INTRODUCTION TO ONE-HUNDRED YEARS
OF THE FEDERAL INCOME TAX
JOSEPH M. DODGE *, STEVE R. JOHNSON ** & JEFFREY H. KAHN ***
Income taxation in the United States got off to a less than auspicious start. 1 A few American colonies experimented with taxes that
crudely attempted to reach certain income from business and professional activities during the 17th and 18th centuries. 2 Secretary of the
Treasury Alexander Dallas urged adoption of an income tax during
the War of 1812, but that conflict ended before action was taken on
his proposal. 3
Both sides adopted income taxes during the American Civil War.4
The victorious North repealed its tax shortly after the war ended. 5
About a decade after the tax had been repealed, the Supreme Court
upheld the constitutionality of the tax in the Springer case. 6
In 1894, a federal income tax system was again enacted. Especially compared to what we have now, that tax was a model of simplicity.
As applied to individual taxpayers, it imposed a flat rate of two percent on any income over $4000. 7 A year later, in the famous (or infamous) Pollock decisions, the Supreme Court, effectively overruling
Springer, struck down the federal income tax as unconstitutional. 8
In 1909, Congress proposed a constitutional amendment to overturn Pollock. This amendment was ratified on February 25, 1913 as
* Stearns Weaver Miller Weissler Alhadeff & Sitterson Professor, Florida State
University College of Law.
** University Professor, Florida State University College of Law.
*** Charles W. Ehrhardt Professor & Associate Dean for Academic Affairs, Florida
State University College of Law.
1. For discussion of the early history of taxation in the United States, see JOSEPH M.
DODGE, J. CLIFTON FLEMING, JR. & ROBERT J. PERONI, FEDERAL INCOME TAX: DOCTRINE,
STRUCTURE, AND POLICY 3-11 (4th ed. 2012).
2. See generally ROBIN L. EINHORN, AMERICAN TAXATION, AMERICAN SLAVERY (2006)
(discussing tax systems of the American colonies); see also HAROLD DUBROFF, THE UNITED
STATES TAX COURT: AN HISTORICAL ANALYSIS 1-2 (1979).
3. DUBROFF, supra note 2, at 2.
4. E.g., Act of August 5, 1861, ch. 45, § 49, 12 Stat. 292, 309; Act of July 1, 1862, ch.
119, § 89, 12 Stat. 432, 473; Tax History Museum: 1861–1865: The Civil War, TAX ANALYSTS, http://www.taxhistory.org/www/website.nsf/Web/THM1861?OpenDocument (last visited Feb. 1, 2014) (describing Confederacy income tax).
5. Act of July 14, 1870, ch. 255, § 6, 16 Stat. 256, 257.
6. Springer v. United States, 102 U.S. 586 (1880) (holding that the Civil War income
tax was not subject to the requirement, imposed by Article I, Section 2, Clause 3 of the U.S.
Constitution, that a federal “direct tax” had to be apportioned among the states in proportion to population).
7. Act of August 27, 1894, ch. 349, § 27, 28 Stat. 509, 553.
8. Pollock v. Farmers’ Loan & Trust Co., 157 U.S. 429 (1895), aff’d on reh’g, 158 U.S.
601 (1895) (holding that the income tax, in taxing income from property, was a nonapportioned direct tax).
xi
the Sixteenth Amendment, which provides: “The Congress shall have
power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several States, and without
regard to any census or enumeration.” Shortly after the ratification of
the Sixteenth Amendment, Congress enacted the Revenue Act of
1913 and, thus, the modern federal income tax was born.9
Few events have been more important in shaping contemporary
American life than the creation and development of the income tax.
“No other branch of the law touches human activities at so many
points” as does income tax law. 10 Income tax considerations bear on
marriage, children, home, work, and the numerous other activities,
transactions, and decisions fundamental to life. Income tax planning
is crucial to businesses large and small. The modern welfare-defenseregulatory state would be impossible without the enormous and predictable flows of revenues provided mainly by the income tax.
Whether the effects of the federal income tax are desirable can be
debated. The pervasiveness of these effects cannot be.
Thus, whether as celebration or lamentation, the centennial of the
modern federal income tax is an occasion to mark. To do so, we at
Florida State hosted an array of distinguished experts who offered
perspectives on what we have learned in the last 100 years and
where we should (or will) go in the future. Joining us for the occasion,
as principal presenters and as commentators, were Steven Bank, Joseph Bankman, David Gamage, James Hines, Jr., Douglas Kahn,
Leandra Lederman, Gregg Polsky, Clarissa Potter, Chris Sanchirico,
Daniel Shaviro, and Lawrence Zelenak. Although they need no
introduction, their institutional affiliations are listed at the end of
this Introduction.
We convened on March 1 and 2, 2013. Eight original articles and
essays examined historical developments, current features, and future possibilities as to the federal income tax. First, authors presented their work, then designated commentators offered their perspectives, then all conference participants participated in rich and freewheeling debate. The pieces appearing in this symposium issue were
enriched by this stimulating discussion.
Beginning this symposium issue, Professor Daniel Shaviro explores The Forgotten Henry Simons. Simons is a household name
with tax scholars on account of his well-known definition of personal
income as the “algebraic sum of (1) the market value of rights exercised in consumption and (2) the change in value of the store of property rights between the beginning and end of the period in ques9. Act of October 3, 1913, ch. 16, 38 Stat. 114. Previously, the federal government
had enacted a corporate income tax. Act of August 5, 1909, ch. 6, § 38, 36 Stat. 11, 112. The
Supreme Court upheld the corporate income tax as a uniform “indirect” tax in Flint v.
Stone Tracy Co., 220 U.S. 107 (1911).
10. Dobson v. Commissioner, 320 U.S. 489, 494-95 (1943).
xii
tion.” 11 This definition of personal income, now referred to as the
Haig-Simons definition, is still used as a standard and remains important in modern tax scholarship.
Professor Shaviro explores the man behind the definition. He provides a brief overview of Simons’ “meteoric” career. The article then
moves to a discussion of the seemingly contradictory nature of some
of his opinions. Simons described himself as “severely libertarian.”
He generally denounced government economic regulation and was
the intellectual leader of the pro-free market law and economics
movement at the University of Chicago Law School. Yet he also was a
proponent of “drastic progression” in a broad-based income tax. Professor Shaviro explores these apparently contradictory views and
attempts to explain why Simons may have held them. Finally, while
acknowledging that Professor Simons favored an income tax system
over a consumption tax system during his lifetime, Professor Shaviro
attempts to discern what Professor Simons might think today on
that issue.
In When We Taxed the Pyramids, Professor Steven Bank explores
the dividends received deduction. 12 This deduction allows a corporation to deduct from its income an amount equal to a certain percentage (or all) of the dividends that it receives from other domestic corporations. The article examines the historical development of the deduction to explain how we ended up with the current tax treatment of
such dividends. Professor Bank focuses on the original purpose for
taxing intercorporate dividends, which was to discourage the formation of corporate “pyramids” or groups of corporations controlled
by one parent holding corporation. These structures were viewed as
abusive and facilitated the concentration of too much wealth and
power in a small group of owners.
The article explores the political shift in attitude over time regarding the concern of multi-level corporate groups and the gradual acceptance of the pyramid structure. Professor Bank uses the fall and
rise of the corporate consolidated return to illustrate this shift of
opinion. This leads us to where we are today, with a dividends
received deduction for corporations that does not appear to fulfill
any policy rationale. Professor Bank concludes the article by proposing reforms that would better align the treatment of intercorporate
dividends with the policy justification for allowing a deduction for
such income.
The individual income tax has increasingly grown more complex
over its 100-year history. In Some Income Tax Simplification Proposals, Professor Joseph Dodge presents explanations of how complexity has come about, while offering reasons why simplification,
11. HENRY C. SIMONS, PERSONAL INCOME TAXATION: THE DEFINITION OF INCOME AS A
PROBLEM OF FISCAL POLICY 50 (1938).
12. I.R.C. § 243.
xiii
especially for individual and small-business taxpayers, has merit.
Professor Dodge then offers an array of simplification proposals, broken down into one list of proposals that do not entail significant reform from the policy perspective and a separate list of commonly
mentioned reform proposals that would also advance the cause of
simplification. The lists are not exhaustive; for example, simplification of capitalization doctrine and capital recovery methods (including depreciation) is not considered.
Many simplification proposals made by Professor Dodge are aimed
at low to moderate individual taxpayers. For example, the taxable
income computation could be simplified by eliminating the different
treatment of various categories of deductions. Low-income allowances
could be simplified by eliminating the separate rate schedules for
unmarried individuals and heads of household, plus collapsing the
existing standard deduction, personal exemption, and dependency
exemptions into a single subsistence deduction based on family size.
Similarly, the earned income credit, the child credit, and the household and dependent care credit could be combined into a single dependent-care allowance for the working poor. Another type of simplification entails elimination of (1) subjective tests, (2) assorted factintensive inquiries, (3) meaningless distinctions, and (4) pointless
computations. Along these lines, the definition of “dependent” could
be simplified by eliminating “support” tests, the Duberstein definition
of “gift” 13 could be replaced by the gift tax definition of gift, 14 depreciation (and basis adjustments) could be disallowed on business or investment use of personal residences, the distinction between tax alimony and child support could be abolished, and various borderline
personal-business costs could be disallowed. Ranging further afield,
Professor Dodge floats notions of cash accounting for small business
(including avoidance of inventory accounting), portfolio accounting
for publicly traded securities held by an individual, and simplification of the income tax rules involving gratuitous transfers, grantor
trusts, and estates. Also considered are various reform proposals pertaining to capital gains, the personal deductions, and the horrendously complex system of taxing retirement income deferrals.
In A Proposed Replacement of the Tax Expenditures Concept and a
Different Perspective on Accelerated Depreciation, Professor Douglas
Kahn revisits the debate on tax expenditure budgets, a concept that
he has previously criticized. 15 The tax expenditure concept rests uneasily on the premise that there is an “ideal” income tax system and
13. See Commissioner v. Duberstein, 363 U.S. 278, 285-86 (1960) (defining gifts excludible from income taxation as transfers animated by the donor’s “detached and disinterested generosity” (quoting Commissioner v. LoBue, 351 U.S. 243, 246 (1956))).
14. See I.R.C. § 2512(b) (defining gifts by reference to the extent by which the value of
the transferred property exceeds consideration rendered for the transfer).
