Words, Precision, and Federal Income Taxation

According to the Internal Revenue Code:

…. the term “taxable income” means gross income minus the deductions allowed by this chapter.

See section 63(a) (emphasis added).

According to the Bureau of Internal Revenue, the predecessor of the IRS:

The word “allowable” designates the amount permitted or granted by the statutes, as distinguished from the word “allowed” which refers to the deduction actually permitted or granted by the Bureau.

See I.T. 2944, XIV-2 C.B. 126 (1935).

According to the Tax Court, in Lenz v. Comr.76 101 T.C. 260 (1993):

Throughout the Code, a distinction is made between the terms “allowable deduction” and “allowed deduction,” which distinction is not insignificant. Day v. Heckler, 735 F.2d 779, 784 (4th Cir. 1984). Unfortunately, as with many terms of art in the area of tax law, these terms are often interchanged with one another, causing confusion. We must rely on the words of the statute as generally understood, and to do otherwise would be to redraft the statute. United States v. Locke, 471 U.S. 84, 95-96 (1985). “Allowed” and “allowable” have fixed meanings in the tax arena, and we interpret statutes using these terms in light of their understood meanings except where to do so would create absurd results. See United States v. American Trucking Associations, Inc., 310 U.S. 534, 542-543 (1940).

“Allowable deduction” generally refers to a deduction which qualifies under a specific Code provision whereas “allowed deduction,” on the other hand, refers to a deduction granted by the Internal Revenue Service which is actually taken on a
return and will result in a reduction of the taxpayer's income tax. See Reinhardt v. Commissioner, 85 T.C. 511, 515-516 n.6 (1985); see also sec. 1.1016-3(a)(1)(i)(a), Income Tax Regs. Respondent in fact defined the terms “allowable” and “allowed” in I.T. 2944, XIV-2 C.B. 126 (1935), as follows:

The word “allowable” designates the amount permitted or granted by the statutes, as distinguished from the word “allowed” which refers to the deduction actually permitted or granted by the Bureau.

Thus, one might have an item of expense which is allowable as a deduction; however, the deduction is not allowed. In Day v. Heckler, supra at 784, for example, it was noted that certain land clearing expenses were an “allowable deduction” under the Code; however, such deduction would not be “allowed” unless the taxpayer made an election to take such deduction.

Id. at 265.

In Central Illinois Public Service Co. v. U.S., 435 U.S. 21 (1978), the Supreme Court held that lunch reimbursements paid by the taxpayer to its employees were not “wages” subject to withholding. In its opinion, the Court stated: “The income tax is imposed on taxable income. 26 U.S.C. § 1. Generally, this is gross income minus allowable deductions. 26 U.S.C. § 63(a).” (emphasis added). Several years ago, in “No Thanks, Uncle Sam, You Can Keep Your Tax Break,” 31 Seton Hall Leg. J. 81 (2006), which can be found here, I analyzed the issue of whether deductions are mandatory, and in doing so, focused on the meanings of the words “allowed” and “allowable.” I did not address the Supreme Court’s language in Central Illinois because it did not turn up in my research. It did not turn up because the issue in the case was a withholding question and not an income tax liability question. As the court itself noted, in rejecting the IRS attempt to equate wages for purposes of section 3401 as coterminous with compensation for purposes of section 61, the withholding rules are in subtitle C and the income tax is in subtitle A of the Internal Revenue Code. The court stated, “The income tax issue is not before us in this case.” So why did the court toss in a gratuitous, and erroneous, paraphrasing of the income tax law? There was no need to explain how taxable income is computed, because the computation of taxable income has nothing to do with whether lunch reimbursements are wages subject to withholding. In other words, the issue in Central Illinois Public Service had nothing to do with the meaning of the words “allowed” and “allowable,” nor does the Court’s language mean that the two words are the same.

Yet clearly the Supreme Court of the United States has written that section 63 defines taxable income as “gross income minus allowable deductions,” whereas the statute clearly states that taxable income is “gross income minus the deductions allowed by this chapter.” Why was the word changed? My guess is that the person writing the opinion, either Justice Blackmun, one of his clerks, or some combination of thereof, was careless, or erroneously thought that "allowed" and "allowable" are interchangeable words with identical meanings. One wonders if the sentences in question were written with the Internal Revenue Code open in front of the writer, or if the sentences were extracted from someone’s class notes, notes reflecting inadequate listening during class or failure to assimilate properly after class by looking again at the Code and cross-checking the language in the class notes or outline being prepared by the student. Perhaps the clerk in question was referring to the outline used in the course, prepared by a predecessor in an earlier instance of the class, without paying due attention to the fact that there are errors in those old outlines floating around law schools. Or perhaps, and it is painful to write this, it could have been a matter of the clerk having been a student in a course taught by someone who was not careful with words, who conflated “allowed” and “allowable,” or who left the students on their own to learn the technical language issues while class time was devoted to tax theory, tax policy, and discussions of what the tax law could or should be rather than what it is.

Could the Supreme Court have intended that the word change convey a decision that “allowed” and “allowable” are the same word? Hardly. The issue of whether “allowed” means “allowable” was not in front of the Court. Nor was the computation of taxable income for subtitle A income tax purposes before the Court. The two sentences in question are irrelevant to the decision. Their removal would not only leave the holding and necessary reasoning intact, but also avoid the confusion that their existence has created for those who, quite reasonably though erroneously, consider the two sentences to be authoritative declarations of black letter law.

To be fair, the sentence in question is qualified by the word “Generally.” That word does not appear in the statute. The statute does begin with the phrase “Except as provided in subsection (b),” which is a reference to the different definition of taxable income for individuals who do not itemize deductions. The word “generally” implies that there are exceptions. Was the drafter of the opinion using the word “Generally” as a substitute for the statutory exception language, or as a hedge against the use of the word “allowable” when the statute provides “allowed,” or both? However that question is answered, it does not justify the use of the word “allowable” when the statute uses the word “allowed.”

It’s no secret that tax law is not a favorite topic at the Supreme Court. See Erik M. Jensen, “Of Crud and Dogs: An Updated Collection of Quotations in Support of the Proposition That the Supreme Court Does Not Devote the Greatest Care and Attention to Our Exciting Area of the Law; or Something the Tax Notes Editors Might Use to Fill Up a Little Space in That Odd Week When Calvin Johnson Has Nothing to Print,” 58 Tax Notes 1257 (1993). Tax, of course, is not the only area of law where precision with words is critical to the analysis. For many, working closely with words is nowhere near the fun as working with theories, policies, and broad concepts. Not only do most people who are not lawyers have difficulty understanding why such a big deal is made of the difference between two very similar words, even some lawyers and law faculty struggle to find significance in the detail. Even in the tax world I discover far too many tax practitioners and tax students who conflate “distributive share” with “distribution” even though they represent two very different things.

Perhaps the answer to how this unfortunate substitution of one word for another came about can be found in one of the quotations in Erik Jensen’s article. Stuart Taylor, Jr., in “Reading the Tea Leaves of a New Term,” The New York Times, Dec. 22, 1986, at B14, quoted Blackmun as saying, “If one’s in the doghouse with the Chief [Justice Burger], he gets the crud. He gets the tax cases. . . .” I wonder if that meant that the justice’s clerk got the tax cases. I wonder if the clerk also considered tax cases to be crud. And I wonder how much focus and attention is given to crud when far more exciting issues are being discussed in the hallways and in other offices.

When Candy Isn't Candy: Life in a Sales Tax World

Earlier this year, in Meals, Candy, Taxes, HoHos, and Lent, I tried to help readers digest a case in which the Supreme Court of Vermont faced the issue of whether popcorn and nachos served by a movie theater are taxable meals. The court had to deal with a regulation, adopted in 1969, provides that "popcorn, potato chips . . . and other similar products" are "[e]xamples of items considered to be candy and confectionary not subject to the [meals-and-rooms] tax." Ultimately, the court had to ask, "What is candy?"

Four years ago, In Halloween and Tax: Scared Yet? , I reported on the decision by New Jersey to remove the sales tax from candy bars made with flour, and shared information, new to me at the time, that licorice, KitKats, and Nestle's Crunch is made with flour. The change brought New Jersey into line with what is done in other states.

Once again, the mind-boggling question of "what is candy?" has reared its syrupy head. Thanks to an alert from Paul Caron's TaxProf Blog, I've learned that Illinois has amended its sales tax law so that candy no longer is taxed at the lower rate that applies to food but at the same higher rate that applies to other taxable items generally. Thus, the question that presented itself to the Supreme Court of Vermont, "What is candy?," has presented itself in Illinois. According to the wonderfully headlined article, The Twix tax test brings twisted results, the Illinois law provides that "Items that contain flour or require refrigeration are not considered candy." Employees of the Chicago Sun Times went shopping to learn what would happen when they purchased Twix. It turns out that four stores treated Twix as candy for sales tax purposes, four treated Twix as food subject to the lower rate, and one store had not yet changed its cash register system but one of its employees was "surprised and confused" to discover Twix is not candy for sales tax purposes. Tax law does that to people. Surprised and confused is a familiar reaction among people encountering tax law.

