Federal Ready Return, Part Three: Income Tax Return Accuracy

Though Ready Return advocates praise their proposal as a generator of increased tax return accuracy, the reality is quite different. To assume that a government-prepared tax return is of a higher quality and has fewer errors is to overlook the deficiencies in systems that give the government the initiative. According to Ryan Young, A Backdoor Tax on the Poor (Nov. 8, 2011), a system similar to Ready Return is in place in the United Kingdom and the government’s error rate in its own favor is 15 percent. If the government makes an error in favor of the taxpayer, the taxpayer nonetheless is liable. The political fallout in Britain, which rose to the level of a major political scandal, demonstrates the dangers of relying on a tax system that is disconnected from taxpayers and that is one in which taxpayers are not engaged.

Ready Return not only fails to guarantee that preparation of the return will be any more accurate than it is when initiated by the private sector, it also opens up opportunities for errors that would not otherwise exist. Consider, for example, a taxpayer who, for several years in a row, looks at the return prepared by the IRS, decides it seems correct, and then decides it’s not worth checking what the IRS prepares. A few years later, the taxpayer sells her house, or perhaps has a child, or maybe gets divorced, or perhaps makes a significant donation to her church. What are the odds that the IRS will reflect these changes in the Ready Return that it prepares? Zero. What are the odds that the taxpayer will resume checking the Ready Return? Very low. What are the odds that the taxpayer’s return will be erroneous in favor of the government? Rather high.

Several advocates claim that the answer is to have the IRS mail the Ready Return to the taxpayer each year. There are all sorts of problems with this remedy. First, who pays for the cost of printing, of envelopes, of putting the return into the envelope, and for the delivery? Second, in an era when the IRS uses increasing less postal and other hard copy delivery, it is a step backwards to go this route, Third, what happens to taxpayers who move and thus do not receive their Ready Return? From time to time the IRS announces that it is looking for tens of thousands of taxpayers for whom it has a refund check. What more incentive can there be to step up than a refund check? Again, the theory breaks down.

In Hi, I'm from the Government and I'm Here to Help You ..... Do Your Tax Return, I described yet another opportunity for error to enter the system:

On the other side of the spectrum, what about taxpayers who deliberately or negligently accept the Ready Return even though it does not reflect additional income that the government does not know exists? After all, the government selects taxpayers for ReadyReturn because it assumes that a person with only wage and interest income in one year will be in the same position the following year. But certainly some not insignificant number of those taxpayers will start a business, or otherwise take in other types of income. Yes, instructions could be added to the ReadyReturn (as it inches closer to looking like the existing process), but will this matter to the folks who cannot read and who might be among those who are taking in cash income for which no W-2 or 1099 is issued? Of course, the underlying problem is not caused by Ready Return. But will Ready Return exacerbate it?

Of course it will.

Federal Ready Return, Part Two: The Value of Self-Compliance

Federal Ready Return will erode the value of the self-compliance principle of the federal income tax system. There is a very good reason that taxpayers have the obligation to step forward, file a return, report their income, and compute tax liability. As Tom Giovanetti points out in Trust Us: IRS Wants to File Your Taxes for You (Jan. 25, 2012), “Our voluntary tax compliance system is a feature, not a bug. It’s a key indicator of self-government, one of the hallmarks of American freedom.”

By taking ownership of their civic duty to pay taxes, citizens participate in the process of government. By focusing on the details of the return, they become aware of what the Congress has been doing with the tax law. As I explained in Hi, I'm from the Government and I'm Here to Help You ..... Do Your Tax Return:

[D]emocracy requires transparency in taxation. That is why I suggested that, instead, all taxpayers should be required to plow through, or pay someone to plow through for them while they watch, their tax return preparation, not as numbers being entered into a computer program, but with a running commentary from the preparer. For example, "The reason it is taking so long to put in all these numbers is that there are many, many steps to be computed. Notice that I am taking information from 12 different pieces of paper, and I asked you 25 questions." "OK, so why does the government need to know all of this?" "Because ......." This would permit them to see how dangerously convoluted the government revenue generator has become, and it is probably the only way that a strong chorus of cries for tax reform can be orchestrated. Yes, being required to watch a tax return being prepared may be cruel, but considering that taxpayers are among those who voted into office the people who created the mess, it's a deserved consequence. After all, we do too much "hide the problem" papering over in this country, be it energy shortages, military mistakes, international embarrassments, economic ignorance, or tax nonsense. Instead, it is better to remember that an educated citizenry is far more valuable to democracy than a pacified (or numbed) citizenry. Or perhaps it should be stated an educated electorate is far more valuable to democracy than a pacified electorate.

This approach also makes it more likely that taxpayers will become aware of what Congress does with the tax law. When sitting down to prepare their tax returns or sit down with a preparer to go over the tax return, the taxpayer might think or say, “What? No more deduction for that?” “Oh, a credit? I didn’t know about that.”

In other aspects of life, people are being encouraged to take ownership. We are advised to question our health care providers, read the labels on the food we purchase, learn how things work, and do research before entrusting our children to a school or our money to a financial institution. Citizens should do no less with their income tax responsibilities.

Federal Ready Return, Part One: Introduction

For quite some time, I have been an outspoken critic of the Ready Return concept, which was adopted in California but which has not taken off the way its advocates promised and hoped. In recent months there have been increasing signs that the IRS is moving forward with plans to implement a similar system, not in one fell swoop, but gradually, beginning with changes to when and how it matches information returns. Today I begin a series, in which I look more closely at the risks that a Federal Ready Return system, or its equivalent, poses to taxpayers and the nation.

The analysis begins with a history of my commentary on the California Ready Return experiment. When California adopted its version of Ready Return, I criticized it, in in Hi, I'm from the Government and I'm Here to Help You ..... Do Your Tax Return and in Ready Return Not a Ready Answer. Several months later, when California dropped the program, I reacted in Ready It Was Not: The Demise of California's Government-Prepared Tax Return Experiment, and subsequently I noted the persistence of Ready Return advocacy in As Halloween Looms, Making Sure Dead Tax Ideas Stay Dead. When California resurrected Ready Return shortly thereafter, I pointed out, in Oh, No! This Tax Idea Isn't Ready for Its Coffin, the disturbing decision of state administrators to restore the program even though the legislature had cut off funding and authorization.

