Thursday, September 15, 2005

An Even Scarier, and Insensitive, "Solution" 

When I wrote my essay in yesterday's post, "What's Scarier? The Problem, or the Proposed Solutions, I did not realize that there were worse proposals than the ones I had criticized. It's bad enough that people are demanding a decrease in the price of a less available product, or that politicians are taking up the cause for unwise reductions in gasoline taxes. The things that ought to get done are getting little, if any, attention, though I did give kudos where kudos were due, much to my surprise, to the angry Philadelphia mayor who did something constructive.

In today's Philadelphia Inquirer, a letter to the editor from Morris W. Feldstein of Philadelphia proposes a solution that startled me. He begins with a call for "some sacrifice for the common good." He then proposes that "the governors of various states call for four no-driving days on one Sunday during each season. (They could be called "family days.") They might result in very little driving except for emergencies and law-and-order situations." He adds that "I have no idea how many gallons of gasoline we would save, but it might at least create some discipline about our individual driving."

Did Mr. Feldstein think for a minute about his proposal? He is, in effect, proposing that on four Sundays of the year, every citizen who attends a religious service on Sundays and who must drive to their church would be prohibited from doing so. Did Mr. Feldstein think about this and dismiss it as unimportant? Did he fail to think of it, period? Is the First Amendment wandering around here, somewhere?

Did Mr. Feldstein think about the impact on a local economy of an empty stadium on a summer Sunday when the baseball team is in town, on the autumn Sunday when the football team is playing, or the spring Sunday when the hockey team is scheduled? Are these "emergencies?" Perhaps Mr. Feldstein sits at home on Sundays and figures everyone else ought to be doing the same.

Mr. Feldstein's approach is seemingly simple, but it's simplistic. If we are going to find ways to cut back driving, let's eliminate driving that can be eliminated without impinging on people's right to worship or on jobs in the local economy. Although I think I see some of this beginning to happen, it doesn't hurt to get widespread adoption of sensible approaches to saving gasoline. First, rearrange school bus schedules so that high school students do not need to drive to school. During the past two weeks, I have seen more students on the school bus, and fewer busses carrying only 25 or 30 percent of capacity. Second, carpool, not just to work but to other events. On Tuesday, I noticed that most of the vehicles arriving at the Phillies game (including the one I was in) held three, four, or more people. Excellent. Third, fix the timing and control of traffic lights so that people aren't wasting gasoline while the light remains green for a road on which there is no traffic. I have a list of these intersections, but if my attempt to undo a gasoline-wasting change in line painting on Lancaster Avenue is any indication of success, I hold out little hope for the upgrading of traffic flow control. Fourth, as I've mentioned in previous posts, let the price of gasoline reflect its value and scarcity, and let citizens make individual decisions with respect to the cost of their discretionary driving. Fifth, if that doesn't work, then ration gasoline, which will reward those who have already adapted their lifestyles to a resource-conserving approach, and send the message home to those who continue to think that there are thousands of oil tankers sitting off the coast holding supplies from the market until the price gougers are finished charging Americans for what should be one-dollar-a-gallon gasoline.

Wednesday, September 14, 2005

What's Scarier? The Problem, or the Proposed Solutions? 

This morning as I was getting ready to head to the gym, I heard a KYW News Radio report in which John Street, the mayor of Philadelphia, was described as "angry" about gasoline price increases. He sounded angry. His reaction to the gasoline price increase is ”I don’t like it. I think it is terribly unfair.” Most people don't like it. Is it unfair? Is it unfair when the price of something in short supply goes up?

To his credit, the mayor explained that his personal protest against gas prices was to give up the city-provided custom Chevrolet van and to use a PT Cruiser. Street informed the reporter that the PT Cruiser gets double the mileage. He also predicted that "this exploitation" will convince many people to change their gasoline-use habits. He's right, and wrong. People already are beginning to change their habits. Far fewer vehicles are zooming down the highways at 20 miles per hour over the speed limit, though there must be some folks indifferent to high gasoline prices or in some huge hurry. But the term "exploitation" remains to be evaluated as truth or emotional exaggeration.

On the way home from the gym, I heard an interview of John Corzine, Senator from New Jersey and candidate for governor of that state. Asked "what are you going to do about the rising gasoline prices?" he responded with a two-fold approach. The first, which makes sense, was described as encouraging the Federal Trade Commission to investigate the price increases to determine if there is any gouging or illegal practices involved. The second was a call for a gasoline tax holiday. What made me wonder about the struggle between rational thought and playing to the crowd was Corzine's comment, and I'm paraphrasing the best that I can, "There are refineries here in the Northeast and they're not damaged. You'd think with the gasoline prices we've seen that the only refineries in the country are in Louisiana." In fairness to Corzine, he did remind listeners that not much has been done to secure the nation's chemical plants.

Here we go again. Two politicians playing with emotion. The contrast is interesting. Street is emotional, using some very strong terms, and yet does a rational thing in response. He changes vehicles and predicts, perhaps implicitly urges, changes in gasoline-use habits. Corzine, calm and at ease, proposes an irrational and countereffective response and makes a statement so inconsistent with a rational understanding of the markets that one wonders how he did manage to succeed in the business world before entering politics.

Here's the core of the problem: there is a finite amount of oil remaining to be extracted. Many commentators think that more than half of what was available before the "petroleum age" began has already been extracted and consumed. Some point out that much of what remains is the oil that is more expensive to find and extract, because it is in such places as deep water oceans, and that the cost of extracting what remains will begin to climb even more sharply. A few commentators claim that the Saudi oil fields are past their prime, explaining why the Saudis have been ordering off-shore drilling rigs (which, incidentally, appear to be in short supply). I recommend visiting the Oil Drum and reading up on the news and commentary. There's a lot there that does not see the light of the mainstream media day.

Corzine's comment begs the question. If, for example, Louisiana refineries processed all gasoline consumed in domestic uses, the sort of damage that was inflicted would have generated such a gasoline shortage that per-gallon prices would be in the double digits, and I'm not talking $12. I suppose once again the question would be, "What are you going to do about it?" There are folks, I think, who have the impression that the government can command an increase in the oil supply. These same folks think food is grown in supermarkets. Perhaps they're among the 90 percent of American adults who do not know what radiation is, the more than two-thirds who cannot identify DNA as a key to heredity, or the twenty percent of American adults who think the sun revolves around the earth. No, I don't make this up, for it comes from Dr. Jon D. Miller of Northwestern, who thinks that this ignorance "undermines" the ability of citizens to participate in democracy in a meaningful way, as explained in this New York Times story. And people wonder why I keep griping about the miserable overall condition of the K-12 and undergraduate education system in this country, especially after we set aside the schools catering to the elite.

Perhaps John Corzine knows it is pointless to try to teach his constituents the truth about supply and demand. I'm ruling out the possibility that he doesn't understand those economic rules, because I am almost certain he not only studied them in school but also used them in his pre-politician careers. Perhaps John Street understands that joining in the emotional reactions of the populace to rising gasoline prices is more beneficial for a mayor than cold, calm analysis.

Under the current circumstances, reducing the pump price of gasoline by suspending the gasoline tax is precisely what ought NOT to be done. It will give Americans the false impression that gasoline is more plentiful, because that's what reduced prices say to consumers. Under the circumstances, treating the gasoline tax as the user fee that it really is, and raising it to reflect inflation since the last time it was adjusted, would be the best thing to do. The increase in pump price would encourage even more of the adjustments that Mayor Street of Philadelphia thinks would occur. And perhaps the decline of net oil availability would be postponed for enough time to permit development of alternatives. The increase in pump price would also make existing alternatives cheaper in comparison and thus more likely to be moved from development to production. To cushion the poor against the impact of the increase, a tax credit would make sense.

There's another problem looming, and suspending the gasoline tax will have no impact. Natural gas supplies and the natural gas on-shore processing facilities were damaged or destroyed with greater adverse impact than crude oil supplies and gasoline refining capacity. Predictions of 70%, even 200%, increases in home heating costs when winter rolls around are making their way across the blogosphere, with only minimal attention in the mainstream media. As serious as is disruption in gasoline supplies and as annoying as is a gasoline price increase, home heating fuel shortages will be deadly, especially if there is unavailability at any price. As a practical matter, what will happen is that natural gas supply to heating will be given priority, thus cutting the supply to electrical generating plants. The ensuing brownouts and rolling blackouts won't be very good for folks who heat with electricity, or for those who use electric fans as part of a forced-air heating system.

