Tax Deregulation

Steven A. Dean - Brooklyn Law School

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What is Tax Deregulation?

Even before the financial crisis thrust deregulation into the headlines, scholars spent decades debating its costs and benefits. Oddly, this is not the case with tax deregulation. Although lower tax rates and reduced tax complexity figured prominently in tax scholarship of that earlier period, tax deregulation itself has been addressed relatively rarely and recently.

Defining tax deregulation is challenging. Even more difficult is explaining why it has gone unrecognized for so long. The collective failure to acknowledge the existence of tax deregulation is remarkable, in part, because the impact of deregulation has been pervasive and affected tax rules of all kinds. The broad reach of the tax laws makes it even more difficult to imagine that deregulation and taxation would never intersect.

Tax rules are not known for their flexibility.1 While environmental laws can articulate emissions targets and allow private parties to find low-cost ways of meeting them, it makes little sense to think of tax laws as specifying a revenue target and inviting taxpayers to determine the best way of collecting that amount.

Surprisingly, the hallmark of deregulation—an increase in private autonomy at the expense of direct governmental control—can easily be recognized in a number of significant business tax reforms implemented in recent decades. The introduction of the check-the-box entity classification rules offers what may be the most striking instance of the deregulation of the federal income tax. Rather than attempting to prescribe a particular tax treatment for different types of business entities, the new rules explicitly empower taxpayers to choose, and even change, those classifications. Other reforms—including safe harbor leasing in the early 1980s, the introduction of the best method transfer pricing rule in the mid-1990s, and the recent liberalization of the tax-free divisive reorganization requirements—produced a similar shift in power from public to private hands.

To understand the nature of the autonomy that tax deregulation generates, it is easiest to begin with an extreme example: a tax that offers taxpayers virtually no opportunity to affect their treatment. A “head tax” imposes an identical lump-sum burden on each individual taxpayer. Taxpayers cannot alter that burden by marrying, shifting income among individuals or time periods, or disguising wages as investment proceeds. Such taxes have been enacted but are rare. The absence of autonomy, which is the essence of a head tax, makes it efficient—since taxpayers cannot lower their tax burden by acting strategically, wasteful tax planning simply does not occur—but not particularly appealing.

An income tax that offered taxpayers absolutely no autonomy would, like the head tax, prescribe the precise tax consequences of any taxpayer behavior. Taxpayers would have no freedom to alter their tax burden (any more than they can prevent what goes up from coming down). A tax system as complex as the U.S. income tax inevitably offers taxpayers opportunities to do just that. Over the past few decades, deregulatory tax reforms have granted taxpayers the sort of power that Neo learned to exercise in The Matrix.2 Taxpayers may not be able to defy the laws of physics like he did, but tax deregulation allows them to do some pretty amazing things, like willing corporations into—and out of—existence.

What Isn’t Tax Deregulation?: Deregulation vs. Simplification

Despite deregulation’s extensive impact on the tax system, the phenomenon remains underexamined by scholars. In one sense, that blind spot is purely semantic. Although tax simplification predates deregulation by several decades, by the 1980s the concept of simplification had evolved to encompass deregulatory reforms.

A classic definition of tax simplification focuses on reductions in three types of complexity.3 The first is rule complexity, which encompasses the costs associated with understanding relevant tax rules. Next, transactional complexity describes the costs taxpayers incur to structure their affairs to minimize their tax burdens. Finally, compliance complexity captures expenses related to filing returns and satisfying ongoing requirements. Each form of complexity also imposes ancillary costs on tax authorities. Today the term simplification is often misused to describe reforms that deregulate but do not simplify the tax law.

While both simplification and deregulation call for easing burdens the tax law imposes on taxpayers, as shown in Figure 1, they do so in different ways. Simplification principally targets the non-tax costs that tax rules impose on private actors and related costs borne by tax authorities. By enhancing taxpayer autonomy, deregulatory tax reforms may reduce those costs. But as the check-the-box rules demonstrate, they may counterintuitively please taxpayers while increasing tax planning and compliance costs.