When the New York Times advanced the idea of a federal Ready Return, I voiced my concerns in Federal Ready Return: Theoretically Attractive, Pragmatically Unworkable. Later that year, I had an opportunity to share my thoughts on public radio, which I described in First Ready Return, Next Ready Vote?.

The IRS is planning to implement Real-Time Tax System (RTTS), ostensibly designed to permit it to match information returns with tax returns before returns are filed rather than during audits after the return has been filed. The proposal is a reaction to one of the major criticism of Ready Return, namely, as I explained in Federal Ready Return: Theoretically Attractive, Pragmatically Unworkable, “Information doesn’t reach the IRS in time to get pre-filled or tentative returns out to taxpayers in time to give them ample opportunity to review the proposed return and then file by April 15.” Advocates of the Ready Return system suggested that the deadlines for filing information returns with the IRS be advanced to earlier in the year. And that is precisely the point of adopting RTTS. Originally and still occasionally described as “Simple Return” and “Return Free,” the larger initiative is a plan to bring Ready Return, despite its California failure, to the entire nation.

As with so many ideas, this is not a new proposal. In How to Really Simplify the Tax Code (Apr. 10, 2012), Bruce Bartlett notes that the idea surfaced in 2003, when the Treasury Department floated a proposal for a return-free system. The proposal collected dust because it would require significant increases in the reporting of income and in withholding, and because it won’t work with an income tax system as complicated as what now exists. Making taxpayers’ lives easier during tax filing season is a matter of simplifying the tax law, not enabling the complexities by turning tax preparation over to the IRS.

Ultimately, the basic idea is that the IRS would prepare returns based on information submitted by employers and payors through W-2 and 1099 forms. Under one variation, what the IRS prepares would be the return unless the taxpayer went online to make changes. Under another variation, taxpayers would go online to retrieve what the IRS had prepared and use it as the starting point for preparing the return. The chief difference is that under the first variation, taxpayers would decide whether or not to check what the IRS had done, whereas under the second variation, taxpayers would be required to do so. See Michael Cohn, IRS Commissioner Proposes Tax Technology Overhaul (Apr. 6, 2011).

Despite the advantages cited by Ready Return advocates, there are so many disadvantages that this sort of approach will not work. Even though there are some benefits to the plan, the drawbacks are so pervasive that they overwhelmingly outweigh whatever advantages exist.

Some Tax Things Cannot Be Forced

A recent Nebraska case, Bock v. Dalbey addressed the interesting question of whether a spouse can be forced to file a joint return. The court’s response was a resounding no. It rested its conclusion on the rationale that “a trial court can equitably adjust its division of the marital estate to account for a spouse’s unreasonable refusal to file a joint return.” The court noted that in the few instances other courts have considered the question, several have reached similar conclusions because of “the possible exposure to liability” for the other spouse’s unreported income or wrongly claimed deductions and credits. The court agreed with decisions of courts in the District of Columbia, Iowa, Florida, Oklahoma, New York, and Oregon. The court chose not to follow contrary decisions in Illinois, Minnesota, New Jersey, Ohio, and North Dakota. At least one of these courts, though refusing to deny the trial court discretion to compel the filing of a joint return, advises trial courts, where possible, to go the route of letting the spouses file separately and making adjustments in the equitable distribution.

The Nebraska court specified four reasons it considers its conclusion the better alternative. First, the return may end up not being treated as a joint return for federal income tax purposes if the compelled spouse demonstrates there was no intent to file a joint return and it was done under compulsion. Second, an order to compel the filing of a joint return is a mandatory injunction, something that is “an extreme or harsh remedy that should be exercised sparingly and cautiously.” Third, predicting the compelled spouse’s liability exposure is difficult to predict, and the compelled spouse could end up with more tax liability than predicted or expected. Fourth, if the spouses are compelled to file a joint return, they usually will have very little time to do so within the federal tax law deadlines and thus risk being held in contempt. Buried in this reason was a fifth one, namely, if the compelled spouse appeals but the joint return was filed, the joint return cannot be revoked, and if the compelled spouse waits until an appeal is processed, the deadline will be missed.

As I tell my students in the basic federal income tax class, there are few, if any, areas of law practice unaffected by tax. To practice domestic relations law without understanding all of the nuances, is more than simply risky. It’s not enough to understand the black letter law of alimony gross income and deductions and the rules dealing with allocating dependency exemption deductions. Domestic relations lawyers ought to read this case, and prepare themselves to help educate their clients who are negotiating divorce and separation terms.

Of course, the issue considered in this case presents yet another reason for the abolition of the joint return and the taxation of individuals as persons independent of their marital, living, relational, or other arrangements or status. But additional discussion of that topic must await another day.

Taxes as an Element in Damages

It is not uncommon for taxes to be an element in the computation of damages. For example, someone who must purchase goods from an alternative source because of a supplier’s contract breach can recover not only the increased cost of the goods but also the sales taxes paid with respect to that increased cost. Taxes also enter into damage computations when the defendant can demonstrate that the defendant’s breach prevented the plaintiff from engaging in activities that would have generated tax liability for the plaintiff. Recently, the Appellate Division of the Superior Court of New Jersey, in Beim v. Hulfish, No. A-5947-10T4 (May 29, 2012), took taxes into account in computing a damage award in a manner that might be a first.

The facts of the case are fairly basic. On January 25, 2008, a car owned by the first defendant and driven by the second defendant collided with another car owned by a third defendant and driven by the fourth defendant. On February 7, 2008, a 97-year-old passenger in the first car died as a result of the crash. His estate sued the defendants in a wrongful death action. The estate argued that had the decedent lived until 2009, his estate’s federal estate tax liability would have been $626,083 less than what the estate paid in 2008, and that had the decedent lived until 2010, the entire $1,196,084 of estate taxes paid in 2008 would have been avoided.

