A Return to the "Check the Box" Regulations

Several months ago, I reported on the Littriello case, in which the District Court held that the "check the box" regulations were valid. In the analysis, I explained how two lines of thought had developed:

Well, some commentators took the position that the IRS lacked the authority to permit something not a corporation to be taxed as a corporation. Or to let an LLC be treated as a division of a corporation. They rested their argument on the Supreme Court's decision in Morrissey v. Comr., 296 U.S. 344 (1935). In that case, the Court held that the Treasury was not barred from revising the entity classification regualations to treat business trusts as a corporations nor that it exceeded its powers in providing that the extent or lack of control by the trust beneficiaries was not solely determinative of the classification. The Court also held that because the trust's characteristics were like those of a corporation, it was an association taxed as a corporation. The commentators consider that decision, absent Congressional revision of the statute, to preclude Treasury (and the IRS) from permitting an entity that is like a corporation from being treated other than as a corporation. For example, in "Can Treasury Overrule the Supreme Court?, 84 B.U. L. Rev. 185 (2004)," (available here) Gregg Polsky argues, quoting from a message to me in response to my question about the issue, "that the regulations are invalid even assuming arguendo that they are consistent with the statute. In a nutshell, my argument is based on three Supreme Court decisions holding that the executive branch is bound by the Court's prior interpretations of a statute. *** Accordingly, I argue that, because the regulations are wholly inconsistent with Morrissey v. Comm'r, 296 U.S. 344 (1935), they would be determined to be invalid if challenged." Vic Fleischer, on the other hand, comes out on the other side, as he explains here. For another analysis supporting pass-through treatment as the default, see John Lee, Entity Classification and Integration, 8 Va. Tax Rev. 57 (1988).

The taxpayer, citing Gregg Polsky's article, moved the district court for reconsideration. The Court considered the argument "even though it amounts to a renewed motion rather than a true reconsideration."

In its Memorandum and Order, the court held that even though the natural answer to the question posed in the title of Polsky's article is "no," that isn't the question. The Court concluded that the "check the box" regulations do not have the effect of overruling the Supreme Court, and that the Morrissey decision does not required invalidating the regulations. The Court stated:

Certainly, the check-the-box regulations are the subject of academic and theoretical questioning. Professor Polsky has proposed that the Treasury has gone too far in adopting regulations concerning corporations and other associations. However, it is a theory only that the check-the-box regulations violate the Internal Revenue Code definitions because those definitions were made in effect permanent by Morrissey. The Court does not believe that Morrissey forever incorporated in all future Treasury regulations a particular definition of an “association.”

Of course, as I pointed out in my initial posting on Littriello, the possibility of appeal cannot be discounted, and this most recent development does not appear to remove or even significantly reduce the possibility, whatever it may be, of an appeal.

The district court's most recent pronouncement rekindled the "academic and theoretical" discussion. One tax law professor directed attention to the case of Estate of Hubert v. Comr., in which the Supreme Court held that the IRS had taken a position that conflicted with the existing regulations. He noted that the suggestion Treasury could fix the problem by revising the regulations, which it did, would not be barred by the failure of the IRS to prevail in the Estate of Huber case. Treasury cannot "undo" the result in the case, but it can change the rules provided it is acting within the scope of the authority delegated to it by Congress is issue regulations. Permit me to elaborate. Thus, even if in Morrissey the Supreme Court held that the regulations then in effect had a certain meaning and applied in a certain way, there is no reason that the Treasury cannot revise those regulations, because the Morrissey case did not hold that the regulations then in effect were the only permissible interpretation of the statute. At least that's my take on the issue.

Gregg Polsky noted that when he wrote the article, his thinking resonated with the consensus of administrative law scholars that the Supreme Court held the position that once it interpreted an ambiguous term, that interpretation was binding on the executive branch, a consensus reflected in opinions issued by "most (if not all) of the lower courts". He noted, though, that in the recent case of National Cable and Telecommunications Ass'n v. Brand X Internet Services, the Supreme Court explained that the consensus was wrong. In other words, the prediction is that any argument against the validity of the "check the box" regulations based on the Supreme Court's decision in Morrissey will be rejected.

Stay tuned, though I doubt there will be any surprising developments even if an appeal is taken. Keep in mind that Littriello does not preclude the Treasury from changing or revising the "check the box" regulations to the extent it decides it needs to do so. Littriello simply precludes taxpayers from challenging those regulations in the rare instances when they work against the taxpayer, as described more fully in my initial posting on Littriello.

The Impact of Disaster on Tax, Economic, and Energy Policy

The just-announced news that the Bush Administration is releasing crude oil from the strategic petroleum reserve raises this question: Why?

Officially, the government is "lending" the oil to refineries. Assuming the loan is repaid, the disadvantage for the nation's security is temporary, and that's assuming that removing a small portion of the reserve causes more of a security risk than not replacing the crude oil that cannot reach the nation because the port of New Orleans is closed.

Practically, with at least eight refineries closed on account of the storm, who will refine the crude oil that is being loaned? Apparently there are a few refineries operating elsewhere that can use some crude. Yet at least ten percent of refining capacity has been shut down. In a matter of weeks, there will be gasoline shortages, to say nothing of huge price increases.

My guess is that the loan of crude oil from the strategic petroleum reserve is not so much designed to "calm the markets" as was announced, but to create some sort of pyschological message that "we are in control of this mess." A close examination of the situation tells me that nature is in control. And that's about it.

It comes back to supply and demand. Supply has been cut. There's no question about that. There's also no question that there is no excess or replacement capacity available, because no new refineries have been built in this country for more than thirty years. It is tempting to take the position that those who opposed refinery building as a matter of principle, a group very different than those who opposed specific refinery construction proposals in specific areas, ought to be prohibited from purchasing gasoline. But that is about as popular a proposal as is the one to bar from highways those who opposed their construction. Of course, why should popular trump sensible?

As for cutting demand, perhaps $3.50 or $4.00 per gallon prices will get Americans thinking. Perhaps there will be fewer vehicles flying by me when I'm driving 65 or 70, making me feel as though I'm standing still. Perhaps errand consolidation will take hold. Perhaps less business travel and more video conferencing? Perhaps fewer energy-gobbling houses being built? Perhaps more serious efforts at conservation?

And it's not just oil. It's coffee. I learned last month, during a visit to New Orleans, that more than half the nation's coffee arrives through that port. It's bananas, many of which come through Gulfport. It's steel, much of which comes in through New Orleans because it is four times more expensive to ship it overland than up the river on barges.

And it's not just imports. In a few weeks, farmers in the Midwest will begin harvesting grain and other crops. American remains the world's breadbasket, and almost all of these agricultural products leave through New Orleans. If some way isn't found to move this product out, people in other nations will be facing food shortages.

And it's not that easy to shift transportation. Again, there is no excess capacity on railroads, and very little in the highway trucking industry, to take the enormous quantities of grain and food, oil and steel, rubber and other products that move on Mississippi River barges. We live in a "just in time" economy, which leaves the nation at risk not only from international disruptions but also from natural disasters.

As the nation attempts to deal with this huge catastrophe, Congress will turn to issues of financial aid and holding the economy on course. What does this mean for the tax law? Increases to fund the tens of billions of dollars needed to rebuild and provide relief? Decreases to put more money into the economy so that the private sector can recover? Would tax decreases fuel the price increases that are looming not only for oil, gasoline, natural gas, chemicals, and other oil-derived products, but also coffee, steel, rubber, bananas, lumber, concrete, wallboard, other construction materials, medical supplies, and all the other materials necessary for the rebuilding of the Gulf Coast? Should significant credits be enacted or enlarged for projects such as construction of gasoline refineries, processing of used cooking oil as fuel, redeployment of rail and highway truck resources to move Mississippi River barge traffic content? Will Congress make charitable contributions for hurricane relief tax-advantaged in some way, even though it's too late in the year to make them deductible for 2004? Will Congress enact prospective restrictions on casualty loss deductions for properties built on barrier islands and other unsafe places?

My prediction is that as the far-reaching consequences of this disaster become apparent to politicians and citizens, it will have long-term implications for a variety of public policy issues, including taxation. It may make environmental impact fees, user fees, and other "think about what you are doing" charges more palatable. Perhaps Congress will start readjusting priorities, giving serious thought to what sorts of activities truly need to be tax-favored and what sorts of things ought not be. If anything, it ought to raise the public outrage against those who are not satisfied with tax cut after tax cut, special credit after special credit, but who create, sell, and buy illegal tax schemes to reduce their taxes to far less than their fair share. I'll leave commentary on the KPMG settlement to a later time, even though its timing is a serendipitous brush stroke on the larger canvas of tax policy.

Here's wishing the best for all those people in New Orleans, the rest of the Gulf Coast, and the inland areas devastated by this disaster. I know a few of them. I haven't heard from any of them. I do hope that when Congress begins to play with the tax law, it does things that helps these people and not those who seek to enrich themselves at the expense of another person's suffering.

