Friday, December 2, 2011

December Programming Note

I will be blogging infrequently for the month of December, due to work and holiday-related obligations.

Happy Holidays! See you in January (maybe late December)

Monday, November 28, 2011

Sheppard on Earnings Stripping

Our favorite tax fashionista, Lee Sheppard, has an interesting article out today. See "News Analysis: The Fashion in Interest Deduction Restrictions," Tax Notes, Nov. 28, 2011, p. 1061.

Earnings Stripping

What is earnings stripping? First, some background. Many jurisdictions, including the United States, permit taxpayers to deduct interest expense in computing net taxable income. Deductible interest reduces pre-tax income and taxes owed to the revenue authority. The deductibility of interest expense creates a difficult challenge for policy makers. The issue will be lurking below the surface as Congress begins wading into the waters of tax reform.

Deductible interest creates a "bias" for debt-heavy capital structures ("overleverage"). The deduction for interest expense artificially decreases the "real" cost of debt relative to the "real" cost of equity. Overleveraged capital structures are more likely to capsize during the "trough" of business cycles, creating turmoil and trauma for stakeholders of the overleveraged business (employees, customers, local communities, etc.).

Deductible interest also permits business owners to "strip" taxable income out of the the tax base. This "earnings stripping" or "base erosion" involves variations on a theme. Sheppard's article focuses on cross-border earnings stripping.

A corporate parent with a foreign subsidiary may be able to fund the subsidiary with "shareholder loan" capital that pays interest. With proper treaty planning, (i) the shareholder loan pays interest, (ii) the interest expense is deductible, reducing taxable income and tax liabilities in the subsidiary's jurisdiction, and (iii) low or no withholding taxes apply to the interest payment. This type of structure permits the parent to "strip" earnings out of a higher-tax jurisdiction into a lower-tax jurisdiction.

Designing an "interest strip" is not rocket science. Tax advisors can use the basic structure in domestic transactions. Assume a group of pension funds pools capital and purchases a U.S. business organized as a corporation. The pension funds capitalize an acquisition vehicle with a mix of equity capital and "shareholder loan" capital. The decision to capitalize with equity and debt is effectively "deemed" to have economic substance. The target business generates taxable income after the acquisition. But the acquisition vehicle pays deductible interest expense on its shareholder loans. The pension funds are tax-exempt entities, so pay no tax when they accrue or receive interest. Voila, an "interest strip" -- shifting tax revenue from the U.S. Treasury to the pension funds.

(In the long run, query whether foreign and domestic pension funds will be able to use their tax-advantaged status to purchase every commercial enterprise on Earth. Marx would be vindicated. The working class -- through pension funds and their investment managers -- would control the means of production.)

U.S. Rules

Congress understands that earnings stripping can be a big problem. It enacted Code section 163(j) to address the issue. Sheppard snorts at the U.S. rules: "[I]t remains ridiculously easy to strip [income out of the United States] using interest deductions, despite a statute squarely aimed at foreign-parented groups."

I won't go into section 163(j) in detail. It limits a corporation's related-party interest deductions if the corporation has too much leverage and too much interest expense. It works in some cases, but has a couple obvious shortcomings. First, it doesn't apply to my domestic example above (where a group of pension funds acquire a U.S. business and use shareholder loans to interest strip). The statute only bites if the shareholder loan capital is provided by a "related" person.

Second, the U.S. limitation does not expressly contain any transfer pricing limitation. Take a technology business. Many technology businesses are capitalized with low ratios of third-party debt to equity ("leverage ratios"). But let's assume that a foreign parent corporation purchases a U.S. target corporation and injects leverage (a shareholder loan) into the target's capital structure. Assume that external leverage ratios in the industry are very low (10% or lower). But the foreign parent capitalizes its new subsidiary with $20x of equity capital and $80x of shareholder loan capital (an 80% leverage ratio).

The U.S. earnings stripping rules do not prohibit the legal structure. And while the U.S. transfer pricing rules impose "arm's length" pricing requirements on intercompany transactions, IRS agents do no commonly focus on shareholder loans (in my experience). Unlike Sheppard, I don't fault section 163(j), so much as lax or unsophisticated U.S. tax administration.

German Rules (and Copyists)

Historically, the U.S. has exported principles of tax law and administration. But the rest of the world has caught up. Sheppard summarizes discussion at a recent International Bar Association annual meeting in Dubai. Tax professionals explored various European earnings stripping limitations. At some point, U.S. policymakers will start paying attention.

According to Sheppard, Germany was the first country to revise its earnings stripping rules. The German rules have serious teeth. The rules apply to all debt of a German affiliated group (an organschaft). The deduction for net interest expense is limited to 30 percent of EBITDA, regardless of whether the payer is related to the lender. EBITDA for this purpose is capped by the group's taxable income. (This effectively limits the benefit of timing or temporary differences to an organschaft with external or internal leverage.)

Practitioners apparently regard the limitation as "stingy." In my view, this is another example of German sensibility and efficiency. The rule is simple to describe and understand. It keys off EBITDA of a business; the financial metric that lenders and equity investors care about when financing an enterprise. The limitation may get low marks on "elegance," but it gets high marks from an administrative perspective. From a tax compliance perspective, policymakers should balance ease of administration against "technical perfection."

Italy has adopted a close variation of the German rule. The French legislature is considering a similar regime to address perceived abuse of French thin cap rules. The Dutch, Irish and Swedish are openly struggling with excessive leverage in domestic capital structures due to cross-border private equity transactions.

If you work in the international tax space or the domestic M&A space, Sheppard's article is definitely worth a quick read.

Friday, November 25, 2011

Hypocrisy and McMansions

Happy Thanksgiving Weekend!

With the national economy sputtering and unemployment around 9%, many Americans will need to tighten their belts this holiday season. Meanwhile, Democrats and Republicans in Washington teamed up to serve up a big order of Hypocrisy on a silver platter.

On November 18, President Obama signed into law a bill that reinstates higher conforming loan limits for the Federal Housing Administration through 2013.

In plain English, home purchasers can now receive cheaper financing on home loans up to $729,750. The financing is "cheaper" because it's effectively guaranteed by the federal government (i.e., taxpayers). The interest rate on non-conforming jumbo loans is roughly 0.75% higher that the interest rate on conforming loans.


Gee, isn't this a sign of progress? Team Obama was finally able to hammer out a bipartisan consensus with Republicans. The House passed the bill with a healthy 298-121 majority. Of the dissenters, 101 were Republicans and 20 were Democrats.

The main progress here was the blatant display of hypocrisy. Politicians didn't hold their noses against the stench and enact this bill in the dead of night. They transparently abandoned their "core principles" in broad daylight.

Let's start with the Democrats. The Obama administration and Congressional Democrats have relentlessly spun the following narrative:
The Great Recession was brutally difficult for lower- and middle-income Americans. But upper-income Americans emerged largely unscathed. And many of them actually profited from the economic downturn. The top 1-2% have "unclean hands" because they have not suffered the harshest effects of the economic downturn. And it is time to "spread around" some of their wealth by creating or expanding government programs funded by increased taxes on the top 1-2%.
Rhetoric aside, these tireless advocates for the middle class understand where their bread is buttered. The most expensive real estate in the United States is concentrated in Democratic strongholds on the East and West Coasts. Wealthy liberal enclaves provide enormous financial support to Democratic politicians. Note that House Democrats overwhelmingly supported the legislation.

A middle-class American cannot afford a million-dollar McMansion. She does not need a $700,000 jumbo loan, conforming or non-conforming. This legislation was nominally intended to keep an ailing real estate market on life support. But the main people hurt by a softer real estate market are the affluent real estate brokers and financial institutions that service upscale local markets. To quote tax blogger James Maule, "boo hoo" for affluent real estate brokers. Democrats howl about cuts to services for the "most vulnerable" Americans. Yet when push comes to shove, they prioritize subsidies to affluent real estate brokers by propping up home values in the wealthiest communities.

How about the Republicans? Most Republicans argue that free markets work, and that government intervention tends to cause more problems than it solves. Many Republicans have criticized government policy for exacerbating the housing bubble that burst in 2007 with such a devastating effect.

But Democrats do not have a monopoly on wealthy political donors in expensive homes. The "crony capitalism" that riled up the Occupy Wall Street crowd has deep roots on both sides of the political aisle. The main Republican advocate of the bill was John Campbell (R-Calif), whose constituents in Orange County have taken large haircuts on million-dollar homes. Republicans lose all credibility when they argue that certain sectors of the economy should remain on taxpayer-funded life support.

Republican also like to play the "certainty" card. They frequently argue that the economy is sputtering because individuals and businesses are uncertain about the future of government policy. But in this case, Republicans reversed course on a prior aspiration to scale back the federal government's role in residential housing finance. The acting director of the Federal Housing Authority bluntly criticized the legislation as "sending the wrong signal."

