Nina Olson, the National Taxpayer Advocate, recently noted the lack of guidance in this area and has suggested that “economic activities associated with virtual worlds may present an emerging area of [tax] noncompliance.”¹ Concerned with the lack of guidance afforded IRS agents and taxpayers alike and concerned that non-compliance in this context could lead to non-compliance elsewhere, she has urged the IRS to “help taxpayers comply with their tax obligations by quickly issuing guidance addressing how taxpayers should report economic activities in virtual worlds.”²

This Editorial examines one of the issues that must be addressed, and soon.  Regardless of what decision is ultimately made regarding the tax consequences of in-world transactions, tax authorities must deal with the question of basis and how to trace it through virtual spaces.  The walls between virtual worlds and the real world are crumbling, and people can now cash out either licitly or illicitly with little difficulty.  Without a basis tracking system, someone who sells a virtual item for cash, an act that is undisputedly subject to tax, will not be able to determine gain or loss and therefore will be unable to comply with his tax obligations.  If the authorities move to tax in-world transactions, the need to determine basis becomes even more important as a substantially larger number of transactions involving virtual items will have real-world tax consequences.

It may be tempting to think that this issue is just a tempest in a teapot and not something on which the IRS should spend its limited resources.  However, the real-world market for virtual goods is large and growing as existing worlds expand and new virtual worlds come on-line.  By one recent estimate, the Gross Domestic Product of all virtual worlds is somewhere between $7 and $12 billion dollars, with annual real-world sales of virtual goods (e.g., taxable sales of virtual goods for real-world currency) estimated to be around $1.8 billion.  While once the domain of gamers, virtual worlds now attract wide variety of participants.  Numerous real-world businesses have established presences in virtual worlds, including Nike, Nissan, and IBM.  Politicians have also set up shop on-line.  If the past is any guide, more and more real-world activity will take place in these fora.  Given the increasing popularity and variety of virtual worlds, the need to clarify how the tax laws apply to virtual worlds will only increase.  It seems better to address these issues now, and in an administrative setting, than to wait until conflicts arise and the law is left to develop in the courts in the context of specific fact patterns that may not reflect or highlight larger issues at play.

In addition to solving a problem faced by those who cash out their virtual wealth, addressing basis in this new context affords us the opportunity to think broadly about basis, the role it plays in our tax system, and the myriad and often inconsistent ways we account for it in our tax laws.  In particular, the opportunity to develop rules for this new context may shed light on the propriety of our existing rules and inspire us to undertake the effort to rationalize those rules.

Any basis recovery system must do two things.  First, it must track previously taxed dollars such that any tax gain or loss matches economic gain or loss.  Second, it must take into account administrative difficulties, such as determining basis ab initio, keeping track of fungible assets with different bases, and accounting for the possibility of numerous tax-free exchanges.  These two concerns provide significant leeway to those who design the rules as can be seen by considering the variety of different basis tracking methods found in the Internal Revenue Code (Code or I.R.C.).  Indeed, the Code and Treasury regulations contain a number of different basis recovery rules that could be models for the recovery of basis in virtual goods.

Generally, the basis recovery models found in the Code follow one of two approaches.  The first, which I will call the tracing approach, grants each item its own basis and determines gain or loss property by property.  In the event of tax-free exchanges, basis is simply transferred from one asset to the next to preserve gain or loss until a taxable transaction occurs.  The key issue under this approach is whether taxpayers may designate which assets are sold or exchanged for other assets or whether some forced ordering rule applies.  Examples of this approach include the rules governing stock sales, tax-free reorganizations under I.R.C. § 368, and inventory accounting.  A simple example may help illustrate.  Assume a taxpayer owns 1 share of stock in Intel and 1 share of stock in Sun Microsystems, each worth $500.  He has a $300 built-in gain in the Intel stock and a $200 built-in loss in the Sun stock.  The taxpayer’s net economic position is a $100 gain.  However, under the tracing approach, each share must be considered separately.  The taxpayer may select which share to sell or hold, causing his tax gains or losses to deviate from his economic gains or losses.  If he exchanges the Intel stock for a share of equal value in some other company in a tax-free exchange, his basis in the Intel share will transfer to the new share, preserving his gain for taxation at a later date.

The second approach, which I will call the pooling approach, pools basis in a number of assets and allocates it back across those assets based on their relative fair market value.  Examples of this approach include the rules that apply to partnership interests, mutual fund shares, if the taxpayer so elects, and corporate formations under I.R.C. § 351.  Thus, a taxpayer who purchases interests in a partnership at different times and for different prices must average his basis.  For instance, if a taxpayer purchases a 1% interest for $100 and second 1% interest for $200, his total basis is $300.  If he later sells one of his interests, regardless of which one he sells, he must allocate to it half of his basis, or $150.  As a result, he will recognize gain or loss for tax purposes in proportion to his total economic gain or loss on the investment.