Blowing Through the Price Regulation Fuelishness

The connection between tax law and energy policy may appear to many folks to be as close as the connection between tax law and baseball, but anyone who works with the tax law knows that there are two connections. The direct connection is the use of tax law to regulate energy. These come in the form of income tax credits and deductions that favor one or another energy policy or taxpayer behavior with respect to energy. The indirect connection is the impact of energy policy on the economy, and vice versa, and the tax law provisions that have been enacted in reaction to economic fluctuations reflecting the energy market.

My dislike for using the income tax law to regulate behavior is no secret. I have a similar disdain for economic regulation that is inconsistent with basic economic rules of supply and demand. My original posting on the effort by some in Hawaii to set artificial gasoline prices, and the followup, stress the theoretical and practical deficiencies in taking such a narrow-minded and short-sighted approach to a much broader and longer-term problem.

A story in Saturday's Philadelphia Inquirer shed more light on the attempt by certain legislators, other politicians, and some citizens to force the natural economic world to suit their particular wishes. Apparently, the effort in Hawaii, which may or may not get past its governor's veto, has triggered similar discussions in other states.

The Philadelphia Inquirer article points out that although some of the proposal's supporters cite price-fixing by gasoline retailers as justification for taking action, federal investigations discovered "no evidence" of price fixing. In fact, government regulating of gasoline prices, which itself is price-fixing, generally causes less competition and higher prices. I'll add that it also will cause reduced supply.

Another argument is that gasoline is a commodity similar to electricity and water, and that its price should be similarly regulated. I suppose those making this argument haven't noticed the disruption in electricity and water markets. The regulation of electricity is a significant factor in the brownouts, blackouts, and grid failures that have plagued portions of the country, striking more seriously in areas where government control receives stronger public support by those with a philosophy that the government knows better. Treating gasoline as a commodity is certain to bring lines at service stations and critical supply failures. This "regulate commodities" argument makes no sense, because taken to its logical limit, it would require government to regulate the price of commodities such as food, beverages, clothing, .... ah, didn't they try that in the very successful Soviet Union as part of repetitive Five-Year plans, he asks sarcastically.

The supporters of government gasoline price fixing insist that "like electricity, gasoline is too vital to the economy to be left in the hands of these corporations that have been gouging us," a quote from Doug Heller, executive director of the Foundation for Taxpayer and Consumer Rights in Los Angeles, which is a consumer advocacy group. The price of gasoline increases for a variety of reasons. First, speculators gambling on the commodities markets have driven up the price of crude. Second, oil producers such as Saudi Arabia and other OPEC members, countries that don't belong to OPEC, foreign companies, and domestic corporations, set prices. Most of them, other than domestic corporations, aren't going to change their prices in response to the acts of a state or even federal legislature. Third, when demand exceeds supply, prices increase. Mr. Heller's organization, and others like it, would be doing everyone a bigger favor if they pushed for actions that increased supply and decreased demand. If, in fact, price gouging is taking place, there already exist laws that permit and require criminal and civil prosecution of those who are gouging, that is, those who are charging more than the market price. The FTC, however, has concluded that price fixing by the industry has not been demonstrated.

The story reports that the Service Station Dealers of America, a trade group, agrees with the idea of government gasoline price fixing. This organization claims that "Fuel is basically a commodity, almost something that should be regulated by the public services commissions, because there is no other product out there that so many consumers depend on." Almost a commodity? Is that like partially pregnant? No other product that so many consumers depend on? Medicine? Food? Beverages? Clothing? Cell phones? C'mon, enough with the "I want a low price for what I sell so I can make money selling it at a high price and I don't think anyone retailing another product is quite as special as I am or as deserving of government assistance" rap. Americans, if they stop and think, and set aside the limbic system reaction to pump prices, can see through these sorts of statements.

Fortunately, others point out the obvious. John Felmy, chief economist for the American Petroleum Institute, simply states, "That would be the stupidest thing on Earth we could do. It would throw us back into the 1970s." In the 1970s, the federal government imposed oil and gasoline price controls. What happened? There were supply shortages, and lines at the gasoline prices. I write from experience for the edification of the tens of millions of Americans who did not drive automobiles in the 1970s for one reason or another, including having been born or having arrived in this country after that decade. What happened when the price controls were lifted in 1981? There was a surge in oil and gasoline supplies, and prices settled at amounts less than inflation-adjusted prices. Wow, a real world proof of the theoretical contention that price controls do not work. I wonder if they teach this episode in the nation's high schools? I doubt it, because if they did, people would be far less impressed with the Pied Piper calls of those who advocate government control.

Now that demand has increased to bump against a finite supply, prices are beginning to climb to what is still less than inflation-adjusted amounts. So where's the justification for pretending that supply is so plentiful that prices should decline?

Some gasoline dealers claim that wholesale gasoline prices are manipulated by the oil companies to reflect the economics of the particular neighborhood in which the gasoline station is located. Called zone pricing, the wholesale price reflects traffic patterns, neighborhood income levels, the degree of competition from other dealers, and similar factors. Some of what enters into zone pricing is market economy. If traffic is heavy, demand increases and pressures the supply. If nearby stations lower their prices, it suggests a decrease in demand or an increase in supply, unless the price reduction is artificial, which raises question of whether existing laws are being violated. If so, existing laws ought to be enforced. The notion that gasoline should be sold at the same price in all locations ignores major differences between locations. Locations further from the distribution terminal require higher shipping costs. Locations in high rent districts need to recoup those higher rents. Locations in areas with higher labor costs also need to recoup those costs. That's part of Hawaii's problem, according to Andy Cassel, who wrote his Friday's column, Filling up on retrograde price controls, at about the same time I was penning my very similar opinions on the Hawaii government price fixing proposals. He pointed out to me in our email exchange, that labor and rent costs in Hawaii are unusually high, something I had heard at about the same time from a colleague who grew up in Hawaii. So, of course, the price of gasoline in the "Hawaii zone" will differ from those in Houston, just miles from a refinery. Incidentally, vendors of just about every consumer product price their wares based on the local economies in which those items are sold.

Now that hurricane Katrina has created havoc in the oil and gasoline markets, another ill-advised cry has blown through the news. The thought is that because the weather-induced shutdown of Gulf oil platforms has cut crude oil production and the closing of the Gulf ports has delayed the unloading of oil imports, it is time to release crude oil from the strategic petroleum reserve.

Why?

What will they do with it? People seem to be forgetting that many of the gasoline refineries are also off-line because of the weather. It is unknown if all will return to pre-storm capacity once the air clears.

In fact, the gasoline price problem is not so much a problem of crude oil supply as it is one of gasoline supply. The gasoline supply is limited because the nation lacks adequate refining capacity. I wonder how many of the folks clamoring for price controls are among those who oppose the construction or expansion of gasoline refineries? Quite ironic, but not unusual, because it is another example of not wanting to pay the price. "I want low gasoline prices but I oppose the construction or expansion of gasoline refineries" is sung to the same tune as "I want less traffic congestion but I oppose the construction or expansion of highways " chant. What it comes down to is this: "I want everyone else out of my way and I want to be at the front of the gasoline line."

That simply isn't a sensible way to participate in the civic life and the political debates of the nation. We can and ought to do better.

Using Taxes to Rescue a Non-Drowning Film Industry?

It really is a shame when politicians fall over each other trying to dish out subsidies to their favorite industries. Although direct subsidies aren't unusual, tax subsidies are becoming ever more popular, because politicians think they're easier to slip past the taxpayers who foot the bill. Fortunately, despite its several negatives, the Internet and modern communications technology has made it difficult for these sorts of deals to escape scrutiny. Unfortunately, despite the attention, these give-aways continue to spill out of legislatures.

The latest target of my criticism is legislation pending in the California legislature, which would extend a state income tax credit to the motion picture industry for films produced in California. The Los Angeles County Economic Development Corporation has released a study, done on behalf of the California Film Commission, that supports the proposed tax credit. The principal concern is that tax incentives offered to the movie industry by other states (seven at last count with proposals pending in another eight) and even other countries (at least seven) will encourage film makers to take their business elsewhere.

Perhaps the California legislature should not be criticized for considering legislation to offset the impact of similar legislation in other states. After all, California didn't "start it," at least with respect to the film industry. On the other hand, state tax incentives in California tax law reach way back in time, so perhaps this is another example of something that had its genesis in California, swept through the nation, morphed into alternative applications, and came back to haunt California.

But there's no need to single out California to make the point. ALL of the jurisdictions who play this game, using taxpayer money to "entice" privileged industries to relocate their business, have run afoul of both a conceptual and a practical principle.

Conceptually, governments ought not to engage in business engineering. They've done enough damage and made enough mistakes with social engineering. The free market principle means "free of government interference" even if government involvement would be beneficial to some citizens. Only when business or other activity threatens the health or welfare of the jurisdiction should a government step into the market. So, if legislatures are looking for opportunities to interfere in the free market, they ought to stick to important safety and health concerns such as development of pharmaceuticals for avian flu, assistance to local transit authorities for security planning and operations, regulation of the sale of alcohol to vehicle drivers, and similar matters that concern the population and not a specially selected segment.