...and McMansions

The federal government (i.e., you and me as taxpayers) provide two main subsidies to the residential housing market. The first involves federal loan guarantees, which shift risk from private lenders to the government and, ultimately, taxpayers. Federal loan guarantees make it cheaper for homeowner to borrow money, which means that they can bid more for homes.

The second involves the deduction for home mortgage interest. Effectively, the mortgage interest deduction is a tax subsidy for home owners. Although the mortgage interest deduction is capped, it has the same overall effect as the federal loan guarantees. By reducing tax liabilities, the mortgage interest deduction frees up cash to service home mortgage principal and interest payments.

Here's the funny thing about the federal subsidies. They are nominally intended to make home ownership more accessible. But they don't make housing more affordable. On the contrary, the subsidies make housing less affordable, because they permit home buyers to qualify for bigger mortgages and pay for more expensive homes than would be possible without the subsidies.

Okay, if homes aren't more affordable, then who benefits from the subsidies? In other words, who benefits from government policies that increase the cost of housing above market rates?

Primarily the housing lobby, comprised of home builders and real estate agents. The former group (home builders) employs large numbers of union and other blue-collar workers in the construction industry. No surprise that Congress might want to direct economic subsidies to this group. In addition, local governments benefit from higher real estate prices, which translates into higher property tax revenues. Many local governments jumped on the bandwagon during the bubble years, assuming that real estate prices and property taxes would increase in perpetuity. They developed long-term budgets and entered into contractual obligations with service providers (teachers, police officers, bureaucrats) that have become unsustainable after the bubble popped.

The deduction for mortgage interest is second largest tax expenditure (estimated to cost $99 billion in 2012). Eliminating it would tend to make housing more affordable over time (by reducing the inflation-adjusted value of residential real estate). That's a bad result for many existing homeowners, but a good result for new homeowners. If political actions mirrored rhetoric, we would expect that Democrats and Republicans could agree on a plan to phase out the deduction over time. Home prices would become more affordable for the 99%. And individuals would re-allocate capital away from (subsidized) housing into more productive activities.

But political hypocrisy is just as certain as death and taxes.

Wednesday, November 23, 2011

Reilly and Solomon on 28% Cap

I want to highlight a terrific article published by Mary Anne Reilly and Martin B. Solomon in yesterday's Tax Notes. See "Sophistry Supporting Complexity: The 28 Percent Deduction Limit," Tax Notes, Nov. 21, 2011, p. 1019.

I'm a big fan of examples in tax articles and reports. Reilly and Solomon provide good examples that illustrate something I've been saying for months. Team Obama is unable or unwilling to articulate a coherent tax policy agenda. The Obama administration sometimes articulates principles that resonate with the political left and the political right. But the principles always degrade into populist mish-mash when translated into specific legislative proposals.


In September, President Obama launched his 2012 re-election campaign by proposing a $447 billion new stimulus measure (ahem, "jobs plan"). With a 9% national unemployment rate, Obama will be facing headwinds in the next election. He decided that he might be able to save one job (his own) by deflecting criticism to "obstructionist" Republicans.

We are running deficits as far as the eye can see. As partial funding for the new stimulus measure, the Obama administration proposed a 28% cap on certain deductions and exclusions. The specific proposal begins on page 137 of this PDF (page 134 of the report). The new cap is projected to raise approximately $400 billion. It's unclear how the new cap would apply if the 2001-2003 temporary individual tax discounts (the "Bush tax cuts") expire in 2012.

Howard Gleckman at Tax Vox reacted to the proposed cap as follows:

An across-the-board cap on the benefit of deductions and the like is often seen as rough justice — a way to tackle the Revenue Code’s trillion dollars in tax expenditures without fighting over each one. The theory: It is an easier political lift to curb such popular breaks as the mortgage interest deduction through a broad reduction of all subsidies than to fight the powerful housing industry head-on.

But Obama does pick and choose the preferences he wants to target. He nails all itemized deductions, all right, but he also goes after some – but not all – above the line deductions. Of the roughly two dozen write-offs available to those who take the standard deduction, Obama targets just eight, including health insurance for the self-employed, medical savings accounts, health savings accounts, and some higher education expenses.

He also reduces the benefit of two other hot-button breaks — the tax exclusions for municipal bond interest and the value of employer-sponsored health insurance. In other words, for those making more than $200,000, some muni bond interest and some of the value of their medical coverage would be taxed.

However, Obama would protect other exclusions, including those for retirement savings. Picking winners and losers this way is likely to defeat any claims of rough justice and make passing the plan that much tougher.

Sophistry, Complexity and Inequity

Reilly and Solomon criticize the 28% Cap Proposal on three grounds.

First, they argue that it represents politically-motivated sleight of hand. I'm not going to dwell on this argument. I believe that we should eliminate tax expenditures directly, not limit tax expenditures through complicated and unfair caps and floors. All variations of the 28% cap represent political expedience, not good tax policy.

Second, they argue that the "complexity created by separating the tax cost of income from the tax benefit of deductions is quite significant." Ironically, the "principles for tax reform" outlined by Obama in his recent message to Congress include "a call for simplification." The 28% Cap Proposal goes in the opposite direction. Do we want simplification? Or do we want to induce migraine headaches for tax preparers? You decide. The 28% Cap Proposal would require:
[A] computation of the tax on a new item called adjusted taxable income (ATI); a determination of another new item, the minimum marginal rate amount (MMRA); computation of tax on the greater of taxable income or the MMRA; and a computation of the "additional amount," which is the excess of the tax on ATI over the greater of the tax on taxable income or the MMRA, plus 28 percent of the excess of ATI over the greater of taxable income or the MMRA. This last number represents the additional tax generated by the new 28 percent deduction limitation.
Third, they argue that the "proposal is loaded with potential inequities and questionable tax policy." Most important, the new rules would have a cliff effect. They would be "triggered on an all-or-nothing basis when a taxpayer's adjusted gross income is above $250,000 for a joint return and $200,000 for a single taxpayer," potentially resulting "in an enormous addition to tax as a result of as little as $1 of additional income."

Reilly and Solomon provide an example of a family (the Cliff Family) with two parents and two children. The example compares the tax liabilities of the Cliff Family assuming AGI of $250,000 and $250,001, respectively. The authors hold other numbers constant to demonstrate the impact of the 28% Cap Proposal. Based on "middle of the fairway" assumptions, the authors demonstrate that $1 in additional salary income to the Cliff Family would trigger a $5,708 incremental tax liability.

The political left has vehemently argued that the "wealthiest" taxpayers are not paying their "fair share." The Obama administration has consistently defined "wealthy" taxpayers to include a family with $250,001 of taxable income. Does a $5,700 tax liability on $1 of incremental income satisfy the administration's definition of "fairness"? Is there someone on the political left creative enough to defend the "fairness" of the cliff effect? I'll stay tuned for that development.

Monday, November 21, 2011

Sacrifice Without Balance

In today's post, I'd like to highlight an excerpt from Joseph Thorndike's article, "What the Civil War Can Teach Us About Tax Reform." See Tax Notes, Nov. 21, 2011, p. 944. Thorndike hits a couple points that are consistent themes on this blog. The emphasis is mine.
What can the Civil War tell us about today's debate over deficit and debt reduction? It's the notion of sacrifice that links the two eras. Then, as now, the nation faced a serious fiscal crisis. And then, as now, lawmakers struggled over how to allocate the pain incurred while solving it.

Differences abound, of course. An entitlement-driven fiscal crunch is not the same thing as a war, no matter how severe it might become. Mortal sacrifice on the battlefield is not the same as economic sacrifice from a paycheck.

Still, the notion of shared sacrifice unites those episodes. Clearly, solving today's fiscal problems will be painful, requiring higher taxes and lower spending. The necessary changes won't be pleasant for anyone -- and they will be deeply painful for some, especially those who depend on key social programs.

But today's lawmakers have failed to acknowledge that broad-based sacrifice will be necessary to solve the nation's fiscal problems. No one in either party is willing to talk about meaningful entitlement reform.

Lawmakers are also not being honest about taxes. If higher revenues are going to be part of the solution, then the extra burden will almost certainly fall on everyone. But so far, the champions of higher revenues have been unwilling to acknowledge that everyone will end up paying more. Instead, they have focused narrowly on raising taxes on those with high incomes.

I've said it before and I'll say it again. Democrats and Republicans have been complicit in deficit-spending for decades. They created entitlement programs that are structurally imbalanced and unsustainable. They designed tax expenditures that distort markets, stoking health care inflation and contributing to the real estate bubble. They manufacture drama to score points with political supporters who cannot or choose not to keep track of the bigger picture.

We cannot address these structural and tax policy challenges by increasing taxes on "millionaires and billionaires." There is no "class war" between the 1% and the 99%. If we want a bigger government and if we want to maintain federal spending on entitlements, we'll need to raise taxes on the top, middle, and bottom of the income spectrum. We may need to eliminate "sacred" tax expenditures. We may need a VAT or carbon tax. The status quo is a path towards extreme hardship for millions of Americans when the bottom falls out from under the political class.