15. Douglas A. Kahn & Jeffrey S. Lehman, Tax Expenditure Budgets: A Critical View,
54 TAX NOTES 1661 (1992).
xiv
that any departures from that ideal system should be scrutinized to
see if they are justified. In this essay, Professor Kahn contends that a
major flaw in the tax expenditure concept is its view that the current
tax provisions can be divided into two camps in black and white
terms. That is, a provision either is a departure from the ideal system or it is within the system; there is no middle ground. To the contrary, Professor Kahn contends that the tax system is too sophisticated for such a crude classification to be appropriate. Instead, he
maintains that the tax system should be analyzed under a more differentiated multivariate standard.
Professor Kahn reviews the tax law's allowance of depreciation
deductions as an example of the flaws in the tax expenditure concept.
Taxpayers generally must capitalize business costs for items that will
be used for more than one year (in contrast to deducting those costs
immediately). The system for annually deducting a portion of the cost
is referred to as depreciation. There has been much debate over the
question of how the amount of depreciation deductions should be determined. Current tax law permits an accelerated method of depreciation (i.e., greater amounts deducted in the earlier years of use of the
item) for some properties. One of the government's tax expenditure
budgets treats depreciation in excess of what would be allowed under
the straight-line method as a tax expenditure. Professor Kahn adopts
an approach that shows that acceleration is not per se inconsistent
with normal tax principles, but he does emphasize that his conclusion does not mean that accelerated depreciation is the proper system
to employ.
In The End of Cash, the Income Tax, and the Next 100 Years, Professors Jeffrey Kahn and Gregg Polsky take the occasion of the income tax centennial to question how future technology might improve
tax compliance under the income tax system, although they note that
such technology ironically may also signal the end of the income tax.
Professors Kahn and Polsky propose that future technological advances in payment systems may shrink the cash economy down to an
immaterial size. They suggest that such a world would lead to an increase in tax compliance since the government would easily be able to
track income transfers between taxpayers, which should lead to increased tax compliance. The shrinkage of the tax gap would make the
income tax system more efficient, thereby strengthening the system.
Those same technological advances in payment systems also could
lead to the demise of the income tax. For a variety of reasons, many
economists and policy experts advocate the move from an income
tax system to one that focuses more intently on consumption. One
difficulty with such a move is the inability to introduce significant
progressivity to such a system. Widespread and exclusive electronic
payment systems, however, could change that and allow the
government to tailor a consumption tax system with progressive
xv
rates, thereby leading to the end of the income tax system that we
celebrate today.
Professor David Gamage’s contribution to the symposium—On the
Future of Tax Salience Scholarship: Operative Mechanisms and Limiting Factors—builds on his earlier work, with Professor Darien
Shanske, that reviewed the developing literature on tax salience. 16
“ ‘Tax salience’ ” refers to how the presentation of tax prices affects
taxpayer behavior. In other words, tax salience measures how taxpayer behavior departs from key assumptions of neoclassical economic theory.” 17 Professor Gamage’s hope is that such analysis will further aid the development of scholarship and policymaking in the area. While he concedes that the body of literature is not quite there
yet, Professor Gamage believes that the area will soon be developed
enough to provide substantial policy recommendations for our federal
income tax system.
Appropriately, most of the attention of this symposium is directed
at the substantive rules of federal income taxation, the policies behind them, and the alternatives to them. But procedural rules—the
provisions governing resolution of controversies as to the meaning
and application of the substantive rules—also are part of the story of
the first 100 years and of the foreseeable future.
Professor Steve Johnson takes a panoramic look at the procedural
rules in Reforming Federal Tax Litigation: An Agenda. He identifies
12 key events and trends—statutory, regulatory, and judicial—that
have shaped the current federal tax procedure and collection regimes.
He finds that four sets of values have driven these events and trends:
providing remedies for taxpayers and third parties that are both fair
and perceived to be fair, protecting the revenue, achieving decisional
consistency, and promoting process efficiency, reducing costs, and
reducing delays.
Applying these criteria, Professor Johnson proposes an array of
reforms to federal tax litigation, as to available fora, available forms
of action, and prerequisites to suit. His recommendations include expanding the Tax Court’s jurisdiction to give it nearly plenary civil tax
jurisdiction, abolishing the Court of Claims’ tax jurisdiction, abolishing nearly all of the so-called TEFRA partnership audit and litigation
regime, revising (though not abolishing) Collection Due Process hearings and litigation, and facilitating tax refund suits by allowing taxpayers to sue after paying only part of assessed liabilities (instead of
having to pay the full assessment as a precondition of suit).
The symposium issue concludes with Professor Larry Zelenak
speculating on the question of whether Florida State University College of Law will hold another tax symposium in the year 2113 “cele16. David Gamage & Darien Shanske, Three Essays on Tax Salience: Market Salience
and Political Salience, 65 TAX L. REV. 19 (2011).
17. Id. at 19.
xvi
brating” the 200th anniversary of the federal income tax. That is, will
the income tax survive for another 100 years? In Will the Federal Income Tax Have a Bicentennial?, Professor Zelenak argues that the
income tax system is defined by more than just its base. He notes
that there are several defining features of the income tax that have
nothing to do with its base. Believing that many of these features will
remain intact, even if the income base changes, leads Professor
Zelenak to conclude that it is arguable that the public would still
consider our system to be an income tax—that is, that the label “income tax system” has become broader than just the income base. If
true, it is likely that Florida State University College of Law will be
issuing an all-digital, holographic symposium issue in 2113 celebrating (or lamenting) another 100 years of the income tax.
We at Florida State are deeply grateful to all the conference participants for their enthusiasm and insights. We present the articles
and essays in this symposium issue in the hope and belief that they
will stimulate further thought and debate as the United States embarks on its second century of the federal income tax.
xvii
FEATURED PRESENTERS AND COMMENTATORS
“One-Hundred Years of the Federal Income Tax”
Florida State University College of Law
March 1 & 2, 2013
Steven A. Bank, Paul Hastings Professor of Business Law, UCLA School
of Law
Joseph Bankman, Ralph M. Parsons Professor of Law and Business, Stanford Law School
Joseph M. Dodge, Stearns Weaver Miller Weissler Alhadeff & Sitterson
Professor, Florida State University College of Law
David Gamage, Assistant Professor of Law, University of California,
Berkeley School of Law
James R. Hines, Jr., L. Hart Wright Collegiate Professor of Law and Richard A. Musgrave Collegiate Professor of Economics, University of Michigan
Steve R. Johnson, University Professor, Florida State University College
of Law
Douglas A. Kahn, Paul G. Kauper Professor of Law, University of Michigan
School of Law
Jeffrey H. Kahn, Charles W. Ehrhardt Professor and Associate Dean, Florida State University College of Law
Leandra Lederman, William W. Oliver Professor of Tax Law, Indiana
University Maurer School of Law
Gregg D. Polsky, Willie Person Mangum Professor of Law, University of
North Carolina School of Law
Clarissa Potter, Deputy Tax Director, AIG; former Deputy Chief Counsel,
Internal Revenue Service
Chris William Sanchirico, Samuel A. Blank Professor of Law, Business,
and Public Policy, University of Pennsylvania Law School
Daniel Shaviro, Wayne Perry Professor of Taxation, New York University
School of Law
Lawrence A. Zelenak, Pamela B. Gann Professor of Law, Duke Law School
xviii
THE FORGOTTEN HENRY SIMONS
DANIEL SHAVIRO *
I. INTRODUCTION..................................................................................................
II. SIMONS’ METEORIC CAREER .............................................................................
III. HENRY SIMONS: A DIFFERENT TYPE OF LIBERTARIAN? ....................................
A. Philosophical Libertarianism ....................................................................
B. Assessing and Explaining Simons’ “Interventionism”...............................
C. Simons’ Support for Progressive Income Taxation ....................................
IV. SIMONS ON THE INCOME TAX ............................................................................
A. Income Taxation Versus Consumption Taxation.......................................
1. Why Did Simons Prefer the Income Tax? ............................................
2. Simons’ View of Realization and Deferral ...........................................
3. What Might Simons Think Today About the Choice Between Income
and Consumption Taxation? ...............................................................
(a) More Pro-Income Tax?..................................................................
(b) Potentially Pro-Consumption Tax? ..............................................
V. CONCLUSION .....................................................................................................
1
5
10
11
15
20
25
25
25
29
33
33
35
37
I. INTRODUCTION
Surely just about everyone in the U.S. federal income tax field has
heard of Henry Simons, although mainly for just one thing: his famous definition of “personal income” as the market value of one’s
consumption plus change in net worth during the relevant period,1 as
stated in his classic 1938 work, Personal Income Taxation. Simons’
formulation of what became known as the Haig-Simons income definition provided a central orientation point for U.S. tax policy
thinking for many decades thereafter. Even today, it remains
extremely important.
The man behind the definition is, in some respects, considerably
less well-known. For example, while most tax aficionados probably
would identify him as a strong advocate of the federal income tax and
of using a broadly defined base, fewer may know how comfortable he
was with retaining the realization principle as a practical accommodation.2 Fewer still may be aware that he advocated eliminating the
corporate income tax, conditioned only on a rule change providing for
shareholder-level gain realization when appreciated stock (or other
* Wayne Perry Professor of Taxation, NYU Law School. I am grateful to Miranda
Perry, Chris Sanchirico, Robert Van Horn, and the participants in conferences at the USC
and FSU Law Schools for helpful comments on an earlier draft.
1. More precisely, Simons states: “Personal income may be defined as the algebraic
sum of (1) the market value of rights exercised in consumption and (2) the change in the
value of the store of property rights between the beginning and end of the period in question.” HENRY C. SIMONS, PERSONAL INCOME TAXATION: THE DEFINITION OF INCOME AS A
PROBLEM OF FISCAL POLICY 50 (1938) [hereinafter SIMONS, TAXATION].
2. See, e.g., HENRY C. SIMONS, FEDERAL TAX REFORM 78 (1950) [hereinafter SIMONS,
REFORM].
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FLORIDA STATE UNIVERSITY LAW REVIEW
[Vol. 41:1
property) was transferred by gift or bequest, and accompanied by the
suggestion that dividends not be taxed until the shareholder had fully recovered her basis in the underlying stock. 3
Perhaps fewest of all realize that today, in active intellectual
memory, there are actually two Henry Simonses—albeit each the
same person, not just biologically but also intellectually—
remembered in two mostly distinct communities. First, of course,
there is the income tax community’s Henry Simons, who, in the
course of advocating a broad tax base and “drastic progression”4
memorably demolished intellectual opponents, 5 vehemently denounced support for his own bottom-line positions that was based on
reasoning about utility or sacrifice,6 and lucidly addressed how a
workable income definition could actually be implemented.7
Simons was not just an income tax writer, however. At the time of
his death, most of his published work discussed other issues—for example, the case for a competitive free-market economy,8 the problems
caused by labor unions,9 and his approach to monetary policy. 10 The
nontax writings included not only Simons’ best-known work at the
time of his death 11—which Personal Income Taxation cites as its underlying policy guide 12—but also the work that he considered his
best. 13 Moreover, while these writings are little-known today in tax
circles, there is a community interested in free enterprise, Chicagoschool economic analysis, and libertarianism, to which they remain
at least historically important but highly controversial.