From a theoretical perspective, the tracing approach makes sense for non-fungible property.  Each item of property is separate and should therefore retain its own basis.  Transferring basis from one asset to another seems wrong as do rules that would force taxpayers to hold or sell certain assets such that their economic and tax gains and losses more closely align.  Taxpayers should have the liberty to decide what to sell and what to retain.  In contrast, the pooling approach makes sense for fungible assets.  A taxpayer who sells half his interest in a business has reduced his position by half.  It should not matter which specific shares or partnership interests he has sold.  Affording each identical interest a different basis amount seems artificial, and it provides taxpayers with significant opportunities to manipulate their tax liabilities so that they deviate from their economic position.

Nonetheless, a review of the different models found in the Code and the circumstances in which they apply reveals that the models employed are not driven by theory.  For instance, the tracing approach is applied to fungible assets, such as a single class of stock in a company, while the pooling approach is applied to non-fungible assets, such as general and limited partnership interests.  Taxpayers are given an election for mutual funds.  In the corporate tax context, pooling is required for transactions covered under I.R.C. § 351 regardless of fungibility of the assets contributed to a corporation, while tracing is the norm for corporate reorganizations under I.R.C. § 368.  The different rules are organized around the different types of assets and transactions, as opposed to the nature of the assets.

Digging a little deeper, one sees that the rules are often a function of historical circumstance or accident.  For instance, the different treatment of stock and partnership interests, both of which represent ownership of a business, likely reflects the fact that stock has been historically represented by separately identifiable certificates, thus highlighting the separate nature of individual shares, while partnership interests were typically spelled out in contracts, obscuring the fact that such interests could readily be divided and separately identified.  In the case of fungible mutual funds shares, where taxpayers are permitted to choose whether to trace or average basis, the impetus for allowing averaging came not from any conclusion about the fungible nature of such shares, but rather from the perceived difficulties mutual fund companies would have in reporting basis under a tracing approach.

This review not only reveals the incoherent nature of the rules from a theoretical perspective and set of rules, but it also highlights the instrumental nature of those rules.  That is, they are not foreordained by some internal tax logic, but rather they are merely a tool that can be designed in any number of ways to carry out their purpose, i.e., avoiding double taxation of income or the receipt of a double benefit.  This affords a significant degree of freedom to policymakers designing a basis recovery system for the virtual context.

This freedom is a good thing because none of the models found in the Code will work very well when applied to virtual worlds.  First, consider a tracing approach.  If in-world transactions are tax-free, as is de facto currently the case, virtual world participants may engage in countless tax-free exchanges before ultimately cashing out.  Thus, under a tracing approach, it is necessary to track basis through these exchanges.  This could be quite difficult, depending on the number of exchanges at issue.  While tracing basis might also be difficult for a taxpayer who engaged in a number of real-world I.R.C. § 1031 exchanges before ultimately selling his property for cash, important differences exist between such a person and a virtual world participant.  The real-world taxpayer must be engaged in a trade or business or profit seeking activity to take advantage of I.R.C. § 1031.  He is likely dealing with items of significant value (necessary to justify the cost of § 1031 transaction), and he is also likely to be advised by professionals who can help him pay close attention to basis as he goes.  In contrast, a virtual-world participant will usually be dealing with items of small value and will likely not be advised by tax experts as he goes along.  In addition, he may solely be participating for entertainment.  Accordingly, his attention to tax attributes will likely not rise to the level of his real-world counterpart.

A second problem with the tracing approach arises with the use of virtual currency.  While virtual currency functions as a currency within a virtual world, for real-world tax purposes, it is property.  This means that different batches of currency may have different bases and different holding periods.  Such currency is generally pooled together in a participant’s account.  If a virtual world participant purchases a virtual item with such currency in a tax-free exchange, a tracing approach would require him to determine which currency was used so that the basis and holding period of the currency could be transferred to the item purchased.  It is not clear whether virtual worlds provide mechanisms for doing this.  Thus, participants would need to keep a separate set of records reflecting their contemporaneous decisions.  As many participants are there for entertainment and the dollar amounts are small, it is not at all clear that this will happen.  Put simply, the administrative difficulties associated with the tracing approach make it an unattractive model for virtual worlds.

Even if tracing were possible, it is unclear that the tracing approach is appropriate.  Currency is fungible, and permitting participants to designate which currency they use in-world to purchase items gives them significant opportunities to manipulate the rules, causing their tax results to deviate from their overall economic results.  For instance, a clever participant will purchase items he intends to use in-world with low-basis currency.  He will purchase items he intends to sell for money with high-basis currency, thus minimizing the amount of gain he will have to realize.  Requiring pooling here would avoid this possibility and likely be less complicated from an administrative perspective than allowing or requiring tracing.