Friday, November 18, 2011

Subsidizing Millionaires

On Tuesday, Paul Caron and Peter Pappas linked to a report by Senator Tom Coburn (R-Okla). The report is entitled "Subsidies of the Rich and Famous: Federal Programs and Tax Breaks That Help Millionaires." The full report is 37 pages. It focuses on tax programs that benefit millionaires, and also spending programs that benefit millionaires.

Teslas and Golf Carts

Pappas is mildly critical of the report. The report lists several tax expenditures and summarizes the share of each tax expenditure captured by millionaires. I agree with Pappas that eligible millionaires are not doing anything "unfair." Congress enacts tax expenditures because it wants to influence economic behavior.

Take the electric vehicle credit. The Coburn report indicates that $12.5 million in electric vehicle credits were claimed by millionaires in 2009. To my knowledge, a $7,500 credit was available for the purchase of electric vehicles during the calendar year (Section 30D). The primary vehicle available for on-road transportation in 2009 was the Tesla Roadster. The base price for the Roadster is $108,000. Middle-class taxpayers were not rushing out and purchasing these vehicles. (As Paul Caron document in 2009, some upper- and middle-income taxpayers apparently claimed the credit to defray the purchase of golf carts.)

Remember, Democrats controlled Congress and the White House in 2009. They had the power to amend the Code and prevent millionaires from claiming the credit against purchases of Teslas (and golf carts). But they want to encourage an overall shift to "green" energy. The tax credits for electric vehicles are consistent with that larger policy commitment. Electric vehicles are expensive. Congress knew or should have known that millionaires would take advantage of the credits, because very few non-millionaires can drop $100,000 on an electric vehicle.

The fact that Congress designs stupid tax policy (like electric vehicle credits for millionaires) to support other policy objectives (like a transition to "green" energy) demonstrates that Congress can be stupid. This is not some kind of "loophole" for the wealthy. Congress opened a door to encourage upper-income taxpayers to purchase electric vehicles. Some upper-income taxpayers decided to walk through the open door. We don't know how many, if any, were encouraged by the credit. Tax incentives that don't change economic behavior are dollars down the drain.

On balance, the Coburn report highlights a number of these intersections between economic/social policy and tax/fiscal policy. The report demonstrates the law of unintended consequences. It doesn't make much sense to give tax credits to millionaires who purchase electric vehicles (but it's a consequence of supporting "green" energy manufacturers). It doesn't make much sense to pay unemployment or Medicare or Social Security benefits to millionaires (but it's a consequence of a political aversion to means testing for entitlements). We should be revisiting and reshaping these policies over time.

Closer Look at the Numbers

The Coburn report parrots a widely-reported data point: that 1,500 millionaires paid no income tax during 2009. To be more precise, 1,470 individual taxpayers reported AGI in excess of $1 million, but paid zero income tax.

I've seen this data point before, and it piqued my curiosity. How are these upper-income taxpayers zeroing out their federal income tax liability?

It seems likely that most of these taxpayers are making large charitable contributions. A wealthy individual may have resources to make a large cash or in-kind donation to charity and claim the amount as a miscellaneous itemized deduction (Line 40 of Form 1040).

In this respect, the Coburn report is misleading. This table in the Coburn report lists a number of "tax breaks" claimed by millionaires. The two biggest "tax breaks" are the deduction for mortgage interest ($27.7 billion from 2006-2009), and the deduction for rental expenses ($64.3 billion from 2006-2009). The report omits to mention the total charitable deductions by millionaires during the same period. I suspect that Coburn's staff included "bad tax breaks" (like mortgage interest expense) while excluding "good tax breaks" (like charitable deductions). This type of cherry-picking tends to muddy the waters -- all tax expenditures should be on the table when we start talking fundamental tax reform.

One thing is clear -- the list of "tax breaks" enumerated in the table would not zero out a millionaire's taxable income during a given year.

* * * * *

Interested readers can locate the 1,470 individual taxpayers on page 40 of this report.

Here's the breakdown among the different income groups:

Paid Tax
No Tax

$1.0 under $1.5 8,274
$1.5 under $2.0 14,322
$2.0 under $5.0 61,918
$5.0 under $10.0 44,273
$10.0 or more 108,096

Wednesday, November 16, 2011

Break Out the Dentures

On Monday, the Supreme Court agreed to review the constitutionality of ObamaCare. That prompted me to sketch out the core principles of ObamaCare. Today I'll discuss the penalty regime in more detail. The penalty regime is arguably the lynchpin of the entire health care "reform" legislation. And it was designed to have no teeth, legally or economically. Call in the dentists.

Core Principles

The crux of ObamaCare is the individual mandate. The individual mandate requires most individuals and families to obtain "minimum essential" health coverage. The individual mandate is critical, because ObamaCare requires insurance companies to provide coverage to older, sicker individuals (i.e., individuals with "pre-existing conditions"). And it prohibits insurance companies from charging higher premiums to sicker individuals (within age bands).

Because ObamaCare will "expand" insurance coverage to older, sicker individuals, it will increase costs to existing participants in health insurance schemes. The costs of older, sicker participants will get transmitted to other participants, increasing premiums. To neutralize this cost spike, Congress needed to persuade/coerce more younger, healthier individuals to purchase coverage.

ObamaCare employs a "carrot" and "stick" approach to persuade/coerce the uninsured to purchase health insurance. The "carrot" involves tax subsidies for low- and middle-income households who purchase coverage through state exchanges. The "stick" involves a penalty regime applicable to individuals and families who do not obtain qualifying health coverage.

Toothless Penalties

I summarized the penalty regime on Monday. The penalty is the greater of a flat dollar amount per individual taxpayer that rises to $695 in 2016 and is indexed by inflation thereafter (with caps for children and families) or a percentage of the taxpayer's household income that rises to 2.5 percent for 2016 and subsequent years (also capped). See examples here.

Based on a CBO/JCT report, Congress assumed that approximately 1% of the population would be subject to penalties after ObamaCare is fully implemented. CBO/JCT estimates that approximately 21 million individuals will continue to be uninsured. However, only 4 million of them have sufficient household income to be dinged by the penalty regime.

Let's step back for a moment. A "penalty" is a punishment for some action or omission. If you drive faster than the speed limit, you get a speeding ticket and pay fines. If you don't have minimum essential coverage, you are supposed to pay a penalty (as described above). But Congress assumed that roughly 80% of the individuals who do not comply will be exempt from penalties. They are not deemed economically capable of compliance, so they are not punished for non-compliance. Does it make any sense to establish a penalty regime that provides an 80% exemption rate?

Ultimately, the penalty regime is window dressing to support deeply flawed legislation. Congress did not want the penalties to have teeth, legally or economically.

No Legal Bite

Democrats in Congress preach a "free lunch" gospel to low- and middle-income voters. The Democratic Gospel of Free Lunch says that the federal government can (i) create or expand social welfare programs, and (ii) "pay" for the costs by increasing taxes on the "wealthy." They want to balance a pyramid on its tip. Longer term, it's an unsustainable strategy. A pyramid won't balance on its tip, and we're heading towards the fiscal abyss. Shorter term, the Democratic Gospel is an effective way to rally support and votes.

Republicans argued that ObamaCare could only be financed through across-the-board tax increases. Democrats were sensitive to this charge for ideological and practical reasons. ObamaCare needed to provide benefits to low- and middle-class voters without increasing their taxes. President Obama vocally and publicly argued that the penalty for non-compliance with the individual mandate was not a "tax." Democratic leaders feared that a rigorous penalty regime would be viewed as a de facto tax on the uninsured (generally low- and middle-income households). The ObamaCare penalty regime was designed to have no legal bite.

The penalty regime will be administered by the IRS. Now, along with auditing tax returns, the IRS will need to track whether individuals and families maintained health coverage each month during the calendar year. Congress might as well have required the IRS to develop and launch a new Mars Rover. It's inconceivable that the IRS will be able to develop a system that (i) tracks whether 360 million Americans have health coverage each month, (ii) flags all non-compliant individuals on a timely basis, (iii) filters out the 16 million Americans who are expected to be exempt from penalties, (iv) provides timely notice of penalty to the 4 million Americans who are expected to owe penalties, (v) provides an efficient dispute resolution mechanism (for errors), and (vi) collects penalties on a timely basis. Congress is okay with IRS dysfunction. In this case, a dysfunctional administrator is consistent with the Democratic Gospel.

If the IRS somehow determines that an individual is non-compliant and owes penalties, the IRS is not permitted to file liens or levies to collect the penalties. In other words, the IRS can only "collect" the penalty out of refunds owed to the taxpayer in question. A taxpayer can "opt out" of the penalty regime by underpaying estimated taxes during the course of the year. Any individual with positive tax liability for a given calendar year will not be required to "pay" anything. Presumably, cumulative "penalties" will carry forward into successive tax years until cumulative refunds are offset against the penalties. Again, there is a huge timing disconnect; the IRS typically issues refunds before examining tax returns. Will the IRS system be able to "match" non-compliant taxpayers and their "penalties" before refunds go out the door?

