about the impact of coupling the assessment reform with rate increases.

There seems to be a consensus that the current assessment process is seriously flawed and that it must be changed. The concern is that the revised assessments, which are being determined by an Actual Value Initiative that is underway, will not be ready for prime time until later in the year. However, the city budget must be approved by June 30. The mayor has proposed a budget that would seek $1.13 billion in property tax revenue, with an adjustment to the rates once the results of the Actual Value Initiative are available.

As a practical matter, once the reassessments are complete, real property tax bills for people living in homes that have significantly increased in value during the past several decades will increase by quite a bit. Though some people would be facing reduced property taxes, many would be dealing with increases. The member of City Council who introduced the legislation represents a district where a sizeable number of properties would be subjected to significant property tax increases.

Another problem is that the $1.13 billion figure includes a $90 million increase above current revenue, intended to alleviate shortfalls in the school system budget. Some members of City Council think that this aspect of the mayor’s plan should be split off and subjected to a separate vote. At least one member of City Council argued, “If you want to vote for a tax increase to support the school board then the public should know what we're doing.”

The mayor argues that it would be “irresponsible” and “disrespectful” to ignore the revised assessments. He is opposed to continuing the use of assessments obtained under a system which he described as “broken.” Others in the mayor’s administration view the plan as an opportunity to make up for tax revenues lost on account of current assessments not reflecting property value increases since the last full reassessment.

One member of City Council argued that the implementation should be “as close to perfect as you can,” otherwise “people have a right to turn on you.” Another member of council, one who supports the mayor’s approach stated, replied, “The majority of folks know we need a fair system, not a perfect one,” explaining, “There is absolute no way we are going to do AVI perfectly. The folks who know they have not been paying their fair share – the loud minority – will scream about it because it’s time for them to pay up.”

If asked, I would advise the mayor and City Council to separate assessment reform from tax increases. That would permit people whose properties are woefully under-assessed to understand that the bulk of the tax increases that they face under the mayor’s current plan arises from the repair of an assessment system that has caused them to be under-taxed for many years. It also permits the tax rate increase proposal to be debated independently of the assessment question. Mixing the two together creates the sort of confusion that perpetuates the flaws in Philadelphia’s real property tax system.