Unfortunately, a pure pooling approach would not work particularly well in the virtual context either.  While virtual currency is fungible, virtual items are not.³ For a pooling regime to work, it must be possible to allocate back to each item some portion of the pooled basis.  This is easy where goods are fungible because each good has the same value and therefore gets the same amount of basis.  However, when goods have different values, they should receive different amounts of basis based on their relative fair market value to prevent creating artificial gains and losses.  For instance, if one were to pool the $90,000 basis of a house worth $90,000 with the $10,000 basis of a car worth $10,000, absent a rule requiring allocation proportional to fair market value, the house would get half the basis ($50,000), creating a huge gain, while the car would get the same amount of basis, creating a huge loss, even though the taxpayer has suffered neither gain nor loss.  Instead, the house should get 9/10 of the basis ($90,000), as it reflects 9/10 of the value.  The car should get 1/10, or $10,000.

Setting aside our predisposition to treat non-fungible assets separately, the pooling approach could work with non-fungible assets where liquid markets exist and it is possible to easily value a taxpayer’s property.  However, in virtual worlds, where value is sometimes difficult to determine, pooling presents as much of an administrative nightmare as does the tracing approach.

Given the wide variety of basis accounting rules found in the tax code, and the instrumental nature of such rules, I argue that policymakers should not feel constrained to follow any of the models used to date nor limit themselves to one of the two basic approaches.  As has been done in the case of tax-free corporate transactions, the tax writers should feel free to create a hybrid system, where some types of transactions require tracing and others require pooling.  However, unlike the corporate tax context, where the decision regarding when to use what approach is based on the type of transaction (contribution under § 351 or reorganization under § 368), I would propose that the choice of regime be made based on the nature of the items involved, i.e., whether the items are fungible.

To reflect the non-fungible nature of most virtual goods, I propose that their basis should be separately tracked and treated, as occurs in the real world.  If a taxpayer has a sword and a shield with different bases because they were purchased for different amounts, he should be allowed to decide which to hold and which to sell.  Gain or loss for each item should be determined separately.  If in-world exchanges are tax free, basis should transfer from one item to the next to preserve gain or loss.  Thus, someone who buys a sword for $50, trades it for a shield in-world in a tax-free exchange, and then sells the shield for $60 must report a $10 gain, as the sword’s basis is traced to the shield.  If in-world exchanges are taxed, the basis in any item received in an exchange should be its fair market value, consistent with the rule that applies to real-world barter exchanges.

In contrast, a taxpayer’s basis in virtual currency should be pooled and averaged, reflecting the fungible nature of such goods and the administrative difficulties associated with tracing basis from a commingled pool of currency to any item acquired with such currency.  An example might help.  Assume a taxpayer has 200 gold coins.  He purchased the first 100 for $100, giving him a $100 basis in the lot, or a $1 basis in each coin.  He earned the second 100 in-world and has paid no tax on them.  Accordingly, he has no basis in those coins.  His total basis remains $100.  If he purchases a sword for 50 gold coins and then sells it for $50, he must pay tax on his gains.  Under a tracing approach, he would be allowed to decide which coins he used to purchase the sword, and their basis would be allocated to the sword.  If he chose to uses coins with a $1 basis, he would report no gain or loss on the sale.  Under a pooling approach, the taxpayer has used ¼ of his coins.  Accordingly, ¼ of his basis in the coins ($25) transfers to the sword.  Thus, when he sells the sword, he must report a $25 gain.  Pooling the basis in currency will prevent taxpayers from unduly manipulating their tax liabilities and having tax results that differ significantly from their economic position.

 
Conclusion

The rise of virtual worlds and the basis issues they engender present tax policymakers with both challenges and opportunities.  The challenge is to create a basis accounting system that ensures the appropriate amount of tax is collected at the appropriate time while being administrable.  In this regard, tax writers must consider both the nature of the transactions involved and the attitudes of those engaged in them.  Virtual worlds are relatively new and not well established.  Onerous tax rules are likely to curtail their use just when they should probably be nurtured.  While no set of rules will be perfect, given the growth of these worlds, remaining silent is no longer an option.

The opportunities are many.  First, tax writers are not burdened by a legacy approach to basis recovery and are therefore free to write on a clean slate.  Second, virtual reality differs from reality in some very important respects that may alleviate some real-world administrative constraints.  For instance, all transactions in-world are electronic, meaning they are already recorded.  It may be possible to add a basis-tracking feature to automate the process.  Similarly, virtual items could be encoded with a basis counter, allowing basis to be tracked within the items themselves and possibly transferred automatically in tax-free exchanges.  Authorities should consider carefully the nature of virtual worlds when designing the rules, as they may have greater liberty in this regard as well.