As the court nicely put it, “The novel issue presented is whether an heir's loss of a prospective inheritance resulting from the imposition of increased estate taxes — incurred due to the premature death of a decedent — is recoverable in a wrongful death action.” The court concluded that “[b]ecause such a tangible, readily-calculable diminishment in an heir's expectancy is in the nature of "pecuniary injuries resulting from such death," N.J.S.A. 2A:31-5, we conclude that it is an element of damages for the jury to consider in this case, subject to appropriate expert evidence.” The court reversed and remanded the case.

The trial court had dismissed the estate’s claim for damages reflecting the estate taxes because they were “too speculative in nature.” It based its conclusion on the uncertainty, at the time, about whether the estate tax would resurface in 2010, and on the actuarial probability that the decedent would have lived beyond 2010. Nine days later, the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 went into effect, prompting the estate to move for reconsideration. It argued that with the estate tax structure for 2008 through 2012 having been established, speculation was no longer a concern in the computation of damages, because the actuarial tables “suggested that [the decedent] would pass away during this time period.” The trial court denied the motion for reconsideration, concluding that the 2010 Act “did not cure the speculative nature of the impact of estate taxes because ‘the rights and liabilities of the parties are fixed as of the date of the tort or wrongful death.’ ”

The court noted that its research turned up only three reported state court decisions that addressed the status of estate taxes under wrongful death statutes. In Elliott v. Willis, 442 N.E.2d 163 (Ill. 1982), the court held that premature payment of estate taxes was not a recoverable loss in a wrongful death action because “[t]he test is a measurement of benefits of pecuniary value that the decedent might have been expected to contribute to the surviving spouse and children had the decedent lived.” In Farrar v. Brooklyn Union Gas Co., 537 N.Y.S.2d 26 (N.Y. 1988), the court held that federal estate tax credits that the decedent would have received had he lived longer could not be recovered in a wrongful death action absent express legislative authority.” In Lindsay v. Allstate, 561 So.2d 427 (Fla. Dist. Ct. App. 1990), the court held that the loss of prospective federal estate tax credits as a consequence of an insured's premature death was not an element of damages under the Florida Wrongful Death Act. Despite these decisions, the New Jersey court concluded that “they reflect neither the view of our Legislature nor the expansive scope of our wrongful death jurisprudence.”

In response to one court’s concern that “Trial strategies and tactics in wrongful death actions should not be allowed to deteriorate into battles between a new wave of experts consisting of accountants and economists in the interest of mathematical purity and of rigid logic over less precise common sense,” the New Jersey court stated that “The New Jersey Supreme Court does not share the view that providing expert tax opinions to juries on the question of pecuniary injuries injects impermissible speculation and conjecture in wrongful death actions.” In reaching this conclusion, the court was not swayed by the rationale provided for prohibiting computation of tax liabilities caused by premature death. That rationale is interesting:

Countless numbers of unknown and unpredictable variables for tax purposes alone include, as mere examples, future marital and family status, changes in rates, exemption and deduction provisions of overlapping tax codes. All sides to this issue would no doubt agree at least that this could produce much guesswork. So, a majority of jurisdictions have wisely stayed with a rule precluding evidence of after-tax income on the earnings damage issue to avoid "turning every negligence case into a trial [at least] of the future federal income tax structure" involving "a parade of tax experts[.]

Putting aside the question of whether a “parade of tax experts” in a courtroom is something undesirable that should be avoided, as the rationale suggests, why is it such a problem to the legal system to take into account future events that are not definitively calculable but that can yield damage computations when probability is taken into account? Consider, for example, the premature death of a youngster who had been drafted by a professional team but had not yet signed a contract. Is it not speculative to come up with a fixed number to represent the future earnings of the youngster? Would there not be a parade of actuaries, sports agents, professional athletic organization executives, to mention just a few? Why would adding tax experts to the parade be so horrible? According to the New Jersey court, it would not be.

As I tell my tax students, tax is everywhere. Attorneys who focus on wrongful death and similar litigation need to read this case. So do tax attorneys, who probably will be getting telephone calls and emails from their personal injury litigator friends. As I also tell my tax students, keep in touch with your classmates who decided to practice tax.

Doing the Math: Ignoring the Long-Term While Focusing on the Short-Term

In The Valuation Effect of Real Estate Taxes,while criticizing a purported proof of how real estate tax changes affect values, I remarked, that, “It’s a classic example of the tendency in the current national debates about almost every issue to focus on the short-term and ignore the long-term.” Another example of that sort of incomplete analysis has popped up in connection with a Pennsylvania legislator’s attempt to compel the Southeastern Pennsylvania Transportation Authority (SEPTA) to purchase buses running on compressed natural gas instead of diesel-hybrid buses.

According to this Philadelphia Inquirer story, Representative Stan Saylor asserts that “bad management” and “politics” are the reason SEPTA decided to purchase additional diesel-hybrid buses rather than CNG buses. Saylor rests his argument on one fact, namely, that a CNG bus costs $410,000 whereas a diesel bus costs $550,000. SEPTA officials, however, pointed out that more goes into the decision that simply the up-front, short-term cost differential. According to SEPTA, the CNG buses are “more expensive to maintain and operate, even though CNG is cheaper than diesel.” The National Renewable Energy Laboratory has concluded that CNG vehicles cost $1.29 per mile to maintain whereas diesel-hybrids cost 75 cents per mile. Diesel-hybrids out-perform CNG vehicles when it comes to fuel mileage, by a ration of 3 miles per gallon to 1.7 miles per gallon-equivalent, which brings the operating difference to $2.31 per mile for CNG buses and $1.41 per mile for diesel-hybrid buses. On top of this, the CNG buses do not provide any emissions benefits compared to diesel-hybrid buses. Purchases of diesel-hybrid buses are subsidized in part by federal grants, and it is unclear if those grants would be available for the purchase of CNG buses.