3. See id. at 112.
4. SIMONS, TAXATION, supra note 1, at 18.
5. See, e.g., id. at 16-17.
6. See id. at 8-16.
7. See id. at 41-60 (Chapter 2: “The Definition of Income”).
8. HENRY C. SIMONS, A Positive Program for Laissez Faire: Some Proposals for a
Liberal Economic Policy, in ECONOMIC POLICY FOR A FREE SOCIETY 40 (1948) [hereinafter
SIMONS, Positive Program].
9. See Henry C. Simons, Some Reflections on Syndicalism, 52 J. POL. ECON. 1 (1944).
10. See Henry C. Simons, Rules versus Authorities in Monetary Policy, 44 J. POL.
ECON 1 (1936). Simons’ previously published nontax writings were collected and posthumously published in Economic Policy for a Free Society (1948). The book includes twelve
previously published essays that together are more than 300 pages long. This admittedly is
slightly shorter than the combined page count for Personal Income Taxation (1938) plus his
only other significant tax policy work, Federal Tax Reform (1950), but the latter was only
posthumously published.
11. Aaron Director, Prefatory Note to ECONOMIC POLICY FOR A FREE SOCIETY, supra
note 8, at v, v-vi (stating that Simons’ “best-known essay” was A Positive Program for Laissez Faire, initially published in 1934, which is discussed in more detail in Part III, infra).
12. See SIMONS, TAXATION, supra note 1, at 2 n.1.
13. See George J. Stigler, Henry Calvert Simons, 17 J.L. & ECON. 1, 5 (1974) (stating
that Simons once said that his article on monetary policy, Rules versus Authorities in Monetary Policy, was “the best piece of writing he had produced”).
2013]
THE FORGOTTEN HENRY SIMONS
3
George Stigler called Simons the “Crown Prince of . . . the Chicago
school of economics,” 14 and others have agreed that he was its “prime
architect.” 15 What is more, Simons labeled and regarded himself not
merely as a free market supporter but more specifically as a libertarian. However, some aspects of Simons’ work—including, but not limited to, his advocacy of progressive income taxation—have caused
this characterization to rankle in some quarters. Indeed, the wounds
are sufficiently fresh that the title of one recent entry, published in
the Journal of Libertarian Studies, used the present tense in proclaiming: “Henry Simons Is Not a Supporter of Free Enterprise.” 16
I first encountered the second Henry Simons at a lecture given by
Ronald Coase at the University of Chicago Law School about twenty
years ago. As I recall, Coase devoted a large portion of his remarks to
denouncing Simons for what Coase considered an inappropriate willingness to rely on governmental regulatory solutions to market failure, rather than asking how markets could themselves handle these
problems. 17 My then-Chicago colleague, the late Walter Blum, a Simons protégé who kindly acted as a mentor to me when I first entered law teaching, told me the next day that Coase had expressed
surprise when Walter told him after the lecture of Simons’ continuing
prominence as an intellectual architect of the income tax.
It may seem most improbable that Simons, at least in his own
self-assessment, was “at the same time an extreme libertarian and a
believer in massive wealth redistribution.” 18 As Herbert Kiesling
notes, however, while “[o]ne can wonder how such a strange mixture
14. Id. at 1.
15. See Bruce Caldwell, The Chicago School, Hayek, and Neoliberalism, in BUILDING
CHICAGO ECONOMICS: NEW PERSPECTIVES ON THE HISTORY OF AMERICA’S MOST POWERFUL
ECONOMICS PROGRAM 301, 304-06 (Robert Van Horn et al. eds., 2011) (accepting the “prime
architect” claim although disagreeing in other respects with Van Horn’s and Mirowski’s
analysis of the Chicago school’s early history); Rob Van Horn & Philip Mirowski, The Rise
of the Chicago School of Economics and the Birth of Neoliberalism, in THE ROAD FROM
MONT PÈLERIN: THE MAKING OF THE NEOLIBERAL THOUGHT COLLECTIVE 139, 140 (Philip
Mirowski & Dieter Plehwe eds., 2009) (calling Simons the “prime architect” of the Chicago
school); see also Edmund W. Kitch, The Fire of Truth: A Remembrance of Law and Economics at Chicago, 1932–1970, 26 J.L. & ECON. 163, 179 (1983) (discussing Simons’ strong intellectual influence on the development of the Chicago School).
16. See Walter Block, Henry Simons Is Not a Supporter of Free Enterprise, 16 J. LIBERTARIAN STUD. 3 (2002).
17. Coase relatedly, but as I recall less prominently at this particular lecture, criticized Arthur Pigou, who famously proposed what are now called “Pigovian” taxes to address negative externalities such as pollution, rather than asking how markets, through
the assignment of property rights, could do the job. I would guess that Coase’s reason for
emphasizing Simons more than Pigou was that he recalled Simons’ close connection with
the University of Chicago Law School, the site and sponsor of the talk, as its first economist faculty member and an important early leader in the Chicago law and economics
movement.
18. HERBERT KIESLING, TAXATION AND PUBLIC GOODS: A WELFARE-ECONOMIC CRITIQUE OF TAX POLICY ANALYSIS 67 (1992).
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could be internally consistent, . . . in Simons’s hands the combination
was logical.” 19 I will argue that he is best viewed as an egalitarian of
a particular kind. He hated wealth inequality, concentrated economic
power (as people on the left often do), and centralized political power
(as anti-state people on the right often do), but for exactly the same
reasons and in exactly the same way. He thus explained that he
would have liked what he called “decentralized socialism,” just as
much as he liked what he called libertarianism, if not for his conclusion that it was self-contradictory and/or would turn into the same
thing anyway.20
By itself, this tale of the two (but actually one) Henry Simonses
would provide ample motivation for looking back at his work in the
context of a conference commemorating one hundred years of the
U.S. federal income tax. In particular, it helps to show why he viewed
comprehensive income taxation as such a good solution to a large
piece of the dilemma that he faced by reason of hating both wealth
inequality and government intervention in the economy.
However, there is also an interesting story to review regarding
Simons’ perspective on the design of the federal income tax. Although
his reasons for favoring comprehensive income taxation were quite
distinctive, other underlying motivations can lead to the same place.
Thus, it is of interest today, for its own sake, to see how his views, as
an undeniably smart commentator early in the intellectual history of
the U.S. income tax, look more than seventy years later. I therefore
will discuss Simons’ views on the choice between income and consumption taxation with an eye both to what has changed since the
1930s and to how these changes might matter to one who shared his
normative framework. In effect, I will ask what Simons might think
today— but with due understanding that it would be both silly and
presumptuous to draw overly confident bottom-line conclusions. 21
The rest of this Article will proceed as follows: Part II offers a brief
overview of Simons’ career; Part III discusses the issues raised by his
self-proclaimed libertarianism, in light of its underlying philosophical
motivations, his support for strong economic regulation in certain
respects, and his support for a progressive income tax; Part IV dis19. Id.
20. HENRY C. SIMONS, Introduction: A Political Credo, in ECONOMIC POLICY FOR A
FREE SOCIETY, supra note 8, at 1, 29-32 [hereinafter SIMONS, Political Credo]. George
Stigler, while offering a strong statement of Simons’ libertarian credentials that I quote
below, also said of Simons that “[m]uch of his program was almost as harmonious with
socialism as with private-enterprise capitalism.” GEORGE J. STIGLER, MEMOIRS OF AN UNREGULATED ECONOMIST 149 (1988).
21. I am not the first to ask this sort of question. See Charlene Luke, What Would
Henry Simons Do?: Using an Ideal to Shape and Explain the Economic Substance Doctrine,
11 HOUS. BUS. & TAX L.J. 108 (2011).
2013]
THE FORGOTTEN HENRY SIMONS
5
cusses his views on the income versus consumption tax debate; and
Part V offers a brief conclusion.
II. SIMONS’ METEORIC CAREER
Henry Simons was born in 1899 in the small town of Virden, Illinois, the second child in an ambitious, upper middle class family.22
Second in his high school class, he was forced by family economic reverses to enroll at the University of Michigan, rather than following
his older sister’s route to an elite eastern private college.23 Here, he
initially planned to become a lawyer like his father, but he became
interested in neoclassical economics. He started teaching economics
at the University of Iowa in 1922. In 1927, he followed his mentor,
the economist Frank Knight, to the University of Chicago Economics
Department.24
Here, things initially did not go well. Many years later, Simons’
close friend Aaron Director reported that “Henry Simons was not
liked in the economics department,” 25 although he had allies as well
as foes. Economics students found him a rude and aggressively indifferent teacher, 26 quite in contrast to his subsequent very positive reception at the University of Chicago Law School. Simons’ scholarly
record was also considered weak, as it consisted of “two book reviews
in . . . twelve years” 27 until finally, in 1934, he published a selfdescribed “propagandist tract” in support of traditional liberalism
22. See Stigler, supra note 13, at 1; SHERRYL DAVIS KASPER, THE REVIVAL OF LAISSEZFAIRE IN AMERICAN MACROECONOMIC THEORY: A CASE STUDY OF THE PIONEERS 30 (2002)
(noting that “[h]e grew up comfortably as a member of the middle class, the son of a moderately successful lawyer and an extremely ambitious homemaker”).
23. See Sherry Davis Kasper, Why Was Henry Simons Interventionist: The Curious
Legacy of a Chicago Economist 6 (June 22, 2011) (unpublished manuscript), available at
http://www.learningace.com/doc/5293928/7fbcc044dab921c837d7204dff3865e7/paper11kasper.
24. Id. at 6-8; Stigler, supra note 13, at 1 (describing Simons as Knight’s “premier
student”). After starting at Iowa, Simons also completed a summer of graduate study at
Columbia University and spent a half-year in Germany studying the work of leading German economists. Id.; Edmund W. Kitch, Simons, Henry Calvert, in 3 THE NEW PALGRAVE
DICTIONARY OF ECONOMICS AND THE LAW 465 (Peter Newman ed., 1998). George Stigler
later noted a view among the University of Chicago economics faculty that Simons “had
been sent to Europe for six months so that he would learn German so he could get a Ph.D.”
Kitch, supra note 15, at 177.