Though I may sound like a disciple of Thomas Malthus, there is something bizarre about the way exploding populations and resulting increases in demand for all sorts of materials gets so little attention because perhaps it isn't quite up to the standards of the post-modern view of life. In a world filled with "pretend" and "say what they want to hear" the important news gets shoved into the corner. How many Americans, or for that matter, how many of the billions of people on the planet, understand supply and demand, or the impact of China's rapidly evolving economy on the price of cement, steel, and fertilizer? While the nation gobbles up PlayStations for the children to use during the next hour, few are thinking about life without PlayStations and all the other conveniences of a world so dependent on a few scarce natural resources that are destined to become even scarcer. I don't buy the "God will provide" message extracted from the lilies of the field parable. It's not that simple and it doesnt' work that way. (A theological aside: Though the parable is sometimes interpreted as "sit back, let God take care if it," has a different meaning for me, namely, stop fretting about the problem and try to do something about it, for only then will God put into your mind the inspiration to a solution.)

Long-term planning that should have been underway decades ago lies unattended, because long-term planning is so antithetical to an instant gratification culture that wants everyone to be happy and spared of inconvenience. Long-term planning is boring. It doesn't sell. It doesn't fit a tidy soundbite. It requires difficult, very difficult choices. It will not generate programs with which everyone will be happy. It will generate programs that easily could make everyone unhappy.

We have seen, at least on television and for some unfortunate victims and courageous relief workers, the impact of planning failures. It will happen again, because long-term planning cannot be accomplished in the few months or years before the next natural disaster, the next major terror attack, or the next disruption, for whatever reason, in the supply of something critical such as pharmaceuticals, zinc, or fresh water.

Suspending gasoline taxes is like putting a bandage on a hemorrhage. Saying "it will be ok" to the bleeding person doesn't quite get the job done. All those politicians quick to lament the lack of leadership, though speaking for understandable reasons, need to figure out how they will take the mantle of leadership voters have asked them to assume and to use it wisely. For the moment, John Street's allegedly anger-induced vehicle change is far more noteworthy than John Corzine's simplistic and countereffective "what they want to hear" gasoline tax suspension suggestion. Why? Because what John Street has done could become a long-term alteration in vehicle use. What John Corzine suggests does nothing to deal with the inevitable drying up of oil and natural gas supplies.

Tuesday, September 13, 2005

The Senate's Katrina Tax Relief 

According to this Washington Post story, a tax relief proposal introduced in the Senate to assist in the recovery from Katrina includes "a tax credit to encourage employers to hire Katrina evacuees, and for companies in the disaster zone to temporarily retain evacuees on their payroll." About a week ago I predicted something quite similar:
I think the existing credits will be expanded. The temporary expansion for second-year wages will be extended beyond this year. I think a large area will be declared an empowerment zone, or perhaps be given a special category not unlike the New York Liberty Zone, generating special tax treatment for wages paid to individuals working in it, amounts paid to rebuild facilities located in it, money invested in enterprises formed to operate in it during or after reconstruction.
What I did not predict is interesting:

* A gross income exclusion on debt forgiveness related to the disaster.

* Waiver of penalties for early withdrawals from retirement plans to be used for recovery expenditures.

* A $500 personal exemption for each evacuee housed by a taxpayer who is not otherwise claimed as a dependent.

The last one is very interesting. Because it is late in the year, it is impossible to bring an unrelated evacuee within the definition of dependent. But $500? Why not a proportionate part of the current exemption amount, which would be on the order of $800?

It is estimated that the Senate package will cost between $3 billion and $7 billion. I wonder whether any attempt will be made to offset this cost, and the otherwise enlargement of the deficit.

There is no certainty that the House will pass the same provisions. The only certainty is that the House will pass additional provisions and leave out or modify one or more of the Senate provisions.

Stay tuned.

Monday, September 12, 2005

Convicted Drug Felons and the Tax Law 

Prof. Ann Murphy of Gonzaga asked this question: "Does anyone know off the top of their head why the Hope Credit has a provision that bars the credit if the student has a felony drug conviction but the Lifetime Learning Credit does not?" It's one of those wonderful "why" questions that most law professors love, and law students dislike, because it goes beyond knowing black letter law and reaches to understanding the law.

Of course, the first thing I did was to check. Perhaps there was some complicated "deemed incorporation" provision, or a cross reference hidden in a maze of statutory spaghetti that made the rule applicable to both credits. No such luck in defusing the question. There is a difference. That energized my curiosity.

When Prof. Murphy asked her question, several other tax law professors responded. One speculated that the idea was to encourage high school students to "just say no." Another noted that she had read that the reason rested on the difference between the per-student character of the HOPE credit and the per-taxpayer character of the Lifetime Learning Credit.

These are valiant guesses. Nonetheless, if using the tax law to discourage drug abuse is something Congress thinks is effective and wise, there is no reason that both credits cannot be disallowed if the taxpayer whose expenses are generating the credit is convicted of a felony drug violation. Even though the Lifetime Learning Credit is per-taxpayer, there is no obstacle to prohibiting the taxpayer from taking into account expenses related to a convicted drug felon.

As one respondent noted, half seriously and admittedly with a cynical bent, was it to give tax professors another Code provision to ridicule in class? To that I add, was it to provide further proof that the tax law ought not be the vehicle for punishing violations of criminal law other than tax fraud? The warnings from those of us who have consistently objected to use of the tax law for social engineering or as a substitute for what should be done by government agencies other than revenue departments or the IRS are reinforced by this nonsense.

Though I may have missed something buried somewhere, there is nothing in the Committee Reports about the prohibition other than a paraphrase of the statute. No rationale for rule with respect to the HOPE credit is provided, though it ought to be obvious, I suppose. More importantly, no mention is made of the absence of the prohibition for the Lifetime Learning Credit appears, and so whether it was a conscious decision, with an undisclosed reason, an oversight, or a conscious decision whose reason was deliberately concealed is unclear. The last possibility is probably unlikely. As between the other two possibilities, I don't know. And, of course, there are no cases or rulings addressing the question. Unless a convicted drug felon challenges the prohibition on the HOPE credit because it doesn't apply to the Lifetime Learning Credit, a challenge surely to fail, I don't see how the issue would be one that a court would need to consider.

Finally, I have not seen any studies addressing the impact of the prohibition on illegal drug use. I wonder how many students think, "Wow, if I do this and get caught, a conviction jeopardizes my tax credit." So, being similarly cynical, I wonder if the prohibition is simply some sort of window dressing that lets politicians say, "See? We are doing things to reduce illegal drug use." But that still does not explain why a similar prohibition was not, and could not have been, inserted into the Lifetime Learning Credit provisions. For that matter, why not put it in all credit provisions. "Convicted of a drug felony? You don't get the adoption credit. After all, do we want to encourage drug felons to adopt children? Convicted of a drug felony? You don't get any other credits. THAT will make you think twice about using illegal drugs." Right. The illegal drug users are shivering with fear of losing tax credits.

Thanks to Prof. Gail Levin Richmond and Prof. Evelyn Brody for their comments. It always is nice to know I'm not the only tax professional who comes away from parts of the tax law muttering, "Huh?"

Friday, September 09, 2005

More on Charities Wiped Out by Katrina 

Here's an update to my post about the impact on annuity recipients if a charity goes under on account of Hurricane Katrina. I've been told that there is another type of annuity arrangement, which is not a CRUT, CRAT, or pooled income fund. A person essentially purchases an annuity from a charity, getting back less than would be received if the annuity had been issued by a commercial annuity company, with the remaining portion accruing to the benefit of the charity.

In these situations there is no trust. The charity's obligation to make the payments is secured by the charity's other assets. If the charity terminates, then the person who paid for the annuity stands in line with other unsecured creditors to get paid. And if something like a hurricane wipes out the charity, leaving it with uninsured losses, the annuitant loses. This is what happened to people expecting annuities from the Baptist Foundation of Arizona, a tax-exempt organization established to assist with advancing causes on behalf of Southern Baptists. Details of the Foundation's financial demise can be gleaned from this long list of articles. In another case, an organization was set up to sell these sorts of annuities, with the investors told that the excess would go to charity. At least one official of the organization embezzled the funds. Without getting into all the facts set forth in the SEC complaint, the would-be annuitants were left out in the cold. This situation, though, isn't one in which the charities themselves failed. Thanks to those who brought these cases to my attention.

Some states regulate these arrangements, subjecting them to rules that are the same or similar to those governing insurance companies selling annuities. Many states don't regulate them. A practitioner informed me that the charitable gift annuity "industry" of the sort just described is "quite large." It seems that many investor advisors push their use. Yet they are much riskier than CRUTs and CRATs, and don't have the protection, in many instances, afforded to commercial annuities. They also pose risk to the charity, because the annuitant can outlive life expectancy, and unless the charity is selling many of these contracts it lacks a sufficient base over which to spread the risk.

A good question is why charities are in the insurance business instead of in the business of doing charitable works. A better question is why charities are permitted to act as insurance companies but escape regulation. A tougher question is why people would go this route rather than set up a CRUT or CRAT. The practitioner who wrote me prefers the CRUT or CRAT, based on experience in the practice world, and I haven't heard or read any reason to ignore them. As students in my Decedents' Estates and Trusts course learn, "use a trust" becomes a good answer to very many of the "how could this problem have been avoided?" questions.