The California Film Commission study points out that the film industry is important to California's economy. That's true. After all, all businesses in California are important to its economy. Who wants to tell an entrepreneur, "Your business isn't important." Tell that to the business owner when he or she hits insolvency. Tell that to the employees who lose their job. The film industry in California, though, is big. Depending on whose numbers are accepted, anywhere from 88,000 to 245,000 people work in the industry, with most of the 245,000 being temporary employees, many of whom presumably have "day jobs." The payroll, again depending on whose numbers are used, is anywhere from 6 to 17 billion dollars. There is no question that the film industry generates jobs, opens up secondary market opportunities for other businesses such as suppliers, caterers, and security guards, pays substantial state and local taxes, and contributes significantly to the economic health of the Los Angeles area economy and in a somewhat less bountiful way to the state economy. But, so, too, do other industries. Why are they not the recipients of similar incentives? Because they aren't in a position to relocate? Or perhaps they aren't populated by high-profile, high-paid "celebrities" who not only think their political views are more valuable than those of the rest of us, but who also have access to politicians and are in a better position to "lobby" for their pet projects.

California may be "stuck." As the report explains, without some economic adjustment, the high costs of production in California, coupled with other economic challenges such as union labor contract negotiations and non-economic difficulties such as community hostility to film and commercial activity on local streets, will encourage more producers to seek other locations for their activities. There is no question that tax incentives have contributed to film, commercial, and other production activity relocating to places outside of California. The question is whether California needs to use the tax law to restore balance to a free market thrown into disarray by the proliferation of tax (and other) incentives in other states.

Practically, it isn't all that clear that tax incentives narrowly tailored to a specific industry solve the problem. In fact, they may create problems.

For example, the report does not explain if the out-migration of film production from California would not have occurred, or would have been less frequent, in the absence of these other states' tax incentives. There's no way of knowing. Surely a film producer in another state isn't going to respond that the production would have moved in any event, because that would be killing the golden goose laying the tax incentive eggs. Of course the tax incentive is necessary, or so they say. The reality may well be that the production would have moved even without the incentive, because of the reasons cited by the study, such as high costs, labor issues, neighborhood objections delaying production, and similar problems. But there are far fewer great games that can be played than to get someone to pay an incentive for what would have happened even in the absence of the incentive.

Similarly, although the report points out that the film industry is growing and will continue to grow, it doesn't consider the possibility that the increase in film production in other states may simply be a reduction in the growth of the California film industry rather than a reversal. The report cites one major threat to the California film industry, piracy, but that problem affects film productions in all areas and is not one that can or should be solved with the tax law. The report also describes the advantages that California has in luring or keeping film production, such as production infrastructure, talent, and excellent film schools and other institutions. The report points out that video game designers have been moving into California. So is there really a problem? In other words, have the tax incentives in the other states been all that harmful to California?

Perhaps not. After all, there's another problem with targeted tax incentives. In order for the tax burden of the film industry, for example, to be reduced, the tax burden of other taxpayers must be increased. Or, state tax expenditures on health, safety, education, and other essential and legitimate government services need to be cut, shifting the cost to the population generally, particularly through increases in local taxes. This puts upward pressure on the wage demands of workers in the state, it puts upward pressure on prices charged by other entrepreneurs in the state, and it puts upward pressure on interest rates as localities increase borrowing to cope with the impact of the state income tax incentive. Though the arrival of a production in the state brings a temporary boost to that state's economy, particularly that of the area in which the production exists, it isn't necessarily sufficient to offset the negative impact of the true cost of the specialized tax incentive. After all, the decision to bless one industry, thus shifting costs to another industry, may encourage those other industries to leave the state.

Economic growth isn't nurtured by states fighting with each other for a piece of the existing pie. If there is growth in the film industry, it's because more people want to see films. Perhaps the films are better. Perhaps air-conditioned theaters have an attraction in summer. Perhaps people have chosen to remain close to home, and to increase movie viewing, rather than traveling to some insecure location. Tax incentives have nothing to do with this growth. Has any state enacted a tax credit for going to the theater or for watching a movie on cable? I don't think so. Notice that the incentives don't go to the citizenry in general, but to "out of towners" who will take the bulk of the film profits with them when they leave.

The film industry is rolling in money. It's not in trouble as are industries such as the airlines, not that I'm advocating tax breaks for airlines. The film industry can afford to pay outrageous salaries to its "stars" and if times get tight, those "stars" ought to take pay cuts. At the moment, of course, they don't need to do so, because the industry is more than financially capable of paying those salaries. The maneuvering for a California state income tax credit appears to be more a matter of exploiting a new money-grabbing opportunity than it is a genuine request from a truly endangered industry.

The chief benefit of this proposal is that it provides yet another opportunity to point out to those who advocate using tax law to engage in social and business engineering, rather than simply to raise revenue for legitimate government activity, the dangers of opening the door to these sorts of tax law provisions. Once the tax law is used to promote some supposedly worthy social policy objective, it will be used to promote every social policy objective, worthy or not, and to promote all sorts of activities, regardless of their importance, economic value, or social worthiness. Ultimately, those with money, access, and power find ways to acquire more money and power through these indirect subsidies, and those without money, access, or power continue as the chumps of the elite. Perhaps it can be proven that using the tax law to engage in social engineering is as likely or even more likely to transform a democracy into an oligarchy as it is to balance the rights and economic opportunities for all citizens.

In the final analysis, California is going to play the game because other states are playing the game. And when they look to Uncle Sam, all they see is the tax incentive game gone wild. Under these circumstances, it is almost certain that no one in power is going to step up, suggest blowing the final horn, and make an effort to close down the tax incentive carnival. Even if the tax reform commission tries to go that route, there's too much vested interest and imbedded power standing in the way.

So why did I bother writing this post? Because hope springs eternal. Because perhaps that glimmer of hope radiating from the irate Pennsylvania citizens pounding their legislatures for giving themselves a pay raise under questionable circumstances (a story left to another time) might catch hold. Perhaps citizens will indeed begin to realize that ultimately the power is theirs. Perhaps they will take it back. Perhaps they will demand accountability. If, and only if, the common good gets to trump the "we are special" claims of the tax incentive seekers. We'll see.

Igniting the Fuelishness

My very recent post about the attempt in Hawaii to control wholesale gasoline prices so amazed me that I decided to dig deeper.

According to a story in the Honolulu Advertiser, the effort is as much a political dance, as I thought, as it is a legitimate process to protect consumers.

* The Public Utility Commission is attempting to implement a law passed last year by the state legislature, but legislative support "appears to be waning." Bills have been introduced that would permit the governor to veto any price cap.

* The governor, to her credit, opposes the cap.

* Most of what is being done has been designed and drafted by a consulting firm from Virginia, which is being paid $121,000. It would have been better to allocate the $121,000 to low-income Hawaiians to assist them with energy bills.

* Though the consulting firm claims, in a most oxymoronic statement, that price caps will cause more market-driven wholesale gasoline prices, it admits that the proposed cap formula and monitoring system is complex, and, get this, doesn't guarantee low prices for consumers. Why? Because "there is no guarantee the savings will be passed on to consumers because the cap applies only to wholesale prices." Brilliant. Just brilliant.

* The proposed formula requires the commission to set 96 separate price caps each week, using a complex formula. By how much will taxes need to increase to pay the salaries of the people who will need to be hired to do this work for the commission's staff?

* The consulting firm also admits that implementing the order by the dictated September 1 effective date "may be difficult."

* So why is this being done? It appears that some politicians, including a state senator, like the idea. One claimed that the report "shows that a workable and enforceable price cap can be achieved." The same report that says there's no guarantee consumers would see any price decrease? The same report that admits that the proposal is complex and that implementation is questionable?

* The same cap supporter stated, "If wholesale prices go down I think that ultimately those savings will be passed on to consumers. The intent behind the price cap is to try to provide for fairer and more reasonable gasoline prices that would more closely track Mainland prices as well as provide savings for consumers at the pump." Right. Any idea, great politician, that gasoline costs more in Hawaii than on the Mainland because of shipping costs? And to say nothing of believing in the tooth fairy. I'll call in the morning and oh, yes, reducing wholesale prices reduces consumer prices. Right.

* The cap supporters are playing off "public frustration" with Hawaii's high gasoline prices. Industry points not only to shipping costs but to Hawaii's high taxes. Aha.

* Aha, the consulting firm also repeated conclusions in a previous, more expensive analysis ($250,000) done by a California firm, "which found the ceilings could result in gasoline shortages and oil companies leaving Hawaii." Duh. No kidding. Just what I predicted before I even dug into these details.

Yes, it's expensive to live on a remote island in the middle of the Pacific. Everything, except a few locally grown items, needs to be shipped into the state. So of course prices will be high. Duh.

Fuelishness from Hawaii

A Philadelphia radio station has reported that Hawaii's Public Utility Commission has imposed a $2.15 per gallon cap on the price in Honolulu that can be charged for regular unleaded gasoline by wholesalers. Adding in taxes, that's equivalent to $2.67 per gallon. Other limits apply to other areas of the state.

The current average price in the entire state is $2.84. Predictably, the refineries who wholesale in Hawaii criticized the commission's action as counterproductive.