In a blog editorial also carrying a fun headline, Sugar tax for good and IL, the writer explains that the impact in Chicago of the sales tax change for candy is an increase from 2.25 percent to 10.25 percent. Writing from the perspective of a Michigan resident, the writer expresses agreement with the concept of "tak[ing] soft drinks and candy out of the nontaxable category," noting that "[p]ediactricians have lobbied for a sugar tax." Pediatricians are not alone in their lobbying, but a sugar tax and a candy tax surely are different things, for Twix escapes the candy tax but would not escape the sugar tax. Technically, bananas, carrots, peaches, and many tomato sauces would not escape a sugar tax levied on all items that contain sugar. So as support for a sugar tax grows, expect to hear and read more about the meaning of sugar. There may be some sweet topics ahead for MauledAgain.

Another Reason Why There Are, and Need to Be, Taxes and User Fees

There are two things guaranteed in New Jersey and some other states. No, I’m not referring to death and taxes. I’m referring to the certainty that everyone complains about the condition of the roads, and to the certainty that almost everyone opposes efforts to raise taxes or user fees to fund repairs to the roads. Trying to persuade people that the bad roads will not get better, and probably will get worse, if taxes or fees to fund the required repairs aren’t generated is akin to trying to teach algebra to the squirrels in my front yard. Hello? How will the roads be repaired if there are no funds provided for doing so? The often-heard answer, “We’re already paying taxes so use that money” flies in the face of the reality that $10 in taxes will not cover a $5 road repair fee, a $7 fire department cost, a $12 police department expense, and a $30 public education outlay. In other words, the cost of what the public wants exceeds the amount the public is willing to pay. We get to do that when we’re children, demanding food, shelter, and clothing of our parents without giving back in equal consideration, even with the performance of chores and even in the absence of allowances. But at some point, we must evolve into beings who understand that we ought to pay for what we want or else learn to live without having what we want. And that is what has happened in many places, including New Jersey.

A compilation issued by Transportation for America, using Federal Highway Administration information, lists New Jersey as the state winning a competition no jurisdiction wants to win. In New Jersey, 28.2 percent of the roads are in “poor condition.” Pennsylvania fares somewhat better, with “only” 11.3 percent of its roads getting that unenviable classification. A spokesperson for the New Jersey Department of Revenue was quoted in this Philadelphia Inquirer story to the effect that there has been a 50% increase in the amount spent to repair bridges, and that more money has been spend in 2008 and 2009 on resurfacing than during the 2003 through 2007 period. Some of the money, however, comes from federal stimulus grants, the price for which ultimately will be higher taxes in the future, on someone. And once the stimulus funds are exhausted, the roads will resume falling apart faster than present funding permits repair. Part of the problem is that New Jersey has the fourth-lowest state gasoline tax in the country. Every attempt to raise gasoline and liquid fuels taxes to reflect the actual costs generated by the use of those fuels is met with organized resistance by those who think that roads will somehow pay for themselves. Toss in the idea of turning highways into toll roads and the resistance gets louder and stiffer. Next year, we are told, New Jersey’s Transportation Trust Fund is slated to use all of its receipts to pay interest on money borrowed in the past to pay for road repairs that should have been funded with fuels taxes and user fees.

A spokesperson for the American Automobile Association points out that unless the highway funding issue is resolved, the problem will get worse. It won’t be long before people will speak nostalgically about the days when “only 30 percent of the roads were in bad condition.” There’s an irony in the fact that this point is being made by the AAA. In a survey of its New Jersey members, almost two-thirds opposed increases in the gasoline tax. I suppose the notion of getting someone else to pay for what one wants is a practice that just won’t die. It’s an idea not distantly related from the attitude that caused and causes some people to think that they can get other people to do their work for them, for free.

If the anti-tax crowd and the tax-everyone-except-me prima donnas continue to be successful in marketing their foolish messages, it won’t be long before highways won’t be the only thing with a high percentage of failure or near-failure. Fire and police services in Philadelphia are on the verge of attaining that embarrassing condition, as I’ve noted in previous posts such as Tax Doomsday Looming for Philadelphia. How long until high rates of failure and near-failure afflict military defense, public education, building and aircraft safety inspections, and every other service on which citizens, including the eliminate-taxes crowd, because of insufficient funding? How long until Americans begin to figure out that if they don’t like driving on roads in bad shape they need to stop opposing the very revenues that are required to put those roads into condition acceptable to them? If it takes too long, the next doomsday won’t be limited to taxation nor to the city of Philadelphia.

Tax Consequences of Kidney Sales

According to a recent CNN report, one of the individuals who supplied a kidney to the Brooklyn resident charged with organ trafficking has come forward to explain that he was paid for one of his kidneys. The CNN investigators who are looking into the scope of the black market kidney business quote Nick Rosen as responding, “Let’s say I donated a kidney and received compensation.” Rosen admitted that he was paid $20,000, although he concealed that information from the medical personnel at the hospital where the kidney was transplanted to the recipient. Medical professionals estimate that as many as 2,000 kidney transplants each year may be black market transactions. That’s $40,000,000 in “sales,” if Rosen’s compensation is the appropriate benchmark. Reports exist that some kidney providers have been paid $25,000.

Among my first thoughts as I read the report were the tax questions. Does Rosen have gross income? Surely. So we are told not only by the Internal Revenue Code but by United States v. Garber, 607 F.2d 92 (5th Cir. 1979) and Green v. Commissioner, 754 T.C. 1229 (1980). Did Rosen report the gross income? I have no idea. The kidney was extracted in New York, so the transaction is subject to federal income tax unless there is some tax treaty provision to the contrary, which I very much doubt. Can Rosen reduce the $20,000 by his adjusted basis in the kidney? If the IRS position that the sale of blood is a sale of services, a position it takes with respect to the charitable contribution deduction, stands up and is followed by analogy, then the answer is no. And even if the transaction is treated as a sale, Rosen’s adjusted basis in the kidney is zero, a conclusion consistent with the reasoning in cases such as Garber and Green. Is the $20,000 capital gain? As explained by court that decided Green, the answer is no, because the kidney either is property held for sale or her activity is a service. Is the income subject to self-employment tax? That’s a tough one. Can the $20,000 be considered wages? Was Rosen compensated for performing services? The IRS position that giving blood is a service, precluding its qualification as property eligible for a charitable contribution deduction, suggests that the self-employment tax would apply. Is or was Rosen in the business of selling kidneys? Unlike Garber and Green, who sold regenerative blood components, Rosen only had one kidney to sell. But a person can be in a trade or business even if he or she is selling only one item. Rosen, of course, by admitting he “received compensation,” makes it easier for the IRS to argue that the $20,000 constitutes self-employment income. The court in Green noted that the taxpayer “performed no substantial service.” Yet the product analogies used by the court, “hen’s eggs, bee’s honey, cow’s milk, or sheep’s wool” and “human hair,” and the processing analogy, “sale of a tangible raw material to be processed and eventually resold by the lab,” can be distinguished because those are all regenerative items whereas the kidney is not, and those items are raw material whereas the kidney is not raw material but is delivered to the recipient intact.

Not surprisingly, there are more tax questions. Assuming Rosen was not reimbursed for his expenses, over and above the $20,000, is he permitted to deduct the amounts he paid in connection with the kidney transfer? Though we can assume that the medical expenses of the removal operation were charged to the kidney recipient or that person’s medical insurance, what about, for example, the cost of flying to New York? The reasoning in the Green case tells us that the answer is yes.

Rosen’s situation is a bit easier to analyze than those in which kidneys are swapped, which I discussed in The Taxation of Kidney Swaps. And there’s no chance that the transaction could be “marked down” to an artificial, and tax-irrelevant one-dollar fee, a suggestion I analyzed in Taxation of Kidney Swaps: Dispelling the "Ivory Tower" Myth.

Two other points need to be made. Rosen also said, “Let’s say I donated a kidney,” which might cause some to think Rosen made a gift and thus cannot be taxed. The point is that Rosen transferred a kidney. He did not make a gift because he received $20,000. Students get annoyed when I interrupt them as they begin a question in these terms, “Suppose an employer gives an employee $10,000 to work overtime.” I object to the use of “gives” as the verb in the sentence and tell the students that if they want to avoid characterizing the transaction, they need to use the neutral term “transfers” and avoid the words “gives,” “pays,” and “compensates.” Does the fact that the transaction was illegal make a difference? Not at all. Gross income from illegal transactions, and the list is very long, is gross income. That’s a long-established principle of federal income tax law.

The Fleeting Nature of Tax References in Popular Culture

The first class in this semester’s basic tax course met on Friday. On Sunday, those paying attention – and I was not one – could have, if they so chose, marked the twentieth anniversary of the conviction of Leona Helmsley for tax evasion. There are lessons to be learned from her case, but a passing reference to her in class surely would mean nothing to most, if not all, of the students enrolled therein. When Leona Helmsley was indicted, these students were toddlers, or perhaps a bit older, but not yet in kindergarten. Even if they overheard their parents talking about Helmsley, which presupposes that their parents were talking about her, it would have meant nothing.