Finally, this exercise affords us the opportunity to re-examine the basis rules found elsewhere in the Code and regulations.  Those rules currently reflect historical accident and are therefore somewhat incoherent.  Focusing on basis in this new context may give us the impetus to re-examine the different treatment of stock, mutual funds, and partnership interests, among others, and perhaps attempt to rationalize and harmonize those rules around some central theory.

Acknowledgments:

Copyright © 2010 Cornell Law Review.

Adam Chodorow is a Professor of Law at the Sandra Day O’Connor College of Law at Arizona State University, Tempe, Arizona.

This Legal Workshop Editorial is based on the following Law Review Article: Adam Chodorow, Tracing Basis Through Virtual Spaces, 95 CORNELL L. REV. 283 (2010).

In academic circles, the shift reflects an emerging new consensus (widespread if not universal) that an ideal consumption tax is unambiguously superior to an ideal income tax, taking into account concerns of both efficiency and distribution.  This view rejects any tradeoff between the two types of ideal tax bases, such as between greater progressivity and greater efficiency, or by a choice between different kinds of efficiency.  Rather, the ideal consumption tax is viewed as capable of being equally progressive but more efficient, or equally efficient but more progressive, causing it to dominate the ideal income tax in any comparison.

There is something mystifying about this shift in ideals, no matter how intellectually persuasive one finds it.  Consider a second possible shift in normative framework, from favoring an annual income or consumption tax to favoring one that is lifetime-based.  Under a lifetime-based system, even if tax payments are remitted annually, lifetime rather than merely annual economic results determine how much one must pay.  Thus, people with fluctuating incomes do not end up paying more tax than those with stable incomes, as happens under an annual system with graduated marginal rates.  A lifetime-based system that still employs annual tax returns can be implemented through income averaging, a system that the economist William Vickrey proposed nearly seventy years ago, and that the U.S. federal income tax featured in a much more limited fashion from 1964 through 1986.  Income averaging has received extensive, but on the whole surprisingly unfavorable, attention in the tax policy literature, even though the intellectual case for it substantially overlaps with that underlying the new pro-consumption tax consensus.  At the level of ideals, leaving aside differences in administrative feasibility, it makes little sense for the one idea to be accepted while the other is rejected.

The reason for the overlap is that the case for a consumption tax, no less than that for income averaging, relies on taking a lifetime, rather than a current-year or snapshot, perspective in evaluating individuals’ welfare and in predicting their behavior.  A simple example can help to demonstrate this intuitively.  Suppose that, in a given year, Xavier and Yolanda each spend their entire $100,000 salaries on consumption, and thus are treated the same by a consumption tax even though Xavier has a million dollars in the bank while Yolanda has no savings.  How can this be justified, when Xavier is obviously so much better off?  The answer, from a consumption tax standpoint, is that Xavier does indeed bear a much higher tax burden, because in the long run he will be taxed just as heavily as if he had spent the million dollars, on top of the $100,000, this year.  This argument, however, requires taking a lifetime rather than a merely annual perspective—and indeed, perhaps, a longer than single-life perspective if Xavier leaves money to his heirs—raising, as we will see, the very same issues as the case for income averaging.

The persistence of the peculiar disjuncture between the income tax versus consumption tax debate and the income averaging debate reflects under-appreciation both of the affirmative case for income averaging and of its relationship to the case for a consumption tax.  In addition, while consumption taxation certainly does not lack critics, its reliance on the same long-term perspective as income averaging remains under-appreciated.  However, this reliance on a long-term perspective makes the cases both for income averaging and for consumption taxation subject to the assumptions needed to support the use of such a perspective.  In particular, such reliance rests on three critical assumptions, each of which is subject to challenge.

1)  Complete markets—Markets are complete when they cover every possible commodity and combination thereof.  In illustration, with complete labor markets one can work at one’s wage rate for any number of hours between zero and full-time.  With complete capital markets, one can hold financial positions that would pay off in every possible state of the world, thus providing effective insurance against any possible contingency.  Complete markets are necessary to the full achievement of allocative efficiency in the economy.  In the income averaging and income versus consumption tax debates, their absence would mean that people with the same lifetime resources might actually face very different circumstances in each period, suggesting that they should not necessarily pay the same lifetime taxes.

2) Consistent rational choice—Under conventional economic assumptions, people have stable preferences that determine the utility they will experience in alternative states of the world, and which they consult to make decisions aimed at maximizing expected utility.  People therefore are assumed to engage in consistent rational choice, suggesting that they will make the same choice from within a given opportunity set no matter how the choices are presented or framed.  Weakening this assumption, such as by positing that people are myopic, can undermine the cases for income averaging and consumption taxation by suggesting that behavior and wellbeing may significantly depend on current period resources, rather than simply on the lifetime total.