The kicker, though, is the cost of installing natural gas refueling stations at SEPTA’s eight garages. At $20 million each, the $160 million outlay chews up most of the $196 million “savings” that seemingly are available if SEPTA replaced its entire 1,400-bus fleet with CNG buses. I put savings in quotes and used the word “seemingly” because replacing all of the fleet makes no sense considering that hundreds of the buses have been replaced within the past several years or are under contract for replacement during the next two or three years, and because it does not appear that federal grant monies would be available for a wholesale turnover. Because the garages are in residential areas, the use of CNG also presents safety concerns, which could add to the cost of each garage, to say nothing of SEPTA’s insurance premiums and self-insurance set-asides.

To placate the Governor and legislators who are hawking natural gas as the economic savior of the state, and who are trying to compel public and private vehicle fleet operators to convert to CNG fuel use, SEPTA suggested that it would take its power plants that generate electricity to power its train lines and convert them to run on natural gas. That, however, did not satisfy Saylor, who claims he “did not believe SEPTA officials” who explained why it would cost more to convert to CNG vehicles. He harped on the fact that the cost of a hybrid-diesel bus is more than the cost of a CNG bus. Like the analysis that I criticized in The Valuation Effect of Real Estate Taxes, Saylor is looking at the short-term, the up-front present moment aspect of the situation, and ignoring the long-term elements. This is a common error, and is exploited by sellers who emphasize the sale price of an item that comes with a long-term contract that saddles the buyer with a higher overall cost than would have been encountered with the purchase of a more expensive item tagged with a less expensive service contract.

Aside from the financial literacy issue that resurfaces in this story, it is also important to pose a question about the tactics of those who are trying to force CNG use on public and private fleet operators. The folks doing this subscribe to the power of free markets, using that mantra to cut down all sorts of what they perceive as government interference in the private sector. Yet, when it comes to natural gas use, instead of sitting back and letting the free market do its thing, they advocate government interference. It’s clear why that is happening. A glut of natural gas has driven down its price, which has cut into the profits of the natural gas industry. It’s ironic, to use a nice term, to realize that Saylor has proposed legislation to spend $6 million in the Clean Air Fund to provide a subsidy to corporate buyers of CNG vehicles. Why is it that subsidies for health and public education are being chopped because of resistance to the notion of subsidizing people perceived as resting on entitlements but it’s acceptable to funnel money into the corporate private sector, which isn’t hurting for cash or profits? The answer is in a much simpler math principal, called campaign contributions.

The Valuation Effect of Real Estate Taxes

A real estate broker has presented a Real Estate Taxation Mathematics 101 that demonstrates how seriously financial illiteracy is harming the nation. The basic point that is made in the broker’s article is that real estate tax increases drive down the value of real estate and real estate tax decreases increase the value of real estate. The analysis through which this conclusion is reached fails to take into account the other factors affecting value, and presumes that all real estate is fully encumbered by debt.

Consider this proposition from the analysis. The broker writes:

First, you need to understand that residential real estate values are based upon what it will cost an average consumer per month to own a home. This number is called P.I.T.I, which represents – principle [sic], interest, taxes and insurance. Most real estate consumers are limited by the PITI limits set by the mortgage lenders. You cannot exceed your maximum PITI amount when buying a home. The PI (principle [sic] and interest) part of this number fluctuates with home mortgage
interest rates. The T – (taxes) fluctuates with the tax increases by the taxing authorities. The I – (insurance) is the most stable part of the PITI and is controlled by insurance rates. The combination of these three factors determines what a buyer can pay a seller for a home.

Has this broker never met someone who paid cash for a home? Has this broker never met someone who rolled over equity from a previous home? Has this broker never met someone who made a down payment on the home using cash from investments, gifts, inheritances, or other sources? The value of real estate reflects location, condition of the property, amenities, number of rooms, and the property’s energy efficiency, to mention just a some of the factors. The idea that “real estate values are based upon what it will cost an average consumer per month to own a home” is nonsense, for taken to its logical limit, all properties would be worth the same amount, reflecting a computation of an average consumer’s financial position.

The broker continues:

The big “T” in the middle of PITI represents our taxes. When this number goes up, the amount that we can spend of PI (principle [sic] and interest) automatically goes down. Since a buyer is limited by the PITI, a tax increase will decrease the amount of money that a buyer can pay to a home seller. When buyers can pay less, sellers will get less. A tax increase will decrease the value of real estate by decreasing what a buyer can pay for that real estate because of the PITI set by mortgage companies.

The first problem with this analysis is that it conflates examining a buyer’s position when acquiring a residence and examining the impact of real estate tax increases on existing owners. It is true that, all other things being equal, a prospective buyer considering two identical houses located in two different taxing jurisdictions, could conclude that the higher taxes in one jurisdiction makes the house located there more expensive than the other house, and perhaps, depending on the numbers, beyond the buyer’s purchasing capacity. The second problem with this analysis is the assertion that a tax increase reduces the amount available for principal and interest. That is not true for owners whose incomes have increased since the purchase.

The broker gives an example of how real estate tax increases allegedly reduce the value of properties:

The school district adds an additional $1,000,000 to the budget. This number is quickly divided by the average value of a home in the school district. Then that number is divided by twelve to get the cost per household per month. Before you know it, parents and teachers are asking if you really want to do away with sports program, music, after school programs for a measly $24 per household per month. The spontaneous answer is “no”. . . . Remember the measly $24 per month, per household tax hike we looked at in the beginning? If you take this little number and divide it by another little number, it leads to a much bigger number. In this case, we divide the $24 per month, by the $6 per month that was discussed above and that equals 4. That four represents $4,000 of purchasing power lost by a buyer and $4,000 of lost potential income for a seller. The question is now whether a buyer or seller is willing to throw $4,000 of home value into the pot to pay for the school programs. It looks a little different at this scale.