Helmsley and her tax woes made headlines for several reasons, but the best lesson to be learned from her and her husband’s behavior isn’t the one that found itself in the brightest spotlight. The tax evasion efforts of the Helmsleys may have gone undetected were it not for the disclosures made by some contractors that the Helmsleys had tried to short-change. Despite all sorts of audits and computer evaluations of tax returns, the IRS continues to identify a significant number of tax evaders, who often are well-known and thus good material for the IRS to use as warning examples, when a displeased spouse, disgruntled employee, disaffected neighbor, or displeased business associate opens up to the IRS. In the Helmsleys’ case, they refused to pay the contractors who had remodeled one of their vacation homes. The contractors sued, and the litigation proceedings revealed that the expenses were billed not as personal items, which are nondeductible, but as business expenses, which they clearly were not. It didn’t take long for Rudy Giuliani, then U.S. Attorney, to indict the Helmsleys and some others involved in the scheme. A wrinkle to this lesson is that greed sometimes backfires.

Another lesson is the answer to the question, what do people with lots of money do with it, especially if they’re not paying taxes, whether on account of tax evasion or special low tax rates on capital gains and high incomes. In the Helmsleys’ case, it was used for things such as a $45,000 silver clock and a $210,000 mahogany card table. I suppose the argument is that by purchasing these items the Helmsleys created work for clock makers and table builders, but would not society have been better served if the money somehow increased the number of people employed as primary care physicians?

The answer, perhaps, lies in the quotation attributed to Leona Helmsley by a former housekeeper, a quotation that Helmsley denied having spoken. According to the housekeeper, when the housekeeper said to Helmsley, “You must pay a lot of taxes,” Helmsley replied, “We don’t pay taxes. Only the little people pay taxes.” Although Helmsley’s assertion is not literally true, for most, though not all, wealthy individuals pay taxes, it surely describes the goals of many people, including those who dream that someday they will join the ranks of the rich.

One last lesson was the one learned by the housekeeper, and then learned by the many Americans who followed news reports of the trial. The assumption that the wealthy pay proportionately more taxes isn’t necessarily true across the board.

Fortunately, not all wealthy people share the greed and obnoxious personality of Leona Helmsley. Her less than admirable outlook on tax policy was just a small facet of the way she mistreated employees and others with threats, tirades, unjustified dismissals, and other behavior that earned her the nickname, “Queen of Mean.”

Leona Helmsley went to jail. The prison doors closed behind her on April 15, 1990. She served 18 months, and after release, lived alone, had to give up control of her real estate holdings, became estranged from almost everyone, including family, lost several lawsuits, and then began handing out money to charities. When she died, her estate was immersed into litigation, including disputes over the $12 million she wanted to leave in trust for care of her dog, a pet aptly named Trouble.

Those who want to get into the details from a legal perspective can read United States v. Helmsley, 941 F.2d 71 (2d Cir. 1991), cert. denied, 502 U.S. 1091 (1992). There’s a nice writeup at Wikipedia.

In the meantime, if I choose to turn my students’ attention to the Helmsley saga, I’ll need to do so with something more than a passing reference. Perhaps when we get to section 162 I can ask the class whether the cost of a $210,000 mahogany card table is deductible. I think it’s safe to assume that a reference to a card table is not merely historical. Despite the proliferation of video games, card tables are still in use, though I’m going to guess that, like me, none of my students have ever seen one that cost $210,000.

Tax Doomsday Looming for Philadelphia

Like many cities and towns, Philadelphia is in dire financial condition. Even though the city has trimmed some expenditures and cut back on some programs, unless it finds a way to increase revenue, cut back spending, or both, it will run out of cash. Before that is permitted to happen, it will need to make substantial cuts in spending, cuts that mean massive layoffs of police, fire fighters, and other city workers and huge reductions in municipal services such as trash collection, road repair, and the like. The city lacks the legal authority to increase revenue without approval of the state legislature, and until and unless the legislature acts, the city’s only recourse is to curtail its spending by significant amounts. According to city officials quoted in this Philadelphia Inquirer story, the midnight hour is September 8. On my calendar, that’s 9 days away.

So why has the state legislature let the city of Philadelphia get so close to the edge of the financial implosion cliff? The answer is, “That’s politics for you.” After being passed by the state House, the bill that authorizes the city to increase its sales tax by one percentage point was amended by the state Senate but only after several controversial amendments were added. One would exclude public officials from the Deferred Retirement Option Plan. Another would require the city to freeze its pension plan and replace it with a new plan for all new city employees. However, a new plan cannot be implemented unless the unions representing the employees agree to do so, and according to this report, union officials oppose the amendments.

Because the bill was amended, it must go back to the state House. The mayor asked the legislators to act as quickly as possible. But late last week, House Democratic leaders decided to wait two weeks before scheduling a vote. Why? They have decided that the state budget is a higher priority and want to devote the next two weeks to a re-convening of the budget conference committee. That committee is comprised of Democratic and Republican lawmakers from both parties. It hasn’t met since early August. Considering the rancor surrounding those budget negotiations, there’s no assurance that anything would be worked out by September 10, the end of the two-week period. And even if the House turns its attention to the Philadelphia legislation after the planned two-week wait, there’s no guarantee that it would pass the House that day. Union officials plan to get members of the House to introduce amendments that would change what the Senate did. That process takes time, and if the House changes the legislation, it must go back to the Senate. All the while, the Philadelphia Tax Doomsday clock is ticking.

In the meantime, the mayor and his aides need to begin preparations for Tax Doomsday because they cannot wait until September 15 to start implementing budget cuts. In order for the city to make the proposed cuts, it needs to submit its revised, bare-bones budget to the Pennsylvania Intergovernmental Cooperation Authority. The city did so on Thursday, but the Authority has until September 11 to approve or disprove the plan. I’m not certain what happens if it disproves the plan. Perhaps the city will issue IOUs to its employees and vendors? If it approves the plan, cuts would begin in mid-September, and at least 3,000 employees would be laid off at the beginning of October.

As I pointed out in Some Ramifications of the Pennsylvania Budget Impasse in the context of state spending cuts, whenever a government fails to approve a budget before the beginning of its fiscal year, a lot of people suffer. For city employees who lose their jobs, for their families, for the people who don’t get the police assistance they need, for the people for whom firefighters arrive too late, for citizens throughout the city, there will be a good deal of suffering unless all sorts of things happen, and happen quickly, in Harrisburg. With Harrisburg’s track record being what it is, I take little comfort in the promises of a few legislators that everything will be fine.

There’s only one silver lining in this dark budget cloud of stormy politics. If the lessons being taught by the fiasco in California aren’t being noticed, perhaps the lessons to be learned from the experience that awaits Philadelphia will help people understand that a government with insufficient tax revenue is a helpless government. The consequences of more and more helpless governments throughout the country is not a pleasant prospect. The alarm bells ought to be ringing now, and loudly.

State Tax Consequences of Cash-for-Clunkers

Although the IRS has made it clear, following the language of the enacting statute, that the amounts paid by the government to auto dealers as part of the cash-for-clunkers program is gross income to the dealers but not the purchasers, there are some important questions to be answered with respect to the state tax consequences of the program.

Over at Right Wing News, to which Paul Caron directed my attention, we are told, in a post entitled "Tax for Clunkers":

Yep, you read that right. In many states car buyers that turned in their "clunkers" for up to $4,500 off the cost of a new car are finding out that they have to pay state sales tax on the $4,500 too. And still others just might find out next year that they'll have to pay income tax on that "free" government money.

Many South Dakotans, for instance, have been shocked to find that the wonderful gift from Obama was still added in with the cost of the automobile for the sales tax calculation, so their tax went up accordingly despite that they didn't pay the $4,500themselves.

Some states calculate sales tax by subtracting from the total cost of a new purchase the trade-in allowance of a buyer's old car. But in the case of cash for clunkers, there is no trade-in allowance and the $4,500 remains added to the car purchase.

Even worse, many states will charge income tax on the $4,500 because the sum will be determined to be the same thing as income to the car buyer.

These assertions have been picked up and repeated throughout the internet world, and soon may leak into print publications.

The point about the sales tax is correct for purchasers in South Dakota, but not necessarily for those in other states. For example, the Minnesota Department of Revenue has advised that "the CARS incentive is deducted from the selling price before Minnesota motor vehicle sales tax is applied, effectively reducing the taxes owed." The Illinois Department of Revenue has reached the same conclusion, as have the revenue departments in Mississippi, Connecticut, Iowa, and California. On the other hand, revenue officials in Rhode Island, Nebraska, and Nevada agree with their counterparts in South Dakota. In releases not on the Internet, Florida, Georgia, Indiana, Kentucky, Louisiana, Massachusetts, Michigan, Texas, and Wisconsin line up with the states not subjecting the CARS payment to the sales tax, whereas Idaho, New Jersey, New York, Ohio, and Virginia take the route taken by South Dakota. Washington does not subject the CARS payment to its transportation tax. As of this writing, other states have not published guidance. Here's a chart on the sales tax question that is worth a look, which I discovered after I looked at a bunch of state revenue department web sites.