25. Kitch, supra note 15, at 176.
26. According to Paul Douglas, Simons’ colleague in the Chicago Economics Department, Simons was “almost openly insolent to those who ask questions and generally tells
them that the questions they are asking are either too elementary for him to pay attention
to or that they are not questions which any sensible person should propound or to
which any sensible person reply.” See STIGLER, supra note 20, at 187 (quoting a letter by
Douglas).
27. Kitch, supra note 15, at 177.
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called A Positive Program for Laissez Faire: Some Proposals for a
Liberal Economic Policy.28
Simons’ long pre-1934 period of academic torpor presumably reflects that, as George Stigler put it, not just “brilliance” but also a
“capacity for boredom . . . marked his entire life.” 29 However, both the
Great Depression and the Roosevelt Administration’s whirlwind “One
Hundred Days” response to it upon taking office in 1933—which Simons detested but considered no worse than what the Hoover Administration had already been doing 30—galvanized him into activity. In
June 1933, he gave a public speech in which he declared: “I must
talk, I believe for the first time of my life, as an extreme conservative,
as an exponent of that much ridiculed political philosophy, nineteenth century liberalism.” 31 Positive Program was then his followup, explaining not only why he favored what he called a laissez-faire
economic policy but also why departures from that approach were, in
his view, responsible for the Great Depression. He subsequently
called Personal Income Taxation merely “part of a scheme of policy
outlined” in Positive Program,32 and the latter includes a section on tax
policy that extensively anticipates the now more famous follow-up work.
I will further discuss Positive Program in Part III below. In terms
of his career, however, while the tract attracted a large audience to
its dissent from the popular New Deal-era consensus against laissezfaire economics,33 skeptics on the Chicago faculty viewed it as merely
“skillful propaganda” that “isn’t basic scholarship[,] and we shouldn’t
be giving our few jobs on that basis.” 34 What is more, while “[n]obody
had any doubts about how smart Henry Simons was, . . . there were
great doubts about . . . whether that book on personal income taxation would ever be finished.” 35 He had been working on it since the
late 1920s,36 initially as his never-completed Ph.D. dissertation. 37
28. SIMONS, Positive Program, supra note 8, at 1.
29. Stigler, supra note 13, at 1.
30. See SIMONS, Positive Program, supra note 8, at 75 (“One cannot criticize the policies of the present administration without seeming to approve those of its predecessors. In
fact, one must condemn the Democrats mainly for their wholesale extension of the worst
policies of the past. The N.R.A. is merely Mr. Hoover’s trust policy and wage policy writ
large. The agricultural measures and many other planning proposals are the logical counterpart and the natural extensions of Republican protectionism.”).
31. Kasper, supra note 23, at 15-16 (quoting a speech given by Simons to the Social
Workers Discussion Group in June 1933).
32. SIMONS, TAXATION, supra note 1, at 2 n.1.
33. See ELLIS W. HAWLEY, THE NEW DEAL AND THE PROBLEM OF MONOPOLY 292
(1995).
34. Kitch, supra note 15, at 177 (quoting George Stigler, paraphrasing the views of
Paul Douglas at the time).
35. Id. (footnote omitted).
36. Aaron Director, Simons on Taxation, 14 U. CHI. L. REV. 15, 15 (1946).
37. Kasper, supra note 23, at 10-11; Stigler, supra note 13, at 1. Reportedly, the rea-
2013]
THE FORGOTTEN HENRY SIMONS
7
There was a clear political and ideological element to the tenure
fight over Simons. His mentor, Frank Knight, is “widely remembered
as . . . one of the most prominent academic advocates of free markets
during the Roosevelt years,” and as a man whose lectures “were credited . . . with transforming incoming socialists into nascent libertarians,” leaving behind ardent disciples such as George Stigler and Milton Friedman. 38 Knight’s and Simons’ arch-foe in the University of
Chicago Economics Department, Paul Douglas—who spent several
years trying to get Simons’ faculty appointment terminated 39—was a
New Deal progressive, highly typical of an era in which institutionalist economists and legal realist law professors strongly favored extensive government in the economy and viewed laissez-faire as a doctrine that had utterly failed. As Milton Friedman later noted, Simons
was “opposed to almost everything that the institutionalists and legal
realists stood for.” 40
Ordinarily, Simons’ limited scholarly output, halfhearted teaching
efforts, and stance outside the intellectual mainstream might have
been expected to lead to his dismissal. However, in the face of
Knight’s extremely emphatic support for Simons, and accompanying
insistence that Simons’ opponents were engaged in a “personal attack
on me,” 41 the easier course for the Economics Department was simply
to put off any final decision. 42
Robert Maynard Hutchins, the energetic president of the University of Chicago, then resolved the impasse by (in Walter Blum’s later
words) “thrusting” Simons onto the law school faculty 43 in 1939, one
year after Personal Income Taxation had finally appeared in print.
Simons had friends in the law school, but “the older members of the
son Simons never finished obtaining his Ph.D. is that he “did not want to be examined by
inferior minds” in oral examinations. Kasper, supra note 23, at 11 n.7.
38. Angus Burgin, The Radical Conservatism of Frank H. Knight, 6 MOD. INTELL.
HIST. 513, 514 (2009). Knight did, however, to the long-lasting puzzlement of his followers,
give a lecture at the University of Chicago in 1932 with the title “The Case for Communism, from the Standpoint of an Ex-liberal.” See id. He may have later regretted giving
this talk, which was not widely published and which his libertarian supporters insisted
was meant ironically or as a joke. See id. at 517-18. Others argue that it reflected his genuine ambivalence about free market capitalism, especially during the Great Depression,
albeit reflecting feelings of “ex-liberalism” more than of actual communism or socialism.
See id.
39. See STIGLER, supra note 20, at 187-89; Stigler, supra note 13, at 1-2.
40. Kitch, supra note 15, at 176.
41. Id. at 177 (quoting George Stigler, apparently paraphrasing what he learned from
reading Knight’s correspondence). In his autobiography, Stigler quotes a letter from Knight
saying: “I ‘feel’ as if eliminating [Simons] is eliminating me, and that when it is done I
would be simply ‘through’ with the group, morally and sentimentally.” STIGLER, supra note
20, at 188-89.
42. George Stigler reports that the “controversy was resolved, Solomon-wise, by retaining Simons and releasing another Knight disciple.” Id. at 189.
43. See Kitch, supra note 15, at 176.
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faculty were either opposed to having an economist or indifferent.” 44
Hutchins’ main motive, apart from resolving the impasse at the Economics Department, was to fill “the practical need to teach economics
in the law school,” 45 an aim he valued given his view that “law
schools as then in existence were mere trade schools anyway.”46
Things immediately started to go much better for Simons, who
became a far more enthusiastic and effective teacher in his new setting. He not only intrigued and bemused law students who (in George
Stigler’s words) had never before met an “intelligent conservative,” 47
but rapidly emerged as an intellectual leader. As Milton Friedman
later noted, “Henry was a very gregarious fellow” and exerted a
“great deal of influence through these social interactions.” 48 Walter
Blum, for example, “got to know him as a result of drinking beer with
him in Hanley’s tavern about once a week over a period of about six
or eight months.” 49
By the early 1940s, according to Aaron Director, Simons “was
slowly establishing himself as the head of a ‘school.’ ” 50 Friedrich
Hayek, the pro-free market economist whose 1944 work, The Road to
Serfdom, became a central libertarian tract, agreed, calling Simons
the “intellectual centre” of a group of like-minded economists.51 Simons’ influence and teachings centered on using economic analysis to
question the basic premises behind interventionist economic programs, such as minimum wage laws, securities regulations, price
controls, and pro-union labor laws. 52
Simons was in touch with Hayek as early as 1934, when Hayek
contacted him to express admiration for A Positive Program for Lais44. Id. (quoting Walter Blum).
45. Id. at 167.
46. Id. at 176 (quoting Aaron Director).
47. Id. at 177.
48. Id. at 179. Aaron Director and Allen Wallis also testified to Simons’ influence. See id.
49. Id. (quoting Blum). Simons’ intellectual influence is clear (although its limits can
also be discerned) in the classic work WALTER J. BLUM & HARRY KALVEN, JR., THE UNEASY
CASE FOR PROGRESSIVE TAXATION (1953). For example, this work shares Simons’ skepticism about theories “constructed on notions of benefit, sacrifice, [or] ability to pay.” Id. at
104. The authors agree with Simons that the main reason for tax progressivity is to reduce
inequality (a much more obvious conclusion today than when the book was written). Blum
and Kalven do, however, note of Simons’ critique of inequality as “unlovely” that “[t]his
approach . . . forecloses any further discussion.” Id. at 72. They question the “contention
[arguably made by Simons] that money represents economic power which permits its owners to make economic decisions affecting the lives of others.” Id. at 78.
50. Director, supra note 11, at v.
51. See Van Horn & Mirowski, supra note 15, at 169 n.10.
52. See Kitch, supra note 15, at 179 (quoting Walter Blum). Blum states that Simons’
intellectual contributions “had a great deal to do with the tone at the University of Chicago
law school at that time and later.” Id.
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THE FORGOTTEN HENRY SIMONS
9
sez Faire, and they soon became close friends. 53 In April 1945, after a
Reader’s Digest condensation of The Road to Serfdom had become a
national best-seller, things reached a new stage. A speech by Hayek
at the Detroit Economics Club, while on a U.S. tour promoting the
book, led a politically activist conservative businessman in the audience (Harold Luhnow, president of the Volker Fund) to propose funding a specifically American version of The Road to Serfdom. 54
While Luhnow wanted Hayek (or someone designated by him) to
write an almost comic-book version of Road, suitable for a barely literate mass audience, 55 Hayek urged that the funding go instead to
support the creation of a pro-free market intellectual center in the
United States. To this end, he promptly contacted Simons, who responded enthusiastically. Simons proposed the establishment, at the
University of Chicago, of an independent Institute to be headed by a
serious pro-free market intellectual—he had in mind his close friend
Aaron Director, whom he hoped to lure back from Washington to
Chicago—and to have a largely academic bent. 56 While this was not
quite what Luhnow wanted, further negotiations (also involving Robert Maynard Hutchins on behalf of the University of Chicago) led to a
more modest plan to create a Free Market Study at Chicago, headed
by Director, whose salary the Volker Fund would pay for five years. 57
There was one catch, however. The plan stipulated that Director
would be granted tenure at the University of Chicago Law School,
and this required approval not just from the law school (which
agreed) but also from a university committee. On June 18, 1946, the
committee rejected the proposal—to Simons’ great disappointment, in
part due to his eagerness to persuade Director to move to Chicago.