3) Within-period information—A final assumption underlying use of the long-term perspective to support income averaging and consumption taxation relates to achieving the tax system’s distributional objectives, rather than to the choice of analytic timeframe as such.  Specifically, this assumption holds that, once one has picked the relevant period for evaluating how well-off people are (such as by measuring their income or consumption for the period), information about when within the period the taxpayer acted or benefited does not provide further useful guidance for distribution policy.  Thus, in an annual system, people who earn or spend a lot in January typically are treated the same as those who ended the year in the same overall position but followed a different sequence (such as earning or spending more evenly across time, or with back-loading instead of front-loading).  With a lifetime perspective, this assumption becomes more controversial. The gap between, say, the ages of 21 and 75 is a lot bigger than that between January and December of a single year.  An individual may change a lot more during such an extended period, and the tax system may have a lot more to gain informationally from looking within the period, rather than just at total results for the period as a whole.  This undermines the case for income averaging and consumption taxation by suggesting that the particular sequence of the taxpayer’s earnings and/or consumption, not just the taxpayer’s lifetime income, should affect how she is treated both overall and at different times within her lifespan.

None of the three assumptions fully holds.  Contrary to the complete markets assumption, people often cannot borrow against their future expected earnings, and one cannot change past consumption decisions by reason of new information about available lifetime resources.  Contrary to the consistent rational choice assumption, people may be myopic or prone to hyperbolic discounting, and the use of mental accounts may lead them to violate the principle that a dollar is a dollar is a dollar.  Finally, as the new dynamic public finance (NDPF) literature in public economics particularly emphasizes, within-period information, such as about the relationship between when one earns and when one consumes, can have important normative policy implications.

Incomplete markets and departures from consistent rational choice can make current-period information about an individual’s circumstances more relatively important than consumption taxation and income averaging effectively recognize.  The effect, however, is more to muddy the analysis than affirmatively to support income taxation or a predominantly annual system.  Problems with the third assumption, pertaining to within-period information, potentially have stronger implications.  In principle, the within-period components of lifetime information could affirmatively support taxing saving, in keeping with an income tax but not a consumption tax, although likely using a very different methodology.  In addition, in some circumstances there may be grounds for imposing higher taxes on people with declining earnings than on those with level earnings, in keeping with an annual but not a lifetime-based system if both have graduated marginal rates.

While the importance of these departures from the new conventional wisdom remains unclear, collectively they cast doubt on the core conclusion of a recent leading article that “based on current understanding, ideal consumption taxes are superior to ideal income taxes.”¹ Reality is simply too messy for overly definite statements about ideal systems to be completely persuasive.  Nonetheless, the case for consumption-based tax reform remains powerful, in large part because it has huge administrative advantages over an income tax by reason of not needing to address issues of realization.  Moreover, there ought to be further exploration of how a limited income averaging system might work.

Acknowledgments:

Copyright © 2009 Stanford Law Review.

Daniel Shaviro is Wayne Perry Professor of Taxation at New York University School of Law.

This Legal Workshop Editorial is based on the following full-length Article: Daniel Shaviro, Beyond the Pro-Consumption Tax Consensus, 60 STAN. L. REV. 745 (2007).

This Editorial takes the opposite position and shows that, barring estimation error, the legislative process accounts completely for the costs of temporary-effect legislation but not permanent legislation.  Consequently, enactment of temporary-effect rather than permanent legislation promotes political accountability and may result in greater fiscal restraint.

The Editorial first explains why the criticism of temporary-effect legislation stems from an understandable, but mistaken, focus on the short-term budget effects of legislation.  It then shows that, from the standpoint of promoting fiscally responsible decisions, temporary-effect legislation is preferable to permanent legislation both at the time policy choices are initiated and when they are renewed.  The nation’s rapidly deteriorating fiscal situation, due in part to the economic crisis of 2008 and 2009,¹ highlights the importance of understanding the budgetary effects of these legislative practices before Congress approves further deficit-increasing changes in the areas of health care, climate change, or other entitlement or tax programs.

 
I.
The Budget Accounting Treatment of Temporary-Effect and Permanent Legislation

For budget accounting purposes, the cost of proposed new spending and tax legislation is the difference between the amount of government revenues or outlays that would occur with the legislation and the amount that would occur without the legislation.  The latter amount is known as the “baseline,” and is determined by applying current law to the relevant economic (and other) variables projected to occur during the budget period being considered.  Baseline estimates generally assume that permanent laws will continue forever but that temporary laws will expire as scheduled.

The baseline cost of an entitlement or tax program may be projected to increase over time even in the absence of any expansion or change to the program.  This is because baseline estimates must assume that “laws providing or creating direct spending and receipts . . . operate in the manner specified in those laws . . . and funding for entitlement authority is . . . adequate to make all payments required by those laws.”² Thus, for example, if due to anticipated economic or demographic changes, participation in a tax or entitlement program is expected to increase in the future, the baseline cost estimate of the program must reflect that increase.