Why the difference? It depends on the wording of the statute. For example, California and Wisconsin treat the $4,500 as a tax-exempt sale to the United States. Other states have statutes that define the taxable cost as the net amount paid by the purchaser. I wonder how many of the assorted bloggers repeating the "the CARS payment is subject to sales in many states" mantra actually searched for, read, and analyzed the statute. The count at this point has more states NOT subjecting the rebate to sales taxation than taxing it. At best, the adjective should be "some."

And when it comes to the state income tax, I'm nowhere ready to agree with the conclusion that "many states will charge income tax on the $4,500 . . . to the car buyer." Most states base their taxable income on federal taxable income, and provide for adjustments to increase or decrease that amount. Because the CARS payment is NOT included in federal taxable income, it will NOT be included in state taxable income unless the state legislature enacts a provision requiring an add-back adjustment. Thus, for example, the Arizona Department of Revenue has explained that the CARS payment is NOT subject to Arizona state income tax in the hands of the purchaser. The same conclusion applies in Nebraska. I'm unaware of any state legislature that has enacted add-backs for the CARS payment. Perhaps some state legislatures will do so, but there's a limited time in which to act, and not all state legislatures are in session or will be in session before such a statute would need to be passed.

The lesson here is that one needs to research things for one's self, and to research things before broadcasting to the world an assertion that not only is incorrect or misleading but that relates to a topic of such widespread interest that the risk of misinformation propogating throughout the world is very high. If the inaccuracies are intentional, there is another lesson, and that is the need for systems that deter people from skewing policy debates with what must be called propoganda. If the inaccuracies are the result of negligence, decency demands that corrective statements be issued, even though it is so difficult to chase down a falsity and purge it from the minds of those who have been lulled through ignorance and reluctance to think for themselves into believing an untruth. As I repeatedly tell my students, first figure out the facts. Don't be in such a rush to provide a legal conclusion on the basis of uncorroborated allegations. It's a tough message to sell in a world where "conclude first, think later (if at all)" permeates the culture.

Please, It's Not a Tax

The headline in this editorial caught my eye: "'Curb tax' is gaining in appeal, like it or not." My first thought was that some jurisdiction had imposed a tax to pay for the installation or repair of curbs. It certainly wasn't listed in that long list of taxes that circulates via email and that I shared in Deconstructing Tax Myths. A search using google for "curb tax" generated the article that caught my eye, and pages of links to sites that use the word curb as a verb, as in the phrases "curb tax evasion," "curb tax cheats," and "curb tax shelters."

To learn what a curb tax is, I had to read the editorial. According to the author, Michael Silverstein, the curb tax is "built around ticketing for parking." Silverstein discusses increased enforcement of parking regulations in Philadelphia and elsewhere, mentions a few infractions that can generate a ticket, notes that Houston permits private citizens to issue parking tickets, shares information on the amount of revenue produced by parking tickets, and criticizes the manner in which parking systems are administered. Though he never explicitly defines the term "curb tax," it is apparent from his questions designed to demonstrate that "there is no effective check on curb taxes right now" that curb taxes refer to parking fines.

Parking meter fees, parking fines, towing fees, impoundment fees, release fees, and parking fees charged by city-owned parking garages aren't taxes. Sorry, Mr. Silverstein, but don't label something as a tax that isn't a tax. I know why you've done that, but permit me to explain why it will backfire.

Silverstein makes some good points about the lack of public input when it comes to setting parking fine amounts, increases in parking meter charges, and enactment of assorted parking regulations and associated fees. He is correct that decreases in sales tax, income tax, and other tax revenue has encouraged many jurisidictions to increase parking fees. Silverstein asks good questions. He asks if it is wrong to use parking ticket fines to fund local schools. He asks if increases in parking fees hurt local merchants more than increases in the retail sales tax. But he then tries to influence the debate by slapping a "tax" label on what clearly are user fees.

Why does Silverstein use the tax label for something that is not a tax? The answer is simple. The anti-tax crowd does a knee-jerk reaction to the word, so that announcing that a "curb tax" has been increased will bring out the anti-tax zealots in far greater numbers and with far more intensity than the more mundane, but more truthful, announcement that parking meter charges and parking ticket fines have been increased. I wonder what the anti-tax crowd would do if someone started referring to the cash register total in a grocery store as a grocery tax, the invoice from People Magazine as a reader tax, and so on. Putting the label of tax on a fee or charge that one doesn't like is a very misleading way of making a point.

Parking charges, whether set by owners of private parking lots or by governments regulating public spaces, ought to reflect the market. In many places, though not all, land is so valuable that parking spaces are limited. Demand often exceeds supply, and this drives up the price in the private sector. Unfortunately, for too many years, government subsidized below-market parking on the false assumption that parking in public areas ought to be free because "everyone owns" public spaces. It makes no sense for government to charge anything less for parking than does the private sector, and if there is a concern that lower-income individuals cannot afford market prices, that problem can and should be addressed through direct subsidies, not unlike the provision of reserved parking spots for those with disabilities and the appropriate hang-tag authorizing parking in those spots.

When it comes to parking fines, the amount needs to be set sufficiently high that the fine deters the gambling that otherwise occurs. A small fine makes it easier to risk letting the meter run out, or to risk not feeding the meter at all. A large fine changes the implicit financial risk-reward probability analysis and increases compliance.

Both the parking fee revenue and the parking fines should be sufficient to cover the costs of maintaining the parking spaces, parking lots, and parking garages, paying for security, paying for attendants or automatic machines, paying for the electricity that provides lighting at night, paying for those who enforce the parking regulations, and paying for the debt payments on the loans undertaken to construct the parking facilities. If the revenue exceeds those costs, which might happen in areas with high demand for parking and low supply of parking spaces, the citizenry should have the opportunity to determine what happens to those funds. On that point, Michael Silverstein is correct.

There is no such thing as a "curb tax," other than fees charged by local governments to repair or install curbs though I don't think such fees exist. Surely parking fees and parking violation fines are not taxes, curb or otherwise. Whether Silverstein invented the term "curb tax" or borrowed it from someone else is something I don't know. What I do know is that "curb tax" is a misleading, and potentially inflammatory, term. What I do hope is that no one else starts using it in this uninformed and provocative manner, because the outcome would be more pressure from the anti-tax crowd for the repeal of parking fees. That, in turn, would create chaos in areas with public parking facilities.

Some Ramifications of the Pennsylvania Budget Impasse

In previous posts, such as A Tax-and-Spend Conundrum, I have commented on the inability of the Pennsylvania legislature to enact a budget. It's long overdue, and it arises principally because one party holds fast to the idea that taxes must not be increased no matter the circumstances, although that party argues that the impasse is caused by the other party's refusal to cut state spending.

The list of services that are or that will be no longer available to state residents continues to grow. During the past week, a variety of reports pointed out some of things that are at risk.

According to this Philadelphia Inquirer article, by the end of the fiscal year, the Philadelphia Court system will be subjected to what the mayor calls "painful, drastic, and devastating" cuts, which would cause "a virtual shutdown of the entire criminal-justice system in Philadelphia." Until the legislature in Harrisburg gets to work on fiscal legislation that permits Philadelphia to increase taxes, each day brings the city closer to a shutdown that could trigger total chaos.

In another article, the plans of state Senate Republicans to take over municipal pension plans as part of fixing the fiscal crisis are described and analyzed. Aside from the fact that wrangling over this issue would cause further delays in fixing the tax problems, state takeover of the pension plans doesn't solve the fiscal issues. Some question whether the state would generate investment returns as high as those attained by the city's plan, which in recent years has attained rates of return surpassing the national average. The Pennsylvania Municipal Retirement System, which would manage the city's pension funds, has admitted it lacks the staff and the expertise to take on the very large Philadelphia fund. Proponents of the plan claim that the city lacks the authority to make the changes that most people agree need to be made to the plan, and that only the state can handle the situation. That the advocates of seizing control of the city's pension plan are taking advantage of the fiscal crisis is apparent from the comments made by a Republican state senator from the opposite corner of the state, "Why not make Harrisburg's approval of Philadelphia's budget-relief requests contingent on real pension change?" Despite claims that the plan would give the mayor help in dealing with the issue, a spokesperson for the mayor explained that the mayor thinks the issue should be left free of state intervention and is a matter for local control. The plan advanced by these senators would require the city to pay more into the pension plan but would put the onus for coming up with the money on city officials who have no say in the state's funding requirements.

In yet another article, foster parents explain that they are struggling to find resources to care for the children put into their custody because the state budget impasse has stopped payments to them from social service agencies. These agencies, cut off from state funding, are taking out loans or relying on emergency funding from a cash-strapped city government, to make up the difference, but these alternatives aren't going to last very long. Some foster parents are contemplating the possibility of surrendering the children now in their homes.