Positive Effects of Tax Deregulation: Cooperative Compliance Spirals

The move toward tax deregulation has both positive and negative effects. One positive effect is the possibility of increased taxpayer compliance. In Responsive Regulation, Ian Ayres and John Braithwaite argue that “public policy can effectively delegate government regulation . . . to the regulated firms themselves.”4 In doing so, “[g]overnment should . . . be attuned to the differing motivations of regulated actors” so that “[t]he very behavior of an industry or firms therein . . . channel[s] the regulatory strategy to greater or lesser degrees of government intervention.”5

Although autonomy is important in the responsive regulation framework, it is a means rather than an end. Taxpayers’ freedom from restrictive regulation serves as an opportunity to demonstrate—and a reward for demonstrating—trustworthiness. Cooperative behavior earns greater autonomy, which, in turn, promotes increased cooperation. Ideally, that iterative process evolves into a self-reinforcing “compliance spiral” in which a light regulatory touch produces increased compliance.6 Simply put, a compliance spiral is a product of taxpayers and regulators operationalizing the notion that one good turn deserves another.

Negative Effects of Tax Deregulation: Fiscal Arbitrage

Tax deregulation also allows for strategic behavior by legislators that undermine important sources of budgetary restraint. In general, an arbitrageur buys in one market and sells at a higher price in another. Fiscal arbitrage occurs when policymakers are able to “buy” targeted tax benefits at bargain prices from an unsuspecting public and “sell” those tax provisions (rebranded as spending provisions) to a favored constituency. When successful, policymakers are able to perform a feat that would impress even the fabled Gnomes of Zurich. As Professor Kornhauser has noted, “the public might not tolerate handing out dollars to every hedge fund trader, but will not notice if these traders receive the money by means of favorable tax treatment.”7 The recipient of the fiscal largesse is indifferent to its form, but the public is fooled by little more than a sleight of hand.

The best understood type of fiscal arbitrage, budgetary arbitrage, occurs where a tax break subverts the well-established process of monitoring the budget impact of tax preferences.8 In the current era of budget deficits, one would expect opportunities for such off-budget outlays to be increasingly tempting and troublesome.

Even when those accounting gimmicks are impossible, policymakers still have reason to engage in other forms of fiscal arbitrage. For example, cognitive psychologists have shown how superficial differences between substantively identical fiscal alternatives can affect the way in which individuals respond to them.9 The resulting cognitive arbitrage distorts the political process even though a completely rational public would ignore purely formal distinctions among policy alternatives.

Legislators’ desires to circumvent parliamentary rules and procedures provides another potential motivation for fiscal arbitrage. For example, direct expenditures can be presented as tax expenditures to avoid parliamentary limits on the use of sunset provisions.10 This third form of fiscal arbitrage, procedural arbitrage, can exist independently or in conjunction with budgetary or cognitive arbitrage.

More Risk than Reward

By helping to promote taxpayer compliance, providing increased autonomy can simultaneously serve public and private interests. Unfortunately, while a compliance spiral tends to behave like a hothouse flower, fiscal arbitrage is a weed. Whenever a change in the tax laws provides taxpayers with a benefit that is the economic equivalent of a non-tax benefit, fiscal arbitrage follows. Increasing taxpayer compliance with tax deregulation requires a specific combination of scale and transparency.

Weighing tax deregulation’s positive potential against its more predictable negative effects strongly suggests that tax deregulation should generally be avoided. Unfortunately, while we have come to appreciate the risks inherent in other forms of deregulation—such as financial deregulation—tax deregulation and fiscal arbitrage have been, until now, less well understood. As a result, tax deregulation tends to be mistaken for its more benign relative: tax simplification.

Fortunately, not all tax deregulation is created equal. Compliance spirals that operate on a broad scale—affecting a class of taxpayers—and those that implicate a specific taxpayer sit at opposite ends of a spectrum. At one end, with a high risk of fiscal arbitrage and a low likelihood of creating a compliance spiral, lies the macro-compliance spiral. At the other, the micro-compliance spiral presents the opposite, much more appealing combination.