On the very next day, Simons died from an overdose of sleeping pills,
possibly or even probably a suicide. 58
Shortly thereafter, Director agreed to come to Chicago even without an up-front promise of tenure. There, in addition to playing a key
foundational role in establishing the law and economics program and
movement at the University of Chicago Law School, Director oversaw
53. Van Horn & Mirowski, supra note 15, at 142.
54. See Caldwell, supra note 15, at 303; Van Horn & Mirowski, supra note 15, at 140-41.
55. Luhnow apparently “suggested the book How We Live by Fred G. Clark (1944) as
stylistic model for the American Road to Serfdom. One doubts if Hayek had ever seen a
copy, for if he had, he would have immediately soured on Luhnow. How We Live was a
large-print book, with didactic pictures facing each page of ‘text,’ which itself consisted of
single-sentence paragraphs written for people who still moved their lips as they read. The
quality of argument resembled a fourth-grade civics textbook.” Van Horn & Mirowski, supra note 15, at 150.
56. See Caldwell, supra note 15, at 303-04.
57. See Van Horn & Mirowski, supra note 15, at 149-53.
58. For a full discussion of the question whether Simons committed suicide, see Robert Van Horn, A Note on Henry Simons’ Death, 46 HIST. POL. ECON. (forthcoming 2014).
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the posthumous publication of two additional Simons books: Federal
Tax Reform, collecting a linked set of essays that Simons had written
in 1943 and 1944 to guide post-World War II U.S. tax policy; and
Economic Policy for a Free Society, collecting a number of Simons’
non-tax works, including A Positive Program for Laissez Faire.
III. HENRY SIMONS: A DIFFERENT TYPE OF LIBERTARIAN?
Biographically speaking, Henry Simons’ credentials as a libertarian and free-market conservative could scarcely be stronger. He called
himself “severely libertarian or, in the English-Continental sense,
liberal” 59 and had what one can only call the audacity to write a spirited defense of laissez-faire economic principles in 1934, at the very
moment when they were at their all-time U.S. low-water mark due to
the Great Depression. He was closely associated both with Friedrich
Hayek, whom contemporary libertarians still revere, and with such
foundational conservative economists as Milton Friedman, George
Stigler, and Aaron Director. 60 Indeed, if one had to name a single “architect” of the pro-free market law and economics movement at the
University of Chicago, Simons’ credentials are as good as anyone’s. 61
Yet there are three at least apparent contradictions in thus classifying Simons. The first is that he was not a philosophical libertarian,
at least as the term has often subsequently been defined in the literature. The second is that his version of laissez-faire economic policy,
as set forth in his 1934 pamphlet, soon came to be seen by pro-free
market conservatives as, in Ronald Coase’s later words, “highly
interventionist.”62 The third is that Simons is rightly known for
supporting progressive redistribution, and to this end championing
a comprehensive income tax. Needless to say, progressivity and redistribution, not to mention the income tax, are anathema today
among libertarians and many conservatives. Yet Simons himself evidently saw no contradiction, lauding progressivity in the 1934 pamphlet 63 and then describing Personal Income Taxation as merely an
59. Simons, Political Credo, supra note 20, at 1.
60. See, e.g., Robert Van Horn, Chicago’s Shifting Attitude Toward Concentrations of
Business Power (1934–1962), 34 SEATTLE U. L. REV. 1527, 1528 (2011) (“From the mid1930s through the mid-1940s, among the economists (and economists in training) associated with the University of Chicago, there was a cohort of young economists—which included
Henry Simons, Aaron Director, Milton Friedman, and George Stigler—who opposed concentrations of economic power on the basis of classical liberal doctrine. Simons was the
public face of this group.”).
61. See, e.g., Caldwell, supra note 15, at 305; Kitch, supra note 15, at 179; Stigler,
supra note 13, at 1; Van Horn & Mirowski, supra note 15, at 140.
62. Kitch, supra note 15, at 178.
63. See SIMONS, Positive Program, supra note 8, at 65-69, 76-77.
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11
elaboration of his 1934 ideas. 64 The rest of this part discusses these
apparent contradictions.
A. Philosophical Libertarianism
In contemporary usage, libertarianism often is defined as a rightsbased or process-based approach to justice that rejects consequentialism. Thus, Robert Nozick, in Anarchy, State, and Utopia, disavows
“end-result principles” that assess distributive justice in society
based on how things have come out, in favor of the “historical” view
that “whether a distribution is just depends upon how it came
about.”65 Therefore, one can defend a state of affairs merely by
showing that it had arisen via voluntary transactions from a just
starting point.
As Nozick recognized, this logic can support the enforceability of
voluntary self-enslavement contracts. It thus can be deployed in defense of the essential justice of a society in which nearly everyone is
observed to be a slave.66 While most libertarians reject this position,
by positing that certain basic human rights are inalienable,67 libertarianism today is often construed as requiring acceptance, at least
in most cases, of a rights-based, non-consequentialist approach to
distributional and other issues. Thus, consider the claim that taking
money from billionaires and giving it to poor people would be desirable if this would greatly increase aggregate human happiness—
taking account both of the relative marginal utility of a dollar to people in the two groups and of the transfer’s incentive and political
economy effects. To a modern deontological or rights-based libertarian, the underlying empirical claim need not be false in order for the
conclusion to be rejected. Its classification as a rights violation rules
it out from the start.
This plainly is not Simons’ philosophical position. Consider the
following statement from the second paragraph of his Positive Program: “There is in America no important disagreement as to the
proper objectives of economic policy—larger real income, greater regularity of production and employment, reduction of inequality,
64. SIMONS, TAXATION, supra note 1, at 2 n.1.
65. ROBERT NOZICK, ANARCHY, STATE, AND UTOPIA 153 (1974).
66. See id. at 331 (“Will it be possible to shift to a nonvoluntary framework permitting
the forced exclusion of various styles of life? . . . The comparable question about an individual is whether a free system will allow him to sell himself into slavery. I believe that it
would.”).
67. See, e.g., Walter Block, Toward a Libertarian Theory of Inalienability: A Critique
of Rothbard, Barnett, Smith, Kinsella, Gordon, and Epstein, 17 J. LIBERTARIAN STUD. 39,
40-41 (2003) (noting that few libertarians agree with his and Nozick’s view that voluntary
self-enslavement contracts should be enforceable, and then proceeding to rebut prominent
“middle ground” libertarians who have argued to the contrary).
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preservation of democratic institutions. The real issues have to do
merely with means, not with ends (or intentions) . . . .” 68
To show how this plays today in deontologically libertarian circles,
consider the libertarian economist Walter Block’s aforementioned
tract, Henry Simons Is Not a Supporter of Free Enterprise.69 Block,
while himself an “anarcho-capitalist” libertarian who deems all government illegitimate, is willing to extend the label to “limitedgovernment libertarians . . . who take the position that a proper government exists only to protect peoples’ rights to personal safety and
to the security of their legitimately held possessions.” 70 Hence, these
libertarians, unlike Block himself, accept the potential legitimacy of
armies, the police, and the courts. Alas, however, even thus given “at
least a sporting chance of attaining the honorific ‘libertarian,’ ” 71 Simons falls so far short that Block convicts him of intellectual “fraud
and false advertising,” 72 and closes by asking “how such a leftist
could attain a reputation as a rightist . . . [and] why he felt the need
to hide his views . . . under the banner of laissez faire. But these are
questions for another day.” 73
Block is surely right that today’s libertarians—even though, in his
view, they are for the most part lamentably heterodox—generally
would be inclined to break Simons’ staff and expel him from the Libertarian Order. As we will see shortly, Simons most definitely did not
view the government’s role as limited to providing an army, police,
and the courts to protect people’s safety and “legitimately held possessions.” 74 However, Block’s reading of the term “libertarian” is both
ahistorical and too narrow—at least, if we are trying to classify Simons as a matter of good intellectual history, rather than simply to
apply one’s own preferred definition (which Block, of course, has every right to do).
Consider Hayek’s The Road to Serfdom—surely, in intellectual
history, a canonical and foundational libertarian work. Rather than
stressing the importance of rights irrespective of consequences, Hayek emphasizes the empirical claim that movement towards greater
centralized economic planning, even when it has as yet gone no further than it had in England and the United States as of the book’s
1944 publication date, will lead inexorably to Nazi- or Soviet-style
68.
69.
70.
71.
72.
73.
74.
SIMONS, Positive Program, supra note 8, at 40.
Block, supra note 16.
Id. at 4-5.
Id. at 5.
Id. at 4 n.3.
Id. at 31.
Id. at 5.
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THE FORGOTTEN HENRY SIMONS
13
totalitarianism.75 This is precisely the concern that Simons expressed
a decade earlier in Positive Program. 76 Simons, just like Hayek, despised the “mongrel system of ‘national planning’ ” not only as a mere
way station on the march towards totalitarianism, but as something
that itself “implies and requires extreme concentration of political
power, under essentially undemocratic institutions.” 77 The New Deal
did not have to turn into Nazism in order for Simons to view it
as containing odious qualities of the same type, even if in vastly
lesser degree.
Even in today’s intellectual climate, it makes little sense to
out Simons as a “leftist” and as “not a supporter of free enterprise,”
merely because he cared about consequences rather than about innate and inviolable rights, and thus was conditionally willing to contemplate rights violations. Such a classification scheme would rule
out accepting the self-proclaimed credentials of any classical liberal/contemporary political conservative who relies on the consequentialist view that free markets, strong private property rights, and
limited government are generally the best prescription for increasing
human welfare. Its adoption would require classifying the likes of
Adam Smith, Milton Friedman, and Richard Epstein, among others,
as likewise “leftists” who oppose capitalism and freedom.
In this regard, consider what Milton Friedman says about graduated income taxation in his classic 1962 book, Capitalism and Freedom. To be sure, Friedman does “find it hard, as a liberal” to see the
justification for graduated rates when they are merely being used to
redistribute income rather than to finance the costs of government.78
He considers this “a clear case of using coercion to take from some in
order to give to others and thus to conflict head-on with individual
freedom.” 79 Yet Friedman defines the costs of government, which everyone must help to pay for, as “including perhaps measures to eliminate poverty,” 80 even though this is redistribution (coercively funded)
plain and simple.
Moreover, Friedman accepts that, in principle, paying for the costs
of government “might well call for some measure of graduation, both
on grounds of assessing costs in accordance with benefits and on
75. See, e.g., FRIEDRICH A. HAYEK, THE ROAD TO SERFDOM 2-5 (1944). Hayek accepts
that wartime calls for centralization of powers, but he views the current English and U.S.
course as clearly towards totalitarianism even in the aftermath of Hitler’s then-impending
defeat.