Once again, it is buyer beware. Even if the buyer is awash in noble purposes, such as assisting the charity.

Katrina, Failed Schools, and Annuity Payments 

A question from an anonymous reader was posted on a tax listserv to which I subscribe. It's a good question, and worth consideration. The person wrote:
What happens when a person sets-up a charitable gift annuity to a college or university, and the university no longer exists? Maybe Tulane will no longer exist due to Hurricane Katrina. Maybe at some future point, UCLA will no longer exist due to a catastrophic earthquake.

Through a charitable gift annuity, the university or college promises to pay an annual income for---life. Life, your life and my life, is a long time. Obviously, if the university (Tulane/UCLA/ University of Miami) no longer exists-- the check will not be in the mail.

Somewhere, there's an elderly couple who may not be receiving their annuity check from Tulane for a long time--a long, long, time.
I am going to provide a longer answer than I sent back to the listserv.

The sort of annuity in question is created when a certain type of charitable gift is made. It is essentially a creature of the tax law. Generally, charitable contributions of less than all of the taxpayer's interest in the property do not qualify for a deduction. There are several exceptions. The relevant one, in section 170(f)(2)(A), provides that if property is transferred in trust, no deduction is allowed for designating a charity as the taker of the remainder interest, unless the trust is a charitable remainder annuity trust (CRAT), a charitable remainder unitrust (CRUT), or a pooled income fund. Though the question did not specifically describe what sort of arrangement was made, it is likely that it was a CRAT or CRUT, and not a pooled income fund. The question highlights a challenge I tell my students they will encounter repeatedly in practice and for which they don't get as much preparation as they should, namely, clients who do not provide sufficient facts in the question. And it isn't just clients. Tax practitioners, and lawyers in general, are not necessarily more attentive to spelling out all the necessary information. For example, on another tax listserv to which I subscribe, a significant number of the questions come with a less than bare-bones outline of the facts, requiring a series of clarification requests to avoid the "if this then that, but if something else, then some other thing, else yet something else" answers that branch into all sorts of possibilities. Fortunately, the question I'm considering can be analyzed without knowing whether it is a CRAT or a CRUT. What matter is that it is a charitable trust.

What happens is that money or property is transferred into the trust, and a trustee is named. The trustee can be a bank, trust company, some other professional trust service. It can be the donor or a family member, and it could be the board or trustees of the charity, though there are reasons that using a bank or trust company generally is preferable. The taxpayer, in setting up the trust, determines how much of an annuity will be paid to the taxpayer (or the taxpayer and spouse). For a CRAT, it can be a fixed amount or iIt can be a percentage of the trust's initial value. For a CRUT, it is a variable amount that reflects the investment success (or lack thereof) of the trust. The annuity almost always is paid for the life of the taxpayer (or the joint life of the taxpayer and spouse), but in some instances for whatever reason it can be a set term of years. When the taxpayer dies (or the last of taxpayer and spouse dies), or the specified term of years ends, the trust terminates and its assets are distributed to the charity that owns the remainder interest.

So what happens if the charity ceases to exist? Though we tend to think of charities as perpetual entities that have been around forever and that will remain until the end of eternity, the reality is that thousands of charities are created each year, and hundreds, if not thousands, go out of existence each year. Charities cease to exist for many different reasons. Sometimes they use up all their money. Sometimes they accomplish their goal, perhaps using up all their money in doing so. When a charity is the beneficiary of a trust, and ceases to exist, unless the trust instrument specifies a successor (replacement) charitable beneficiary, the trustee must turn to the courts to obtain a determination of what to do. Courts have general supervisory jurisdiction over trusts.

Centuries ago the courts developed the doctrine of cy pres to deal with this sort of question. It was so long ago that Norman French was still the official language, and so the term "cy pres" emerged from the longer phrase describing the doctrine. The full phrase? "Cy pres comme possible" It means "as near as possible" The pronunciation is fun. In Norman French it would be close to "see pray" but lawyers say "sigh pray" (an interesting look at how language evolves). In modern French "as near as possible" translates closer to "aussi pres comme possible." Go ahead. Put "cy pres comme possible" into this translator and see what happens!

Originally, what the cy pres doctrine provided, and still provides, is that when the purposes of a charitable trust have been accomplished or are impractical to attempt, and money remains, the court will find another purpose, as close as possible to the original purposes. Technically, in some instances, centuries ago in England, the crown could dictate the substitution once the court determined that the original purpose could not be accomplished, but that's not of any relevance to the question. In the United States, the leading case (Jackson v. Phillips, 96 Mass. 539 (1867), for those moved to read it) involved a trust established to support abolition and support for fugitive slaves. The court crafted a substitute goal of assisting the education of emancipated slaves and the alleviation of poverty among former slaves in the city where the trust donor had lived. Over time, the doctrine expanded to include resolution of the problem suggested by the question, namely, what happens if the charitable institution benefitted by the trust ceases to exist?

If a charitable organization that is the beneficiary of a CRAT or CRUT (or any other charitable trust) ceases to exist, the court will select a substitute. How does it do this? As in every cy pres case, it is a question of fact and judgment. The court tries to find another institution which resembles the defunct organization. It considers whether its goals are the same or close to those of the defunct organization. It can examine if it reaches to the same sort of population or one close to it as targets of its charitable works. It notes if it operates in the same or nearly the same geographic areas. There is no set list of things to examine, because the facts of each particular case will set those parameters.

Now for the wrinkle. There's always a wrinkle. What I described is trust law as it developed in England and was absorbed and refined in those areas of the United States whose law has its origins in the English common law. Louisiana, however, because it was founded by the French and under French rule for many years, has a law originating in French civil law. Unlike common law, which developed principally from judicial application of legal doctrine to facts, civil law has its roots in extensive codes, or statutes, which are applied to the facts. Think of an Internal Revenue Code equivalent for every possible aspect of the law. In recent times the distinction has blurred, because statutes and administrative regulations have come to dominate a substantial portion of American (and English) law. So does Louisiana have a cy pres doctrine? Yes. See In re Succession of Milne, 230 La. 729 (1956) (reviewing the origins and application of the doctrine), and it has been codified at La. Rev.Stat. 9:2331.

If an educational organization goes out of existence, my guess is that the court would try to find another educational organization in the same area, with the same (or nearly the same) sort of student demographics, with the same (or nearly the same) programs of study, etc. I'm in no position to make guesses as to specific institutions. But what is clear is that if Tulane or some other school ceases to exist, the trust will continue to exist and the donors will continue to receive their annuities.

Hopefully, this was an interesting academic question. It would be sad, and indicative of far greater upset, if any practicing lawyer had to deal with this issue. All of these institutions, not just Tulane, need to be sustained and need to return to full operations after their properties have been restored. Anything less would compound what already is a horrific tragedy into something unthinkably worse.

Thursday, September 08, 2005

Addendum on the CGUD Tax: The Lock-In Effect 

My posting yesterday that summarized the discussion to that point between Stuart Levine and myself on the substitution of an income tax at death on unrealized net gains for the estate tax brought a response from Ben Bateman of Amarillo, Texas. He wrote:
Your argument in favor of taxing capital gains is correct, but for the wrong reason. The proper argument is that current law encourages people to hold appreciated assets until death, rather than shift their holdings to something that's more economically efficient. The proper argument is economic distortion, not some socialist cliché about rich vs. poor and the importance of progressivity.

You also missed the real problem about determining basis after death. What's the difference between figuring basis one hour before death and one hour after? Simple: One hour before death, the person most likely to know something about the basis is still alive to tell us. Dead men tell no tales, and they aren't very good at explaining basis records, either. I completely sympathize with the goal of taxing gains at death, because current law creates the sort of economic distortion that tax professionals should abhor. But taxing those gains would also mean that the children pay tax based on their ability to produce information that they had no legal right to obtain before death. Your father didn't keep good records? That means you pay extra.

Granted, this situation already occurs in cases of extended incapacity. If your father becomes disabled and you need to sell some of his property, then the amount of gain will in fact vary based on the quality of records that you had no right to maintain. But taxing gains at death would turn that relatively rare unfortunate situation into a commonplace injustice.
Here is the reply I sent to Ben:
Your point about the lock-in effect of not taxing gains at death is a good one. It should get mentioned, and I'll do that in a follow-up post.

In my experience figuring out basis for a client when doing a return, almost always they had to retrieve paper. None of them remembered anything other than "roughly something" and those were wild guesses. Now, finding the papers might be easier for the "organized" clutter-making client, but eventually it will turn up. The Code has rules for determining donor basis when gifts are made of property that were gifts to the donor by an earlier donor, who often is long gone. So I don't think it's as big an issue as you do. And as more and more recordkeeping goes digital it may get easier across the board. Many items of property, including stocks, bonds, land, commodity investments, vehicles, boats, etc. can have a basis determined fairly easily if date of acquisition is known (something that may be apparent from tax return and other records such as local government land title records, vehicle registrations, information from stock and other brokers, etc.). Many of the items for which records of cost and purchase date are not maintained aren't worth enough to worry about (or are loss items) such as clothes, housewares, etc. The general exception would be those special items on homeowners' insurance: guns, jewelry, antique furniture. How much, though, in the context of the entire picture, are those worth?