Congress typically agrees each year to a limit on the cost of new legislation passed that year.  Importantly, the budget limit applies only to the costs projected to occur during the “budget window period”—generally, only the five or ten years following the legislation.  Given this limitation, political debate naturally centers around whether legislative practices and budget accounting rules result in an accurate measurement of the costs of proposed legislation within the budget window period (such costs are referred to in this Editorial as the “official cost” of the legislation).

Supporters of legislation have long used various techniques to reduce the official cost of legislation and thereby enhance its likelihood of approval.  One technique is to delay the start of the legislation until late in the budget window period or gradually phase in the legislation’s effect.  Because this technique has the potential disadvantage of delaying the realization of benefits produced by the legislation, lawmakers sometimes employ an alternate technique of allowing the legislation to begin immediately but then terminating or “sunsetting” its effect prior to the end of the budget window period.  By using either or both of these techniques, supporters can reduce the official cost of legislation to a fraction of what it would have been had the legislation been in effect throughout the entire budget window period.

Although these techniques have been used for a number of years, the extent and frequency of their use in the tax area grew dramatically beginning in 2001.  In that year, Congress approved major tax cut legislation, virtually all of whose provisions expired nine months before the end of the budget window period.  In addition, it phased in or delayed the effect of many of the provisions.  These two steps significantly reduced the estimated total cost of the legislation over the budget window period.  Much the same occurred in 2003 when Congress passed another major tax cut.

Many analysts sharply criticized these practices.  According to these critics, the practices enabled the Bush Administration and Congress “to hide the true budgetary costs” of the policy changes and thereby “avoid the constraints imposed by the budget rules.³ One observer went so far as to label these techniques “Enron-style accounting” that caused “the official budget projections [to be] universally seen as unreliable and even fraudulent.”⁴ The observer concluded that the “[2003] bill’s true cost . . . will be close to double its ‘official’ cost.”⁵ To prevent these misrepresentations, some have suggested barring the practice of sunsetting legislation in certain circumstances or requiring such legislation to gain supermajority support before it is approved.

Critics are surely correct that the motivation behind many of the delayed effective dates, phase-ins, and sunsets of recent tax legislation has been a desire to shrink the official cost of legislation taken into account for budget purposes.  Since budget rules provide consequences that depend upon that official cost, political advantage can be gained by manipulating this amount.  For the same reason, opponents of the legislation have generally focused on this same official cost.

But from the broader perspective of promoting fiscal responsibility, both proponents and opponents of the recent legislation have overlooked the real budgetary impact of these nontraditional legislative practices.  The budget process should provide a mechanism that conveys to lawmakers the true cost of their legislative activity before they act.  This information not only enables lawmakers to make more informed decisions but also permits the public to hold lawmakers accountable for their choices.  But the true cost of legislation is not necessarily the “official cost” used for budget purposes; rather, the true cost includes the budgetary consequences of the legislation throughout the entire period that the legislation remains in effect.  Since the “official cost” incorporates only the budget consequences falling within the budget window period, it systematically understates the true cost of any deficit-increasing legislation extending beyond that period.  Thus, when proponents of permanent legislation go on record as having approved the official cost of such legislation, they escape responsibility for the full budgetary impact of their action.  By contrast, barring estimation error, the official cost of legislation not extending beyond the end of the budget period is its true cost, so lawmakers who support such legislation must therefore internalize the full budgetary consequences of such legislation.

These observations mean that at least from the standpoint of promoting political accountability and fiscal restraint, legislation whose effects extend beyond the end of the budget period, such as “permanent” legislation, generally should be disfavored, whereas legislation whose effects end no later than the end of the budget period, such as temporary-effect legislation, generally should be favored.  The following Sections illustrate this principle’s application both at the time policy choices are first adopted and at the time they are later continued.

 
II.
Initial Adoption of Policy Choices: The Medicare Prescription Drug Legislation

The greater budget transparency of temporary-effect rather than permanent legislation when policy choices are first adopted is starkly illustrated by considering the passage of the Medicare prescription drug legislation in 2003.  Early on, the President and congressional supporters agreed that this legislative effort should cost no more than $400 billion over the ten-year budget window period.  To fit within that constraint, Congress created a “doughnut hole” in the benefit structure to remove any federal subsidy for an intermediate level of prescription drug spending and delayed the start of the basic benefits until January 1, 2006, with only limited transitional assistance provided prior to that time.  Importantly, however, unlike most of the tax laws passed in 2001 and 2003, the effects of the new Medicare prescription drug law were not sunset.  Rather, the bill was enacted as a “permanent” change in the law.⁶