In a report whose headline suggests the story has nothing to do with the budget and fiscal mess, we are told that Heidi Ramirez, the "most outspoken member of the Philadelphia School Reform Commission," once described by the governor as the "most qualified" member of the commission, has stepped down. Those familiar with the situation are questioning her stated reason, namely, that her perspective is "inconsistent with that of many others," especially in light of the fact she was just reappointed to a five-year term, and instead are speculating that her resignation "might be tied to a deal to settle the state budget deadlock" by making room for a Republican on a commission currently filled with Democrats. Fueling the speculation is the governor's statement that he would "support her if she chose to stay" but that "he had in mind a successor who was recommended to him by Republican Senate Majority Leader Dominic Pileggi." But Pileggi, according to this report, denies any connection between the budget and the opening of a vacancy on the school reform commission. Yet he admits that he was approached by the governor and asked to provide a suggestion for a vacancy that had not yet, at the time, arisen. The governor declined to comment.

Wow. Why did the governor approach the person who has been leading the opposition to the governor's budget proposals to seek a name for a vacancy that had not yet been announced? Did the governor seek suggestions from others? What else was discussed in the conversation? Is it simply a matter of the governor calculating that if he gives Pileggi the impression that the latter's opinion matters, the latter may be more amenable to working out the budget? Is it something more direct? Unfortunately, politicians live in a world where things get traded one for another, for no reason other than the existence of leverage and crises that demand action. Trading a political appointment for agreement to legislation is an almost everyday transaction in the world of politics. And that's one of the reasons politicians aren't getting the long-run problems solved. The idea, for example, that a seat on a school reform commission would be used as a bartering chip to resolve the state budget impasse is downright wrong. One has nothing to do with the other, aside from the mere happenstance that one can be used to hold the other hostage. Even though it is something that goes on so often that its defenders, its apologists, and even those fed up with how politics works consider it simply "part of the system" and "the way things are done," we the people ought not sit back and accept this sort of nonsense.


Legislators are elected to get things done, in timely fashion. The well-being of the Commonwealth and its citizens ought not be held hostage in order for politicians to exalt disproven theoretical principles over practical considerations, and the determination of what is best for the reform of city schools ought not be tainted by back-room deal-making with respect to the problems caused by the inability of legislators to do their jobs. It isn't difficult to imagine that some or many of the politicians in Harrisburg enjoy playing the political game more than they care about bringing the process to a satisfactory conclusion. It's a problem that afflicts both parties, from the Republicans holding fast to their no-exception oppoistiuon to tax increases to the Democrats overriding Republican attempts to carve out funding for specific social services. Using the budget as a political football is an unwise and dangerous political game inconsistent with the obligation of elected officials to meet the call to service that they sought when they tossed their hats in the ring.

Taxes as a Price Well Paid

A story earlier this week about the new South Street Bridge caused me to think not so much about the point of the story, which was the fact that a final design had been selected, but about the tax policy lessons that can be learned from the tale. Those involved in designing the new bridge faced a variety of suggestions, demands, and concerns. Public officials and citizens wanted a bridge that would not provide opportunities for graffiti artists. Law enforcement and public safety advocates objected to anything that gave muggers and other criminals hiding places or better chances at plying their trade. Others were concerned that the homeless might find accommodations on or under the bridge. Social workers did not want the bridge to attract would-be jumpers. Taxpayer representatives and politicians wanted the bridge to be built as inexpensively as possible, and the highway and street workers wanted a bridge requiring little or no maintenance.

These are all laudable goals, but they are inconsistent with each other. To build a bridge with the features sought by those desiring a pristine and safe low-maintenance structure requires more money than building a plain old bridge that is more likely to fall victim to graffiti artists, harbor criminals, attract the homeless, and require the attention of repair crews. It’s so symbolic of the present-day American affliction: we want it all but we want it for free. Whether it’s a demand for universal top-quality health care unfettered by tax increases or user fees, or for energy-efficient, environmentally-responsible vehicles that come with price tags under $5,000, there is an unending conflict between what the consumer wants and what the consumer thinks should be the price. A bridge that resists or discourages graffiti and crime while remaining almost maintenance-free isn’t priced at discount rates.

When I challenge advocates of tax cuts and tax elimination to propose candidates for removal from the spending lists, the answer almost always is that there is plenty of waste and inefficiency that can make up the difference. Occasionally a specific program is nominated for removal, but most government spending is directed toward people surely would hurt if the program were curtailed or toward projects the elimination of which would bring howls of protest.

It might be that the advocates of a low-cost South Street bridge don’t care about crime, graffiti, and maintenance expenses, but from a financial perspective, it doesn’t make sense to skimp on the dollars invested in the bridge if the present value of the increased costs of fighting crime, removing graffiti, and repairing the structure exceeds the initial cost reduction. Far too many people do not appreciate the difference between long-term and short-term investments and costs, and these include most politicians. In this instance, though, according to the story, a decade of debate has ended with a design that is workable, not only in terms of function but in terms of architectural common sense, as it is “light, inexpensive, and nearly indestructible.” The debate involved city officials, the private architectural firm retained to turn the bridge into a landmark befitting its role as the southern approach gateway, the streets department, residents of the neighborhood, pedestrians, bikers, and community leaders. What isn’t known is how many tax dollars were invested in the debate, but ultimately that sort of expenditure is literally a price that is paid for expenditure. It is a price worth paying.

Tax Talk at the Gym

On Monday, one of the retired guys at the gym asked me how my latest tax book project was going and if I was going to have it finished before classes resumed. I told him it was just about done and would be on its way before the semester begins. He asked how many books I had written, including revisions. One might think I would know, but I didn't. My rough guess was about 40. But, I hastened to point out, that's over a 26-year-period.

When he asked me what the latest book covered, I explained that it dealt with tax incentives for hiring and retaining employees. To his inquiry, "like what?" I rattled off the work opportunity credit, the Indian employment credit, the various disaster employee retention credits. He asked about the previous books. Those, I explained, dealt with tax incentives for energy production and conservation and with family and household transactions. Again, I listed some of the provisions, and he stopped me and asked why the tax law was filled with so many provisions that weren't a matter of revenue collection but expenditures. The answer is an easy one, because it's asked every semester by students in the basic tax course. Why not have the Department of Energy write checks to companies and individuals who are doing things to develop or conserve energy instead of administering the grants through tax refunds? Why not have the Department of Labor reimburse employers who hire members of targeted groups? The answer rests in the Congress' confidence with those other agencies and with the supposed speed with which tax refunds can put money in the taxpayers' hands in contrast to check-writing programs.

During this conversation, I noted to this fellow that it was surprising that the Cash for Clunkers program didn't involve the IRS. Does the Congress have a higher level of confidence in the NHTSA than in other agencies? Considering the reports of long delays faced by car dealers waiting for reimbursement checks under the program, I would not be surprised to see Congress return to administration of these sorts of programs through the IRS. I would prefer the Congress investigate why there is such sluggishness in the NHTSA processing the reimbursement claims.

The guy at the gym then said to me, "The more I listen to you talk about tax, the more I find myself supporting a flat tax." So I explained that a flat tax, in the sense of a flat rate, would change nothing, and that the computation of tax liability once taxable income is determined does not pose any particular problem nor is it complicated. The complexity arises from the parade of exclusions, deductions, and credits in the tax law. I pointed out that in some versions of the flat tax, simplicity is attained by limiting gross income to wages and taxing it at a flat rate in the 20 to 30 percent range while leaving all other sorts of income untaxed. Reducing complexity requires cutting out most of the non-tax programs that have been inserted into the tax law. I doubt that would happen, because these provisions are vote-generators for members of Congress. Ironically, the same people who complain about tax law complexity then turn around and vote for the re-election of the people who make the tax law complicated.

Finally, this fellow said to me, "The more I listen to you explain taxes, the more depressed I get." I laughed and said, "Just like my students, except that you won't be getting a grade." He laughed and I continued, "Unless you'd like to try the exam in December." He walked away, laughing, and saying, "No thank you."

One of the things I enjoy about going to the gym, aside from the benefits of physical exercise, is the opportunity to talk with people who are in or have been in all sorts of professions and occupations. Lawyers are a minority there. So are teachers. I get the perspective of people who are selling products, writing software, providing financial services, wiring commercial buildings, fixing air conditioners, and so on. I see the impact that mainstream media and the vast array of blogs and websites have on people's perception of the tax law, government, politics, and the economy. I am reminded that even for people whose primary focus is not the tax law, the tax law permeates their lives. My experience while engaging in tax talk at the gym is something that cannot be learned in a classroom or from a book. It's a great fringe benefit from the gym membership. But it's not taxable.

How and Why I Became a Law School Professor

Some weeks ago someone asked me why and how I ended up teaching law school. After I answered the question, this person suggested that I should share what I said by blogging the topic. Considering that on Friday I put all of the finishing touches on my fall courses that can be accomplished before final rosters are established, it seems that today is an appropriate day to amuse, bore, frighten, or surprise MauledAgain readers with the story.

Perhaps the best way to begin is to explain that I was born to be a teacher. How do I know that? I’ve been teaching since shortly after I learned to talk, though I know it started that early in my life only because my parents remembered to tell me what I was like before my memory processes fully developed. As I grew older, I took delight in explaining things, not simply to demonstrate that I knew something, though many took it that way, but because I had fun watching people go through the “ah ha” moments that often occurred as a result.