76. SIMONS, Positive Program, supra note 8, at 40-41, 76-77.
77. Id. at 52.
78. MILTON FRIEDMAN, CAPITALISM AND FREEDOM 174 (1962).
79. Id.
80. Id.
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grounds of social standards of equity.” 81 The only problem he sees is
that the “present high nominal rates [then reaching 92%, under the
federal income tax] . . . can hardly be justified on this ground—if only
because their yield is so low.” 82 In short, under Block’s standard, not
only is Milton Friedman no libertarian (a point that is uncontroversial), 83 but only as a matter of degree can he fall short of being a “leftist” who opposes capitalism and freedom despite having used those
two words in the title of his most famous book. So perhaps the next
question should be why Friedman, like Simons, declined to admit his
ostensibly true nature as a secret “leftist.”
Returning to Simons, he certainly did not claim to be a libertarian
in today’s deontological sense—unsurprisingly, since any such claim
would have been anachronistic. Rather, Simons placed himself
squarely in an intellectual tradition whose “distinctive feature . . . is
emphasis upon liberty as both a requisite and a measure of progress.”84 While consequentialist and thus “largely pragmatic” in his
view of social ethics, he described his views as “giv[ing] special place
to liberty . . . as a ‘relatively absolute absolute.’ ” 85
George Stigler helped make the case for the accuracy of Simons’
self-characterization in a 1974 retrospective:
The central philosophy of the Positive Program was highly individual. Simons believed that it was essential to the preservation
of personal freedom that a large sector of economic life be organized privately and competitively—this was a fundamental element of the liberal position that many, perhaps even an increasing
share of us, still believe. . . . Simons’ central goal is as vital and as
81. Id. (emphasis added).
82. Id. A few pages earlier, in response to the view that progressive income taxation
could be viewed as an insurance device that effectively pools people’s income and ability
risk, thereby addressing the market failure that arises if the market fails to supply a suitable insurance vehicle, Friedman objects only that “the taxes are imposed after” market
outcomes are known, with “taxes [being] voted mostly by those who think they have drawn
the blanks.” Id. at 163. He states that he would have no objection if one generation voted
the tax schedules that were to apply on this ground to as yet unborn generations, although
he posits that the resulting rate structure would be much less graduated. Id.
83. Block has noted a long set of issues on which Friedman and libertarians disagree.
See Walter Block, Milton Friedman RIP, MISES DAILY (Nov. 16, 2006),
http://mises.org/daily/2393. He also has published correspondence in which Friedman goodhumoredly called him “a fanatic, not . . . a reasonable man.” Walter Block, Fanatical, Not
Reasonable: A Short Correspondence Between Walter Block and Milton Friedman, 20 J.
LIBERTARIAN STUD. 61, 61 (2006).
84. SIMONS, Political Credo, supra note 20, at 1. In naming his precursors within the
liberal tradition, Simons did not restrict himself to people we would call libertarians. The
people he cited included, for example, Adam Smith, John Stuart Mill, John Locke, David
Hume, Jeremy Bentham, Alexis de Tocqueville, and his friend (as discussed above) Friedrich Hayek. Id.
85. Id. at 2. As I discuss below, the full quotation that I excerpted in the text above
states that Simons “gives special place to liberty (and nearly coordinate place to equality)
as a ‘relatively absolute absolute.’ ” Id. (emphasis added).
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THE FORGOTTEN HENRY SIMONS
15
irresistible today as it was forty years ago: to devise a decentralized, unpoliticized world in which personal freedom and economic
efficiency find wide scope and strong defense. 86
Stigler had strong grounds for reaching this conclusion. For example, Simons was, as Stigler notes, a “violent critic” of New Deal
industrial policy legislation such as the National Recovery Act
(NRA). 87 Nor was he kinder to specific NRA and industrial policy
proponents, calling Henry Wallace, Secretary of Agriculture and
then-Vice President in the Roosevelt Administration, “our leading
advocate of the totalitarian or pre-totalitarian economy of negotiation
among tightly organized, monopolizing functional groups.” 88 Simons
also hated labor unions, saying that “our [most] serious and ominous
monopoly problem lies in the labor market and in the power of unions
to behave monopolistically.” 89
Simons argued that the greatest social and economic ill that the
U.S. faced was monopolistic price-fixing, along with “excessive political interference with relative prices,” 90 such as through tariffs and
industry subsidies. In his view, such interference with market prices
was not merely allocatively inefficient (the standard neoclassical
claim). Worse still, it was a prime cause of the Great Depression.
However, worst of all, in Simons’ view, was the fact that such interference fundamentally violated principles of economic and political
freedom and equality, and would lead inexorably to the need for dictatorship to mediate the conflicts between organized groups. 91
One might almost say here that the case is closed regarding Simons’ classical liberal and generally pro-free market credentials, except for one further consideration. Simons did indeed support a set of
policies that involved significant government intervention in the
economy. My next topic, therefore, is what to make of what he called
his “positive program for laissez faire.”
B. Assessing and Explaining Simons’ “Interventionism”
As noted above, one reasonably might expect that a libertarian, or
even a generally pro-free market classical liberal, would support
86. Stigler, supra note 13, at 3, 5. In Part III.B, infra, I discuss certain crucial qualifications to Stigler’s view that Simons favored free markets and laissez-faire.
87. See Kitch, supra note 15, at 178. Simons stated, for example, that “[n]o diabolical
ingenuity could have devised a more effective agency for retarding or preventing recovery
(or for leading us away from democracy) than the National Recovery Act and its codes.”
SIMONS, Positive Program, supra note 8, at 75.
88. Henry C. Simons, For a Free-Market Liberalism, 8 U. CHI. L. REV. 202, 203 (1941).
89. Id. at 205. Simons further discussed his negative view of unions in his article
Some Reflections on Syndicalism. See Simons, supra note 9.
90. SIMONS, Positive Program, supra note 8, at 42.
91. See id. at 43-46.
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keeping the government’s economic and regulatory role quite limited.
What about Henry Simons? In Positive Program and elsewhere, he
called for the “outright dismantling of our gigantic corporations” with
a “[l]imitation upon the total amount of property which any single
corporation may own.” 92 In addition, he favored regulating companies’ financial structure by providing that they could issue only two
or three types of securities, centered on a single class of common
stock and what we might call plain-vanilla debt. 93 Likewise, almost
startlingly (or, as Block says, “eerily” 94) anticipating the classic 1958
book, The Affluent Society, by the decidedly progressive and antilaissez-faire economist John Kenneth Galbraith, Simons condemned
advertising for its capacity to manipulate—rather than actually satisfying—consumer demand. For this among other reasons, he urged
that advertising face heavy taxation.95
Given such features of Simons’ thought, it is unsurprising that
Ronald Coase, at a 1983 retrospective session among founders of the
Chicago law and economics movement, should find it “difficult to understand” characterizations of the “highly interventionist” Positive
Program as pro-free market, adding that he “would be interested if
someone could explain this pro-market view of Henry Simons.” 96 As
Brad DeLong, in telling this story, recounts, “Simons’ former Chicago
pupils, his successors as upholders of classical liberalism in economics, did not [respond by] ris[ing] to his defense.” 97 Instead, they admitted that “ ‘You can paint him with different colors,’ ” and that
“ ‘[i]t’s quite a mixed picture,’ ” to be defended on the ground that,
when he wrote in the 1930s, almost everyone else, both at the University of Chicago and around the country, was even further to the
left. 98 Aaron Director, his closest friend in the group attending the
92. Id. at 58-59.
93. See SIMONS, Positive Program, supra note 8, at 59.
94. Block, supra note 16, at 28.
95. See SIMONS, Positive Program, supra note 8, at 71-73. Simons complains that
“[p]rofits may be obtained either by producing what consumers want or by making consumers want what one is actually producing. The possibility of profitably utilizing resources to manipulate demand is, perhaps, the greatest source of diseconomy under the
existing system.” Id. at 71.
96. Kitch, supra note 15, at 178. Not long after this session, Stigler wrote in his autobiography that “Simons had preached a form of laissez-faire in . . . A Positive Program for
Laissez Faire, but what a form! He proposed nationalization of basic industries such as
telephones and railroads because regulation had worked poorly. (I am reminded of the king
who was asked to award a prize to the better of two minstrels. After hearing the first, he
said, ‘Give the prize to the second.’).” STIGLER, supra note 20, at 148-49.
97. J. Bradford DeLong, In Defense of Henry Simons’ Standing as a Classical Liberal,
9 CATO J. 601, 601 (1990).
98. Id. at 601 (quoting Kitch, supra note 15, at 178 (quoting Harold Demsetz and
George Stigler, respectively)). Thus, Milton Friedman pointed out that, “in 1934 when [Positive Program] appeared, I would say that close to a majority of the social scientists and the
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THE FORGOTTEN HENRY SIMONS
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retrospective, even offered the suggestion that one of Simons’ reasons
for expressing support for “interventionist programs was to make the
private system of production palatable to his colleagues,” 99 as opposed to actually favoring such programs—as it happens, a suggestion that finds some support in Simons’ private correspondence. 100
Simons’ old friends may not entirely have remembered, however,
the extent to which their own views had changed since the 1930s.
Thus, consider Milton Friedman, who recalled viewing Positive Program as “strongly pro free market in its orientation” when he first
read it in the 1930s—only, upon later rereading, to be “astounded at
what [he] read.”101 Part of the reason for this change in perspective
may have been that Friedman himself had changed in the interim.
Friedman, not just in the 1930s but as late as 1947, had been sufficiently worried about the corporate monopoly problem to resemble
Simons in favoring regulatory restrictions (albeit milder ones) that
he hoped would discourage corporate mergers and the existence of
large companies.102
Private monopoly, as a potential consequence of corporate size and
thus perhaps even its cause, was a major concern to Chicago school
economists until empirical work in the 1950s persuaded them of two
things. The first was that competition in private markets pervasively
undermines monopoly even if it is briefly established. 103 Thus, regulatory intervention is not needed to combat it. Second, they now concluded that the main danger of monopoly “come[s] not from large corporations that exploit purely private economies of scale . . . but from
interest groups that enter a symbiotic relationship with a government that purports to ‘regulate’ them.” 104 Hence, concern about the
private exercise of monopoly power should make one all the more eager to restrict the scope of regulation, since “[w]henever the governstudents in the social sciences at the University of Chicago were either members of the
Communist party or very close to it,” and “the general intellectual atmosphere was strongly prosocialist.” Kitch, supra note 15, at 178-79.