As it turns out, much controversy surrounded the $395 billion ten-year official cost estimate of the final Medicare legislation, and the estimate was eventually revised upward by $41 billion.  But the significance of this error pales in comparison to the real misrepresentation of the legislation’s budget consequences.  The “true” cost of the Medicare prescription drug benefit, meaning the present value of all future costs obligated by the new program, has been estimated by the Medicare trustees to be $17.2 trillion.  Thus, enactment of the Medicare law represented a huge new financial commitment by the federal government—one which no member of Congress ever was required to endorse.  The budget process, which is supposed to provide information to Congress so it can make responsible choices about the nation’s priorities and to the public so it can scrutinize those choices effectively, therefore failed in the case of the Medicare legislation, because the process disregarded any budgetary effects occurring after the budget window period.  In contrast, had the Medicare legislation been enacted instead as temporary-effect legislation, the true cost of the legislation would have been equal to its official cost (barring estimation error).  Congress, therefore, would have acted with full knowledge of the law’s budgetary implications and subjected itself to full scrutiny from the public for its choice.

 
III.
Continuation of Policy Choices: The R&E Tax Credit

The contrasting budget accounting treatment of temporary-effect and permanent legislation is also important when policy choices are continued, and is illustrated by considering the tax credit for research and experimental activities (“R&E tax credit”).  In 1981, Congress approved a new R&E tax credit to provide an incentive for certain research activities.  Congress provided that the credit would sunset at the end of 1985 after being in effect for 4.5 years.

The R&E credit has proven to be extremely popular and remained in effect, with only minor changes, for virtually the entire period since 1981.  After its initial term, the life of the credit has been regularly extended, generally in one- or two-year increments.  Indeed, even though there is no suggestion that its initial temporary term was in any sense a budgetary gimmick, the credit is often pointed to as the poster child for fiscally irresponsible “sunset” provisions.  Yet by adopting the credit as a temporary measure and then extending it only in short-term increments, Congress has had to take its cost into account in the legislative process for every one of its over twenty-five years of existence, a period far longer than that of any budget window period thus far.  As a result, legislators regularly have had to struggle with finding an acceptable offsetting change to “pay for” an extension of the credit.  Even where no offset has been found, the extension has theoretically displaced other spending initiatives or tax expenditures in the same manner in which the continuation and expansion of discretionary spending programs compete with and displace one another.

Moreover, as experience with and data about the R&E credit have accumulated, the estimates of the cost of continuing the credit—currently more than ten times the cost estimated in 1981—can be expected to be more and more accurate.  Thus, because of the temporary nature of the credit, Congress has been confronted by, and has had to take into account in the legislative process, current and increasingly accurate information relating to the cost of continuing the program.

Contrast the budget accounting treatment of continuing a permanent tax or spending program.  In that case, the cost of continuation largely disappears from the legislative radar screen because continuation occurs as a result of legislative inaction rather than legislative action.  Moreover, by approving a program as a “permanent” change, Congress modifies the budget baseline to incorporate its cost in all subsequent years, including any growth in costs resulting from increased participation in the program or other factors not due to legislated changes.  Thus, enactment of permanent measures makes any continuation of the program beyond the initial budget window period appear to be cost-free.

Proposals made by the George W. Bush and Obama Administrations to change the baseline to disregard the temporary nature of the 2001 and 2003 tax cuts demonstrate how important this budget accounting difference is.  If the baseline were changed to treat these tax cuts as if they had been enacted as permanent law (despite the sunset clause), it would allow a continuation of the cuts beyond 2010 to appear to be cost-free and thereby facilitate their extension.  In 2007, in response to the Bush Administration’s proposed change to the baseline rules, then-CBO Director Peter Orszag explained why this change would be a form of bait-and-switch that would substantially undermine the integrity of the legislative process:

[S]coring expiring provisions as entailing no budgetary cost after their expiration, but then assuming their extension in the baseline, would cause the costs of extending those provisions to “disappear” from the process—which would substantially undermine its integrity.⁷

Despite this criticism, in 2009, the Obama Administration’s Office of Management and Budget (OMB), headed by Dr. Orszag, made precisely the same proposal as the Bush Administration to change the baseline.⁸ In a remarkable display of chutzpah, the OMB captioned this proposal as a “Return to Honest Budgeting.”⁹ The Obama Administration proposal would allow a total of $3.5 trillion in costs to disappear from the budget process during just the next ten years.¹⁰ In other words, during the current period of rapidly growing deficits and debt, this amount of additional spending (or lost revenue) could be approved without any member of Congress or the Administration having to take responsibility for it.

Dr. Orszag’s initial criticism of the Bush Administration proposal was correct.  Moreover, the reason he offered shows equally well why the current budget accounting treatment of permanent legislation substantially undermines the legislative process.  Permanent legislation is scored as entailing no budgetary cost after the end of the budget window period even though the baseline assumes continuation of the legislation forever.  Thus, the costs of such legislation after the end of the budget window period “disappear” from the legislative process in exactly the same manner as Dr. Orszag’s example, with the same deleterious effect on the integrity of that process.