Of course. How long can a business survive if it is commanded to sell its product for less than the sum of the cost of the raw material and the prices paid to process that material? Does the commission think that the refineries' vendors will reduce the price they charge to the refineries? Oh, perhaps OPEC and other crude oil producers will reduce the prices they charge to their buyers, and the reduction will "trickle down" to Hawaii?

This is another limbic system, rabble pleasing, vote begging reaction to a situation that isn't going to be well managed when rational thought is pushed out the door. As I've pointed out in previous posts, the most recent one here, the solution requires cutting demand for oil, increasing supply, doing both, switching to alternative means of energy, or packaging some sort of combination of these options.

I really do hope that the refineries decide it makes no sense to sell gasoline in Hawaii for a price less than total cost of acquiring and processing it. Why? Because I want to see what the next brilliant decision to come out of Hawaii with respect to the gasoline market. Perhaps Hawaiian officials will then order gasoline producers to deliver free gasoline. Perhaps they'll even order OPEC and other crude oil producers to lower prices.

Reality check for Honolulu, anyone?

Getting Taxed on a Good Deed?

Sometimes the simplest of things can generate complicated tax law discussions, a phenomenon inconsistent with the assertion that tax law complexity is attributable to the complexity of the transactions in which taxpayers engage. According to a report in the ABA Journal eReport, when the pastor of a church challenged his congregation "to reflect their beliefs by devoting time, talent, and money to the church and the community," one member, an attorney, decided to draft simple wills in exchange for a small donation to the church by the people whose wills he drafted. The requested donation was less than his usual fee. He ended up writing about 45 wills, most for church members, and the church ended up with approximately $2,000.

It didn't take long before the tax experts scrutinized the arrangement. Prof. Ann Murphy of Gonzaga wondered if the attorney had gross income, and if he had a charitable deduction. She also asked if the church would be liable for the tax on unrelated business income. Good questions.

Simple transaction, simple rules, simple analysis, simple answer?

Nooooooo. Not at all. Well, the transaction is simple, the rules are simple, the answer is simple, but the analysis isn't.

A person who performs services for compensation must report gross income, subject to several exceptions not relevant to this discussion, such as the performance of certain services overseas. At first glance, someone unfamiliar with tax law would conclude that the attorney was not paid and thus has no gross income. But years ago, in fact, decades ago, the courts held that a person could not avoid gross income by having the compensation paid to another person. This principle reflects what is called the assignment of income doctrine, namely, assigning income to another person does not shift the tax incidence. Thus, there's no tax advantage to telling the employer or the client to pay the salary to the children, a trust for the children, or a charity. In fact, in Regulations section 1.61-2(c), the Treasury Department explicitly provides that in the sort of situation being described, the person providing the services must report the gross income.

So the attorney has gross income, and then is deemed to pay the amount involved to the church as a deductible charitable contribution. Would it make a difference if the attorney did not report the income and did not claim the charitable contribution deduction? Wouldn't taxable income, and tax liability be the same as if the gross income were reported and the deduction claimed? No, because the tax law is loaded with limitations, floors, ceilings, and other wrinkles that don't guarantee a dollar-for-dollar offset of deductions against gross income, though it can happen, but no one but the attorney knows whether any of those wrinkles would apply to his tax return. For example, if the attorney claimed the standard deduction, the charitable contribution deduction would be "wasted," though this is an unlikely scenario.

Yet isn't there something intuitively "wrong" about requiring the attorney to report gross income? After all, what if someone approaches the choir director and says, "If the choir sings Rutter's Magnificat on the third Sunday of Advent, I'll donate $3,000 to the music fund." Do the choir members have gross income? The answer surely is no, but why? Is it because the choir members aren't professionals? Suppose one or another of them is a professional, earning a living by singing during the week at other venues? Certainly there are differences between this example and the lawyer preparing the wills. The choir members did not pre-arrange the payment in exchange for their services. They did not perform a service solely for the donor, but instead provided it to the church (and I suppose, in a theological sense, as a worship gift to God). They almost surely would have sung something on that Sunday. As a practical matter, the donation probably was used to pay professional musicians whose presence would be needed for the piece, but that is a distraction from the core question.

The intuitive reaction, though, sparked an interesting discussion. One participant in the discussion initially noted that the lawyer did not receive the money, and the money was not available to him, thus precluding application of the constructive receipt doctrine, and thus precluding gross income. The constructive receipt doctrine is in part a gross income identification doctrine and is in part a timing doctrine. In its classic form, it deals with situations in which a taxpayer tries to defer gross income to a later year, because the time value of money encourages postponement of income that generates tax liability and because the tax rates in a later year might be lower. It also is a doctrine implicated in the principle that income deflected to another person is nonetheless the income of the person who performed the services because they were in constructive control of the income. But whether or not the constructive receipt doctrine applies, the assignment of income doctrine surely does, as evidenced by Regulations section 1.61-2(c).

It is fascinating that a matter as to which the law is settled can trigger extensive discussion. Yet, that is one way the law evolves. Otherwise, if no one discussed the question because the law was settled, the law would be less like to change, even if change was sensible.

The participant who raised the constructive receipt issue then backed away from that approach, and pointed out another interesting authority. In Revenue Ruling 74-581, the IRS concluded that law professors operating clinics under the auspices of law schools, who receive payment for services, and who turn those payments over to the law school, are NOT required to report gross income. It appears that the rationale is that the law professors are acting as employees of the law schools, receive the payments as agents of the school, and thus do not own the payments. This makes sense. A cashier in a store does not report as gross income the amounts paid by customers to the cashier because the cashier is acting as an employee and agent of the store owner. The gross income is the store owner's gross income. So the clinic income is the law school's gross income, but because the law school is almost certainly tax-exempt, it won't pay a tax on that income. Could the lawyer assert that the amounts paid to the church are not his gross income because he is acting as agent for the church? No, not under these facts. The lawyer is not the employee of the church. The church is not, and cannot be, in the business of preparing wills. One participant noted, in a very clever and smile-generating comment, that "I have always thought that part of a church's 'business' was to prepare people for the hereafter and seems that will-prep fits right in to that mission !" I doubt, though, this would get very far in tax litigation!

Several participants pointed out that "it does not make sense" to treat the donations as the lawyer's gross income. There's something to be said for this position. Yet, it is not unusual for the tax law to require an outcome that does not make sense.

Another participant pointed out a serious practical problem. The persons whose wills were drafted and who wrote a check to the church probably claimed charitable contribution deductions. Yet, applying the assignment of income principle, they were in effect writing checks for legal services for which no deduction is allowable (because of the personal nature of the services). The attorney, required to report the gross income, and allowed to claim a charitable contribution deduction, already claimed the deduction. It violates basic tax law principles, and policy, to permit two taxpayers to claim the same $50 charitable contribution deduction for one $50 check written to the church. Yet, absent the imposition of additional reporting rules (translate: more paperwork), the IRS is unlikely to identify these situations and correct the tax returns.

Note that if the services are provided directly to the church, there is no gross income and there is no charitable contribution deduction. Thus, had the attorney volunteered to fill out information and/or payroll tax returns for the church, there again would be an easy answer. The attorney isn't being paid, no one is making a payment "in recognition of" the attorney's volunteer work, and no income is being assigned.

And note that if the person whose will is prepared donates more than the services are worth, which apparently was the case with several of the people involved in the story, the excess would be not be gross income to the lawyer, would not be deductible by the lawyer, but would be deductible by the person making the donation. Determining what the services are worth ought not, as a practical problem, be too difficult.

Thanks to Paul Caron for bringing the story to our attention, and thanks to Bryan Camp, Joe Dodge, David Hasen, Calvin Johnson, Stuart Lazar, and Elliott Manning for their helpful, interesting, and sometimes humorous comments.

Still More Tax Charts

Too often, someone starts an on-line project and then lets it go, for whatever reason, good or bad. If the project is a good one, it's disappointing to see it fall by the wayside. That's not the case, though, with Andrew Mitchel's tax charts collection. It's growing. This is at least his fourth update. Perhaps I've missed one or two, but in the previous three posts (here, here, and here), I described generally what he was mapping out and why it's worth a visit.

Of course, each update brings new material, but the reasons for visiting don't change. The tax law, like most other areas of the law, lends itself to visualization through charts, pictures, animation, and other devices that helps us "see" the rules and their application to the facts.

This time Andrew has added charts for cases such as American Manufacturing (Outbound D Reorganization), Clark (Boot Treated as Received in Hypothetical Redemption), Kimbell-Diamond (Stock Purchase & Target Liquidation Treated as Asset Acquisition), J.E. Seagram (Tender Offers with Forward Triangular Merger), and rulings such as Rev. Rul. 70-106 (Minority Redemption & Majority Liquidation Not a Sec. 332 Transaction), Rev. Rul. 70-140 (Purported 351 Followed by B Reorg) ,Rev. Rul. 75-161 (D Reorg with Liabilities Exceeding Basis), Rev. Rul. 83-142 (Circular Flow of Cash in Foreign Spin-Off), and PLR 200225032 (U.S. Tax Treatment of German Organschaft).