My first foray into classroom teaching happened in fourth grade. The nuns who taught me couldn’t quite figure out what to do with me. I was, as my mother sometimes has noted, a “challenging child.” So the fourth-grade teacher sent me to one of the eighth-grade classrooms to explain something or other about geography. It was only years later that I began to suspect that the nuns had pre-arranged this task. The eighth-grade classroom to which I was sent happened to be the one in which my older brother was enrolled. So during my “presentation,” some of his friends decided to grill me, hoping, I suppose, to trip me up, and so back and forth we went. I learned that I was comfortable in front of a classroom no matter the age or grade level of the class, that so long as I was prepared I had a good chance of getting it right, and that teaching was fun. Every now and then during the next four years I was given the chance to go teach something to some other class, as the person teaching my class would find some reason to get me out of the room.

During my freshman year in high school, I returned to my elementary school to teach Latin to eighth-graders who signed up for an after-school class designed to give them a head start for the mandatory freshman-year Latin class. I think there were about a dozen or a dozen and a half students in the class. It was a much more formal arrangement than the ad hoc teaching episodes during my elementary school days. There were tests and grades, and I had to file lesson plans with the parish pastor and the school principal. Again, the experience was fun and my positive perspective on teaching was reinforced. Was I qualified to teach this class? The school and the teachers thought so. By that point I had already been through the equivalent of three years of Latin classes.

The last three years of high school also brought the opportunity to tutor other students. This was a different experience for two reasons. It was a one-on-one experience, and in some ways that is a very different teaching process. Attention can be focused on the specific academic needs of the student, and thus some degree of control over content and pacing shifts to the person who is being taught. The other difference was of a totally different nature. I was paid.

But I had not made a decision to obtain a degree in education. By then, I was hearing too many stories from teachers in the family or who were friends or friends of friends that suggested that the environment in K-12 schools was changing in ways that made teaching less fun and even frustrating. This was at a time when the number of teachers resigning before reaching retirement was increasing at an alarming rate. There were so many other directions in which to go. Science had beckoned, then business, and then business law, accounting, economics, and finance.

Though I did some tutoring while I was in college, other activities, ranging from jobs to working at Penn’s student radio station WXPN, took much of my time. It was when I arrived in law school that I found not only new opportunities to teach but time to do so. This is when the idea of teaching law school took hold. I figured that because law students were grown adults, many of the difficulties that were afflicting K-12 teachers would be avoided. Little did I know, but that’s another story! Five things affecting my teaching future happened in law school. First, I tutored classmates, both singly and in groups. Most of this took place in the context of study groups which sooner or later evolved into tutoring sessions. Second, in one of my classes, the professor was willing to let me teach a good bit of the course, through the pretext of calling on me to explain something. Third, I discovered that I liked doing this, that I was capable of doing this, and, in a fit of egomania, that I could do it well enough so that I could improve law school teaching in ways that would dispel the agonies and inefficiencies that hampered most of my classmates. Fourth, a group of my professors, taking notice of what was going on, took me under their wing to groom me as a law school professor. They talked with me about the aspects of teaching that either were not observable by law students or were not readily observable. In other words, they shared some, perhaps many, of the secrets of law teaching, or at least what they perceived as the secrets of law teaching. I suspect that they also were trying to figure out if I had a genuine interest in teaching and were determined to tone down my idealistic enthusiasm with a heavy dose of reality. It was at that point in my life, for example, that I was told I would find law school faculty meetings to be almost painful. One of my law professors invited me to sit in his first-year Contracts course, to experience the class as an observer rather than as a participant. This permitted me to ask questions, after class, concerning how he had dealt with specific dialogue between him and students or among students. It was an eye-opener. Fifth, another of my professors asked, and encouraged, me to take on a special tutoring task, and for most of my third year I worked with two first-year students, one of whom was on the brink of failing out and the other of whom was his friend who wanted to go along for the ride, so to speak. When I learned after graduation that the friend, who had been performing adequately, had excelled, and that the student at risk had done fairly well, the deal was sealed. I was going to teach law school if some law school faculty would have me.

I could say that the rest was history, but it wasn’t and I won’t. There was the job search, roughly four years after graduation, following the advice to go out and experience the practice world. There was the difficult decision of choosing from among the schools that indeed wanted me to join their faculties, soothing the ego-dampening awareness that what today are considered the top 30 wanted no parts of me. There were those initial days in the classroom that seemed to go well, though students later told me that for the first few classes I gripped the podium tightly. I don’t remember that, but I believed them then and I believe them now. There was the not-so-surprising phone call from Villanova two years later, telling me that the long-planned Graduate Tax Program was finally up and running and it was time to expand the faculty to include another tax professor. There was the challenge of adapting teaching methods that worked in J.D. programs to a graduate law program enrolling both lawyers and accountants, at the time many of them with more than a few years of seniority on me in life and tax practice.

Indeed, what comes around goes around. A few years after I returned to Villanova, I ended up with a student in my courses who not only was a high achiever but also had an interest in teaching. The following year, there also happened to be a student in the basic tax course who was at risk of earning the most undesired grade and who came to me for help. After some discussion, I put the two students in touch with each other, and the one doing the tutoring ended up sitting through the basic tax course a second time, for the law had changed significantly and because that person had heard my de facto third-year law student as teaching intern story. It was more than just tax, or teaching, that I had learned from my mentors. Eventually, that person and more than a few others of my students have ended up teaching, some as full-time law faculty, some as adjuncts, including some in our Graduate Tax Program, and one or two in business and other graduate schools that offer law courses.

In some core part of my personality, I want people not only to know but to understand what they need to know and understand. Ignorance frustrates me and the consequences of ignorance sometimes frighten me. Helping a person get their head wrapped around a concept or problem so that they can minimize adversity and maximize potential, for themselves or others, is wired into my psyche. There appears to be a genetic connection with the need to teach, whether in an academic setting, in a pulpit, through a book, or in some other expressive way, but figuring that out is an incomplete project and a story I’ll tell some other time.

If you made it this far, you’ve made it to the end. Thanks for letting me share.

Another Tax Break for Big Business?

According to several reports, including ones from the Central Penn Business Journal, the Philadelphia Inquirer, and the Pennsylvania Budget and Policy Center, Republicans in the Pennsylvania legislature are trying to extract a tax cut that favors big business as a price for the governor’s attempt to delay the phase-out of the state’s antiquated capital stock and franchise tax. This attempt at a trade-off is part of the ongoing attempt to break the budget impasse, which has arisen because Democrats are willing to increase taxes to preserve state services whereas Republicans are willing to pay any price to prevent any tax increase of any sort. The stalemate, which I described more than two months ago in A Tax-and-Spend Conundrum, continues.

This particular proposal originates with the planned phase-out of the capital stock and franchise tax. There is no way to describe that tax in a one sentence other than to note that it makes the federal income tax system appear to be a work of art. The computations are complex, the tax is subject to a variety of exceptions, and the effective rates are high. A few years ago, the legislature agreed that it was time to eliminate the tax, and chose to do so by phasing it out by the end of 2010. Because the state is in a cash crunch, the governor is suggesting that the phase-out be suspended for a year, though one wonders if the suspension would continue so long as fiscal problems plague the state. Republicans in the legislature consider the phase-out suspension to be a tax increase, and thus argue that there needs to be an offsetting tax decrease. This logic is amazingly flawed. If the lack of a tax cut is a tax increase, then this philosophy demands that taxes be decreased in order to avoid an increase. The ultimate goal of eliminating taxation, and thus government, is exposed. Of course, most people who buy into this philosophy buy into the sound bites without realizing the underlying policies that spawn this logic nonsense. Worse, if the point of suspending the phase-out of a tax is to prevent additional decreases in state revenues, what’s the point of offsetting it with a tax cut that would decrease state revenues? How does that get the state any closer to the balanced budget it is required to produce?

To understand the tax cut that is being proposed at a time when the state’s budget problems arise from declining revenues, one must understand how Pennsylvania taxes corporate income. Pennsylvania is prohibited by the federal Constitution from taxing out-of-state corporations on out-of-state income. That is why a corporation organized in Indiana and that conducts all of its business in Indiana is not required, and cannot be required, to file Pennsylvania income tax returns or to pay Pennsylvania income tax. But what happens if that corporation begins to do business in Pennsylvania? How does one compute the portion of its income that is attributable to Pennsylvania? Should it be based on the percentage of its sales in Pennsylvania? The percentage of its payroll expended for services rendered to it in Pennsylvania? The percentage of its property located in Pennsylvania? Under current law, it is based on all three, with the ratio reflecting 70 percent of the sales factor, 15 percent of the payroll factor, and 15 percent of the property factor.

Republicans are proposing to ditch that formula in favor of one that relies solely on the sales percentage. It’s called the single sales factor. What happens is that large companies located in Pennsylvania but whose sales are mostly out-of-state would find less of their incomes deemed attributable to Pennsylvania. The property and payroll factors, which weigh heavily in favor of attributing income to Pennsylvania, would be knocked out of the computation. On the other hand, for small companies whose sales are entirely or almost entirely within Pennsylvania but that have payroll or property outside the state, would incur an increase in income tax liability, though not on a scale sufficient to offset the revenue decline from the tax cut for the large companies. According to this report, the Pennsylvania Manufacturers’ Association and the Pennsylvania Chamber of Business and Industry support the proposal. What a surprise.