No Economic Bite

The ObamaCare penalty regime also lacks economic bite. Let's assume miraculous administration (i.e., the IRS timely assesses and collects "penalties" out of tax refund amounts). In 2016, the penalty for a non-compliant individual will be approximately $700. The projected average cost of an individual employer-sponsored insurance policy is approximately $8,300.

(Remember, subsidies under ObamaCare will encourage more people to purchase health insurance. As demand for insurance rises, insurance premiums will increase. Plus, insurance companies will be required to cover more older and sicker individuals, spreading higher costs to other participants.)

Go back to my post from Monday. Let's say I'm a young, single, uninsured Gambler with no dependents. I make enough money to cover rent, car loan payments, school loan payments and recreational opportunities. Even with subsidies under ObamaCare, I can't afford an $8,300 annual policy. I can easily afford a $700 penalty. Plus, I've heard that insurance companies must offer me coverage at any time, irrespective of my health status (no discrimination for "pre-existing conditions"). I can cruise along for the time being without health coverage. If I get very sick or seriously injured, I'll enroll in a health insurance scheme through one of the state exchanges.

The drafters of ObamaCare understood the perverse economic incentives. They could have given the mandate some economic bite, simply by linking penalties to average insurance premiums on the taxpayer's resident state exchange. But again, a rigorous penalty regime would be inconsistent with the Gospel of Free Lunch. Democratic leaders were not attempting to create a penalty regime with teeth. They just needed to put some lipstick on a pig.

Monday, November 14, 2011

Kenny Rogers vs ObamaCare

As widely expected, the Supreme Court has agreed to address several constitutional issues arising from the Patient Protection and Affordable Care Act (a/k/a ObamaCare).

Individual Mandate

Most of the public scrutiny of ObamaCare focuses on the constitutionality of the "individual mandate." The individual mandate requires individuals and families to purchase "minimal essential" health insurance. Individuals and families that fail to comply are subject to penalties. No penalties apply to very low-income taxpayers. Certain individuals are exempt from the mandate and penalty regime (e.g., illegal immigrants).

The penalty is the greater of a flat dollar amount per individual taxpayer that rises to $695 in 2016 and is indexed by inflation thereafter (with caps for children and families) or a percentage of the taxpayer's household income that rises to 2.5 percent for 2016 and subsequent years (also capped). See examples here.

Ghost Penalties

True to form, Congress designed a complicated penalty regime that isn't projected to raise much revenue. The Congressional Budget Office and Joint Committee on Taxation estimated that approximately 21 million non-elderly residents will be uninsured in 2016, but that a substantial majority of them will not be subject to the penalty. CBO/JCT projected $4 billion in annual revenue from the penalty from 2017 to 2019.

As the CBO/JCT numbers illustrate, Congress designed the penalties to lack teeth. Approximately 50 million individuals were uninsured in 2010. Roughly 40% of that pool (21 million) will remain uninsured after implementation of ObamaCare. Not so hot. Of the remaining uninsured (21 million), only 3.9 million (20%) have sufficient taxable income to be dinged for penalties.

These numbers are astonishing. Congress assumed that, by 2016, nearly 99% of the population would not be subject to penalties. (We're projected to have approximately 320 million Americans in 2016.) We don't have the assumptions underlying those assumptions. Congress must have concluded that the uninsured would either purchase insurance to avoid penalties, or use new tax subsidies to fund premiums (irrespective of the penalties). More on this "carrot" and "stick" approach below.

You've Got to Know When to Hold 'Em...

Why did Congress impose a "mandate" that individuals and families purchase minimal essential coverage?

Let's step back. Approximately 50 million individuals were uninsured in 2010. Many of those individuals made a conscious or unconscious economic decision not to purchase health coverage. In other words, they had sufficient discretionary income to purchase health coverage, but they chose to spend money on goods or services other than health insurance. These individuals were effectively "gambling" that they would not become sick or injured. Many of the Gamblers were young and healthy individuals who are unlikely to become sick on an actuarial basis.

Congress wanted to coerce these Gamblers to participate in the private health insurance market for reasons discussed here by Princeton economic professor Uwe Reinhardt.

In layman's terms, private insurance depends on a large "pool" of younger, healthier individuals whose premiums are used to pay the health care expenses of older, sicker individuals. If younger, healthier individuals become Gamblers (stop paying premiums), the costs of older, sicker individuals are spread among a smaller "pool." This increases the average premiums charged to the remaining members of the pool, encouraging even more younger, healthier individuals to become Gamblers. If enough young, healthy individuals become Gamblers, a private insurance scheme can face a "death spiral" effect.

ObamaCare created new incentives for young, healthy individuals to become Gamblers. Remember all the buzz over "pre-existing conditions"? ObamaCare requires health insurers to accept all applicants willing to pay (guaranteed issue). And it requires that health insurers charge the same premiums, regardless of the health status of the applicant (community rating). See Reinhardt for more. The key point is that guaranteed issue and community rating tend to increase the cost of insurance for younger, healthier individuals, because insurers cannot exclude older, sicker individuals, and they cannot modulate premiums to reflect health status.

Let's imagine a young, healthy individual in his or her early 20s (a Gambler). Our Gambler graduated from high school or college and landed a job in a service industry that pays decent wages but offers no health benefits. Our Gambler has no dependents, and prefers to allocate his or her disposable income to rent, car loan payments, school loan payments, vacations, beer and "medicinal" marijuana rather than purchasing health insurance. Under ObamaCare, our Gambler can coast along as an uninsured, spending the "premium savings," until stricken by accident or injury. If hit by accident or injury, our Gambler calls up a health insurer and starts paying premiums. The health insurer cannot reject our Gambler based on a "pre-existing condition." And it cannot charge higher premiums based on the health status of our Gambler.

Our Gambler presents a big problem for the drafters of ObamaCare. The mandate and penalty regime are supposedly the "stick" that discourage rampant gambling. They are supposed to backstop the "carrot" of tax subsidies.

...And When to Fold 'Em

ObamaCare arguably involves more "carrot" than "stick." Gamblers not impressed by the penalty regime will receive tax subsidies if they participate in the private insurance market. Specifically, ObamaCare provides for refundable tax credits that individuals and families can use to help cover the cost of health insurance premiums paid to a state exchange.

State exchanges are intended to improve the transparency and competitiveness of health insurance markets, thus lowering costs. The mechanics are fairly open-ended and complicated. In theory, an uninsured individual should be able to browse a "menu" of standardized insurance plans from different carriers through an exchange. The exchange concept raises various issues beyond the scope of this post. The tip of the iceberg: why create 50 government-regulated state exchanges rather than trying to create a competitive national health insurance market?

Congress assumed that virtually nobody would pay penalties. The penalty regime is expected to generate annual revenue of $4 billion for several years after implementation. In contrast, the CBO has estimated that the "exchange subsidies and related spending" would cost more than $100 billion annually during that period (see PDF p. 16).

Big picture, it appears that Congress believed that the tax subsidies and a more accessible "menu" of insurance options (the state exchanges) would encourage Gamblers to fold 'em. I'm surprised by the CBO numbers. Remember, Congress expected that ObamaCare would move approximately 30 million uninsured out of Gambler status into the system. In the 2016-2020 period, the average tax subsidy per uninsured is projected at roughly $3,800. $3,800 sounds very low relative to the cost of individual health insurance.

Break Out the Dentures

The Supreme Court is poised to examine the constitutionality of the individual mandate and penalty regime. The penalty regime was designed to have no teeth, legally or economically. We live in strange times. The constitutionality of ObamaCare hinges on a mechanism that Congress did not intend to have any teeth. Anybody have a good dentist? More to come in my next post.

Friday, November 11, 2011

If You Talk the Talk...

On Wednesday, I examined a Monday post by James Maule. See The Tax and Spending Stalemate: Can It Destroy the Nation?, MauledAgain (Nov. 7, 2011).

Maule blamed Republicans for the legislative gridlock surrounding competing infrastructure proposals. The Democrats are pushing a $60 billion spending measure, "funded" by tax surcharges on "millionaires and billionaires." The Republicans are pushing a $40 billion spending measure, "funded" by unused outlays for other programs.

Maule was nominally venting about our crumbling infrastructure and jobs crisis. In substance, he was channeling the anxiety of the political left. If Maule were serious about infrastructure spending and economic stimulus, he would have lectured the Democrats for rejecting the $40 billion measure. A compromise starts with common ground. As between $60 billion and $40 billion in spending, $40 billion is the "common ground."

I'm sure that Maule is genuinely concerned about the current unemployment crisis. As such, I'm guessing that he'll be disturbed by a recent setback to energy infrastructure development.