Andrew also announced that he had "updated many of the charts that were previously posted," and that the "site now has a total of 88 charts (25 cases, 32 rev. rul.s, 1 PLR, 9 generic tax free reorgs, and 21 indirect stock transfers)." He welcomes feedback. Hopefully there's some "More, more" among the comments.

Incidentally, this is a great resource not only for tax practitioners, but also for people teaching tax courses in these areas and for students taking courses that deal with these topics. That type of cross-activity utility is one of the reasons I'm a fan of Andrew's tax chart site.

More Praise for Chocolate, with a Tax Twist

Chocolate is back in the news. More specifically, the medicinal qualities of chocolate are back in the news. According to this story, there is even more scientific evidence that the flavanols in cocoa beans somehow reduce the risk of heart attacks, strokes, diabetes, dementia and hypertension. That's good news.

But when there is good news, the bad news isn't far away, is it? The bad news is that most chocolate available for purchase lacks the flavanols. They're removed during the manufacturing process because they have a bitter taste. More bad news. Chocolate has calories. And fat. So it needs to be ingested in moderation. My mother has been preaching that point for years, along with the principle that a good meal is multi-colored. After all, fat per se isn't bad. It's the quantity. Try taking all the fat out of a diet (as I did), and it's amazing how the energy simply disappears. And so, if fat is necessary, why not get it in a healthy form (chocolate) rather than in some other form that doesn't bring benefits and has other risks?

Of course, one can get flavanols out of red wine, grapes, apples, and green tea, but cocoa beans apparently have much more flavanol per ounce. Red wine and chocolate. Hmmm.

The news has had an impact on the food industry. Mars announced that its dark chocolate Dove bars are full of flavanols. Hershey's is introducing a new Extra Dark chocolate bar. Mars is also marketing a CocoaVia snack bar, to which sterols have been added. Isn't technology great? Getting through life living on medicinal chocolate snack bars..... :-)

But the bad news is that to reduce blood pressure, a person needs to eat a lot of chocolate. Bad news? Yes, if the caloric intake matters to the person.

Sarcasm time. How long until there is a tax credit for eating chocolate? After all, with its beneficial health consequences, increased chocolate consumption could lower health care costs. Or perhaps a tax credit for manufacturing and selling dark chocolate and reducing the sales of flavanol-poor chocolate. Wouldn't it be fun to write the regulations under that provision?

The Revived Forbes Flat Tax Plan

Former student Nakul Krishnakumar sent me an email a few days ago, inviting me to comment on Steve Forbes' revived flat tax proposal. Nakul wrote:

I'm sure you've already seen this, but Steve Forbes has a great article in the WSJ regarding the flat tax. Of course, having read this article, I was reminded about a discussion you and I had about two years ago on this same topic. I'm sure you've probably discussed this topic ad nauseum with other people, but I would like to get your take on his plan.

His plan calls for (I'm outlining the basic plan) the following:

(1) a 17% flat tax on all income;
(2) no tax liability for families that make under $47K;
(3) a 17% corporate tax rate (with immediate deductions for business expenses, thus no depreciation!);
(4) a 0% capital gains tax; and
(5) elimination of the death tax

Overall, I like this plan because it would simplify the tax code and result in an economic expansion (although I cannot say this for sure). At the very least, I think it would be easier to comprehend than the current system (then again, anything, including quantum physics is easier to understand than the current system).

I suppose the flat tax plan, no matter which version is current in vogue, is the tax reform idea that will not die.

This specific Forbes plan has been criticized by Michael Kinsley and others, and Forbes has penned a rebuttal. Despite all of the arguments, there are a few simple things about "flat tax" plans that need to be understood.

Flat Rates

As Kinsley notes, the basic rate structure is not the cause of tax complexity. Although there is a wee bit of multistep computational exercise in calculating tax at x% on the first $n and at y% on the next $m, computer software can handle that task and most taxpayers who paid attention during arithmetic class can figure out a tax liability even without the aid of a computer, though a calculator could come in handy. On the other hand, removing the alternative minimum tax and scrapping the special corporate taxes would be a worthwhile simplification. And keep in mind that so long as there are progressive rates, some sort of mitigation system and its complex computations is required to deal with after-the-fact adjustments in income.

What makes the tax law complicated is the definition (or computation) of the taxable income with respect to which the tax liability is computed, and the proliferation of artificial social policy credits that are subtracted from tax liability. The latter are even more convoluted than first meets the eye because some are refundable, and some are not, some can be carried over to other years and some can not, and some allowable against the alternative minimum tax and some are not.

Tax simplification will occur only when the special interest infections in the tax law are wiped out. Despite law professors taking their students on tours of the definitional edges of "what is income," in most instances income stands up and identifies itself. It's the exclusion list, the deduction list, and the timing rules that take the simple thing and make it unduly complicated. To the extent that any reform proposal, flat or otherwise, removes the exclusions and deductions, it simplifies the tax law. But political support would disappear once taxpayers understood that deductions for home mortgage interest would end, that scholarships and gifts would be included in the tax base, and employee fringe benefits would be taxed. Of course, the emotional outcry would prevent most people from taking the next logical thinking step, which would be to consider the huge decline in tax rates that such a truly broad base would permit.

I can hear the shouts now. "It is immoral to tax scholarships because these are poor kids trying to get an education." Au contraire! If they are truly poor, and a income less than the poverty level or something equivalent to it is exempt from tax, the youngster with only a $12,000 need-based scholarship would not be taxed, but the independently wealthy but highly intelligent student with a $12,000 merit scholarship would probably incur some small amount of tax. Similarly, taxing all social security received in excess of the employee contribution is a proposal that triggers cries of horror from every corner, but it makes no sense to tax more or less than what the recipient has received over and above his or her contributions, and again, the wealthy person hauling in these payments would be taxed and the poor person would not. All of the shenanigans in section 86 could go down the drain.

It would take, at most, one millisecond before the "my activities are special" bleatings begin to fill the hallways of Congress. This mentality, which is self-focused and cannot put the overall common good above the narrow-minded concerns of the self-appointed special, would bring highway traffic to a halt if it were applied to bridge and turnpike tolls. "We're on our way to college, so we get a discount on the toll that will take 20 minutes to compute...Hey, honey, do you have that information on how many nonqualified courses Johnny is taking?" "Hey, speed it up, my spouse and I are on social security and we need to figure out if we use the base amount or the modified base amount in computing the toll." "We're on our way to a hospital. Can we go through now for free and pay double when we return?" You get the picture. Do members of Congress see it?

Exemption Amounts

The idea that income under a specific amount should not be taxed makes sense. The tough question is faced when it is time to determine that amount. Should it be based on individual income? Household income? Marital unit income? Extended family income? I have proposed, over and over again, to no avail, that the amount should be computed for each individual, that it should reflect 110% (or some similar percentage) of the poverty level, and that an individual whose income is less than the exemption should be permitted to transfer or sell any "unneeded" (excess) exemption to anyone else. A similar arrangement exists with respect to pollution credits, and in the context of the income tax it would generate income for the poor and tax savings for self-defined groups, ranging from marital units to mutual friends and unmarried siblings sharing a household. It moves part of the tax law out of the government and into the private free market. Rarely is this proposal criticized. It simply is ignored. That suggests to me that it frightens a lot of people who are in the power elite. That, in turn, suggests to me that it poses a threat because it might, just might, work. And be the first crack in the present system of designing tax law.

Flat Corporate Rates and the Elimination of Depreciation

If I had my way, corporate income would be taxed to the owners of the corporation. Many other people share that idea, but it never seems to get off the ground. So long as corporations must be taxed, that is, assuming they cannot or do not elect to be treated as an S corporation whose income is in fact taxed to the shareholders, then the argument for a single rate fails for the same reason it fails in the individual context. It isn't the reason for complexity. Corporate tax law is complicated not only for the same reason as is individual income taxation (exclusions, deductions, credits, timing, etc.) but because the structural transactions of corporations, such as divisions, mergers, reorganizations, and similar changes, are subject to a complex maze of tax rules most of which could be eliminated if the special interest groups were pushed to the side.

The question of whether expenditures for property that is not consumed within the taxable year should be deducted has been vexing tax policy for decades. One side claims that income used to purchase buildings, equipment and other property ought not be taxed. The other side points out that the tax law is so twisted that people who purchase office buildings are permitted to deduct depreciation even as those buildings increase in value. I think the compromise would bring quiet to the room, at least until the tar and feathers are ready. I'd agree to deducting the cost of a building if the taxpayers agree to include in income the increase in wealth that occurs when the building increases in value. Why should a corporation, or any other business for that matter, be allowed a deduction when it is increasing its wealth? It makes no sense.