As for penalizing children for failure of parents to keep good records, that already happens, in tax and other areas (what if dad has no record of the $10,000 loan to A? the estate doesn't get to collect an asset). One way of dealing with this, going forward, is to have taxpayers report purchases on their income tax returns so that the record is established when the transaction is fresh. It won't be perfect but it would be much better.
Here's a little more about the lock-in effect. Knowing that gains would be taxed if property is sold during lifetime, and knowing that the gains forever escape taxation if the property is held until death, many taxpayers choose to take the latter course, thus "locking" themselves into a "hold the property until death" position. This is especially true if the estate tax would not apply and impose a tax cost to holding the property until death. Thus, increasing the estate tax exemption or repealing the estate tax exacerbates the lock-in effect.

The lock-in effect is one of the arguments raised by supporters of lowering or eliminating the tax rate on capital gains. After all, they argue, if capital gains are not taxed when there is a lifetime sale, there would be no lock-in effect. That's true. However, the lock-in effect can also be removed by taxing gains at death. Both approaches make lifetime sales and holding until death equivalent (aside from the time value of money that might favor holding until death, although the risk of higher income tax rates being enacted shortly before death has a offsetting impact on the decision making analysis). None of the other arguments for eliminating or reducing the tax on capital gains persuades me that it is a superior approach to taxing unrealized net gains at death.

Ben is correct. I should have made this point, but overlooked it.

Discussion on Estate Tax Substitute Continues 

Stuart Levine has posted a response to my summary of our on-going discussion concerning estate tax repeal/modification. It's not a disagreement with the summary, but a sharing of additional concerns about my proposal to impose income taxes on gains at death (which he calls the CGUD tax).

Because I'm paying attention to other, more immediate tax issues, such as gasoline tax suspension/reduction, I will be brief in my response even though I had contemplated letting the discussion sit until the issue resurfaces in the Congress.

Stuart's first point is that "it is truly revolutionary to throw out a tax regime with a system of rules and decisional interpretations that has been built up over many years in favor of a wholly new design." Indeed, it is. And though Stuart is correct that this ought not to be done blithely, there are times when wholesale revision is necessary. Just because something exists or has existed for a long time is not enough, in and of itself, to perpetuate its existence. Akin to zero-based budgeting, a tax system ought to prove its worth year after year, rather than rest on past glories. The estate tax has created far more problems than it is worth.

Stuart notes that "One aspect of the current tax regime that contributed to the force of the political drive to abolish the estate tax in its entirety was the failure to automatically adjust the unified credit to take account of inflation." He is correct. The same can be said of the income tax personal and dependency exemption, which went from the $600 on which a person could live 60 years ago to a minuscule $3,100 on which no one can live today. As Stuart notes, this problem energized the "force of the political drive" but isn't the only flaw. Fixing it before the political storm erupted might have kept the issue off the radar of the folks who want estate tax repeal without any substitution, but now that the cat is out of the bag, I'm not certain that the die-hard repeal advocates would relent if the unified credit were adjusted as Stuart proposes.

Stuart suggests that "many of the abuses in the present system can be easily abolished" and gives insurance trusts and family limited partnerships as examples. He also notes, realistically, the political pressure that insurance companies would bring to bear against abuse correction with respect to insurance trusts. It's not as though I'm against fixing abuses. What concerns me is that after Stuart fixes these, those folks with nothing better to do in their lives than to dream up ways to reduce their clients' share of tax revenue payments will conjure up some other crafty device that won't hit the IRS radar for a while and then will require several years of legislative activity. What do we get? A parade of increasingly complicated and voluminous estate tax provisions. For an example of how that can happen, see the income tax. Look, for example, at the mess subchapter K has become as the battle for abuse prevention has been fought at the fringe of almost every Code subsection.

Stuart then points out that "the manner in which qualified plans are taxed has to be changed, since they are frequently subject to both income tax and estate tax at roughly the same time." I agree. Here's an area of tax law that affects a huge portion of taxpayers, and it has to be one of the most complicated areas of taxation. When people tell me Partnership Taxation is the toughest area of the Graduate Tax Program, I tell them that I think the deferred compensation/employee benefit area takes first prize. Maybe I'm wrong. No matter. Stuart is right. Whether it's the worst, or second to worst, messy part of the tax law, it needs to be fixed.

Stuart then turns to "what [he] perceive[s] to be some negative aspects of the CGUD Tax."

He doesn't think that the CGUD tax could be sufficiently progressive. That is true, as the report he quotes points out, if we use the same tax rates in place today. However, as a staunch advocate of taxing capital gains at the same rates as other income, the income tax revenue of the CGUD tax would be far more than what was computed for purposes of the comparison made in the study. And I would not be adverse to higher income tax rates on incomes (including CGUD) above, say, $10 million, with perhaps progressive rates within that "above $10 million" range.

How do I square that with my overall tax philosophy? I see those high rates (or perhaps a substitute) as a "user fee." Most people who are wallowing in tens of millions, hundreds of millions, and billions of wealth, are in that position because the market for their products has doubled, tripled, etc., on account of population increase. The user fee is a way of getting these folks to repay society for society having bred a large consumer base. It's also a user fee for society having globalized into a wider market that contributed to this wealth. After all, could a professional athlete make $20 million a year to play ball if the population of the U.S. was still 40 million and the population of the world, say, 800 million? Could the maker of the consumer products whose sales enriched the families Stuart mentions have been sufficiently voluminous to generate that wealth had there not been a world population explosion? I know these thoughts will cause some to brand me a "socialist" (as already has happened) even though Stuart thinks I'm "somewhat conservative" in my outlook. That's why I introduce the user fee concept, which is what someone with my outlook uses as the core revenue generating justification.

Stuart thinks that the CGUD Tax "would be both extraordinarily complex and subject to a whole new set of rules." I think not, though I can contemplate the lobbyists having a field day turning a simple concept into a special interest morass. My proposal, rather than setting up a separate and new user fee (or excise tax), rides on the income tax system which already is in place. A final income tax return already is filed for almost all decedents. My proposal eliminates the filing of transfer tax (estate, gift, GST) returns without creating new returns to be filed. If the rules are drafted properly, there ought not be the "years of controversy and litigation" that Stuart thinks "would likely result." After all, the principal reasons for controversy and litigation in the tax world are (1) bad drafting that is incomplete, ambiguous, inconsistent, and not thought through, and (2) taxpayers who use the complexities and bad drafting of tax law to find an unjustified personal tax benefit. Stuart's concern about complexity justifies my demand that anything that is enacted be drafted properly and free of special interest interference.

Stuart notes that "the current estate tax carries with it a strong incentive to make charitable contributions." The existing income tax charitable contribution deduction (which does need a LOT of fixing) would be available to offset the gains taxed at death. Perhaps the limitations based on AGI should be made inapplicable to "at death" charitable contributions. Stuart raised a good point, and though it take us deeper into the drafting of my proposal, it illustrates the benefit of discussion. Time, perhaps, to let our readers chime in.

Gasoline Tax Reduction/Suspension: THINK Before Proposing 

All around the country, in reaction to the gasoline price increases triggered by the adverse impact of Hurricane Katrina on domestic refinery capacity, taxpayers and politicians are clamoring for a reduction or suspension of gasoline taxes. As described in this report, legislators in Maine, Tennessee, Wisconsin, and Michigan have called for such action. In Pennsylvania, the governor is considering a suspension. In Michigan, legislation to this effect has made it through the state House. Although surely legislators and governors in other states not highlighted in the report have joined in this tax-cutting chorus, a complete list is not critical to the analysis.

Now there is pressure growing for the Congress to suspend the federal excise tax on gasoline. According to the L.A. Times, at least one bill has been introduced in the Congress to this end.

It will not surprise anyone that I am opposed to cutting gasoline taxes. Doing so would be adding fuel to the fire, pun intended. Why?

1. Higher prices cut demand, and anything that lowers price, including proposed freezes as well as the suggested tax reductions, will hold demand steady rather than cutting it. Considering that the world's oil supply is being consumed faster than it can be replaced, consumers should not be enabled in the gasoline and oil-consumption frenzy. Yes, I know how dependent we and our economy are on oil, but the one of the blessings from an otherwise horrific disaster is that people may be compelled to think rather than emote about gasoline prices, supply and demand, exploration, environment, alternatives, and the need to think about something more than the next day or the next election. Those who want to dig into the issue with perspectives not found in the mainstream media may find the news and commentary at The Oil Drum to be informative, alarming, and even frightening.