99. Kitch, supra note 15, at 179.
100. As Sherry Davis Kasper recounts, in response to a letter from Hayek questioning
Simons’ proposal for direct government ownership (in lieu of regulation) of natural monopolies, Simons wrote: “I may confess privately to having used a low, debating trick. . . . I am
willing to prostitute my judgment somewhat, in advocating government ownership, in order to vent my spleen fully as to the merits of a grand system of private monopoly with
government regulation of prices and wages.” Kasper, supra note 23, at 28.
101. Kitch, supra note 15, at 178.
102. See Van Horn, supra note 60, at 1540.
103. See id. at 1540-43; see also Arnold C. Harberger, Monopoly and Resource Allocation, AM. ECON. REV., May 1954, at 77, 86-87 (suggesting that the deadweight loss resulting from the exercise of monopoly power was relatively small).
104. DeLong, supra note 97, at 615.
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ment does something, it probably acts in the interest of some powerful and monopolistic interest group.”105
Given this change in empirical knowledge (or at least belief),
DeLong argues that Coase and others were mistaken, in later years,
to classify Simons as an interventionist rather than as truly one of
them. He merely differed from them empirically, based on the Chicago school’s state of knowledge about monopoly problems when he was
writing, as compared to later. Thus, “Simons was a consistent classical liberal of his times, even if, in retrospect, he may now appear to
have been [empirically] wrong in his judgment on specific issues.”106
DeLong concludes that, under Simons’ empirical beliefs concerning the monopoly problem (which, again, were standard in Chicago at
the time), restricting corporate size so that markets will remain competitive is merely “a completion of the idea of the night watchman
state. The night watchman state enforces contracts and guards
against explicit theft. A monopolist is also an implicit thief because
his possession of market power leads to the exchange of commodities
at prices that do not reflect underlying social scarcities.” 107
Simons makes very much the same point in Positive Program. Responding to laissez-faire’s reputation as “a merely do-nothing policy,”
he calls this characterization “unfortunate and misleading. It is an
obvious responsibility of the state under [laissez-faire] policy to maintain the kind of legal and institutional framework within which competition can function effectively as an agency of control.” 108 In short,
breaking up large companies is no more a violation of laissezfaire than enforcing contracts and protecting private property
against thieves.
The same line of argument could also, perhaps, apply to Simons’
support for heavily taxing advertising. A key complaint he makes
about advertising is that, because it is so costly, it “[e]ntrenches monopoly by setting up a financial barrier to the competition of new and
small firms.” 109 Relatedly, it creates wasteful arms races among
firms, which “must spend enormous sums . . . if only to counteract the
expenditures of competitors.” 110 Thus, even if he adds the Galbraithstyle complaint that advertisers manipulate consumers into
105. Id.
106. Id. at 614.
107. Id. at 606. Consistently with this view, Simons defines “commutative justice,”
which he distinguishes from “distributive justice” while regarding both as important, as
“connot[ing] exchange of equal values, as measured objectively by organized [but competitive] markets.” SIMONS, Positive Program, supra note 8, at 4. Monopoly is indeed theft under Simons’ view.
108. SIMONS, Positive Program, supra note 8, at 42.
109. Id. at 72.
110. Id. at 71.
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“want[ing] what one is actually producing,” 111 which seems to raise
broader issues about the welfare effects of market outcomes, one
could argue that he is mainly just seeking to advance his antimonopoly program, while also addressing a collective action problem
as between business rivals that leads to waste.
As George Stigler later noted, Simons’ hostile view of advertising
was widely held among economists before the 1960s, when Stigler’s
own work on the economics of information made the case for viewing
advertising much more benignly, as “an extremely efficient way of
conveying much of this information . . . [that] is as essential for competitive firms as for monopolies.” 112 Thus, in defense of Simons’
standing as a pro-free market classical liberal notwithstanding his
view of advertising, one could again argue that the dispute is merely
empirical, concerning means rather than ends, and that it is anachronistic to judge Simons based on whether he had accepted, in advance, arguments that the Chicago school only made decades later.
Nonetheless, his view of advertising does indeed suggest a more capacious sense of market failure, and of the need for government intervention, than one might expect from a “laissez-faire” economist.
The metaphor of the mere night watchman grows increasingly
strained as the list of market failures that the state must address
keeps growing.
Suppose one nonetheless accepts Simons’ classical liberal and
generally pro-free market credentials. How does one square them
with his favoring significant redistribution through an income tax
that features “drastic progression”113 in its rates? One possibility is to
separate the two Henry Simonses as if they were different people.
Thus, DeLong “place[s] to one side” Simons’ tax policy views when
assessing his classical liberal credentials, 114 and George Stigler—
sounding less certain than one might have expected—describes these
views as “surely independent” of Simons’ other beliefs.115
Simons himself evidently did not thus classify his tax views, however. Indeed, Positive Program treats a set of tax policy recommendations that are largely identical to those in Personal Income Taxation—mainly written by this time, although not yet published—as
part and parcel of his libertarian and laissez-faire program. As we
will see next, this reflects a commonality of motivation that has powerful internal logic, even if it is not at all how people typically parse
the issues today.
111.
112.
113.
114.
115.
Id.
STIGLER, supra note 20, at 164.
SIMONS, TAXATION, supra note 1, at 18.
DeLong, supra note 97, at 603 n.3.
See Stigler, supra note 13, at 4.
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C. Simons’ Support for Progressive Income Taxation
In determining why Simons favored “drastic progression,” a natural first stop is Personal Income Taxation, and in particular the first
half of its forty-page first chapter. Here Simons evaluates at length
various grounds for favoring progressivity, while the second half of
the chapter considers tradeoffs to pursuing redistribution (such as
effects on efficiency) and the question of what tax and other fiscal
instruments might be deployed in its behalf. Unfortunately, the result of this inquiry—unless supplemented by looking at other writings by Simons—is disappointing and even perplexing, potentially
creating the false impression that his endorsement of progressivity is
so whimsical and seemingly unmotivated that the question of how it
might relate to his other economic views is destined to remain mysterious. Only when one supplements it, in particular by looking at Positive Program and at A Political Credo, which offers a broader account
of his political views, 116 does the mystery lift to a degree.
Simons opens the first chapter of Personal Income Taxation with a
harsh attack on tax policy writers who “dissemble” their true underlying beliefs by “maintain[ing] a pretense of rigorous, objective analysis untinctured by mere ethical considerations.” 117 These aspiring,
but fake, scientists “religiously eschew a few proscribed phrases, clutter up title-pages and introductory chapters with pious references to
the science of public finance, and then write monumental discourses
upon their own prejudices and preconceptions.”118
Whom exactly might Simons mean by this? The answer appears to
be: virtually everyone in the then-existing academic literature on tax
policy. He starts by mentioning the “doctrine of taxation according to
benefit,” under which “[e]ach person may be called upon, as in his
dealings with private enterprise, to pay according as he receives.” 119
But given the impossibility of measuring different people’s benefit
from the provision of public goods, such as national defense and internal security, this “slogan, of course, has little more than emotive
content,” and “leads nowhere at all.” 120
Next he addresses “[t]he greater part of what has been written
about justice in taxation . . . couched in terms of sacrifice. This concept, along with ‘ability’ and ‘faculty,’ ” rests ultimately on the con116. Simons wrote A Political Credo in 1945, although it was only published posthumously “in an endeavor to formulate specifically the political predispositions implicit in his
work.” SIMONS, Political Credo, supra note 20, at 1 (editor’s note).
117. SIMONS, TAXATION, supra note 1, at 1.
118. Id. at 2.
119. Id. at 3.
120. Id. at 4.
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cept of utility. 121 Unfortunately, however, each version of these doctrines (in Simons’ view) is utter nonsense—unsurprisingly, given how
“absurd” and “naïve” he finds all “hedonistic ethics” and welfare economics (i.e., anything relying on the concept of utility).122 So what if
“[m]any professors of economic dialectic still find comfort and intellectual satisfaction (and ‘filler’ for courses and textbooks) in the ‘explanations’ of hedonism,” and if they “continue to practice a kind of
utility therapy and to write their prescriptions for the economist’s
millennium in the hedonistic code”? 123
Thus, John Stuart Mill’s doctrine of “equal sacrifice—that tax
burdens should so be distributed that the same total sacrifice is imposed upon every individual”—has received “devastating criticism,”
in particular from Francis Edgeworth, who “demonstrates conclusively—so far as is possible with such dialectical tools—that equal individual sacrifice by no means minimizes the total burden” in utility
terms, which definitionally is the proper utilitarian aim.124
Yet Edgeworth’s “minimum sacrifice” theory fares no better in Simons’ hands. This theory ostensibly supports complete leveling of
income, on the ground that everyone has the same utility function,
characterized by declining marginal utility of income. Thus, so long
as A has even one dollar more than B, equalizing their after-tax incomes will increase B’s welfare more than it reduces A’s welfare. Simons raises numerous objections, however. What about people’s attachment to their current levels of income? 125 And what about the
unproved “assumption that all individuals are, or must be treated as,
equally efficient as pleasure machines”? 126 Given these absurdities (in
Simons’ view), “[w]hat really commends the Edgeworth doctrine to
liberal students, of course, is its conclusion—its pseudoscientific
statement of the case against inequality.” 127
Having thus disposed, at least to his own satisfaction, of what remains today the most widely followed ground in the public economics
literature for favoring progressive redistribution, 128 Simons concludes
121. Id. at 5.
122. Id. at 12.
123. Id. at 14-15.
124. Id. at 6.
125. Id. at 8-10.
126. Id. at 11.
127. Id. at 10.
128. I refer here to the claim that people have, or should generally be treated as having, identical utility functions characterized by declining marginal utility. Edgeworth’s
claim that this leads to favoring a 100% tax rate and full equalization of everyone’s aftertax income is generally rejected today due to concern about incentive effects. The literature
on optimal income taxation, building on James Mirrlees’ work, generally treats the question of tax rate design as turning on the tradeoff between Edgeworth’s logic and concern
about the incentive effects of positive marginal tax rates. See generally J.A. Mirrlees, An
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his scathing survey of the existing literature by dismissing the work
of writers who assert that tax burdens should vary based on “ability”
or “faculty.” 129 This standard is “totally ambiguous,” and thus not
even to be described as a “principle” except in scare quotes. Given
that “ability or faculty . . . cannot be conceived quantitatively or defined in terms of any procedure of measurement,” their use “indicates
that the writer prefers the kind of taxation which he prefers; that he
is unwilling to reveal his tastes or examine them critically; and that
he finds useful in his profession a basic ‘principle’ from which, as
from a conjuror’s hat, anything may be drawn at will.”130
This brings us near the end of Simons’ almost wholly destructive
survey in Personal Income Taxation of why one might favor a progressive tax system. What does he propose to do instead? In a word,
he proposes simply to be forthright about his own priors and prejudices. Then comes what is probably the most famous sentence in Personal Income Taxation, other than the income definition: “The case
for drastic progression in taxation must be rested on the case against
inequality—on the ethical or aesthetic judgment that the prevailing
distribution of wealth and income reveals a degree (and/or kind) of inequality which is distinctly evil or unlovely.”131 And with that said, Simons moves on to discussing tradeoffs and methods of implementation.