The Zero Percent Capital Gains Tax

This is the deal breaker. Forbes wants to retain the special treatment of capital gains. Most tax practitioners, but few taxpayers, know that at least one-third, and perhaps one-half of the complexity in the substantive portion of the Internal Revenue Code, a similar portion of the regulations, and a huge chunk of rulings and cases, arise from the need to distinguish capital gains from other income. The existence of any capital gains tax break encourages taxpayers to play the "let's make ordinary income look like a capital gain" game. What a waste of time. Income is income. The bartender doesn't ask if the dollars being used to pay for a drink are capital gains dollars or ordinary income dollars. The only plausible argument for treating capital gains differently is that some of the gain is artificial because it reflects inflation. The solution to that problem is to index the adjusted basis of property, just as all sorts of amounts in the tax law are adjusted for inflation. It's easily done, and it would permit trashing a huge portion of the tax law.

Any "flat tax" that has a capital gains preference is not going to be simple. Not by any stretch of the imagination. And the presence of such a preference in a proposal is an excellent clue as to the consequences of such a flat tax, whether or not that consequence is intended or simply misunderstood by the proponent. And until and unless the American tax-paying public comes to understand what's going on with the capital gains game, the prospects for genuine reform are slim.

Elimination of the estate tax

I have mixed feelings about this one. The gap between the haves and have nots is widening, and the middle class is beginning to disappear. So the emotional reaction is a temptation to advocate some sort of "tax the [fill in the adjective] rich" provision, whether it is the very rich, exceedingly rich, super rich, filthy rich, whatever. But logic also suggests that the cost of administering an estate tax, especially when it affects such a minuscule percentage of estates, is inefficient.

There are two easier ways of achieving the same goal. The first is to tax unrealized gains at death, subject to a rate that reflects the bunching effect of putting all that income into the final income tax return of the decedent. Perhaps "year of death" gains should indeed be subject to lower rates, coupled with a much higher exemption amount. The second is to tax unrealized gains as they are realized (remember the folks who want deductions for property that is increasing in value?), with a deferral of the tax payment until property is sold and cash becomes available. The tax payment provision is not a new one; it already exists in the tax law for certain estate tax situations.

Either of these two solutions removes the emotional argument that is made on the repeal side of the issue. It would eliminate the "it's being taxed twice" argument, one that does not withstand logical analysis even when the current income and estate tax structure is considered.

I'm sure this is much more than Nakul had expected. No, wait, he's been in my courses, and he knew that my short email response to him would expand when I took this to the blog. And none of it is news to him. He's heard, at least one and probably a few times, my income tax reform plan: genuinely expand the base by removing exclusions and deductions, provide a substantial per-individual transferable exemption, trash the social policy credits, and subject the taxable income to a genuinely progressive rate structure. And he has heard me say that the chances of this happening are slim to none.

But it is fun to discuss. And it is fun to write about it. Even if it is ad nauseum. What's nauseous, of course, is a close look at the existing tax law.

Beer, Softball, 4-Day Weekends: Is This Any Way to Learn Law?

In eight days it will be time, once again, to teach the first class of the new semester. The students in my Introduction to Federal Taxation course are second and third year students. During the past decade, the enrollment in this necessary, but elective, course has become progressively more self-selective. Students who do not want to do the work that I require during the semester, and who prefer a course in which they can coast, find an old outline, and cram for an "all eggs in one basket" final examination avoid my courses. It's no secret.

They claim that I am too demanding. My response is that I am as demanding as is the law, as are the clients, and as are the partners, judges, or other supervisors to whom the students will be reporting when they graduate. There's little room in practice to coast for fourteen weeks and then cram everything into one all-nighter. Law practice is a rude shock to most law graduates. Those who make the smoothest adjustment are those who have been in law school clinics, in well-run externships, in law firm summer programs that are more demanding than the "we are wooing you, so let's go to a ball game or concert" experience, and those who somewhere in their previous education acquired robust self-discipline and good academic study habits.

One of the reasons that my courses are so challenging is that they involve subjects requiring far more than the 42 50-minute class sessions allocated to them. Introduction to Federal Taxation remains a three-credit course, as it was 30, 40 years ago, even though the Internal Revenue Code, the regulations, and case law have multiplied many-fold during that time. Even setting aside the arcane and irrelevant, the individual income tax provisions that are the primary focus of the course have blossomed like weeds after a week of rain. There's insufficient time to devote several classes to one provision, and there's insufficient time simply to have extended discussions about the specific tax policies reflected in the provision or to air each student's "feelings" about tax law (as if none of us could guess).

To learn the basics of federal taxation, therefore, students need to do a significant amount of self-teaching. They need to read and ponder before class, even if they don't quite grasp what's going on with the statute. After all, as I explain to them on the first day, a failed effort is far more valuable than no effort. After class, they need to assimilate the material. By creating their own outlines, graphs, charts, tables, or other learning aid, they are learning through that process. Grabbing someone else's outline or other work product from the previous year is useless, not only because it is equivalent to trying to get in shape while watching someone else run the treadmill, but also because in tax the previous year's work product will be obsolete to some extent. I always include a few questions during the semester and in the examination designed specifically to identify those students who studied from an outdated study aid, and during the past few years, as self-selection has increased, the number of students making this particular, and critical, mistake has diminished significantly.

Note that although it is important to take notes, I teach in a way that emphasizes the need to think about what is said in the classroom, and to write down the essential points, rather than to take dictation. To discourage note-taking of the college lecture-hall variety, I make my Powerpoint slides and other materials available ahead of time so that students have less need to write things down. Fortunately, the days of students asking me to slow down as I read a Code section so that they could write every word have come to an end, because students do understand there's no point in writing down what's already in front of them as I read it. Instead, they can rely on my voice tones, pacing, and repetition of phrases to highlight the key words and phrases in the provision.

Yet, for most students there still is a rude shock when on the first day of class I tell them that I expect them to do several hours of work outside the classroom for every hour in the classroom. I explain why, pointing out what I've already written in this post. That they are no longer in college is a fact that needs to be highlighted. I describe how they are at a disadvantage, trying to earn a doctoral degree in a discipline in which they have not studied and for which they do not have a bachelor's or master's degree. There's a lot of catching up to do. Underneath my policy is this simple dose of reality: Law students are enrolled in a graduate program, working toward a doctoral degree, in preparation for professional practice. Concomitant with that posture is a requirement of diligence, independent study during the semester, class attendance, preparation for class, and post-class assimilation. Yes, welcome to what should be, and often is, a most demanding graduate school preparation for professional practice.

There is so much to do that proposals have been floated from time to time suggesting that law school be extended from three years to four years. This would provide the opportunity to increase course credits in areas where the law has expanded since the current core method of teaching law school was adopted more than a century ago. It would permit, assuming the requisite funding were obtained, additional law school clinics so that every law student, rather than several dozen, had a taste of law practice before entering law practice. It would provide more flexibility in scheduling, so that more students could enroll in an externship, another experience that, if properly administered and operated, can introduce students to the realities of law practice. The principal downside is that the cost to a student of a law school education would increase by roughly 33 percent. If adopted, the proposal would put classroom and other physical facility strains on those law schools (translate, most law schools) lacking capacity to absorb a larger student body.

Others have proposed that law school be shortened to two years. The principal argument for this proposal is that the third year of law school is a waste of time because students are learning anything they haven't already learned. Wow, that must be a surprise for the third year students who've been in my courses. Of all the criticisms, they've never said they're not learning anything, or that they are bored, or that they are wasting time.

Thus, carrying the outlook on legal education part of which I have shared in this post, I was shocked to read the following excerpt from a New York Times article on the wisdom of having a third year of law school. Entitled "Some Question Third Year of Law School," it begins with this delightful yet eye-catching anecdote:

Now a corporate lawyer, Jennifer Leong fondly recalls her third and final year of law school. A job secured, she traveled frequently. Her courses included feminist jurisprudence and a half-semester bankruptcy seminar -- each carefully chosen to get her weekend started by Wednesday afternoon.

"A lot of beer and softball," recalled Leong, who got her University of Virginia law degree in 2000. "Third year was probably the best year of my life."

Here's a graduate of an arguable elite law school sharing but one example of many anecdotes that permitted the article's author to then write:

At many top law schools, the third year is famously relaxed, a halcyon interlude between rigorous introductory courses and the long hours that await graduates at law firm jobs. There is research and volunteer work, but also a lot of bar-hopping and little studying: 15 hours per week, according to one survey at 11 law schools, compared to 33 hours for first-year students.

Note that according to my computations, a student enrolled in 14 hours of class during a semester should be putting in anywhere from 28 to 56 hours a week outside of class, with most students needing roughly 40. First year students at top law schools are very bright, so the 33 hour average probably isn't that far off the mark, but 15 hours for the third year students? What's going on?

My guess is that what is going on is that the students are not being offered, or are staying away from, demanding courses. By definition, a demanding course, one that reflects what the practice world will require, doesn't permit a student, no matter his or her intelligence, to get by on what works out to be about 3 hours a week per course. Where is the rigor? Where is the in-depth focus that a capstone third year course should bring to an area of law, where material learned in multiple previous courses is synthesized into a transactional experience? For those who haven't been to law school, a quick example would be Business Planning. Students in this course, having been through the Business Entities or Corporations course, perhaps a Securities Law course, certainly a course covering Corporate or Business Entity Taxation, and maybe a Secured Transactions or Bankruptcy course, are given the opportunity to plan the formation, operation, and termination of a corporation, limited liability company, and partnership. Goodness, it's like being in a law firm practicing law. It isn't going to go well, except for the rare paralegal who previously practiced in the area or the occasional student who had an externship doing this sort of work, if the investment is 3 hours per week.