On Thursday, Team Obama delayed the proposed Keystone XL oil pipeline until after the 2012 election.
The proposed Keystone XL Project (click here for map) consists of a 1,700-mile crude oil pipeline and related facilities that would primarily be used to transport [oil] from an oil supply hub in Alberta, Canada to delivery points in Oklahoma and Texas. The proposed Project would also be capable of transporting U.S. crude oil to those delivery points. The proposed project could transport up to 830,000 barrels per day and is estimated to cost $7 billion.
The announcement marked a sharp reversal by Team Obama. The State Department had previously supported the pipeline on national security grounds. Obviously, importing oil from Canada reduces our dependence on Middle Eastern oil imports. The $7 billion project would upgrade the nation's energy infrastructure; a Democratic priority until yesterday. It was expected to created tens of thousands of jobs during the midst of a national unemployment crisis. And it was funded with private capital, thus avoiding Congressional gridlock entirely.

Unfortunately, the end run around Congress ran into the brick wall of regulatory delay. Environmental activists were particularly hostile to the Keystone XL project, because the pipeline would transport oil from Canadian tar sands. (Never mind that Canada could route the oil from tar sands to the Pacific coast for export to Asia.) As noted by the LA Times, the decision exposes Team Obama "to the same criticism the White House has leveled at congressional Republicans regarding deficit reduction: delaying a tough call in hopes that the politics will be better after next November's election."

The building trade unions, whose members have been disproportionately hurt by the Great Recession, condemned the decision:
Terry O'Sullivan, general president of the Laborers' International Union of North America, said the move would "inflict a potentially fatal delay to a project that is not just a pipeline, but is a lifeline for thousands of desperate working men and women. The administration chose to support environmentalists over jobs—job-killers win, American workers lose."
Mr. O'Sullivan's comments are right on the mark. The political left talks the talk about infrastructure and jobs. But they don't walk the walk, as evidenced by the flip flop on the Keystone XL project. It boils down to a question of priorities. We're in the midst of a national unemployment crisis. Do we want a government that responds flexibly to balance environmental, labor and other considerations while fostering public and private infrastructure spending? Or do we want a government that prioritizes environmental or other regulatory considerations above infrastructure upgrades and job creation?

A cynic might take a hard look at the Keystone XL decision and allege that Team Obama is trying "to do everything they can to drag down this economy." But I'll leave that commentary to Harry Reid and left-wing academics.

Wednesday, November 9, 2011

Whitesnake Maule's Again

I spent a couple posts last week debunking Beale's Law (see here and here). On Monday, another tax professor jumped onto the factual manipulation bandwagon. This time, left-wing blogger James Maule put himself in the spotlight. [To demonstrate the echo chamber effect, Linda Beale promptly cheered Maule's post.]

As I said last Friday:
When it comes to data manipulation for political purposes, the right and the left are engaged in a long-running tug of war. They both abuse statistics* and economic common sense to influence public opinion in the short term. It's great sport for incumbent politicians, blogging left-wing academics and Washington lobbyists. Not so great for the country in the long run.

* Okay, I should have said "facts, statistics and economic common sense."
Why am I calling out Maule for factual manipulation?

On Monday, Maule linked to this report on the latest political volley between Senate Democrats and Republicans. Maule fumed over Republican opposition to a $60 billion infrastructure proposal from Team Obama. He then scolded Republicans for a proposal to allocate $40 billion to infrastructure spending from "unspent funding for other domestic programs." In Maule's view, the Republican proposal was a non-starter because it "included provisions intended to make the nation’s air quality worse than it is, under the pretext that less regulation means better lives for, oh wait, more money for those already with plenty of it."

According to Maule:

[1] Team Obama's infrastructure proposal ($60 billion) kills two birds with one stone. It begins to address our massive deficit in infrastructure spending. And it pumps needed federal outlays into the economy, where they will support construction jobs.

[2] Republicans oppose the $60 billion spending measure for several reasons. First, it is "funded" with a surcharge on millionaires. ("Boo hoo for the wealthy," says Maule.) Second, it is too large of a government commitment. Senate Republicans have given us a middle finger, telling us that we don't deserve quality highways and bridges. (Probably a fat middle finger, swaddled in expensive rings.)

[3] Harry Reid correctly identified that the Republicans intend "to do everything they can to drag down this economy."

[4] Democrats properly rejected the $40 billion spending measure, because Republicans were just using it as a vehicle to further undermine our nation's impossibly toxic air quality. (I know that I cannot run outside on the trails of northern California without several gas masks and tanks of oxygen.)

[5] Republican partisan politics, as obvious from the above reprimand, are reprehensible. Democratic partisan politics, as obvious from the Harry Reid quote, are a necessary counterweight against those damned partisan Republicans.

Let's review how Maule's key points hold up against a dash of facts and a pinch of logic.

[1] Maule is correct that we need more long-term investment in public infrastructure. However, as I've previously discussed, infrastructure is not a holy grail of short-term job creation. Meaningful infrastructure projects require several years of development. Neither the Democratic proposal ($60 billion) nor the Republican proposal ($40 billion) would have an immediate stimulative impact on the construction industry.

The Department of Transportation has a $70 billion annual budget (rough numbers). States and municipalities spend many billions more on transport infrastructure annually. Public utilities spend many billions more on energy infrastructure annually. We don't need to spend money on infrastructure just for the sake of spending money. We should be focused on developing high-quality infrastructure using the slack in the labor market to get the highest "bang for the buck" on construction expenditures.

[2] Maule wants to increase taxes on the "wealthy," so no surprise that he favors the Democratic proposal ($60 billion in spending "funded" by a surcharge on millionaires). However, if we're going to increase taxes on the wealthy, why not use those revenues to address the existing budget deficit? The Republican proposal was also "funded" by "unused" outlays to other programs. Both sides are engaging, to some extent, in accounting gimmicks. But the Republican proposal is more fiscally responsible (although gimmicky).

Maule accuses the Republicans of espousing that we "don't deserve quality highways and bridges." He completely ignores the $40 billion Republican proposal. Or perhaps Maule believes the $20 billion difference between two measures would provide us with "quality highways and bridges."

[3] Maule criticizes Republican allegations that Democrats were pursuing a tactical agenda focused on 2012 elections. He praises Harry Reid for comments that Republicans are attempting to damage the economy.

How much more biased can someone possibly get? Let me be clear. The political left and the political right are both playing this game with an eye towards 2012. If the Democrats were serious about infrastructure spending, they could have worked with Republicans on the $40 billion measure.

[4] In point [1], Maule argues that the $60 billion Democratic proposal could address our under-investment in infrastructure and provide stimulus the construction industry. He criticizes Republicans for arguing that $60 billion is "too big" a number. Then he criticizes Republicans for a $40 billion spending measure (presumably "too small" for Maule).

But if infrastructure spending is good for the economy, shouldn't the Democrats be working with the Republicans on a bipartisan $40 billion package? Why should they resist all spending just because they want to spend a higher number? Maule reminds me of schoolkids on the playground. Apparently, if the Democrats don't get their way, they should pack up their toys and go home.

Maule gripes about the regulatory conditions affixed to the Republican bill. I'm highly confident that he hasn't perused the actual bill (S.1786). The Republicans were mainly trying to streamline the regulatory process applicable to the very same infrastructure projects that are funded by the bill.

[5] Yes, partisan politics are obnoxious. As a political independent, nothing is more frustrating than empty posturing over budgetary gimmicks and class warfare tax policies. However, the political left has no monopoly on virtue. When you start quoting Harry Reid, you confirm that you are a card-carrying cheerleader for Team Obama.

What's with the title of this post? I realized that I've spent the past several posts debunking Linda Beale and James Maule. My friends on the political left are probably thinking, "here he goes again." So I dedicate this one to you:
Here I go again on my own
Going down the only road I've ever known
Like a drifter, I was born to walk alone
And I've made up my mind
I ain't wasting no more time

Monday, November 7, 2011

Inequality and U.S. Economic Hegemony

In my last two posts, I've discussed Beale's Law (see here and here). Beale's Law posits that pre-tax income inequality has an "inverse" relationship to top tax rates. Today's post explores the more complex reality underlying the increased economic inequality in the United States.

The Decline of U.S. Economic Hegemony

The political left has convinced itself that inequality of income and wealth is primarily a function of tax rates. The narrative is easy to promote through soundbite politics. It stokes our base emotions (envy) and offers a simple government remedy to economic inequality.

The left clings to this narrative for a several reasons. The narrative is simple and politically expedient. It offers an excuse for failed left-wing policy initiatives that were supposedly enacted to improve equality of opportunity. (If past initiatives have failed to address inequality, why should we trust the same policymakers to implement "new and improved" policies to address inequality?) Most important, the narrative permits left-wing politicians to bury their collective heads in the sand. A simple narrative that 'tax policy drives inequality' fails to acknowledge the decline of U.S. economic hegemony over the last 50 years.

During the second half of the 20th century, the United States had the world's largest, strongest and most stable economy. We had an educated workforce, a developed energy and transport infrastructure, and stable government institutions. Following World War II, we experienced an economic surge associated with the Baby Boom generation. We supported our major trading partners during a period of post-war economic redevelopment. Capital markets activity was largely domestic. Through the 1970s, we ran consistent trade surpluses. From an economic perspective, we were the 'only game in town.'