The flaw in this analysis is that it fails to take into account the property value increases that benefit a school district that, in contrast to others, institutes or retains an educational or extracurricular program. It also fails to take into account the economic value of education. When the broker’s hypothetical owner, who has supposedly maintained home value by successfully resisting real estate tax increases, decides to sell, that owner faces a greater risk that the pool of available buyers has vaporized because their increasingly watered-down education left them with little or no skills to offer the job market. It’s a classic example of the tendency in the current national debates about almost every issue to focus on the short-term and ignore the long-term. So when the broker announces, “That’s right; a $10 million dollar tax increase will decrease the value of real estate in the school district by $138 million dollars using basic real estate taxation mathematics,” he is leaving out the externalities, the positive impact of quality school districts on real estate values, and the long-term impact of improved education.

The broker then concludes that “The only other viable solution is the elimination of real estate property taxes.” Of course, he makes no suggestion as to what funding source would replace the real property tax. Perhaps he would do away with them entirely, leaving people without schools, local police, road maintenance, county courts, and all the other things funded by real property taxes. It is mind boggling to think that real estate values would soar in a township that eliminates all public services. If pressed, perhaps the broker would argue for some other sort of tax, and my guess is that it would be a tax that disproportionately afflicts those not in the real estate business. These considerations surely were a factor in Tuesday's decision by North Dakota voters to reject, by 76 to 24 percent,a proposal to abolish the real property tax.

Can the Philadelphia Real Property Tax System Be Saved?

The litany of posts that I have written about the Philadelphia real property tax is long. It began with An Unconstitutional Tax Assessment System, and continued with 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?, The Bad Tax System That Will Not Die Might Get Another Lease on Life , Robbing Peter to Pay Paul, Tax Style, Don’t Rob Peter to Pay Paul: Collect Unpaid Taxes, The Philadelphia Real Property Tax: Eternal Circles , and most recently ended with A Tax Problem, A Solution, So Why No Repair?. But that is not the latest chapter in the everlasting story about tax administration gone awry.

Last week, as reported in this story, Philadelphia City Council approved two pieces of legislation that would deal with the real property tax problem. The catch is that the two bills are totally inconsistent. Council approved, by a vote of 11 to 6, the Actual Value Initiative that has been discussed in many of my previous posts on this issue. Council also approved, 13 to 4, a bill that delays implementation of AVI. So what’s it going to be? AVI or no AVI? At least the Council president admitted that the passage of both bills means nothing, except that the debate continues. Some members of Council admitted that they haven’t decided what they want to do.

While those initiatives were wallowing in the morass of legislative maneuvering, Council also amended the first bill to create an exemption of $30,000 so that the tax would apply only to the excess of value over $30,000. A first reading was given to another bill that caps market value increases in neighborhoods where values have soared. Though one member of Council tried to share some calculations showing that the tax rate would be $1,810 for each $100,000 of value, others pointed out that the computation cannot be final until the total value of property in the city is taken into account. The snag is that no one knows that number because the reassessment process is not finished.

In the meantime, as Philadelphia’s politicians struggled to implement a system that numerous other jurisdictions have been using, another story reported that accumulated unpaid real property taxes had increased by $43.8 million to an aggregate total of $515.4 million. Those delinquencies are spread over 103,000 properties, which is about 18 percent of the total properties in the city. So in addition to not having in place a realistic assessment system, the city also struggles with flaws in the delinquent tax collection process. That the blame cannot be put solely to the pockets of impoverished neighborhoods in the city is demonstrated, at least in part, by the fact that cities with higher levels of poverty, such as Detroit and Cleveland, have lower delinquency rates. The blame is on a system that fails to set firm deadlines for collection, that lets unpaid tax bills collect dust in some file cabinet, and that tolerates 2,100 properties on which taxes have not been paid for 30 years or more.

Legislators in the state capital and in the city have proposed solutions that would require initiation of foreclosure actions once a tax bill become one year delinquent. Another idea is to establish a land bank that would take title to properties on which taxes are unpaid. The downside to the land bank concept is that the city would be responsible for maintenance and would be exposed to liability for injuries and other problems caused by derelict properties. The city has proposed some bureaucratic refinements, but none seem to address the problem head-on. Perhaps the city should be given the power to levy on the assets of property owners who fail to pay their taxes. Although in some instances those taxpayers have nothing much in the way of other assets, some of them have accumulated other properties and investments, perhaps in part because they are not paying their tax obligations.

If a workable solution is not designed and implemented quickly, the delinquency crisis will snowball into a catastrophe that will make the AVI issue a matter of deciding who closes the barn door after the horses have escaped. If doing the right thing means angering campaign funding contributors and ending up as a one-term legislator, so be it. Sometimes the price of putting public duty in first place is high.

Practical Impacts of Supreme Court Tax Decision

The facts are simple. For many years, when the city of Indianapolis wanted to build or reconstruct sewers, it divided the cost equally among all properties adjacent to the project. The city issued an assessment against each property, and the owners had a choice between paying in full or spreading the payment over time in installments. In 2001 the city started a project that affected 180 home owners. When assessed, 38 paid the full amount, and the others chose to pay in installments. In 2002, the city changed the manner in which it financed these projects by issuing bonds. The City’s Board of Public Works passed a resolution that wiped out the obligation of home owners to make any additional installment payments, including payments that were in default. No refunds were issued to the home owners who had paid in full at the outset. The 38 home owners who had paid in full asked for a refund and were rebuffed. Of the 38, 31 sued the city in state court, claiming that it had violated the equal protection clause of the U.S. Constitution.

The trial court granted summary judgment to the homeowners, and the Indiana Court of Appeals affirmed. However, the Supreme Court of Indiana reversed, holding that the distinction between those who had paid in full and those who had not paid in full was rationally related to its legitimate interest in reducing administrative costs, providing financial hardship relief to home owners, transitioning from the old financing system to the new one, and preserving its limited resources. The United States Supreme Court granted certiorari, and affirmed the decision of the Supreme Court of Indiana.