The Times article nicely explores some of the arguments for shortening or lengthening law school. It points out that some third year law students put in enormous numbers of hours. Enrollment in a clinic, for example, will make that inescapable. The article quotes faculty whose research disclosed that many third-year students attend no more than 60 percent of their classes. A well-taught course brings the tag "going to class is essential." Even though I would expect someone preparing to be a professional to attend classes because of dedication to the goal, I also understand that a poorly taught course can make class attendance counter-productive or at best, useless. There are ways to encourage class attendance, and the best ones are those that also improve the course and make it so attractive that students cannot afford to stay away.

Some of the arguments with respect to the length of law school involve money. Money, though, should not be such a driving force that quality is sacrificed for the sake of economy. That's true in other worlds, as manufacturers of many products have discovered. Yes, if there are less expensive ways to achieve the same level of quality those opportunities should be pursued. But if it takes four years of law school, including a semester of externships and a law school clinic experience, to produce law graduates who can more easily and efficiently transition to law practice and provide quality services to the clients who ultimately pay their salaries, then that is what needs to be done. After all, medical professionals invest far more years in their studies, including the advantage they get by starting their medical studies while in college through courses such as organic chemistry. Law school ought not be, for the reasons described in Money for Nothing and Work for Free?, a "quick and (therefore) cheap" path to a high-salary career, nor should it be a "cash cow" for universities seeking to finance economically inefficient academic programs or athletic departments. The appropriate investment, in time and money, must be made.

I know there are many lawyers, and law students, who work hard, attend(ed) class, prepare(d) for class, study, and continue to self-teach (which is, of course, as I describe in Learning to Teach and Teaching to Learn, the best form of learning). But I wonder if the rising levels of frustration among young associates in law practice is not only the product of the changing nature of practice that demands high billable hours and fosters cutthroat behavior but also is the difficulty of making up for lost law school education opportunities in a practice world that doesn't permit billing out the learning of an avoided course or the re-learning of an unattended course and that cannot afford to provide hours of mentoring time by similarly pressed older associates and partners.

Law schools, hopefully under increasing pressure from practitioners and judges, need to do some serious self-examination. Long before the details of curriculum, schedule, credits, number of years, adoption of clinics and other matters are tackled, law schools need to resolve the question of what they are trying to do. Putting aside the elegantly worded mission statements, the ultimate inquiry comes down to resolving this debate: Are law schools preparing their students for the practice of law or are they preparing their students to be legal philosophers? I've engaged in that debate numerous times.

On the one side is this sort of statement from former Supreme Court Justice Felix Frankfurter:

T]he business of a university [is not] to turn out finished practicing lawyers. A law school is not a law office or a court room. In these days of overemphasis upon the immediately practical, it cannot be insisted upon too often that a university law school is part of a university. Intellectual issues are its concern. [A law school must promote and encourage] the continuous critique of all law-making and law-administered agencies. [This falls] peculiarly within the competence of scholars, and the promotion through formulated reason of wise adjustments of the multitudinous and increasingly conflicting interests of modern society.

Do I dare disagree with the great Frankfurter? Yes, unless one understands that he made his statement when the practicing bar still had preceptorships that were to law graduates what residencies are to medical school graduates. Yes, the practicing bar has contributed to the problem by abolishing preceptorships, which it did because those were expensive experiences, more in terms of mentoring time than in terms of money, but expensive nonetheless. After all, if they fit within the profit-centered business approach that has overwhelmed the profession, the profession would have brought them back.

More importantly, there is no conflict between the notion that law schools prepare students to be practicing lawyers and the idea that law schools should engage in analysis of the law. Law schools are not trade schools. It's inefficient to teach law students, other than in clinics, how to find the office or web site of a court clerk. On the other hand, when second-year students tell me that I'm the first professor to use the word "client" in a classroom or to put issues in terms of client interaction, it alarms me. Clients, after all, are an ingredient in how the law develops, and anyone who wants to focus on analysis of law needs to understand the reality, because reality is what stands between theory and implementation (or non-implementation) of theory.

The point is that law school should, and usually does, teach its students to think. Not that lawyers are the only people who need to learn how to think, and not that one should expect the K-12, or the undergraduate system, to have done the job, but there is something a bit more refined in legal thinking than is found in most K-12 classes and many undergraduate classes. Law, whether in practice or at the theoretical level, is and needs to be focused on the prevention of problems and the solving of problems. It is, therefore, a matter of learning how to solve puzzles and how to understand the creation of puzzles, as I argued in Doing Puzzles While Learning & Practicing Law. It requires rigorous effort. Any program that permits a student to slide by drinking beer, playing softball, having 4-day weekends, and investing only a few hours in studies, is failing. Whether it is an individual student who isn't meeting requirements, or a culture that tolerates mediocrity, the situation demands correction. After all, do practicing lawyers really want to hire students who have not maximized their opportunities? Are law firm interviewers asking the right questions of their law students?

I was embarrassed to read the quotation that led the Times article, and I'm not even affiliated with the law school in question. I'm embarrassed for the legal education profession. After all, what are the readers of the Times article to think when after hearing for years that law school is "so tough" they see that its third year gets portrayed as, to quote the article, a "famously relaxed, a halcyon interlude." And then practitioners wonder why their clients object to the $500 per hour fees that are charged.

Visit No. 5 to the World of Gasoline

It was inevitable. As gasoline prices resumed their climb, conversations have once again turned to the "awfulness" of "high" gasoline prices. Toss in discussion of home heating oil price concerns as the oppressive heat and humidity fail to deter homeowners from pondering the not-so-distant change in seasons, and the makings of a good flurry of rumors and panicked cries are beginning to percolate.

This morning, as I was driving home from the gym, burning all of four cups of gasoline, the air personality on a New Jersey station was commenting that even though American gasoline prices were nowhere near those in places such as Europe and Hong Kong, there was something about the sticker shock that he didn't quite grasp. He did a fine analysis of how gasoline prices have risen proportionately to income over the past 30 years. He challenged people to compare their gasoline prices to their incomes, and to ascertain if the percentage has changed significantly.

His take on the question makes sense, but it misses several key points. First, for someone who began purchasing gasoline in the late 80s or early 90s, gasoline prices have risen more quickly than has income. For these people, the relative price of gasoline 30 years ago is history rather than experience. The same can be said for someone who started paying for gasoline a year or two ago. It all depends on the precise point in the price-history curve that the person arrives. Second, for some people, income has not risen as quickly as has gasoline prices. After all, average income increases are inflated by the huge pay inflation at the top of the pay scale. Third, comparing per-gallon gasoline price to income misses one of the chief ingredients of the energy crisis, namely, that most people are driving more miles each year.

I addressed the gasoline question in detail more than a year ago, in May of 2004, when gasoline price increases were being closely covered by the press. That discussion followed an earlier post in which I argued that gasoline taxes needed to be increased to keep pace with inflation and the rising costs of road maintenance, and it was quickly followed by a Memorial Day 2004 post rejecting the notion of toll-free highways for vehicles with higher fuel efficiency. Late last year, in an election-oriented post, I pointed out that politicians don't help Americans analyze the problem because they present inconsistent and inaccurate soundbites with respect to the issue, choosing to say what people want to hear rather than the truth that needs to be told.

Considering how much bad information, emotionally-driven exaggerations, politically-motivated alarms, and frustrated expressions of self-centeredness have infiltrated the newspapers, radio talk shows, and cable networks, it's worth once again looking more closely at the facts. Failure to do so is what lets lawn contractors get away with increasing overall prices by 20% when gasoline prices, constituting 15% of their costs, increase by 25%. Do the math.

Has the passing of 15 months discredited any of my comments from May of 2004? Here are those comments, and today's reflection on them.

I began with the same point I just made:

It's amazing how an increase in gasoline prices can generate so much consternation. Politicians grab onto the issue as though it's the be-all and end-all of life. Accusations fly, bizarre solutions are suggested, and very few take the time to sit down and THINK their way through the situation.

In this respect, nothing has changed. No surprise there. I then proceeded to assert that "There are five major considerations: supply and demand, inflation-adjusted cost, industry patterns and government regulation, taxes, and strategic reserve." and I continue to think that these remain the focus of any analysis.

Turning to the first one, I stated:

Supply and demand is easy. If demand goes up, or supply goes down, or both, prices go up. That's Economics 101, which ought to be taught in high school, and perhaps it is, here and there. Demand is going up at a phenomenal rate, on a global basis, particularly because China is growing and its need for energy is skyrocketing. Total miles driven by Americans has increased at rates far beyond the rate of increase in the population. Supply has been decreased, but will be tweaked up a bit in the near future, for a complex array of economic and political reasons. Although OPEC controls only a small fraction of total world-wide oil, the oil market is a marginal one, which gives OPEC supply decisions a noticeable impact. Although OPEC is perceived as making its supply decisions solely for political purposes, in fact it is influenced by economic conditions in its member nations and by their desire to manage a finite national natural resource in careful ways.