2. Cutting or suspending taxes generates a revenue loss. Almost every gasoline tax, state and federal, is "dedicated" to specific expenditures. If the revenue is cut, the expenditures cannot be made. "So what?" may ask the opponents of "big" government. The "so what" is answered by a list of the things funded by gasoline taxes. In most states, the tax generates funding for road and bridge repair. Imagine what happens if the tax is suspended, bridges are not repaired, and there is a catastrophic bridge collapse. Who will be the first in line crying about "the failure of government to plan for and fund disaster prevention"? To their credit, Massachusetts legislative leaders rejected the gasoline tax reduction proposal for this very reason. There is hope. One person commented that the reduced revenues ought to be made up by freezing work on repairs and projects in the home districts or states of the members of Congress who vote for a gasoline tax reduction or suspension. I'd like to hear them explain how the resulting loss of jobs was so good for the citizens who they are supposedly trying to help.

3. Even in states where monies can be moved from other funds to make up for the lost gasoline tax revenue, there are problems. In Wisconsin, the proposal is to make up the gasoline tax revenue loss by cutting money that would have been used in the public school system. If that isn't unwise, it's simply stupid. Cutting education funding at a time when education isn't doing exactly a top-notch job getting people ready to live in the modern world (do they teach survival techniques, rescue skills, and CPR in our high schools?) is pretty much close to eating the seed corn. Fortunately, the governor and some legislators in Wisconsin have raised their eyebrows at the proposal.

4. Cutting gasoline taxes has so little impact on an individual that it can be seen as nothing more than window dressing, soundbite generation, and posturing for votes. In Pennsylvania, a suspension of the state's 30-cent-per-gallon gasoline tax would save the average driver $66 over four months, but it would cost the state $660 million in highway maintenance money.

5. There is no guarantee that the reduction in the gasoline tax would cause a concomitant reduction in the price at the pump. The bureaucracy required to make pump price reductions occur would be enormous and expensive. And there's no guarantee it would be effective. Surely we would hear claims that a further increase "wasn't as high as it otherwise would be" as though something like that could be proven. The governor of Pennsylvania, acknowledging this problem, noted that the state is investigating the use of paying rebates to motorists when they renew vehicle registrations. Yep, more bureaucracy.

Yes, there is a problem. Gasoline prices have increased, dramatically, as a result of a catastrophe. This is not a surprise. Experts have predicted that any sort of natural disaster, accident, terrorist or criminal act, or other cause of a disruption would cause price spikes. Was anyone listening? Perhaps they listened as closely as they listened to the weather forecasts. Prices still are not at an inflation-adjusted equivalent to gasoline prices in the late 1970s, when a supply disruption caused by OPEC's political decision spiked the prices. People adjusted.

Once again, as they did 26 years ago, people will adjust and reset priorities. The argument that it is a "food or gasoline" choice is true for the very poor, who also face "food or medicine" choices. For most other families, the answer may be in cutting gasoline use, consolidating car trips, postponing the unnecessary frill purchase. The solution is to assist the poor rather than cut gasoline prices for everyone, including those who are wealthy enough to use gasoline unwisely. For example, do driveways really need to be cleared with gasoline-powered leaf blowers rather than brooms? Youngsters, rather than complaining about their parents' decision to forego purchase of a new video game cartridge so that gasoline can be purchased, can earn some money and get in shape by hiring themselves out to sweep driveways and shovel snow by hand. It's good exercise, too. How necessary is the consumption of gasoline for recreational use of all-terrain vehicles? What I'm saying, without digressing into another topic, is that the gasoline price spiking may end up as a catalyst (another pun intended) for a change in the overly materialistic, luxuriated culture that has overtaken almost all of America save the very poor.

After all, the nation has itself to blame for this problem. Prices have increased because there is a lack of excess refinery capacity. No one wants a refinery built in or near their town. Yet almost everyone wants what refineries produce. This sort of "have it all" scenario, symbolic of the platforms on which most politicians run for office and on which many people look at life, simply doesn't work. And now, thanks to nature, we are finding out what some have known for decades. It's also a nation which, by not doing good planning and giving developers free reign, has ended up with most people living so far from their places of employment and shopping that gasoline consumption has had to increase. I'm not advocating additional government regulation of what is an almost-too-late-to-fix-it problem. I'm simply asking where was the common sense when decisions were being made? The current crisis certainly provides an excellent reason and a fine opportunity for some deep, long-term, well-pondered consideration of where this nation is, how it got to be where it is, and, most importantly, where it is going. Yes, and how it is going to get there, literally and figuratively.

Yes, to the extent higher prices reflect price gouging, and a small portion of the increase does, then what politicians can do is to support those officials who have the responsibility to enforce existing laws against price gouging. A few highly publicized arrests and prosecutions should get the message across to most of the opportunists who use national crises to line their own pockets. Suspension of gasoline excise taxes does absolutely nothing to end price gouging. It might even encourage it by making people less concerned about it and thus less likely to file complaints.

If anything, gasoline prices should be increased. After all, their inflation-adjusted equivalent has been dropping for years. As a practical matter, it would be politically impossible to increase gasoline prices (at least until the next hurricane or other natural disaster takes out half of the remaining refinery capacity). But surely it makes no sense to cut taxes that are too low as it is. After all, a gasoline tax is a user fee imposed for the maintenance of the highways and bridges used by the consumers of gasoline. And user fees ought to reflect the true cost of what is being used.

I can't imagine what we will hear from the politicians when home heating bills start arriving in late November and early December. More of the same, I'm afraid.

Wednesday, September 07, 2005

In Case Estate Tax Repeal Proposals Get Back Up Off the Floor 

Last week, in a post that examined my initial reaction to the impact of Hurricane Katrina on the tax system and my suggestion that the decision on making estate tax repeal permanent be delayed, which then happened, I commented:
I'm more than willing to make estate tax repeal permanent, in exchange for taxing capital gains at death subject to a sensible exemption.
In his generally favorable reaction to my post, which he kindly labelled as a "must read regardless of one's location on the political spectrum," Stuart noted:
(However, he is willing to consider a full estate tax repeal in exchange for taxing capital gains at death subject to what he terms a "sensible" exemption. Here, we part company.)
Our subsequent email correspondence has helped us identify the issues raised by the trade-off I suggest that go beyond the basic arguments for and against estate tax repeal. Though the postponement of the decision may be, as Stuart points out in another post, a death warrant (I know, I know, ...) for the estate tax repeal plan, it is helpful, while the matter is still fresh in our minds, to outline the parameters of the trade-off issues so that when/if the estate tax issue returns to the spotlight there will be a foundation on which to build further, more extensive discussion. Of course, it would not surprise me to see the advocates of estate tax repeal push their proposals back on to center stage a few months from now. All of us know how it works in horror movies, as we think or yell, "He's not dead yet, don't celebrate too soon."

The suggestion that the estate tax be replaced with an income tax on net gain inherent in the decedent's assets at death reflects a wish to correct a fundamental flaw in the income tax system. Permitting these gains to escape income tax forever gives an advantage to those who can afford to hold on to their assets until death, specifically, those who are relatively more wealthy. Factored into a computation of effective income tax rates, this tax escape pretty much contributes to a regressivity in the tax system. Considering that one of the "defenses" for the failure to tax built-in net gain at death is the estate tax that is imposed on the value of the assets holding the gain, any repeal, or even significant minimization of the estate tax, removes that "defense" and requires re-examination of the question.

Taxation of net built-in gain at death is simple. Determining the values of the assets is fairly easy, because it is done not only for federal estate tax purposes, but for state inheritance and estate tax purposes and for state probate purposes. Those estates that as a practical matter don't value assets are almost surely to be within the scope of an exemption structured to let the net built-in gains of poor decedents and those with modest amounts of gains to escape taxation. The adjusted basis of the assets in question can be determined. After all, if the decedent in fact sold such an asset before dying, the need to determine the basis would exist and would be satisfied using the various rules in place to determine adjusted basis. I always scoffed at the argument, raised decades ago as one justification for repealing the short-lived and effectively eliminated taxation of built-in gains at death, that such a provision was "unadministrable" because "no one knew how to figure out, factually, the decedent's adjusted basis in the assets." Hogwash. If the decedent sold the assets, there is no way the courts, the IRS, or even the advocates of letting built-in gains at death go untaxed would accept an argument from the decedent, "Hey, I can't report gain because there's no way of figuring out the adjusted basis because, after all, if I died moments before the sale, there would be no way of figuring out the adjusted basis according to the advocates of not taxing built-in gains at death."

The amount of the exemption needs to be determined after doing some revenue estimation computations that I cannot do because I don't have the information available to the revenue estimators. That is, we need to know how much of an exemption would cause taxation of non-exempt gains to generate revenue equivalent to what the estate tax generates. To do that, we need an income tax rate. The amount of the exemption also needs to be set sufficiently high so that poor and low-income taxpayers do not get taxed. Whether the exemption should be $300,000 or $1,000,000 can be debated, but it ought not be $10,000,000.