A former Secretary of Revenue in Pennsylvania, who is now active in the state’s business community, sent a letter to the governor and legislators explaining why the proposal to shift to a single sales factor is a bad idea. He notes that five years ago the Pennsylvania Business Tax Reform Commission developed a plan to fix the problems in the state revenue system, but that special interest tax breaks continue to impede progress towards efficient, broad-based business taxes. The writer of this editorial notes that the tax cut proposal would benefit companies such as PPG Industries, U.S. Steel, and Hershey Foods. In its policy brief on the issue, the Pennsylvania Budget and Policy Center explains that the change would increase taxes for roughly 10,500 companies, cut taxes for 4,380 corporations, and cost the state $100 million in annual revenues. It also examined what happened in the eight states using the single sales factor approach, and discovered that manufacturing jobs declined in those states during the past 7 years, whereas the four states with increases in manufacturing jobs do not use the single sales factor. The Center concluded that the arguments by those in favor of the tax cut that it will create more manufacturing jobs are unsupported by the evidence. According to the former Revenue Secretary, half of the $100 million tax cut would benefit roughly 15 corporations.

My concern isn’t simply the notion that at a time when Pennsylvania is facing a fiscal crisis, a small group of well-represented corporations is trying to reduce their tax liabilities. My concern also reaches to the worsening problem of uninformed citizens being unaware of what actually is happening in their state capital. How many Pennsylvanians understand these tax issues? How many understand the impact of what is being proposed? What resources are available for those who care enough to try to learn what is transpiring during these budget talks? If people comprehended the impact of the single sales factor proposal, they would be making their opinions heard in Harrisburg. What should matter is that every dollar doled out in tax cuts to these large corporations will cause either a dollar increase in a state tax paid by individuals or a dollar decrease in vital state services. That’s what happens when the state constitution requires a balanced budget.

More of Those Possibly Looming Tax Law Changes

On Monday, in Federal Tax Law Changes Looming?, I reviewed, albeit briefly, some of the ideas set forth in a Congressional Budget Office report with respect to ways that the federal revenues can be increased or decreased. At least some of those that I omitted do deserve attention.

The report notes that revenues could be increased if the exclusion for income earned abroad were repealed. The principal argument in support of the exclusion is that Americans living abroad do not receive as many benefits from the federal government as those living in the United States. Assuming that this proposition is true, how can it justify excluding the first $91,400 of earned income? Would it not justify, instead, an exclusion of a percentage of income, or, perhaps ideally, a credit equal to a percentage of tax liability subject to a fixed dollar limitation?

The report's focus on taxing carried interests as ordinary income is not new. It is an idea whose time is long overdue. The fact that the tax law can be adapted to convert income received in exchange for services into capital gains taxed at special low rates is an indictment not only of the complexity of the tax law but also of the dangers of carving out certain types of income for special rate treatment. The thicker the tax maze, the easier it is for a taxpayer to hide in it. Thin out the tax weeds, and there will be far fewer opportunities for people to take advantage of unintended consequences.

Another idea is to consolidate the American Opportunity Tax Credit, the Lifetime Learning Credit, and the student loan interest deduction into one credit. Those are but three of a variety of tax law provisions designed to encourage education. The advantage of the consolidation is that it would simplify the tax law. The number of taxpayers not taking advantage of existing provisions because they are unaware that they exist or do not understand how they apply would be reduced. I wonder, though, if the tax law is the appropriate vehicle for encouraging education. Surely there are non-monetary incentives that a civilized society can use to encourage people to attend school. And to the extent that monetary constraints hamper people who want to continue learning in a formal setting, thus making financial assistance a necessity, what does it say of the Department of Education that the Congress chooses to have the IRS administer multiple programs to funnel money to taxpayers who qualify for help? Consolidation of these three provisions is not a bad idea per se, consolidation of more of the provisions makes better sense, but reforming the entire governmental perspective on education is a better, and absolutely necessary, goal.

The suggestion that the child tax credit be eliminated or modified also gets attention in the report. The tax law is riddled with provisions that are intended to provide financial benefits to persons raising children. Aside from the child tax credit, there is the dependency exemption deduction, the adoption credit, the adoption assistance exclusion, increases in the earned income tax credit on account of children, the credit for dependent care, and others. These provisions account for disproportionately high levels of taxpayer noncompliances, often to the disadvantage of taxpayers. Some also are of little use to taxpayers; for example, the child tax credit does little or nothing for low-income taxpayers. Why not one credit that accounts for the cost of raising a child? Why not a consolidation similar to that floated with respect to education incentives? A consolidated credit, incidentally, ought not be an incentive to have children, but simply part of the "ability to pay" principle underlying the federal income tax.

In the area of corporate taxation, the report floats two contradictory ideas. One is to lower corporate tax rates by five percentage points. The other is to set the corporate rate for all corporations at a flat 35 percent. Both of these proposals in turn contradict the idea of integrating the corporate and individual income taxes, which the report also discusses, as mentioned on Monday in Federal Tax Law Changes Looming?. Absent integration, of which I am a fan, I struggle with the question of whether the corporate rates should be progressive, flat, or, as under current law, phased-out progressive. I struggle because S corporation income, with a few technical exceptions, is not subject to double or even the triple taxation that C corporations encounter. What is it about C corporations that justifies separate taxation, and does the answer carry with it the possibility of some other form of taxation or user fee to be imposed on corporations? The principal justification for taxing corporate income, namely, that it would not otherwise be taxed, is best solved with integration of the two taxes.

The report considers the elimination of deductions for exploration and development costs incurred by taxpayers engaged in extractive industries. In other industries, the costs of exploring or setting up facilities must be capitalized, and if deducted, generate deductions over a period of time. Extractive industries get special treatment simply because they've had efficient lobbyists for the past 70 or 80 years. I still remember my reaction when I learned that the costs of a drilling platform qualified as intangible drilling costs. Intangible? That's a sign of how warped these provisions had become. Reform is long overdue.

Would it make sense to repeal the low-income housing credit? The report asks that question, and I respond in the affirmative. If Congress wants to direct resources into housing for individuals with low income, it ought to do so directly rather than through the convoluted, complex, and inefficient tax credit approach that has been in use for many years. The report describles the flaws of the credit, pointing out how it helps lower middle-income persons far more than low-income individuals, and explaining how direct grants are economically more efficient. The latter conclusion arises in part from changes to the tax law that permits states to shift into direct subsidies some of the amounts allocable to the credit. To these reasons I add the assertion that the IRS ought not be in the business of administering and auditing programs to develop low-income, or any other sort of, housing. There are other Departments in the federal government responsible for housing and related matters and it is with those agencies that responsibility should be placed.

The report notes the idea of extending the recovery period for depreciation of certain assets. During the past twenty years, more and more specifically identified types of property have been singled out for extremely generous, and economically unrealistic, recovery periods. Not only does it make sense to derail this particular gravy train, it also would make sense, as I have advocated in the past, to eliminate depreciation on real property.

Another idea that has been floating around since the deduction for domestic production activities was enacted is to repeal it. It was a bad idea from the outset, it has been roundly criticized, it has created a variety of issues in the international taxation context, it is complicated, it encourages game-playing by taxpayers, and it has burdened the IRS. The report elaborates on these concerns, and also notes the few arguments in favor of retaining the deduction.
Revenue projections would decrease if the research and experimentation credit were permanently extended, but the report considers this idea because otherwise the credit loses much of its punch. Of course, I question whether the credit should exist, for again, direct subsidies to research and experimentation activities that are in the national interest makes more sense. But if there is to be a credit, it doesn't accomplish its goals if taxpayers do not know if the credit will exist the following year. The Congressional game of waiting until the last moment, or even after a credit expires, to extend its application by another year or two is counterproductive, in the case of most credits, but particularly in the case of this credit which involves commitment to expenditures over periods of time extending beyond whatever happens to be the current termination date of the credit. When politics trumps efficient tax administration, the nation pays the cost. Politics isn't worth that price.

A huge amount of revenue would be raised if the maximum limitation on taxable wages for social security purposes were repealed or increased. Should that happen? The report analyzes the possibilities. If social security benefits are limited, why should the tax base be unlimited? On the other hand, if social security is insurance (The I in FICA is for insurance), premiums aren't directly related to the specific recoveries received by specific covered individuals. On a more practical level, when the maximum limitation was enacted, it caused 92 percent of earnings to be subject to social security tax on the employee. Over time, that percentage fell as real wages increased, and Congress amended the law and provided for cost-of-living increases to the specified maximum dollar amount. Yet, presently only 80 percent of wages are subject to social security taxation on the employee. Would it make sense to raise the limit so that 92 percent of wages are covered? There's much logic in that proposal.