Fast forward to 2011. The U.S. is now a player on a crowded and competitive international stage. We have no structural advantage relative to our major trading partners (the EU, Canada, Japan and Australia). Developing countries have better educated workforces, and armies of low-skilled workers that cost less than their U.S. counterparts. We have no discernible energy policy, and our dependence on oil imports drives chronic trade deficits. Technology has diminished the economic significance of geography, while promoting the relevance of talent. Financial capital markets are globally integrated. Global capital flows to the most profitable opportunities.

With that historical context, we can isolate on the major causes of U.S. economic inequality:

- On a macro level, the U.S. has been dragged into intense economic competition with its major trading partners and developing economies. We are no longer the 'only game in town.'

- On a micro level, the low-skilled U.S. worker has become far less valuable than his or her counterpart in the mid-20th century. Developing economies have large pools of low-skilled workers, and multinational businesses can access those low-skilled workers at lower costs than U.S. workers.

- Conversely, the best educated and most talented U.S. entrepreneurs have become more valuable than their counterparts in the mid-20th century. Technology has concentrated returns to talent and genius.

- Moreover, the byzantine U.S. regulatory system has created a "lock out" effect. In large sectors of the U.S. economy, only the largest businesses can thrive. If a business requires an army of lawyers or lobbyists to navigate regulatory, commercial or tax issues, it qualifies. The individuals that climb to the top of the pyramid generate economic premiums by "locking out" competitors. In the mid-20th century, how many CEOs depended on armies of lawyers or lobbyists?

Acknowledging the truth about economic inequality requires us to take off the blinders. We aren't going back to a period of U.S. economic hegemony. We are required to compete in markets that are ruthlessly efficient. Our low-skilled workers are at an enormous competitive disadvantage, and will continue to lose ground relative to better educated and more talented peers. The wealth gap will probably get steeper before it flattens out again. We aren't going to reverse the long-term trend by increasing top tax rates on "millionaires and billionaires."

However, all is not bleak. Our country has an extraordinary tradition of innovation and resilience. We need to acknowledge the competitive challenges facing our nation, and coalesce around strategies to align educational opportunities with a knowledge-based economy. We need to re-boot policies and institutions that worked in the mid-20th century to reflect the challenges of the early-21st century. We need to be realists, but realism is not mutually exclusive with optimism.

Friday, November 4, 2011

Higher Taxes, Lower Pre-Tax Incomes?

In Wednesday's post, I debunked Beale's Law. Beale's Law reflects the pseudo-scientific economush advocated by the political left and political right. It provides that "income inequality levels inversely track the top tax rate--as the rate increases, income inequality decreases." Sounds like physics, right? But a close look at the numbers demonstrates that income inequality levels do not track "inversely" to the tax rate.

I'm not picking on Professor Beale. She is a bombastic advocate on behalf of the political left, which provides some counterweight to her counterparts on the political right. When it comes to data manipulation for political purposes, the right and the left are engaged in a long-running tug of war. They both abuse statistics and economic common sense to influence public opinion in the short term. It's great sport for incumbent politicians, blogging left-wing academics and Washington lobbyists. Not so great for the country in the long run.

As I said on Wednesday, this is all about political expedience: fitting complex economic issues into a simple box for widespread consumption by the relatively unsophisticated masses. But enough on data manipulation. One more question about Beale's Law while the topic is fresh.

Pre-Tax Income vs After-Tax Wealth

Beale's Law posits that income inequality is inverse to tax rates. Imagine that we plot a curve with the pre-tax incomes of the lowest-earning taxpayers on the bottom left, and the highest-earning taxpayers on the top right. Beale's Law predicts that, when top tax rates are high, the curve will "flatten out." Conversely, when top tax rates are low, the curve will "steepen up." Put another way, the difference between the pre-tax incomes of the top 400 taxpayers and the bottom 400 taxpayers should decrease as tax rates increase. And vice versa.

My last post demonstrated that Beale's Law doesn't apply in the real world. It reflects ideological and political wishful thinking, not an interpolation of real-world data. However, I remain puzzled by the logic underlying the pseudo-science. Specifically, I find it puzzling that the political left attempts to link the pre-tax income gap to the top tax rate.

The data indicate that we have a pre-tax income gap and an after-tax wealth gap in our country. I follow that increasing tax rates may "flatten" the after-tax wealth gap. If we taxed the highest-earning taxpayers at 90% marginal rates, we would diminish their ability to accumulate wealth.

In response, many of those individuals would ramp up tax sheltering activity -- shifting taxable income into non-taxable perks, relocating to lower-tax jurisdictions, etc. Longer term, such a policy would drain the wealth controlled by the richest Americans. We wouldn't necessarily observe a "redistribution" of wealth. There is no reason to expect an increase the wealth of the bottom 50% of taxpayers or bottom 400 individuals. But the curve plotting the difference between the top 400 wealthiest individuals and the bottom 400 individuals would likely flatten over time, because the wealthiest individuals would become less wealthy and/or relocate to lower-tax jurisdictions.

The fact that we could flatten the after-tax wealth gap does not mean that we could also flatten the pre-tax income gap. In 2010, LeBron James, Chris Bosh and Dwayne Wade signed $100+ million, six-year contracts with the Miami Heat basketball team. If the top tax rate were, say, 70%, would we expect that James, Bosh and Wade would have signed for less money? Or is the theory that higher tax rates at the top would support higher government spending and thus "trickle up" into higher wage rates across the board?

It's very difficult to identify any logical nexus between higher top tax rates and lower pre-tax income inequality. But no surprise -- as noted, Beale's Law is ultimately about ideological and political wishful thinking.

Wednesday, November 2, 2011

Beale's Law Debunked

The political left and political right are engaged in a knock-down, drag-out competition. Although they seek to sway public approval numbers, the competition is not about public approval per se. They are competing to see who has the defter hand at data manipulation to suit their respective political objectives.

A post today by Linda Beale provides a suitable case study in data manipulation. Beale links to this CivilAmerican report, which presents a series of graphs plotting (i) top marginal income tax rates over the decades, and (ii) income earned by the top 10% of taxpayers and top 1% of taxpayers over roughly the same time period.

According to Beale, the graphs evidence the fact that "income inequality levels inversely track the top tax rate--as the rate increases, income inequality decreases."

Beale's argument has a intuitive appeal, which reflects the beauty of data manipulation. The use of data to support an ideological argument cloaks the argument with a pseudo-scientific legitimacy. Beale's position evokes the law of universal gravitation ("the gravitational force between two objects is proportional to the mass of each, and inversely proportional to the distance between them"). How could we possibly challenge the foundational concept of gravity? And how can we possibly challenge Beale's Law: that income inequality levels inversely track the top tax rate?

But let's take a harder look at the data in the graphs. How does Beale's Law hold up to a skeptical analysis by a political independent? (Spoiler: not so much.)

The first graph from the CivilAmerican report plots the top marginal tax rate applicable to individual taxpayers over time.

The second graph plots the percentage of total income going to the top 10% of taxpayers for a period ending in 2006.

The third graph plots the share of income reported by the top 1% between 1913 and 2007.

I don't have access to the data underlying these graphs, but let's assume that the underlying data and the graphing tools are accurate. We observe that the graphs are not exactly apples to apples -- the first graph plots data for a period ending 2010; the second graph 2006; the third graph 2007. The use of different time periods is somewhat misleading, but bigger problems emerge when examining Beale's Law against the graphical data. So we'll give a pass to the apples to oranges presentation.

The inclusion of data on the top 10% in graph 2 is outright misleading. The first graph and third graph are focused on the top 1% (rates and income). The second graph creates an inference that the top 10% benefit from the same changes in marginal tax rates as the top 1%. But taxpayers in the 90th income percentile are light years away from taxpayers in the top 0.01% and the top 0.001%. The "tippy top" of taxpayers distorts the income numbers. Meanwhile, we don't have data regarding the tax rates paid by the 90th through 99th percentiles. None of this data supports Beale's Law. The graphical presentation is a mess.

Now, on to the graphical data. If your eyes -- like mine -- have seen better days, crack out the microscope.

[1] First Decade of Income Tax (1913-1923)

The top tax rates jumped from less than 10% in 1915 to around 75% in 1917 or 1918 (first graph). That's an increase of more than 750%. The top rates stair-stepped down from roughly 72% in 1920, to 58% in 1922 or 1923, to roughly 25% from 1925 through 1932.

Despite a 750% increase in the top tax rate from 1915 to 1917 or 1918, the top 1% of taxpayers reported a roughly 20% decrease in income from peak (1918-19%) to trough (1922-15%).

We only have data on the top 10% beginning in 1917. Between 1917 and 1923, the top 10% bounced from a low of 38% in 1921, to a high of 43% in 1923. The reported incomes of the top 10% were not apparently impacted by the 750% increase in top marginal rates.