There are several approaches to determining the income tax rate. One is to use the rates applicable to taxable income generally. But because this might put a decedent's gains into a higher bracket than would apply if the decedent sold the property uniformly over lifetime, there is a case to be made for using a lower, flat rate. However, because the highest income tax rate is less than the highest estate tax rate, the potential application of higher rates doesn't necessarily require that it be avoided.

The problem of liquidity, that is, finding cash with which to pay what would be the decedent's final income tax liability, can be solved by using the same sort of payment deferral arrangement that exists in the present estate tax for postponement of estate tax payment with respect to certain types of assets. There would be no need to reinvent the wheel.

In our email correspondence, Stuart raised some good questions about the impact of the proposed trade-off of estate tax repeal for taxation of built-in gains at death. I've merged our emails into a dialogue of sorts.

Stuart: I believe that such a tax would, unless modified by some degree of progressivity, shift the tax burden represented by the current estate tax downward, from the more wealthy to the less wealthy and even the middle class. (By way of example, the wealthy have a greater ability to do tax planning that would allow matching of recognized losses and gains, etc.

Jim: If the exemption is set at the appropriate level, and existing income tax rates are used, the burden would be progressive and would not shift the revenue sourcing downward. In fact, properly designed, it would shift it upward, because there would be far less opportunity to escape taxation. The current estate tax is riddled with loopholes that let enormous amounts of wealth go untaxed. The income tax that applies to gains provides far fewer opportunities. Providing the current income tax system is repaired to prevent the use of artificial losses that some taxpayers seem to "discover" in time to offset gains, the income tax is less fragile than the estate tax. There are far more estate tax planning games than gain avoidance games, and with some cleaning up of the grantor trust provisions, the concept of "actual or deemed" ownership can be retained.

Stuart: Perhaps more significantly, intuitively, I suspect that a tax on untaxed capital gains would more than likely burden "new" wealth. That is, a family that has built a significant business with a fairly low basis would be taxed more than, say, a Bush in (at least) the fourth generation of wealth accretion.

Jim: To the contrary, I think taxing capital gains at death favors the new wealth. A taxpayer who starts a business and dies within a short period of time has a high basis to value ratio (unless the thing took off, in which case taxation would not be as burdensome). If the taxpayer started the business 40 years before death, there would be more tax, but the business formed by the taxpayer's grandfather and passed down through gifts, where the basis would be much lower relative to value, would bear a higher burden. So it's "old" wealth that would be carrying the higher burden. That's all transitional, for once in place, basis would step up at death, and thus the business
held for the longer period of time (say, 40 years) would be taxed more than the one held for, say, 10 years. Which may not be that bad of an idea.

Stuart: Finally, how would the system work if, say, Dad gave stock to Sonny. Would the tax be deferred upon Dad's death? In that case, there would be significant gifting and property would likely never get taxed.

Jim: The gift question is interesting. After all, the gift tax "backs up" the estate tax. Because there's no chance, really, of section 102 being repealed, one approach is to tax the donees on the built-in gain when the donor dies (when there would be a higher likelihood of liquidity because the donee is likely to be an heir of the donor). Another possibility is to require donors to include in gross income the net gain built into gifted property. Alternatively, gifted property could be added back and treated as belonging to the donor, with something equivalent to an unlimited section 2035 mechanism. Or, as an alternative to that, gifted property gifted (rather than consumed) by the donee could be added to the capital gains tax applicable when the donee dies.

I expect Stuart will reply on his blog. When he does I'll post a link. Then, because the issue has retreated to the back burner, he and I will wait until it resurfaces before continuing with an extensive continuation of our dialogue.

Tuesday, September 06, 2005

Empowerment Zone Prediction Beginning to Take Shape 

In yesterday's post I predicted that tax incentives for the rebuilding of New Orleans and the rest of the devastated Gulf Coast would come in the form of empowerment or other zones similar to those already in existence, such as the New York Liberty Zone:
I think a large area will be declared an empowerment zone, or perhaps be given a special category not unlike the New York Liberty Zone, generating special tax treatment for wages paid to individuals working in it, amounts paid to rebuild facilities located in it, money invested in enterprises formed to operate in it during or after reconstruction.
This evening an (look at 4:14 P.M.) AP report picked up by New Orleans' WWL-TV (operating out of Baton Rouge) explained that Representatives Peter King and Charles Rangel are working on legislation that does exactly that, create empowerment zones for the damaged areas. Considering that King is a Republican and Rangel a Democrat, it is safe to predict a high likelihood that this legislation will be enacted in some form. King and Rangel expect the tax relief to exceed the $8 billion enacted after September 11, 2001, for the New York Liberty Zone.

An aside: The same AP report asserts that not all $8 billion of the New York Liberty Zone tax incentives were claimed.

Estate Tax Vote Postponed 

Yesterday, I commented in a post about the impact of Katrina on taxation:
I really do hope the members don't waste time on things that can be postponed, such as permanent estate tax repeal or additional lowering of rates on capital gains.
In Friday's post, Taxes and Sustaining a Civilized Society, I argued:
And it surely is not time to make estate tax repeal permanent. Yes, I know that certainty is good for planning, but there are a lot of things that are and must remain uncertain when it comes to planning. I'm more than willing to make estate tax repeal permanent, in exchange for taxing capital gains at death subject to a sensible exemption. But the nation needs time to contemplate such a plan, and September 2005 is too soon.
Some, it appears, are listening. And agreeing.

One of those someones is Senate Finance Committee ranking minority member Max Baucus, who declared, "I am supportive of working on repealing the estate tax, but now is not the appropriate time…" At the moment, his position on the estate tax permanent repeal proposal isn't the focus. It's the willingness to postpone that debate so that other, far more urgent matters can be given attention. According to this report, the scheduled vote on the estate tax debate has been postponed indefinitely.

So perhaps my pessimism, which surely oozed through those two posts from which I quote myself, will turn out to have been a bit too intense. Is it any wonder? It's becoming easier and easier to be pessimistic about too many things.

Monday, September 05, 2005

Labor Day: Jobs and Taxes after Katrina 

What a way to celebrate Labor Day. A day set aside for Americans to think about and express appreciation for the contribution made to the nation, its people, and its economy by those who labor at their chosen or assigned tasks has not only evolved into a "last gasp of summer" vacation jaunt for many, it has also, this year, become a day of sobering estimation of what Hurricane Katrina has done to the livelihoods of many Americans. Estimates vary. According to this site, referencing this article, as many as 750,000 people have been left jobless by the storm and its aftermath. A higher estimate of one million jobs is offered by an economic forecasting expert in this report.

Whether 750,000, a million, or some other number of jobs have been lost, there are a lot of people who are going to face tough times in the near future. Some may have easily relocated skills. Others, though, are totally dependent on the devastated area for their livelihood. Shrimpers can't pick up and do their job in central Kentucky. River boat pilots can't parlay their skills into navigating the plains of Kansas. Oil field workers and refinery technicians won't find work in the farmlands of Missouri.

It matters very much to American that some way be found to help these displaced workers get back to doing what they do best. Those shrimpers, and the other fisherfolk, bring in one-third of America's seafood harvest. The river boat pilots help bring America's grain to market. By now, anyone who can read or understand cable news talk knows why those oil field workers and refinery technicians need to get put back to work expeditiously. These are but a few examples, because surely there are all sorts of other jobs that suddenly disappeared but that are needed by Americans.

How will that happen?

More than a few commentators have tossed around a variety of ideas for rebuilding the facilities, the buildings, the institutions, the towns, yes, the life, damaged or destroyed by the hurricane and the subsequent flood wall breaches. Many of those ideas involve taxes. That is not a surprise.

The connection between jobs and taxes is close, intricate, and ancient. It's not just the inclusion of wages in gross income. That part is straight-forward. It's the use of the tax law to encourage the creation of jobs that is complicated, frequently changed, and surely ready for another entrance onto the tax stage.

There is an income tax credit for a portion of first-year wages paid to individuals in targeted groups. Targeted groups are, for the most part, those who traditionally have difficulty finding jobs, such as members of family receiving certain public assistance, certain veterans, individuals between age 18 and 25 who reside in an economically distressed area, and another half dozen specific and carefully defined groups. The credit was temporarily expanded, until the end of this year, to include second-year wages in the case of individuals who are long-term family assistance recipients. There is a separate credit for a portion of wages paid to certain members of Indian tribes.

There are deductions for compensation, subject to certain limitations. There are deductions for contributions made to retirement plans, also subject to certain limitations. The cost of many fringe benefits, even those not subject to taxation when received by the employee, are deductible by the employer.

There are indirect incentives. To the extent the tax law encourages investment in certain activities, or purchase of particular types of items, the industries making those items and the entrepreneurs operating those activities will face increased demand and hire more workers to meet that demand. So the theory goes, and sometimes it works that way in practical application. After all, every once in a while a bad-armed pitcher can hit the side of a barn.