Moving away from income and social security taxes, the report makes a place for the continuing proposal to increase the excise tax on motor fuels. Readers of MauledAgain know that I'm all for this idea and that, at best, the debate should be about the extent of the increase and not whether one is required, justified, sensible, or economically efficient. That's because increasing this tax indeed is necessary, justifiable, sensible, and economically efficient. Until motor fuel taxes reflect the true cost of those fuels, motorists will continue to make decisions thinking that fuel is cheaper than it actually is.

The report examines several proposals to impose excise tax on the emission of specified noxious pollutants, namely, sulfur dioxide, nitrogen oxides, and greenhouse gases. This is a good example of what ought to be called a user fee, or a pollution charge, rather than a tax. The reason for an excise tax is not simply that there is a revenue stream that can be tapped, but that the nature of what is being emitted is harmful to civilization. When a tax distinguishes between that which is good and that which is not good, it's really not a tax, but a fee or charge for the harm done by that which is not good. Is it a good idea to impose a fee, charge, tax, or whatever one wants to call it? The answer rests in the decades-long argument between those who look to the future and at the true cost of emitting these substances and those who look to the present and near-term and see these sorts of taxes as constraints on the development of business, the generation of profits, and the production of near-term consumption.

The report also looks at a parade of user fees for services provided by the federal government, from the Inland Waterway to food and drug reviews and bank examinations. Perhaps it makes sense to charge those whose activities need to be examined and reviewed for the cost of doing so. The alternative is to impose those costs on society through general taxation. Though society benefits from government oversight of activities such as food processing and drug manufacture, if those industries operated ideally no such government regulation would be necessary. The cost of these reviews and examinations are better placed on these industries because they are the ones who cannot manage to reach the ideal. Yes, these costs probably would be passed on to consumers, but they would be attached to the products in question and not to other industries.

Even after briefly reviewing this second list of options in the CBO report, I've not touched on all of them. Some I have ignored because they are very technical. Others I have skipped because they are very narrow. One I omitted because it's simply a focus on the wide-open question of what to do with the estate and gift tax, a discussion to which I have nothing to add at the moment that I haven't already said at some point in the past. For those who are interested in what sorts of ideas are floating around Capitol Hill but that are not getting attention in the mainstream media or even in some tax-focused outlets, the report is worth a visit.

Federal Tax Law Changes Looming?

Everyone, or perhaps almost everyone, has ideas about how the tax law should be changed. Some want this or that new credit. Others want a deduction for some specific purpose. Still others suggest raising rates, while their ideological counterparts advocate more tax cuts. Yet others want to eliminate many or most deductions, credits, and exclusions. Another group wants to shift to, or add, a value added tax or a consumption tax.

There always are ideas floating around to “improve” the tax code. There also are ideas that aren’t tagged as improvements but that are suggested because their proponents think that the proposal is necessary. When the Congressional Budget Office jumps in with a list of possible changes, it’s time to pay attention, for many tax law changes in past years have CBO attention in their histories.

In a report dated “August 2009” and titled “Budget Options, Volume 2,” the CBO finishes its analysis of federal expenditures and turns to possible increases and decreases in federal revenue, particularly through tax law changes. There are 66 separate items analyzed by the CBO. No one blog post can do justice to all of them, so a select few will be examined.

The first item in the CBO report, not surprisingly, is a cluster of variations on the theme of raising tax rates. One possibility is to increase the percentage for each regular tax bracket by one point. Another is to do this, plus increase the AMT rate by one point. A third is to take the second option, and add to it a one-point increase in the rate applicable to capital gains and dividends. Another group of proposals is the increase of the rate for only the top bracket, or for the top two brackets, or for the top three brackets, etc. Still another idea is to add a new bracket for incomes over $1,000,000 ($500,000 for taxpayers not filing joint returns). Has someone at the CBO been reading MauledAgain? If so, they don’t cite it.

The report then follows up that proposal with its opposite. It explores the consequences of extending the tax cuts that are scheduled to expire at the end of 2010. Under current law, if Congress does not act otherwise, tax rates – and a good number of other provisions – will revert to where they were in 2000. The cost of extending the 2001 tax cuts is enormous, on the order of two and a half trillion dollars over the next decade. As the report implies, Congress will need to pick and choose among the various provisions expiring in 2010, because each has its own separate advantages and disadvantages, and it would be unwise to deal with them as one package.

The third item is to extend permanently the zero and 15 percent rates for dividends and capital gains. Readers of MauledAgain know my response to this idea. These special low tax rates should be repealed, sooner rather than later. Their promise of invigorating the economy remains unfulfilled, and a decade is long enough to experiment with the financial well-being of America for the benefit of a select few who haven’t come through. This idea is followed with a suggestion that special low rates be replaced by a deduction equal to 45% of net gains. Something like this was in the tax law a long time ago. Its chief flaw, other than favoring investors over wage earners, is that those in higher brackets benefit more from a deduction than those in lower brackets. Though it presents the advantage of ditching the complex special capital gains rates computations, put simply, it’s a bad idea.

Another item involves the AMT. There are several ideas. One is outright repeal. Another is to make permanent the annual “fixes” that have been enacted for the past decade. Still another is to expand the deductions allowed under the AMT. One thing is certain. The AMT needs to be fixed, or, ideally, repealed. Its repeal would be possible if the flaws in the regular tax that create the need for an AMT are removed. That would simplify the tax law while improving its equity.

The mortgage interest deduction is the subject of two ideas. One is to convert it into a credit. Another is to reduce the $1,000,000 and $100,000 limitations to a combined $500,000 limitation. I wonder where is the idea of repealing it outright. And what about limiting it to the principal residence? Following this item is one suggesting repeal or curtailment of the deduction for state and local taxes. This, particularly the proposed cap equal to 2% of AGI, will pit legislators from, and lobbyists for, high-tax states against those from low-tax states.

The CBO is recycling some old ideas. The report explores the possibility of limiting the benefit of itemized deductions to 15% of taxable income. This is a classic theoretically justifiable idea that would trigger complexity at the practical level. There’s a better approach. Turn the deductions into credits, and limit credits to a percentage of income. That’s a much easier idea to implement, and it’s theoretically not that far from the one highlighted by the CBO.

Another set of old ideas resurfaces in he CBO report. These include imposing a 2% AGI floor on charitable contribution deductions, creating a preferred deduction for charitable contributions, and limiting the deduction with respect to appreciated property to the taxpayer’s adjusted basis in the property. The last idea makes sense and is long overdue. Allowing a deduction for gain that is never recognized by the taxpayer is inconsistent with general tax accounting principles. On the other hand, the tax law doesn’t need more floors. And it surely doesn’t need a reprise of the failed above-the-line charitable contribution deduction. Been there, did that, abandoned it, for good reason. Would it not make more sense to turn the deduction into a credit, and more easily and simply accomplish the same goal?

The report considers the repeal of the additional standard deduction for the elderly and blind. This is a good idea, another than I have suggested from time to time during the past several decades. The presumption that the elderly need an additional standard deduction judges people’s economic status by age rather than by income or wealth. It’s a bad way to proceed. And as many students have asked me, why a preference for the blind but not the deaf, mute, or paralyzed? Good question, fun to bat around in class, but in the tax practice world, it lacks justification.

When I read the proposal concerning the taxation of social security and railroad retirement benefits, I became convinced someone at CBO was reading MauledAgain, or something written by a reader. I like the idea. What is it? It suggests taxing benefits received that exceed the amounts paid in by the employees. This is how pensions are taxed. It makes sense. It not only is theoretically sound, it is much simpler than the current maze in section 86 that defies rationality. And anything that makes the basic income tax course easier to teach and easier to sit through certainly should get careful scrutiny and the benefit of the doubt.

Here’s a very old idea. The report mentions the notion of replacing the exclusion of state and local bond interest with a credit. This was the topic of the paper I wrote in Fred Rothman’s Tax Policy class during my third year as a law student at Villanova. I literally wrote the paper, because there was no personal computer and the typewriter broke. I think I still have a copy of the paper somewhere in my files, along with Fred’s copious notes in red ink. Moving beyond the limited question of deduction versus credit, I wonder why there should be any tax break, especially as it benefits higher income taxpayers much more than it does the rest of the citizenry.

Speaking of old ideas, integration of the corporate and individual income taxes once again finds attention. This idea has been around since before I was born. Oh, yes, I wrote about it 30 years ago. Though by that time it had been the subject of more than a few articles, no one had paid much attention to the impact of the idea on state and local taxes. So I chose that topic for my LL.M. thesis, persuaded the administration at George Washington University National Law Center to let an adjunct be my advisor, and eventually published the thesis in both full and abridged form. To this day I remain indebted to Tom Field, the Tax Notes guru and publisher, who shared his extensive tax knowledge and experience, especially in the area of state and local taxation, in reviewing what I had written.

There are many more items in the report. Some involve technical issues, some deal with international and compensation issues, some deal with environmental and energy issues, some deal with various credits. Though most involve the income tax, some focus on the estate and gift tax, payroll taxes, excise taxes, and user fees. There’s more to be said and written, so don’t be surprised if I return to more of these items in the near future. In the meantime, it will be interesting to see how far each of the ideas in the CBO report goes before it falls by the wayside.