The data on the top 10% doesn't support Beale's Law. However, I question the credibility of all this early data. I'm guessing that compliance/enforcement was selective and that tax shelters were widely available to the top 1%. Those issues make it very difficult to compare data from the early decades of the income tax (generally unreliable) to more current data (generally reliable).

[2] Second Two Decades (1923-1943)

As noted, the top rates stair-stepped down from roughly 72% in 1920, to 58% in 1922 or 1923, to roughly 25% from 1925 through 1932. They jumped back above 60% in 1933, and were close to 90% in 1943.

The reported income of the top 1% plummeted from its peak of 23.9% in 1928 to approximately 15% in 1931 or 1932. Top tax rates were stable, but 1932 and 1933 were the worst years of the Great Depression. Even the richest Americans are not immune from the forces of wealth destruction. (A similar trend emerged in the wake of the 2007 financial crisis.)

From 1933 through 1937, top rates climbed precipitously, but the top 1% saw their reported incomes rebound to approximately 19% of reported totals. Their reported income then began a period of gradual decline, reaching approximately 12% in 1943.

The top 10% of taxpayers reported approximately 45% of total income from 1923 through 1940. Reported income declined sharply around 1941, hitting 34% in 1943.

Lessons from the period? The top 10% were basically insensitive to the top marginal tax rates for most of the period. Beale's Law does not hold if we focus on that group. The top 1% saw income losses while rates were stable, and income gains during a period of increasing rates. In the early 1940s, Team Roosevelt increased the top rate above 90%. The top 1% began to report a lower share of total pre-tax income. However, we don't know how much of that decrease is attributable to weak compliance/enforcement and tax shelter activity by the ultra-wealthy. My guess is that tax sheltering drove much of the data for the next two decades.

[3] Third Two Decades (1943-1963)

The top tax rate was consistently in the 90% range throughout this period.

The top 1% bounced from peak income of approximately 12.5% (1944) to approximately 10% in the late-1950s and early 1960s. These data are somewhat consistent with Beale's Law. However, Beale's Law would not predict a 20% decline in reported income during a period of rate stability. Remember, Beale's Law suggest that income inequality is inverse to rates. During periods of rate stability, we'd expect to see stable levels of income inequality.

The top 10% bounced from peak income of approximately 37% (1946) to approximately 33% in the early 1950s. The reported incomes of the top 10% were very stable, which is consistent with Beale's Law. However, taxpayers in the 90th to 99th percentiles reported income gains, while the top 1% reported income losses over the period. Guess who can allocate more cash to planning and implementation of tax shelters?

[4] Fourth Two Decades (1963-1983)

President Kennedy slashed the top rate from 90% to 70% in 1964. Reagan chopped the top rate to 50% in 1982.

Despite the top rate decrease, the top 1% reported approximately 10% of pre-tax income throughout the period. The trough was 8.9% in 1976. Reported income began to trend upward around the time of the Reagan tax cut.

Similar to the prior period, the reported incomes of the top 10% were very stable. Again, taxpayers in the 90th to 99th percentiles reported income gains, while the top 1% reported income losses.

Lessons from the period? Under Beale's Law, we would expect to see a jump in income inequality after Kennedy cut the top rate from 90% to 70%. Something else was going on, because the top 1% reported declining incomes through the mid-70s. I smell ... tax shelters!

[5] Fifth Two Decades (1983-2003)

From a historical perspective, this period was relatively volatile. The top rates declined from 50% in 1983 to 28% in 1988. Bucking his predecessors, Clinton raised the top rate to 40%. Bush Jr. cut the top rate to 35% in 2004.

The top 1% reported approximately 15% of pre-tax income in the mid-'80s through about 1994. From 1994 through about 1999 or 2000, the group's reported income spiked to approximately 22%. Reported incomes fell when the dot-com bubble popped (2000-2001), and then rebounded to 23.5% in 2007.

The top 10% largely tracked the top 1%. The group reported approximately 36% of total income in 1983, spiked to approximately 47% in 2000, fell for a couple years, and then rebounded to a high of approximately 50% in 2006.

Lessons from the period? Under Beale's Law, we'd expect to see a decline in income inequality after Clinton raised the top rates. In fact, income inequality continued its sharp ascent notwithstanding the tax increase. History repeats itself. The top 1% took a relative hit when the dot-com bubble popped (compare peak years of Great Depression). They rebounded before the Bush tax cuts took effect.

[6] Conclusion

Beale's Law is a pseudo-scientific assertion seemingly grounded in historical data. When we scrub the numbers, however, the theory crashes and burns. During periods that tax rates changed, we don't see "inverse" reactions in reported taxable incomes of the top 1%. During periods of relative stability, we see patterns that aren't consistent with Beale's Law. For much of the history of the income tax, the top 1% (or perhaps the top 0.01%) were able to exploit tax shelters that were unavailable to taxpayers in the 90th to 99th percentile. When loopholes were tightened, their share of reported income rebounded significantly.

Moreover, Beale's Law disregards the macroeconomic currents that cause income inequality to ebb and flow over time. In the late-'90s, for instance, we see increasing inequality despite the Clinton tax increases (no inverse relationship). The evolution of new technologies and increased fluidity of global capital markets have concentrated the rewards to talented innovators and entrepreneurs. Beale's Law, and other pseudo-science on the political left and political right, is guided by political expedience: fitting complex economic issues into a simple box for widespread consumption by the relatively unsophisticated masses.

Although I've spent too much time debunking Beale's Law, her fundamental argument misses the point. Beale anguishes over the fact that income inequality has ebbed and flowed over time. She yearns for the "good old days" when the top 1% reported a smaller percentage of total income (8.9% in 1976). But the key question is whether the top 1% are paying a fair share of taxes necessary to run the government that Americans desire. The top 1% paid approximately 37% of total income taxes in 2009. Is that enough? Too little? How much would satisfy Professor Beale? And what if we increase taxes and don't cause a dent in income inequality? What's the next step from Professor Beale's perspective?

Monday, October 31, 2011

Free Lunch Politics

I've been critical of the tax and economic policies advocated by Team Obama and its cheerleaders on the political left. However, for the last 30 years, Republicans in Congress have been complicit in the debt-fueled expansion of the federal budget.

Despite their public animosity, Democrats and Republicans have each promoted a "free lunch" philosophy to the voting public. Of course, their marketing of the "free lunch" philosophy is slightly different.

Democrats target their message to middle- and lower-income taxpayers. They argue that increased taxes on "millionaires and billionaires" can finance larger entitlements and higher discretionary spending. The middle-class can enjoy a "free lunch" courtesy of income redistribution. The harsh reality -- which most Democrats won't acknowledge publicly -- is that we cannot plug the long-term budget gap through increased taxes on "millionaires and billionaires." To fund Democratic spending initiatives, we'll need higher taxes across the board. Today, the political left defines the "wealthy" as working professional families with $250,000 in taxable income. How low will they go to finance tomorrow's spending initiatives?

Republicans target their message to middle- and higher-income taxpayers. Under Team Bush, they cut taxes while increasing entitlement spending for seniors. Lower taxes, higher spending? Sounds like a "free lunch" to me. Except for that little problem with deficit financing. Today's deficit spending will increase future interest expense and impose higher tax burdens on future generations of taxpayers. I'm not suggesting that all deficit spending is problematic. But Republicans have been disingenuous by attempting to kick the can permanently down the road.

Today, Republicans oppose "tax increases" as a mechanism to reduce the federal budget deficit. Like obsequious courtesans in the House of Norquist, they conflate elimination of tax expenditures with marginal tax rate increases. But tax expenditures have the same impact on federal deficits as on-budget cash outlays. Lowering tax expenditures will increase taxes for some taxpayers, but may permit broader tax relief for all taxpayers. As Congress grapples to slow the accumulation of federal debt, Republicans should be aiming to reduce federal spending and tax expenditures.

The other problem with tax expenditures is the fact that they distort economic behavior. Tax expenditures provide government subsidies for activities that Congress wishes to encourage. Given his defense of tax expenditures, Grover Norquist must believe that members of the Ways and Means Committee are better capital allocators than the free market.

By distorting economic behavior, tax subsidies can lead to over-consumption of goods and services. For example, the exclusion from taxable income for employer-sponsored health insurance is a major contributor to the runaway inflation of health care costs. Employees with generous health care packages have no incentive to control costs. Absent a price transmission mechanism, they consume more and higher-cost health care services. The excessive demand outstrips supply for medical products and services. The supply-demand imbalance translates into higher insurance premiums for individuals and businesses.

Tax expenditures can also lead to the mis-allocation of capital. For example, the mortgage interest deduction encourages taxpayers to "stretch" and purchase a little more home than they can otherwise afford. The behavior wasn't a problem during the real estate bubble. However, it had devastating consequences on thousands -- if not millions -- of homeowners during a period of high unemployment and real estate deflation.