Will the tax law be used to encourage, fund, and motivate the recovery? I would be shocked if it weren't. That's not to say there won't be non-tax laws enacted or amended, for surely a long list of things need attention, and some aren't even financial in nature. But the tax law is going to be the beneficiary of many changes, enacted as early as this fall.

What do I predict? I think the existing credits will be expanded. The temporary expansion for second-year wages will be extended beyond this year. I think a large area will be declared an empowerment zone, or perhaps be given a special category not unlike the New York Liberty Zone, generating special tax treatment for wages paid to individuals working in it, amounts paid to rebuild facilities located in it, money invested in enterprises formed to operate in it during or after reconstruction. I've read suggestions that the low-income housing credit be adjusted so that it attracts investment into rebuilding the some of the hundreds of thousands of destroyed or damaged homes. It would not surprise me to see hundreds of activities, investments, purchases, and other enterprises nominated for special tax treatment.

Should the tax law be used in this manner? It depends, in part, on one's outlook and in part on one's conclusions on the effectiveness of using the tax law to encourage economic behavior. Is there not sufficient incentive in the private sector, absent tax provisions, to undertake what needs to be done? Yes, there is, but there are insufficient resources. How does an uninsured homeowner rebuild? Part of the problem, of course, is that the existing tax law has flaws that put many taxpayers in a worse financial position than they would be if the tax law were more equitable, sensible, and efficient. But even a zero tax rate on a displaced homeowner won't pay for rehabilitation of a home. But would it not make sense to distribute grants rather than fooling with the tax law? Yes, and I think that we will see a variety of new and expanded grant programs. In fact, most of the tax incentives that I think will be enacted do not reach directly to the worker, the homeowner, or the individual. They reach businesses, trying to encourage them to hire and invest in ways that ameliorate distressed economic conditions in a specific area. Why not direct grants to businesses instead of indirect payouts through the tax code? Yes, why not? Would that not be easier to administer?

One of the causes of tax law complexity is the relocation of social welfare and similar programs from other laws and federal agencies into the Internal Revenue Code and the IRS. Many of the newest credits and other incentives, such as those applicable to empowerment zones, renewal communities, and the like, require the IRS to issue regulations that are reminiscent of regulations issued by those other agencies. Some go so far as to incorporate regulations issued by other agencies. Why can't those other agencies do this work and administer these sorts of programs? Could it be that the IRS, despite being perpetually maligned in the press, holds a secret place of respect in the heart of Congress? That speaks volumes about the federal bureaucracy, but I doubt much needs to be said after the past 9 days to make this point. It's been made. Unfortunately, at huge cost.

There are serious questions that need analysis and that will be the subject of intense debate before the specifics of these anticipated tax law incentive enactments are worked out. Some reach far beyond the details of the upcoming reconstruction. Some will be framed as a referendum on whether tax dollars should be used to rebuild New Orleans. Others will focus on whether tax dollars, through direct grants or tax incentives, should be used to encourage rebuilding of homes on barrier islands and other at risk areas. There will be a parade of soundbites advocating the construction of affordable housing for the poor and lower middle class, and how the tax law should be fine-tuned to accomplish such a result. That's assuming the tax law can produce the desired consequences.

It's unclear whether the various tax law provisions that now substitute for other agency programs are effective. Despite a credit for hiring native Americans, the economic conditions on Indian reservations, aside from casino enterprises, remain difficult. Poverty among tribal members remains high, and an embarrassment for the nation. Many of the enterprise zones and renewal communities continue to stagnate economically. Even an alleged success story such as the New York Liberty Zone is difficult to assess because New York probably would have recovered without such incentives.

These sorts of provisions are complicated. And I'm no fan of complex tax law. In all fairness, if the alternative is a complex law for some agency other than the IRS, is that any real improvement? But there is some good news on the complication front. If Congress piggybacks the Hurricane Katrina tax incentives onto existing provisions, and can manage to avoid fiddling with the definitions, the increase in complexity can be minimized. However, if Congress chooses to enact totally new incentives rather than working with existing credits and empowerment and similar zone definitions, it will make the complexity problem much worse.

Congress needs to move quickly. Yes, time is needed to debate the serious questions I mentioned, along with the others that did not get articulated. But taking time to craft new provisions rather than using existing ones would extend the suffering of those displaced workers who need jobs, preferably the ones they had. Worse, trying to do the technical drafting at the last minute, in the wee hours of the morning when most brains are at the low ebb of their biological cycles, guarantees the combination of complexity and technical error. It will be interesting to see how Congress, whose members understandably have been critical of the sluggishness with which government responded to the crisis, reacts when time is of the essence. I really do hope the members don't waste time on things that can be postponed, such as permanent estate tax repeal or additional lowering of rates on capital gains.

The nation's workers, and the nation, deserve no less.

Friday, September 02, 2005

Taxes and Sustaining a Civilized Society 

"Taxes are what we pay for civilized society." So spoke then Supreme Court Justice Oliver Wendell Holmes. He said that back in 1927 in a case called Compania General de Tabacos de Filipinas v. Collector of Internal Revenue, 275 U.S. 87. That was a long time ago, when there were Collectors of Internal Revenue, but no Commissioner of Internal Revenue. Yet the statement, trite as it might seem, carries a strong message.

Although the term "tax" has been used in many places and at many times to mask what today could be called pillaging, theft, or collection of protection money, in principle taxes are what citizens pay so that they can live, work, play, and flourish in a society that provides opportunities, safety, and support not found in an "every person for himself or herself" barbaric or backwards existence.

Without taxation, and more specifically efficient and just taxation, society cannot exist. Even the utopian dreams of the idealists, in which there is no government and no hierarchy, requires some sort of contribution. Though the genesis of such an experiment might be characterized by unanimous voluntariness, it isn't long before mandatory rules need to be created and enforced. Why? Because some people think they are special, and deserve to curtail their contribution to fit their individual wishes. Whether this is human nature, or something learned from culture, is a question to which no one has provided a definitive, proven answer.

In most modern societies, taxation is mandatory, but it is enacted by representatives of those (or, technically, some of those) who elect those representatives and will pay those taxes. Those same representatives specify the details of what gets taxed and how taxes are computed. In theory, citizens subject themselves to taxes because they accept the fact that the services they want from government need to be funded. In theory, the democratic process permits discussion, free determination, and election of representatives who put the needs of the nation at the top of the list. In practice, of course, it doesn't work that way. Many taxpayers don't vote. Representatives are more sensitive to the demands of lobbyists and special interest groups than to efficient and just taxation. When taxes do enter the electoral or political arena, almost all of the chatter is about tax rates.

One significant disadvantage of the practical reality, in contrast to the theoretical principles, under which tax law is developed is the complexity that it brings to the tax law. Complexity generates noncompliance on account of confusion and misunderstanding, fraud because there are always people who consider themselves and their goals paramount and superior to law and who find unending opportunities in the rabbit warrens of the tax law, economic inefficiencies because those with the loudest lobbyists aren't often those with the best arguments, societal malaise because honest citizens feel overwhelmed by the reports of the annual $300 billion in owed but unpaid taxes, and governmental inadequacies because of the time, attention, and resources consumed by the political tax game.

Many of my commentaries on taxation offer up criticism of tax complexity. But today I want to focus on another significant disadvantage of the practical reality. What turned my attention to this problem is the unacceptable, horrifying, distressing, and embarrassing aftermath of Hurricane Katrina.

Yesterday, last evening, and this morning, as the news reports filtered in, I began to wonder if the people of New Orleans and the other damaged areas thought for a moment about the civilized society that taxes supposedly were purchasing. Despite the glimmers of hope, the heroics of the courageous, and the kindness of some strangers, the dark side seems to have ascended over not just New Orleans, and not just the Gulf Coast, but over the nation. We are seeing non-civilization at its finest, in other words, we are seeing the best of barbarism. It is a barbarism rooted in lack of discipline, and fueled by the inadequacies of the governments charged with protecting those who live and want to live in civilized society.

It's too soon to do a full analysis that will help us learn how to react to the next natural or person-generated disaster. We do know there will be one. All of the efforts to prevent person-generated disasters do nothing, and cannot do nothing, to prevent the formation of the next Category 5 hurricane or to control where it goes. And for those advocating the use of taxes and government controls to "remove global warming and end hurricanes," as one brilliant observer (he says sarcastically) advocated, keep in mind that some of the worst hurricanes occurred long ago, even during the time of the earth's "Little Ice Age" from which it began to emerge not that long ago.

No matter which government, official, agency, program, or process is targeted by the critics, the question for me is whether these arms of government could have been, and in the future will be, more responsive, more organized, more aware, and more effective had there been more resources available to them long before the inevitable happened. Understandably, I am a firm believer the mere availability of resources is no guarantee, because resources in the hands of mediocre bureaucrats, sound-bite politicians, corrupt officials, or lazy civil servants are wasted resources. There are understandable reasons some citizens advocate turning as much as possible over to the private sector. Nonetheless, there are some things only a government can do when disaster strikes and that cannot be put into the hands of the private sector, regardless of how one resolves the continuing debate over which governments, state, local or federal, should be involved and to what extent.