The relationship between the probability of success and the nature of the compliance spiral in question is relatively straightforward. If tax authorities have the capacity to observe the behavior of particular taxpayers, they can readily adjust their enforcement intensity to suit each taxpayer. In other words, if tax authorities are able to observe a taxpayer closely enough to detect a defiant attitude towards her compliance obligations, they can redouble their scrutiny of her claimed tax benefits. Likewise, they can demand more thorough documentation and explanations of any aggressive transactions that such rigorous scrutiny might reveal.

At the same time, if a taxpayer believes that changes in her behavior will directly influence the intensity of the treatment she receives, she will be more responsive to the prospect of more favorable treatment. If another taxpayer’s treatment depends not only on his actions but those of all the other taxpayers in a given class—so that if they collectively demonstrate a cooperative attitude, they will receive more favorable treatment—the link will inevitably be much weaker.

Even worse, increasing the scale of the compliance spiral increases the need for fiscal arbitrage. If tax authorities are to communicate successfully with a large group of taxpayers, the signal they use to invite taxpayer cooperation would need to be the tax-policy equivalent of a billboard to its intended recipients. Fiscal arbitrage allows policymakers to conceal the cost of the tax break from the public even though its benefits are obvious to its recipients. In other words, although the billboard may be easily seen from the boardroom, fiscal arbitrage makes that billboard seem like a postage stamp when seen from the street.

Conclusion

Tax deregulation has emerged as an important feature of the tax policy landscape. It has done so even as scholars have failed to grapple with its normative significance. In most cases, the likelihood of fiscal arbitrage will outweigh the prospects for a compliance spiral. Deregulatory provisions that aim to produce micro-compliance spirals offer the most promising risk-reward profiles, but even they may cause more harm than good.

Acknowledgments:

Copyright © 2011 New York University Law Review.

Steven A. Dean is a Professor of Law at Brooklyn Law School.

This Legal Workshop Editorial is based on the following Law Review Article: Steven A. Dean, Tax Deregulation, 86 N.Y.U. L. REV. __ (forthcoming 2011).

  1. See George K. Yin, The Taxation of Private Business Enterprises: Some Policy Questions Stimulated by the “Check-the-Box” Regulations, 51 SMU L. REV. 125, 130 (1997). (“In general, the tax system does not permit taxpayers to elect the rules applicable to them. Rather, the system generally attempts to impose tax rules that follow and are consistent with some economic characteristic of the taxpayer or the taxpayer’s activities.”).
  2. See THE MATRIX (Warner Bros. Pictures 1999).
  3. See DAVID BRADFORD, UNTANGLING THE INCOME TAX 266–67 (1999).
  4. IAN AYRES & JOHN BRAITHWAITE, RESPONSIVE REGULATION: TRANSCENDING THE DEREGULATION DEBATE 4 (1992).
  5. Id.
  6. John Braithwaite, Large Business and the Compliance Model, in TAXING DEMOCRACY: UNDERSTANDING TAX AVOIDANCE AND EVASION 188 (Valerie Braithwaite ed., 2003).
  7. Marjorie E. Kornhauser, Cognitive Theory and the Delivery of Welfare Benefits, 40 LOY. U. CHI. L.J. 253, 264 (2009).
  8. Stanley Surrey is credited with popularizing the tax expenditure concept that attempts to make tax benefits equivalent to direct spending for budget purposes. See STANLEY SURREY, PATHWAYS TO TAX REFORM: THE CONCEPT OF TAX EXPENDITURES (1973). By highlighting the equivalence between direct spending and tax expenditures, Surrey endeavored to prevent “[g]overnmental financial assistance programs“ from being “grafted on to the structure of the income tax proper.” Id. at 6.
  9. See Kornhauser, supra note 7, at 264 (“[T]ax expenditures are less salient than direct expenditures; the public is less aware of them, less interested in them, and more confused by them.”).
  10. See Rebecca M. Kysar, Lasting Legislation, 159 U. PA. L. REV. 1007, 1018–19 (2011) (“[Congressional budget committees] ignore sunset provisions for spending programs with current-year costs greater than $50 million, but not for other programs. For purposes of estimation . . . [the committees] assume sunset provisions take effect even though, for the most part, temporary tax cuts do not expire but instead are routinely renewed.” (internal citations omitted)).

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