 
IV.
Passage of Permanent Legislation Permanently Distorts Budget Process Information

The adoption of a permanent program permanently distorts the information provided by the budget process even if the program itself, as a result of subsequent congressional action, turns out to be only temporary (or, indeed, never goes into effect).  Although this phenomenon is derivative of effects already discussed, the consequence is so counterintuitive as to merit a brief, separate discussion.  The impact is also very important:  It means, for example, that the $16.8 trillion of Medicare prescription drug program costs for which no lawmaker has ever been held accountable has permanently distorted budget accounting by that amount even if the program itself is curtailed or repealed in the future.

The phenomenon is illustrated by considering legislation affecting a tax law provision concerning the allocation of interest expense between domestic- and foreign-source income.  In 2004, Congress liberalized this provision to provide a cut in taxes but deferred the effect of the change until 2009.  The estimated cost of the liberalization during the applicable ten-year budget window period (FY 2005-2014) was about $14 billion.  In 2008, prior to the liberalization going into effect, Congress delayed its effect for two years until 2011.  However, because the baseline for FY 2009-2018 assumed that the new liberalized law would be in effect as a result of the 2004 legislation, the two-year delay in this tax cut was estimated to raise about $8 billion in revenues.  In 2009, in approving health care legislation, the House Ways and Means Committee agreed to an additional delay of the tax cut until 2020, producing a further estimated increase in revenues of about $26 billion.¹¹

If the Ways and Means Committee proposal becomes law, the net budget effect of the three changes would be an estimated increase in revenue of $20 billion ($14 billion revenue loss from 2004 legislation plus $8 billion and $26 billion revenue increases from 2008 and 2009 legislation), most of which would be used to finance the cost of health care reform.  But the interest allocation rules would not have been changed at all by this legislation—taken together, all of the legislation would leave the law (until 2020) precisely where it was prior to 2004.  Thus, the estimated $20 billion increase in revenues resulting from the “changes” to those rules cannot be an accurate reflection of the budget impact of the legislation.  No program would have been started, modified, or cancelled as a result of the legislation; the $20 billion would simply be the byproduct of how the budget accounts for the delay of a program that has not yet gone into effect.

Moreover, this misrepresentation can be repeated over and over again.  For example, if the 2009 Ways and Means Committee bill is enacted (delaying the effect of the 2004 liberalization until 2020), Congress could later delay it again, thereby “raising” billions more in revenue to finance other spending or tax cuts.  Again, all of this would occur despite the absence of any change whatsoever to the interest allocation rules.

The reason for the misrepresentation is the “permanent” nature of the 2004 amendment to the interest allocation rules.  As permanent legislation, it changed the baseline for all succeeding years even though Congress was charged with just a small portion of the cost of the change—the $14 billion loss in revenues estimated to arise during the forthcoming ten years.  Thus, subsequent delays in the effect of the 2004 amendment effectively credit Congress with an amount for which it was never charged in the first place.  This example shows how enactment of permanent legislation permanently distorts the information provided by the budget process even when the legislation itself turns out to be only temporary or, as in this case, never goes into effect at all.   The budget treatment of permanent legislation allows Congress to generate fake cost savings or revenue increases whenever it wants.  Congress simply has to pass permanent spending increases or tax cuts that are never intended to go into effect, and then to vote repeatedly to delay the start of such programs.

 
Conclusion

In early 2009, in one of the first laws passed under the new Obama Administration, Congress extended for 4.5 more years an entitlement program providing health insurance benefits to children.  The law, however, was approved under a special budget rule that accounted for its cost as if the extension were permanent.  Hence, even as lawmakers expressed concern about the daunting fiscal challenges facing the nation, they approved a new program whose true cost may far exceed the official cost revealed in the legislative process.  Congress may soon take similar action if it passes permanent health care or climate change legislation or converts Pell Grants from a discretionary program into a permanent one, as recommended by the President.¹²

This Editorial has shown that after taking into account the budget accounting rules in the legislative process, it is preferable to pass temporary-effect rather than permanent legislation to promote political accountability and fiscal restraint.  Barring estimation error, the full cost of legislation is revealed to Congress and the public when temporary-effect, but not permanent, legislation is adopted and continued.  The budget implications of these legislative practices should be understood clearly before Congress undertakes major reforms of entitlement and tax programs.

Acknowledgments:

Copyright © 2009 New York University Law Review and George K. Yin. All rights reserved.

George K. Yin is Edwin S. Cohen Distinguished Professor of Law and Taxation at University of Virginia School of Law.

This Editorial is an updated and abbreviated version of George K. Yin, Temporary-Effect Legislation, Political Accountability, and Fiscal Restraint, 84 N.Y.U. L. REV. 174 (2009).

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