This continues to be the case. The law of supply and demand has not been repealed or amended. All that I will add is that gasoline, heating oil, and other energy products are simply in the vanguard of a long line of commodities that will become relatively scarcer as populations skyrocket, developing nations develop, and environmental and other pressures curtail production; I'm thinking principally of fresh, clean drinking water.

On the second consideration, I noted:

Inflation-adjusted cost is easy. Take a look at gasoline prices in 2004 dollars over the past 85 years and it's obvious that gasoline has been selling for less than its real price for many years. During the 1990s gasoline prices reached record lows in real dollar terms. Consider this gem from a letter to the editor of the Augusta Chronicle in 2001: In 1960 gasoline sold for 30-33 cents a gallon and a full size Ford sold for $2,000-$3,000, and in 2001 the Ford sold for ten times as much. Why Americans think they are entitled to "cheap" gasoline bewilders me. I've spent time in Europe, and despite the "non shock" of seeing "1.30" as the price, once that price in Euros is adjusted for the fact it is a per litre price, it's pretty obvious that the per gallon cost of gasoline in Europe is far more than what's being paid in the U.S. today. Part of the reason is taxes. More on that in a moment.

As with supply and demand, nothing much has changed here. As I pointed out, these sorts of comparisons don't resonate emotionally with people who entered the gasoline market as purchasers at times when the price curve was below the overall average, but the same can be said with respect to any commodity that experiences a significant price fluctuation.

The circumstances with respect to the the third consideration also appear to have held constant. I stated:

Industry patterns and government regulation is more complex. Gasoline prices go up in the summer, because demand increases. But industry isn't always ready to crank up the production, because if there has been a cold and/or longer winter it has to replenish heating oil stocks and thus delay the switch over to increased gasoline production. Short-term prediction for tne next six months show gasoline prices dropping back after the summer. It's a pattern as familiar as the sun rising in the east and setting in the west. There hasn't been a new refinery built in this country for the past 30 years. Why? Unprofitable? Yes, after taking into account the cost of trying to wade through a gauntlet of government regulations. Some of those regulations are necessary, and some are well-intentioned but badly designed. This isn't a problem fixed overnight. The time from beginning a search for new oil fields and gasoline from that field reaching the pump is at least 10 years, perhaps more.

I should add, however, that work has begun on the construction of several new refineries and the expansion of several others. Though refinery capacity does not change crude oil supply, it might alleviate some of the seasonal cycling in gasoline prices. Whether that will ease people's distress is unclear.

The fourth consideration, gasoline taxes, hasn't had much, if any, attention during the current gasoline price surge. I will repeat what I stated so that I can tag an addendum onto my comments:

Taxes in this instance are easy to understand. Yes, the anti-tax politicians (who try to get elected on the "no taxes ever it's all free" delusion that sells to non-thinking voters) are yelling that the reason for the increase in gasoline prices is taxes. Rubbish. Here and there a few states have increased gasoline taxes but during this last gasoline price run-up taxes haven't changed. They should, of course, because a ten cent per gallon gasoline tax enacted in 1970 to pay for road maintenance needs to be more than that to provide the same level of maintenance. These politicians scream that the solution is to reduce gasoline taxes. Well, then who pays for road maintenance? And what does that do to the "there's an energy crisis and something needs to change" message? These politicians are catering to the uneducated emotionally upset folks, some of whom, granted, operate businesses that are adversely affected by gasoline price increases (such as florists and pizzarias that deliver). Sorry, but pass those costs onto the consumer. If anything, taxes should be increased. That's the case in most other nations, where the true cost of consuming a gallon of gasoline, in terms of impact on highway infrastructure, environment, police highway patrols, accidents, and all of the other economic effects of driving is reflected in the gasoline tax. Yes, I'm back to my preference for the user fee model.

When I suggested that gasoline price increases incurred by businesses be passed onto the consumer, I was not suggesting using "gasoline prices have increased" as an excuse to raise prices by more than the prorated portion of the increase. My somewhat overstated example of what at least some lawn contractors are doing may not be the numbers applicable to most who are doing so, but they demonstrate a pattern that often is seen in businesses dealing with supply price increases, namely, establishing consumer price increases higher than the supply price increase. In the ideal free market, customers challenge these increases. I know someone who did (no, not me), and the entrepreneur relented. Unfortunately, most people don't have the skill, time, or willingness to "work the numbers" and determine if they are getting the short end of the deal. After all, I guess that sort of exercise reminds people of doing taxes, and triggers some sort of traumatic response.

The fifth consideration,tapping the strategic petroleum reserve, has also disappeared from the current conversation, so I'll simply state that nothing has happened that changes my conclusion that tapping into it to alleviate gasoline prices is unwise.

If the current gasoline price increases are so horrible, would we not begin to see some changes in lifestyle? Here and there a person is quoted by a news reporter as having cut back driving or combined errands into one trip, but what I've seen on the roads and in life generally suggests that most Americans aren't adversely affected, or don't see the connection between their lifestyle and driving habits and gasoline prices. Fifteen months ago, I pointed out five significant lifestyle or behavioral factors that contribute to higher gasoline prices, principally on the demand side, namely, development sprawl, teen-age autonomy, inefficient public transportation, insufficient telecommuting, and impulse decisions. Read the earlier post for the details. After fifteen months of increasing gasoline prices and record-setting crude oil prices, sprawl continues unabated, as developments continue to pop up "in the middle of nowhere" miles from stores, offices, hospitals, and other necessary facilities. Many teen-agers continue to drive to school rather than ride school busses. Public transportation, long hampered by its inability to move most people quickly from where they are to where they want to go in a straight line, has been saddled with the impact of terrorism and a drop-off in ridership. Until someone invents a cheap, safe, alternative along the lines of a custom carpool system, not much supply efficiency will be realized in this sector. I don't know if telecommuting has increased. If it has, it hasn't been a significant change, because the quantity of vehicles on the local roads during commuting hours has surely not decreased. Have people managed to condense errands into fewer trips and to cut down on the impulse run to the store? I don't know. Traffic volume suggests no, that hasn't happened.

I didn't expect much to change, and predicted that in my May 2004 post:

None of this can or will be changed in the near future. Houses have been built where they are and they're not going to be moved. Jobs are where they are. It would take years to get public transportation back to where it once was, that is, something that was of good use to most Americans. Maybe high schools can compel the use of school busses, or perhaps the driving age can be increased to 18 (for reasons far more important than gasoline consumption), but let's face it: not going to happen. Telecommuting and distance learning probably will increase over the next few decades but not at rates that would alone offset increases in per capita driving mileage. What MIGHT change driving patterns is an increase in gasoline prices (yes, increase) through taxes (yes, taxes) to levels comparable with world prices, reflecting inflation, and sufficient to keep the highway infrastructure in repair (remembering that bad roads cause decline in fuel efficiency).

And I noted that my analysis wouldn't play in the political universe or in the media world of sound bites.

I did some driving this summer. Enough to figure out that at 65 mph the fuel mileage was 10 to 15 percent higher than at 75 or 80 mph. Yes, those speeds were within the applicable speed limits. At one time maximum mileage was said to be at 55 mph, but perhaps it's improved technology or the fifth gear in the transmission that has shifted that higher, at least for the vehicle I was driving. For several reasons, including fuel efficiency but also involving the more relaxing nature of 70 mph as compared to 80 mph, I settled in, where possible, for 70 mph. I could have been killed. I was a roadblock, even when speed limits were at 60 or 65. Yesterday, back home, driving at 62 on a highway with a 55 mph speed limit, the doors were almost blown off the vehicle by the traffic that went by, at speeds easily in the 75 to 90 mph range. I may have passed two or three vehicles, not counting a slow-moving truck. If these folks are upset about gasoline prices, they're surely not showing it by their driving actions. Do they even know that by slowing down to 60 or even 65 mph, still above the speed limit, that they will reduce gasoline consumption by 10 to 15 percent? As an interesting aside, it wasn't just the high-performance sports cars that zoomed by. Minivans, panel trucks, SUVs, sedans, motorcycles, you name it, they got to some checkered flag somewhere before I did. Well, I never saw it. Even though they flashed by, I could see these drivers. Young, old, male, female, every size, shape and color. Everyone is in a hurry (except, of course, when they're in front of me in a line). I'll leave that discussion for some other time. The difference between 65 mph and 75 mph for a 65 mile trip is 8 minutes. For a 16 mile trip, it's 2 minutes. For an 8 mile run, it's 1 minute. Putting aside the increased risk of accident, is that 1 minute or 2 minutes worth the additional $2 for gasoline consumed? Americans seem to be voting with their accelerator pedal and griping with their mouth. So what's louder? The action, or the words?

As I pointed out fifteen months ago, when a crisis really hits, and lines begin forming at the pumps, then a lot of people will start running around, and screaming, and shouting, and asking, "How did this come to be?" and "Why weren't we warned?" And all the folks who yelled "Chicken Little" at the prophets will begin picking up pieces of the sky.