The Supreme Court held that denying the refunds to the taxpayers who had paid in full created a classification that does not involve a fundamental right or suspect classification, does not discriminate against interstate commerce or new residents. Accordingly, all that the city must show is “any reasonably conceivable state of facts that could provide a rational basis for the classification.” The Court concluded that the city’s decision to stop collecting unpaid assessments owed under the former financing arrangement was rational because trying to collect those debts might have turned out to be complicated and costly. Similarly, the Court concluded that issuing refunds would have burdened the city with the administrative cost of issuing refunds.

Constitutional law scholars have started to, and will continue to, debate the soundness of this decision from the perspective of Constitutional law issues. See, e.g., Taxation and Orwell’s Animal Farm (describing the decision as a “travesty”); How Convenient (characterizing outcome as “lamentable setback”); SCOTUS Likes “Moral Hazard” — Conscientious Property Owners Get Screwed Again; Armour v. Indianapolis: “Money Down the Sewer” (majority opinion “avoided the specifics and spoke in generalities”); SCOTUS: Property Owners Who Paid Sewer Assessements In Full Are Fools.

At the same time, practitioners who advise taxpayers, and taxpayers fending for themselves without the assistance of professional expertise, need to learn a lesson. As Paul Larkin pointed out in Armour v. Indianapolis: “Money Down the Sewer”, “The Armour case is a minnow in a sea where whales like the Obamacare and Arizona immigration cases are swimming. Few people will be affected by the decision; fewer will read it; fewer still will care. But even small cases can teach us a big lesson.” The big lesson, though, is not that the public treasury is a black hole, as Larkin suggests. Instead, it is a bifurcated guideline. First, anyone who pays taxes or any other government fee in full when the option exists to pay in installments is foolish, because one never knows when a government will imitate the politicians running the city of Indianapolis. Second, anyone negotiating for payment from a government for services rendered or materials to be supplied needs to push for as much payment up front as possible, because politicians who do what the city of Indianapolis did are just as likely to cancel future payments on contracts under which goods and services have been delivered.

There’s an even bigger lesson to be learned. It is a notion that could bring about the fall of the very governments that shelter politicians who think nothing of behaving as did those who run Indianapolis. When governments grant tax amnesty relief to delinquent taxpayers, they don’t make adjustments for the compliant taxpayers who paid in full, on time. Will increasing numbers of taxpayers gamble on the chance of future amnesty and conclude that paying on time, in full, is no less foolish than hindsight taught those 38 Indianapolis home owners that their decision was the unwise choice? Are increasing numbers of taxpayers already embarking on that path? Are short-sighted politicians inadvertently encouraging the nonpayment of taxes by rewarding those who don’t pay as did the brilliant public servants of Indianapolis?

And as for the nonsense about the cost of refunds and the cost of enforcing payment of the outstanding installments, I offer two propositions. First, the cost of enforcing payment of the outstanding installments was a cost to which the city committed to the installment payment option. Second, the cost of issuing refunds is minimal. This nation, from its capital down to its small towns, is rapidly becoming a place where public servants are putting the public second, or third, or last, and are making idiotic decision after idiotic decision. But if voters keep putting these folks back into office, or tolerating the judicial decisions that permit faceless, international corporations to purchase public office, voters will continue to get what they ask for in the voting booth.

User Fees: Differential Rates Based on Residency

A practice that has been occasionally used by tolling authorities has become widespread in recent years. According to a recent USA Today story, transportation authorities in at least six of the 14 states where EZPass is used provide discounts for residents, or for transponders purchased through the state, even if used by a nonresident. Similar situations appear to exist for some of the toll road systems that do not accept EZPass. The discount for residents is the equivalent of a surcharge for nonresidents.

Unless motorists research the toll charges by visiting the authorities’ websites, they almost certainly will not be aware of the preferences given to residents. The president of AAA noted that “There is no reason for one authority to charge some EZPass holders a higher toll except . . . to take advantage of drivers who may be from out of state.” Spokespersons for at least two authorities explain that the reason for the differential rates is “to raise money in tough times.” That explanation, however, explains why rates were raised, but not why the increase fell disproportionately on nonresidents.

There are instances in which charging nonresidents more than what residents are required to pay can be defended. For example, some states charge a higher tuition for nonresidents to attend state colleges than is paid by residents. The justification is that, by paying taxes that go into the state’s general fund, residents are supporting the state college system, whereas non-residents are not making a similar financial contribution. That justification, however, does not apply to toll roads. As a general proposition, toll roads pay for themselves and in too many instances supply funding, out of toll receipts, for projects not connected with the toll road, as I have noted in posts such as User Fees and Costs, When User Fees Exceed Costs: What to Do?, Soccer Franchise Socks It to Bridge Users, Bridge Motorists Easy Mark for Inflated User Fees, and Timing, Quantifying, and Allocating User Fees. In contrast, residents are not funding toll roads out of general revenue funds in the manner that they finance state college systems. If they are, the differential rates could be justified, but evidence of toll roads feeding off general revenue funds does not seem to exist.

What’s a motorist to do? Should someone who travels widely for work or recreational purposes purchase an EZPass transponder from each toll authority? I don’t think that’s possible, either technologically or in terms of making multiple purchases in that manner. Motorists can support legislators who refuse to impose tolls disproportionately on nonresidents, but aside from making contributions to their campaigns, they cannot vote for them because they are non-residents. If motorists turn to the Congress for a solution, they will meet resistance from those who hold state rights in high regard. Motorists can seek to litigate the issue, but the amount in question for an individual motorist is too small to make the litigation worthwhile, and attempts to bring a class action will generate resistance from those who dislike class action litigation. About the best motorists can do is to hold state officials up to a higher standard than the simple but indefensible ploy of taking advantage of non-voting nonresidents.