Finally, tax expenditures can result in tax "windfalls" for high-income taxpayers that don't need the underlying tax subsidy. Take the home mortgage interest deduction. The home mortgage interest deduction has a higher value to a high-income taxpayer that pays a top marginal rate of 35% than a lower-income taxpayer that pays a top marginal rate of 25%. The lower-income taxpayer saves $250 in tax on $1,000 in mortgage interest expense. The higher-income taxpayer saves $350 in tax on $1,000 in mortgage interest expense. But capping the benefit of the mortgage interest deduction is no solution. If a taxpayer can afford a half million dollar home -- or a million dollar home -- why are we providing a tax subsidy at all?

I'm not the first to highlight the problems with tax expenditures, and I won't be the last. We desperately need fundamental tax reform, which I define as base broadening combined with marginal tax rate reductions. The first step towards any such tax reform must include an acknowledgement by Free Lunch Republicans and Free Lunch Democrats that tax expenditures are on the chopping block.

Friday, October 28, 2011

Yahoo Evaluating Cash-Rich Split Offs

The Wall Street Journal (sub. required) has reported that Yahoo Inc. is considering a disposition of its stakes in Alibaba and Yahoo Japan through cash-rich split offs. Yahoo owns a 43% stake in Alibaba, a Chinese search engine, and a 35% stake in Yahoo Japan.

The split-off transactions would make Yahoo a more attractive target for a subsequent acquisition by a private equity group or strategic investor (e.g., Microsoft). The market has speculated that Yahoo's complicated relationships with Alibaba and, to a lesser extent, Yahoo Japan, have discouraged potential suitors from offering a marriage proposal.

So what is a "split off" transaction? Why does the WSJ article describe the proposal as a "cash-rich split off" transaction? Can the tax lawyers save the day for Yahoo and its beleaguered long-term shareholders?

Spin Offs, Split Offs and Split Ups

Section 355 of the Internal Revenue Code governs "spin off" transactions, "split up" transactions and "split off" transactions.
  • A "spin off" occurs when a distributing corporation (let's call it "Distributing") distributes the stock of a controlled subsidiary (let's call it "Controlled") pro rata to its shareholders. Following a spin-off transaction, the shareholders of Distributing also own stock of Controlled.

  • A "split off" is similar to a "spin off," but with a twist. A "split off" occurs when Distributing redeems shares from one or more shareholders -- but not all shareholders -- in exchange for stock of Controlled. Following a split-off transaction, some of the historic shareholders of Distributing continue to own stock of Distributing. However, other historic shareholders own stock of Controlled. The latter group "trades" its interest in the overall Distributing business for a more direct interest in the Controlled business.

  • In a "split up" transaction, Distributing engages in more than one business, for example, Business A and Business B. Distributing redeems stock from some shareholders in exchange for stock in a corporation that owns Business A. Distributing redeems stock from other shareholders in exchange for a stock in a corporation that owns Business B. Distributing is like the head of the Hydra. Following a split-up transaction, Distributing has disappeared, and its former shareholders go their own separate ways with stock in Corporation A (which owns Business A) and Corporation B (which owns Business B).
Yahoo's proposed dispositions of Alibaba and Yahoo Japan would be structured as "split off" transactions. As noted, Yahoo is a shareholder of Alibaba and Yahoo Japan. If the parties implement the "split off" proposal, Alibaba and Yahoo Japan would be the distributing corporations. Alibaba and Yahoo Japan would redeem their stock currently owned by Yahoo in exchange for stock in a controlled subsidiary. Following the transactions, Yahoo would cease to own any shares in Alibaba and Yahoo Japan. Instead, it would own stock in a corporation formerly owned and controlled by Alibaba and Yahoo Japan, respectively.

To qualify under Section 355, the split-off transactions contemplated by Yahoo must satisfy a number of technical conditions. If those conditions are satisfied, the split-off transactions would be non-taxable to the distributing corporations (Alibaba and Yahoo Japan) and to its shareholders (Yahoo itself). Section 355 thus permits a corporation to "shuffle" the form of its investment in a lower-tier corporation, without triggering income tax on any appreciation in the stock of such corporation.

Cash-Rich Split Offs

Now we're getting to the real action. Yahoo may be able to exchange its stock in Alibaba and Yahoo Japan for stock of a new corporation. But what does that accomplish? The market is already penalizing Yahoo for its unwieldy legal structure, which includes large but non-controlling stakes in Alibaba and Yahoo Japan. Would a split-off transaction address the market's concerns?

For Yahoo's shareholders, I have good news and bad news.

Good News

The good news is that Yahoo could effectively "monetize" its investments in Alibaba and Yahoo Japan through a cash-rich split off. By "monetize," I mean that Yahoo could convert its stock in Alibaba and Yahoo Japan into stock of new corporations whose principal assets are cash or other liquid securities. Although each of the new corporations must be engaged in a historic (five-year) trade or business after the split-off, up to two-thirds of its assets may be composed of cash or other liquid securities.

If the parties implement cash-rich split offs:
  • Immediately before the split offs, Yahoo would own 43% of the stock of Alibaba and 35% of the stock of Yahoo Japan, respectively; and

  • Immediately after the split offs, Yahoo would own 100% of stock of two new corporations. The first corporation would have a historic (five-year) trade or business formerly conducted by Alibaba, and a bucket of cash or other liquid securities. The second corporation would have a historic (five-year) trade or business formerly conducted by Yahoo Japan, and a bucket of cash or other liquid securities.

  • Then Yahoo's shareholders and its pointed-headed tax lawyers would pop some champagne and haul out their dancing shoes. Well, maybe the shareholders would haul out their dancing shoes.
You might be curious whether Alibaba and Yahoo Japan could simply redeem Yahoo's shares for cash. Why does Yahoo need an army of pointed-headed tax lawyers to monetize its investments in Alibaba and Yahoo Japan? Alas, life is not so simple under current U.S. tax rules. The redemption transaction (exchange of stock for cash) would be taxable to Yahoo. Yahoo would incur U.S. tax expense and its after-tax cash proceeds would take a corresponding haircut. So bring on the tax lawyers!

Bad News

Now for the bad news. Unlike a corporation that owns 100% of a business, Yahoo owns a large, non-controlling stake in Alibaba and Yahoo Japan. Yahoo would require cooperation of the boards of directors of each company to implement a cash-rich split off transaction. Each board (including Yahoo's) would have a fiduciary duty to ensure a "value for value" exchange. It might be very difficult to negotiate a valuation that makes everybody happy. That said, if the tax savings to Yahoo were sufficiently material, Yahoo may be able to "share" some of that savings with Alibaba or Yahoo Japan to bridge any gaps in the numbers.

The parties would be required to navigate the various conditions of Section 355. For the most part, those should be manageable. The biggest hurdle would probably be Section 355(g), which was enacted in 2006 to diminish the appeal of cash-rich split offs. Section 355(g) limits the "investment assets" of a controlled corporation to two-thirds of the fair market value of all its assets. For such purposes, "investment assets" include cash and other liquid securities. To comply with the limitations of Section 355(g) any cash-rich split off would need to include material business assets of Alibaba and Yahoo Japan, respectively.

Finally, Alibaba and Yahoo Japan would need to "stuff" the controlled corporation with cash or liquid securities. Such an effort may require external financing, which may or may not be palatable to the directors of Alibaba and Yahoo Japan. The tax tail is not going to wag the dog unless the parties can round up financing to make the cash-rich split off work.


Another hurdle for Yahoo would involve the repatriation of cash from its new subsidiary companies. Although I can only speculate on the transaction form, Yahoo is likely to own stock in a new foreign subsidiary following a split off from Alibaba or Yahoo Japan. As described above, the foreign subsidiary would have a historic (five-year) trade or business, and a large amount of cash and liquid securities.

If Yahoo repatriates the cash by causing its new subsidiary to pay a dividend, the dividend could be taxable to the U.S. group. Yahoo may or may not have sufficient foreign tax credits to offset the resulting U.S. tax liability. Any limits on repatriation may reduce the attractiveness of the split-off idea.

Alternatively, after the dust has settled on the split-off, Yahoo may be able to liquidate the foreign subsidiary and repatriate cash in the liquidation transaction. Such a liquidation would also be taxable to the extent of the foreign subsidiary's earnings and profits.

In either case, a portion of the distributing corporation's earnings and profits would be allocable to the controlled corporation immediately before the tax-free split off. Under the mechanical allocation rules, the new corporation may inherit a very small earnings pool from Alibaba or Yahoo Japan, respectively. If the earnings pool is small, a liquidation transaction may be a viable repatriation option for Yahoo. In any case, tax nerds and Yahoo shareholders will stay tuned for developments in the Yahoo story.

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For more on cash-tax split offs, two articles by the ubiquitous Robert Willens are worth a read. See "Liberty Media and News Corp. Will Be Parting Ways," 114 Tax Notes 697 (Feb. 12, 2007), and "Can STI Efficiently 'Monetize' Its KO Stake," 120 Tax Notes 601 (Aug. 11, 2008). He even mentions Yahoo! in this interview (published Saturday, October 22).