When the time does come to study what happened, I am confident that in addition to things that money doesn't necessarily buy, such as planning creativity, honesty, intelligence, and leadership, there will be a long list of things that money could have provided. Others have already started these lists, from water inflow protection similar to those in the Netherlands, more FCC concern about cell phone tower location and design (and less on the more attention-getting but far from life-saving concerns about trivial immaturities on the airwaves), and arrangements to provide evacuation transportation to the sick, vehicle-deprived, and helpless. I haven't yet seen much discussion about the other possible disasters in other possible locations, where different terrain, different population numbers, different potential evacuation routes, different disaster causes, and other factors require something more than the "let's react to and prevent a repetition of the last problem put the money into airplane defense while terrorists and nature cook up something different" mind set that neglects or gives minimal attention to planning for the eventual huge earthquake in the Midwest, the destruction of pharmaceutical plants making insulin, or alien hackers taking down the Internet.

To make resources available to government, taxation is necessary. Well, we have taxation. So perhaps the better analysis is that to make sufficient resources available to government, sufficient taxation is necessary. Few welcome taxation, but fortunately most understand its necessity provided its proceeds are used appropriately. Support for taxation is a measure of support for the government programs funded by tax proceeds.

During the past several decades, the anti-tax movement gathered steam and rolled through the political landscape. The impetus for this movement is understandable. Aside from corruption and other commonly held unacceptable activities, the most significant object was the use of tax proceeds to fund government programs that did more to enrich bureaucrats than the intended beneficiaries, and to nourish government programs that were inconsistent with the goals of those who flocked to the anti-tax movement. Cries for tax reduction reflected a frustration with a political process that was not responsive.

Unfortunately, the cries for tax reduction drowned out the rest of the argument. Full and open debate on how tax proceeds ought to be spent took a back seat to the rush to find ways of "cutting taxes." Trickle-down or not, even with the occasional tax increase (including one that doomed the re-election of one president), taxes were cut. Tax revenues increased at times as the economy grew, with tax cut supporters claiming that tax cuts were the cause of the economic upswings. Does that mean cutting taxes to almost zero would generate almost infinite tax revenues? No. The economy bounces up and down for many reasons, tax being just one, and not necessarily the most important one.

But when the need for tax revenues increased, when the belated response to terrorism finally found attention in the halls of Washington power, those in control decided not to increase taxes. Instead, they marched on with the tax-cutting programs. The federal budget deficit returned. And grew. Guaranteed, Hurricane Katrina isn't going to be put on the list of things that reduced the federal budget deficit. Neither is the military action in Iraq. And even today, members of Congress continue to discuss legislation to reduce taxes more, and to extent the reductions.

The nation allegedly is at war. We are allegedly at war with terrorism, or terrorists, or terrorist-sponsoring states, or insurgents, or well, bad people, I suppose. Whether or not one supports none, one, or all of the various military actions undertaken in connection with this war, it is inconceivable to me how one can disagree with the notion that if there is a war the war must be funded because wars cost money. Would opposition to specific military campaigns been stronger, or developed sooner, had taxes been increased to fund the campaign, as good fiscal management demands? Maybe. My guess is that those who supported a campaign, or at least most of them, would have acquiesced, reluctantly or otherwise, to a tax increase. The failure to seek a tax increase, or at least to put the brakes on the tax cutting, probably reflected a policy of trying to make everyone happy even though the long-term cost is far higher than would be the cost of an immediate, and thus smaller, tax increase. I've been told, and I've read, that when the nation went to war in 1941, and even as it was preparing to do so in 1939 and 1940, taxes were increased. I don't know if there was much griping, or how extensive it was, but people knew that war means war. It requires sacrifice. My parents have described what life was like under a rationing program for a long list of items. The nation allegedly is at war. A few individuals and their families, constituting a very tiny percentage of the population, have made and are making sacrifices. The rest of us, it seems, are living lives that somehow don't seem consistent with what life is like during war. Perhaps I am wrong, but for me, war is like pregnancy. Either a woman is pregnant or she isn't. Women cannot be partially pregnant or have limited pregnancies. Concepts of limited war or partial war get used not only to create the sorts of conditions that preclude victory, as happened in Vietnam and Korea and as is beginning to happen in Iraq, but also to deflect the effects of war-waging decisions so that war seems, somehow, more palatable. War, at times, unfortunately, is necessary. War, though, should never be palatable.

Now the nation faces another, more serious catastrophe. Hurricane Katrina has all but destroyed a city. It has closed the nation's largest port. It has shut down a significant portion of gasoline refinery capacity. It has closed and damaged much of the Gulf of Mexico oil and natural gas production, the latter getting very little attention, but wait until October's chills set in for that to flare up as a mainstream media and politician soundbite. A quarter of the nation's coffee supply is rotting in New Orleans warehouses. Steel, zinc, rubber, and bananas must find their way in through some other port, if that is possible. Most of the grain harvest, and other domestic agricultural product, has no way out. If 9/11 disrupted the economy, Hurricane Katrina has the potential to devastate it.

And thus I turn back to taxes. Money is being spent, and more money will be spent, by governments on rescue, relief, and recovery. Government surely will spend money on rebuilding, as will the private sector. Where does government get that money? Does it borrow, thus increasing the deficit and thus fueling the "foreign ownership of dollars" problem? Does it raise taxes, thus taking money out of the private sector? Doesn't the private sector have a better chance of spending the money more efficiently than does the government? Perhaps taxes need to be raised. Certainly, they should not be lowered.

There are several things, however, that need to be considered when someone advocates raising taxes. One is whose taxes? Another is what income? And a third is what rate? Too often tax increases are rate increases on those already paying taxes. It is time to consider raising taxes on those whose taxes are not as high as they ought to be. Those folks happen to be the ones enjoying low tax rates on dividends and capital gains. I've yet to see the evidence that lowering taxes on dividends and capital gains, but not on wages is better for the economy. Many of the displaced people in the Gulf Coast region have been paying taxes at higher rates than those imposed on dividends and capital gains.

As I've often said, the answer to all the arguments about the taxation of capital gains is to index basis. The low rate on capital gains does nothing but to encourage speculators and others who parlay the low rates into economic gain that doesn't generate real goods. A dollar is a dollar. By indexing capital gains, and then making dividends and capital gains subject to the same rates as other income, Congress not only raises necessary revenue, it simplifies the tax law. It might even permit fixing the alternative minimum tax problem before the middle class gets taxed into poverty and the ultra-wealthy continue to amass wealth.

It is time to put an end to the dividend tax rate preference. Sure, a retired person living on dividends who saves $400 in taxes has been duped into thinking a low rate on dividends makes sense, but that person would benefit more from a sensible and realistic personal exemption deduction that reflects the poverty income level. Throwing $400 to a retired person living on dividends so that someone earning $3,000,000 a year in dividends can save taxes so there is more money for their investment game is not the way most Americans would design a tax system if they had a real say in the matter.

And it surely is not time to make estate tax repeal permanent. Yes, I know that certainty is good for planning, but there are a lot of things that are and must remain uncertain when it comes to planning. I'm more than willing to make estate tax repeal permanent, in exchange for taxing capital gains at death subject to a sensible exemption. But the nation needs time to contemplate such a plan, and September 2005 is too soon.

The tax reform commission has been blessed, or cursed, with good, or bad, timing. Attention is focused on the suffering in the Gulf Coast, and even many miles inland, so we are forgetting that the commission will be issuing a report in the not so distant future. To me, it's a great opportunity. This disaster can be a catalyst for genuine tax reform. After all, we have been reminded that the nation's tax policy, like its energy and other policies, isn't quite up to what it needs to be to accommodate these sorts of disasters.

We have been warned. Despite all the death and destruction, the nation still has a chance to reset its course. The next time, we may not be so lucky. Yes, the next one could be worse. Much worse. Is the nation ready? Oh, how I hope so. But I fear not.

Thursday, September 01, 2005

A Return to the "Check the Box" Regulations 

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

In its Memorandum and Order, the court held that even though the natural answer to the question posed in the title of Polsky's article is "no," that isn't the question. The Court concluded that the "check the box" regulations do not have the effect of overruling the Supreme Court, and that the Morrissey decision does not required invalidating the regulations. The Court stated:
Certainly, the check-the-box regulations are the subject of academic and theoretical questioning. Professor Polsky has proposed that the Treasury has gone too far in adopting regulations concerning corporations and other associations. However, it is a theory only that the check-the-box regulations violate the Internal Revenue Code definitions because those definitions were made in effect permanent by Morrissey. The Court does not believe that Morrissey forever incorporated in all future Treasury regulations a particular definition of an “association.”
Of course, as I pointed out in my initial posting on Littriello, the possibility of appeal cannot be discounted, and this most recent development does not appear to remove or even significantly reduce the possibility, whatever it may be, of an appeal.

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

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

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

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