The Revenue Diversion Problem

Readers of MauledAgain know that I take a dim view of governments diverting user fee revenue to purposes unrelated to the reason for imposing the user fee. Just last week, in Limiting User Fee Use: Beach Tag Fees, I bemoaned the funneling of beach tag user fees to town expenditures having nothing to do with repair, maintenance, policing, use, or preservation of beaches. This particular commentary followed several others, such as User Fees and Costs, When User Fees Exceed Costs: What to Do?, Soccer Franchise Socks It to Bridge Users, Bridge Motorists Easy Mark for Inflated User Fees, and Timing, Quantifying, and Allocating User Fees.

Now, thanks to the alert eyes of a reader, I have become familiar with news of a different, though similar, sort of revenue diversion by state and local governments. In February of this year, according to a Department of Justice news release, the federal government and the attorneys general of 49 states reached a $25 billion settlement with the nation’s five largest mortgage servicers, which had been sued by the various governments on account of alleged loan servicing and foreclosure abuse. Of the $25 billion, $10 billion “will go toward reducing the principal on loans for borrowers who . . . are either delinquent or at imminent risk of default and owe more on their mortgages than their homes are worth.”Another $3 billion “will go toward refinancing loans” for certain homeowners. Another $7 billion “will go towards other forms of relief, including forbearance of principal for unemployed borrowers, anti-blight programs,” and several other programs. Of the $25 billion, $5 billion must be paid to federal and state governments, of which $1.5 billion “will be used to establish a Borrower Payment Fund.” The press release explained, “The remaining $3.5 billion of the $5 billion payment will go to state and federal governments to be used to repay public funds lost as a result of servicer misconduct and to fund housing counselors, legal aid and other similar public programs determined by the state attorneys general.”

According to an editorial appearing in several newspapers (e.g., it also appears in the Chicago Tribune), some states are diverting their share of the settlement proceeds to purposes other than those specified in the settlement. For example, as also reported in this story, Arizona intends to apply most of its share of the proceeds to funding its prisons. The editorials report that Virginia is releasing 89 percent of its share of the settlement funds to local governments to help make up shortfalls in state funding. A New York Times article from two weeks ago reports that California’s governor has proposed using most of its $400 million share of the settlement to pay state debts, Texas put $125 million into the general fund, Missouri is using its $40 million share to offset cuts to higher education, and Indiana is dedicating more than half of its money to pay low-income families’ energy bills. Georgia has decided to use its $99 million share to make payments to corporations in an effort to try to persuade them to relocate to that state. Lest there be any doubt about the scope of the criticism, in which I join, this is a de facto bipartisan reallocation of the settlement funds.

The good news, though it is more of a small silver lining in the dark cloud of disrespect for taxpayers and citizens, is that 27 states have used or scheduled use of their share of the funds for housing programs. Examples include a fund for low-interest loans to build housing in low-income neighborhoods, payments for housing counseling and legal assistance, housing in areas where residences are scarce, and demolition of blighted property.

This story is just developing. Lawsuits have been filed and more are threatened. Lawyers already are parsing the terms of the settlement agreement, claiming that there are loopholes that permit use of the money for purposes unrelated to mortgage relief, housing remediation, legal assistance to homeowners, and loan counseling. And who ends up paying the legal fees?

What has happened to responsible representation? What has happened to faithful attention to fiduciary duty? Why is it so easy for the public trust to be breached? Why is it so difficult to refrain from grabbing money collected for one purpose and using for something entirely different? Somewhere, somehow, something is very, very wrong. If it isn’t fixed quickly, the consequences will reach far beyond any one particular user fee or settlement fund.

A Tax Problem, A Solution, So Why No Repair?

The saga of the troubles afflicting the Philadelphia real property tax continues ceaselessly. First addressed by me in An Unconstitutional Tax Assessment System, it then got attention in 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?, The Bad Tax System That Will Not Die Might Get Another Lease on Life , Robbing Peter to Pay Paul, Tax Style, Don’t Rob Peter to Pay Paul: Collect Unpaid Taxes, and The Philadelphia Real Property Tax: Eternal Circles .

This time, the focus is on the plight of property owners who face the long-scheduled expiration of real property tax breaks. Last week, a Philadelphia Inquirer article described a “frustrated taxpayer” who is facing homeownership after the tax abatement on her property comes to an end. Years ago, Philadelphia decided that to encourage home buying in the city, it would provide a ten-year period of substantially reduced real property taxes on properties purchased during the qualifying period. The tax abatement would persist even if the property was resold to a new owner during the ten-year period. The taxpayer in question purchased her home in 2009, “knowing that the house was in the final years of a 10-year tax abatement.” The property was assessed at $350,000, but her tax bill was only $453. She knew that in 2011, when the 10-year-period expired, her taxes would go up. Go up they did. To $10,563. In a city where the average real estate tax bill on a residence is roughly $1,350, the invoice came as quite a shock.

There are two reasons for the huge jump in the taxpayer’s real estate property tax bill. First, although, as discussed in many of the previous MauledAgain posts on the topic, most properties are underassessed, properties blessed with tax abatement are assessed at or close to actual value. Considering that some properties are assessed at 3 to 3.5 times below market value, a property assessed at or near actual value will be subject to a real estate tax bill 3 to 3.5 times what it would have been had it, too, been underassessed. Second, when the assessors placed a value on the taxpayer’s property, they overvalued it.

A private sector valuation expert noted that “anyone shocked by a post-abatement bill was being ‘willfully ignorant.’” Yet, he explained that if enough people are “willfully ignorant but upset, then the city has a problem.” The extent to which property owners do not appreciate the impact of tax abatement in the long term is reflected by a comment made by the taxpayer in question, “I guess I didn’t really understand the tax implications.”

Long-term residents have little sympathy for taxpayers who enjoyed ten years of tax breaks. The taxpayer featured in the story owned the property for only several years, but the previous owner had the benefit of the abatement. In a buyer’s market, ought that not have been taken into account in determining the purchase price? Should the taxpayer have said to the seller, “Look, you’ve pocketed a cumulative real estate tax savings of tens of thousands of dollars over the past seven or eight years. I’m looking at a huge tax increase in two or three years. That reduces the amount I’m willing to pay for the property.” During the real estate boom, that might not have worked, but in today’s market, the buyer has the leverage to take this approach. I wonder how many realtors and home purchasers in Philadelphia take into account looming abatement expirations.

The pending Actual Value Initiative, offered as a solution to the various issues afflicting the city’s real property tax, would also resolve the abatement expiration difficulty. But that effort is stymied by politics and, most likely, a deep misunderstanding of the economics. Politicians, like most taxpayers, aren’t as adept with numbers as they ought to be and need to be.

The taxpayer appealed to the Bureau of Revision of Taxes, which lowered her assessment. But it got hung up on the math, specifically, the conclusion by the State Tax Equalization Board that the city was not assessing at the appropriate fair market value percentage. At the moment, both the taxpayer and the city have filed appeals though the court has not yet scheduled a hearing.

With the real property tax system falling apart, it would make sense to conclude that the officials charged with a fiduciary responsibility to protect the city, and its revenue process, would be working assiduously to solve the problem. Instead, the crisis becomes a political football, as is the case with pretty much every other public issue confronting this country, whether nationally, regionally, or locally. The well-being of the public good has become the neglected child of a political system co-opted by those giving highest priority to continuity of office, personal power, and aggrandizement. There is a problem, a workable solution exists, and it’s time for the city’s politicians and the state’s legislators to do the job they were elected to do.

Limiting User Fee Use: Beach Tag Fees

Earlier this week, in an Asbury Park Press story headlined Shore Towns Rake in Millions from Beach Fees, Ken Serrano focused on a specific user fee. The issue is not so much what appears in the headline, namely, that there are beach fees and that millions of beach users generate millions in beach fee revenues. The issue is what shows up in the secondary headline: “Towns May Be Illegally Using Surpluses for Tax Relief.” For whatever reason, towns along the New Jersey shore are collecting more beach fee revenue than they are spending to maintain and repair the beaches and to provide services such as lifeguard protection and public restrooms. In all fairness, when the cost of a beach tag is set, it reflects two estimates, specifically, the number of beach tags that will be sold and the cost of providing beach maintenance and services. If more visitors arrive than expected, if those costs drop, or if there is some combination of the two, a surplus will be generated. At that point, the town faces a simple question, “What should be done?”

A beach fee should be used to maintain beaches and to provide beach services. That is all. More than four years ago, in User Fees and Costs, in addressing a different user fee, I concluded, “It is difficult, therefore, to justify charging motorists on the toll roads for programs that have nothing to do with the toll roads.” Shortly thereafter, I followed up that conclusion, with a similar one, in When User Fees Exceed Costs: What to Do?, by explaining, “But when a government imposes a user fee, it ought to charge no more than is necessary to provide what the user fee purchases.” Two months later, in response to a story about Delaware River bridge tolls being diverted to financing of a major league soccer franchise, I argued, in Soccer Franchise Socks It to Bridge Users that “[T]he tolls should be used for repair of the bridges,” and that “[I]t should not be a surprise that I find it indefensible that motorists paying to cross a bridge are charged more than it costs to operate the bridge because some of the toll that they pay is being funneled into a major league soccer franchise.” A few days later, in a follow-up posting, Bridge Motorists Easy Mark for Inflated User Fees, I noted that when considering the responses to the question of why the Delaware River Port Authority pumped tolls into unrelated projects, “I can imagine the excuses but there aren't any viable worthwhile justifications.” I also pointed out that “the bridge-using motorists are easy marks for those who want to divert public money to the benefit of private entrepreneurs. That's no way to run a tax system, and it's no way to run a user fee system.” About a year ago, in Timing, Quantifying, and Allocating User Fees, I considered a proposed $20,000 fee on each mortgage servicer and advocated that “any proposed user fee should not be treated as a source of revenue to be used for unrelated purposes.”

Though in When User Fees Exceed Costs: What to Do?, I argued that a user fee ought not exceed what is necessary to provide what the user fee purchases, I did not intend to require a precision unattainable when estimates must be used. But the core principle of user fees, that they must be directed to their purpose and not diverted to other activities or projects, provides three possible answers to the question faced by the towns with beach fee surpluses. One, rather difficult to administer, would be to provide refunds to those who purchased beach tags. Another is to reduce the fee for the following year. Yet another is to establish a beach maintenance fund, and to hold the surplus in reserve for the year when costs exceed revenues because of unexpected price increases, unanticipated decreases in the number of visitors, or some combination of both.

According to Serrano, in Shore Towns Rake in Millions from Beach Fees, towns are using the beach fee surpluses to reduce local taxes. Doing so is illegal under New Jersey law, according to one expert quoted in the article, but a town official for one of the towns cited a different law that requires the excess revenues to go into the general fund. The towns claim that the general fund covers expenses that benefit the beaches, and that even with the surplus beach tag revenues pumped into the general fund, they are losing money on the beaches. My suggestion is to bring in the cost accountants, and to allocate the towns’ expenses between beach costs and other costs. It’s not difficult to do, provided the town records are properly maintained.

In determining the use to which beach tag fees are put, it is important to specifically identify the costs of maintaining the beach, aside from obvious items such as lifeguards, cleaning the sand, and emptying beach waste receptacles. Should the cost of building and maintaining parking lots for beachgoers be covered? Certainly. Should an allocated portion of police and EMT services representing calls requiring them to deal with a situation on the beach be covered? Probably. Should the cost of running the town’s school, or collecting residents’ trash, be covered? No. Should the cost of providing a tax reduction for a private entrepreneur building something blocks from the beach be covered? No.

The principle is simple, and the application doable though intricate and tedious. There is no reason to avoid dealing with this user fee properly. Beach tag revenues ought to be directed toward the cost of the beach, and nothing more.