Reading Personal Income Taxation all by itself can make it seem
natural to conclude that Simons’ aversion to inequality—and his consequent support for “drastic progression”—is a mere isolated prejudice or sentiment that he sees no need to explain. We have the biases
we have, he suggests, so all we can do is acknowledge them and move
on, as distinct from reasoning or arguing about them. 132 And if that is
so, then there might perhaps also be no point in seeking to relate this
particular sentiment to anything else that Simons believes, given the
lack of any broader discussion of his views in Personal Income Taxation. And while careful readers may have observed that Chapter One
has a footnote at the start, stating that one’s tax policy views are
“properly a derivative, or subordinate part, of a broader position on
general questions of economic policy,” as to which (for Simons’ views)
readers are encouraged to consult Positive Program, 133 this precedes
Exploration in the Theory of Optimum Income Taxation, 38 REV. ECON. STUD. 175 (1971).
129. Simons finds a kind word for the “so-called sociopolitical theory of [the German
writer] Adolph Wagner.” SIMONS, TAXATION, supra note 1, at 15. Wagner is praised, however, for saying that one needs a prior view as to the proper distribution of income in order
to support any particular theory. Thus, “[h]is views (if we pursue them no farther) seem
eminently sensible and represent sound criticism of other writers.” Id.
130. Id. at 17.
131. Id. at 18-19.
132. See id. at 2.
133. Id. at 2 n.1.
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the famous “unlovely” statement by a full sixteen pages and thus is
easy to miss.
As it happens, the words “evil” and “unlovely” are in fact derived
from Positive Program, where Simons states the following:
Turning now to questions of justice, of equitable distribution,
we may suggest that equitable distribution is at least as important
with respect to power as with reference to economic goods or income . . . . Surely there is something unlovely, to modern as
against medieval minds, about marked inequality of either kind. A
substantial measure of inequality may be unavoidable or essential
for motivation; but it should be recognized as evil and tolerated only so far as the dictates of expediency are clear. 134
This still does not offer an underlying rationale for Simons’ dislike
of inequality. It does, however, reveal the core of what his support for
laissez-faire has in common with his tax policy views. Both political
power and economic wealth, in his view, should be distributed more
equally, rather than less equally, albeit subject to “dictates of expediency” to the contrary. 135 With respect to political power, this means
having a limited government that leaves alone relative prices and the
allocation of capital between industries. With respect to economic
power, it calls for redistribution through the income tax.
Positive Program’s reference to “unloveliness” comes right after a
sustained denunciation, first of centralized economic planning as
leading inexorably to dictatorship, and then of private monopoly
power as equally odious and dangerous. 136 Simons has the same revulsion for state actors wielding centralized authority to tell us what
to do—the case of unequal political power—as he does for princes living it up in their castles while paupers starve—the case, in his view,
of unequal economic power.
Elsewhere in Positive Program and Political Credo, Simons expresses more of the same vision. Thus, to offer a full quote that I selectively edited above, he says that classical liberalism “gives special
place to liberty (and nearly coordinate place to equality) as a ‘relatively absolute absolute.’ ” 137 These two values are linked, however, by
the difficulty of having either one without the other. “Freedom without power, like power without freedom, has no substance or meaning.” 138 And this presumably applies to economic freedom no less than
to political freedom, given Simons’ habit of linking the two. In Simons’ view, therefore, an economically unequal society, even if re134.
135.
136.
137.
138.
SIMONS, Positive Program, supra note 8, at 51-52 (emphases added).
See id.
See generally id. at 40-51.
SIMONS, Political Credo, supra note 20, at 2 (emphasis added).
Id. at 6.
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flecting free market outcomes rather than the exercise of government
or private monopoly power, is one in which the worst-off people are
not entirely free.
This is a horizontal, or even a leveling, vision of both economic and
political power. Simons does not like plutocrats rising far above the
peasants (even if the latter, as a formal legal matter, are entirely
free), any more than he likes Washington bureaucrats telling private
economic actors what to do. Is this “liberal” in the classical sense?
That depends on how one defines the tradition. In any event, however, emotionally no less than intellectually, it is certainly no Ayn Rand
or Paul Ryan version of the laissez-faire creed. Simons does not yearn
for a world in which the great are permitted to thrive, but for one in
which the small do not have anyone too far above them, either politically or economically. 139
In this regard, Sherry Davis Kasper makes an important point
about the difference between Simons’ intellectual background and
that of his successors in the Chicago school. She notes that he, like
other economists who received their training between the two World
Wars, was influenced by the immediately preceding era’s Gilded Age
economists, for whom “the primary problem . . . [was] the concentration of economic wealth and power and the accompanying inequality
it engendered.” 140 She later adds that Simons “worked in the climate
of interwar pluralism. As a result, he looked through the world with
a different set of lenses, colored primarily by elements of progressive
social science that the pluralism of interwar economics allowed to
linger.” 141 Only, Simons amalgamated these classic Gilded Age and
interwar concerns of economic power with a commonly motivated dislike of centralized political power that his successors would hold
without retaining the Gilded Age element.
One last point worth noting here concerns how Simons’ views
about economic and political power cohered to make a comprehensive
income tax so attractive to him. One of its greatest virtues, in his
view, was that, insofar as it treated all different types of income neutrally, it avoided engaging in selective economic regulation—the
great vice, along with regressivity, that he ascribed to the tariffs and
excise duties that were still a key U.S. federal revenue source when
he wrote and published Personal Income Taxation. Taxing all income
as alike as possible keeps the government out of the price-fixing and
resource allocation business, thus preserving free market conditions
139. See id. at 23 (“A cardinal tenet of libertarians is that no one may be trusted with
much power—no leader, no faction, no party, no ‘class,’ no majority, no government, no
church, no corporation, no trade association, no labor union, no grange, no professional
association, no university, no large organization of any kind.”).
140. Kasper, supra note 23, at 5.
141. Id. at 28.
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and limiting centralized political power, even if people face very high
tax rates.
IV. SIMONS ON THE INCOME TAX
With Simons’ general philosophical commitments and motivations
better in focus, I turn now to his work on income taxation and will
focus on why, and to what extent, he preferred income taxation to
consumption taxation. After discussing his main arguments and conclusions, along with the separate issue of the degree to which he actually favored an income tax in practice, I will ask what has changed
since he wrote and how that might affect the views that one who
shared his intellectual commitments would hold today.
A. Income Taxation Versus Consumption Taxation
1. Why Did Simons Prefer the Income Tax?
For a number of decades, the leading big-picture issue in U.S. academic debate about tax policy has been whether the federal income
tax should be replaced by an individual-level consumption tax that,
like the income tax, has graduated rates. Experts’ awareness that
one can levy a consumption tax at the individual level—as distinct
from, say, a retail sales tax or value-added tax model, in which businesses’ role in collecting the tax impedes applying varying individual
rates—often is thought to date from no earlier than 1955, when the
British economist Nicholas Kaldor published a book advocating cashflow taxation of individuals, 142 or perhaps even 1974, when Harvard law professor William Andrews published a classic article on
the subject. 143
It thus may come as a surprise to see Simons addressing this very
topic at length, in both Personal Income Taxation and Federal Tax
Reform. This, however, turns out to reflect two antecedents. The first
is economist Irving Fisher’s advocacy of a progressive consumption
tax, to which Simons responded at some length—and, by his acerbic
standards, quite respectfully—in Personal Income Taxation. The second, less well-known today, although cited by both Simons and Fisher, is an actual legislative proposal for a cash-flow tax, which Congressman Ogden Mills introduced in 1921 and wrote about in the National Tax Journal. 144 This was essentially a Kaldor- or Andrewsstyle cash-flow consumption tax avant la lettre. It involved replacing
the existing income tax with a tax on people’s consumer expenditures
142. See generally NICHOLAS KALDOR, AN EXPENDITURE TAX (1955).
143. See generally William D. Andrews, A Consumption-Type or Cash Flow Personal
Income Tax, 87 HARV. L. REV. 1113 (1974).
144. Ogden L. Mills, The Spendings Tax, 7 NAT’L TAX ASS’N BULL. 18 (1921).
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during the year, which it would have computed by requiring taxpayers to report on the following information:
(1) Cash or equivalent assets on hand at the beginning of the
taxable year ;
(2) Total receipts including amounts borrowed ;
(3) The amounts of the items exempt from taxation [i.e., deductible], including investments ;
(4) Cash or equivalent assets at the close of the taxable year. 145
With Ogden Mills’ proposal retaining its status as a known though
untested alternative as of the late 1930s, debate concerning its merits took on an odd form. Based on an argument that went back at
least to John Stuart Mill, 146 Fisher asserted that such a tax not only
was both feasible and desirable, but was actually the true form of an
“income tax.” In Fisher’s view, an income tax, as conventionally defined to include both consumption and returns to saving, involves the
“fallacy of double counting,” because it applies twice to assets’ capitalized value—first when they are received, and then again when
they generate annual consumption or cash returns. “[S]avings may
be invested in land or in confectionery. The only true income is the
use of the land or the use of the confectionery. To include also the
value of the land or the value of the confectionary is to count as income the capitalization of income.” 147 Thus, taxing returns to saving
was not merely a bad policy idea (although it might be that as well, if
it reduced saving). In addition, Fisher viewed it as actively fallacious,
reflecting the “confusions” 148 promulgated by sloppy writers.
Simons’ response to Fisher is partly semantic, reflecting the character of Fisher’s own argument. He calls his disagreement with Fisher “essentially one of terminology rather than of logic.” 149 While the
question of how to define a given term is “only that of choice among
verbal symbols . . . , it seems a hardly debatable proposition that usage is already too firmly established to permit our accepting Fisher’s
proposal”150 regarding what “income” actually means. “His proposal
comes all too tardily in the history of our language; and his pleas
145. Id. at 19-20. Items that were effectively deductible included not only most investment outlays, but also ordinary and necessary business expenses, other taxes paid, charitable gifts, amounts paid for medical and dental services, and funeral expenses. Id. at 19.
For examples that mention the Mills bill, see Irving Fisher, The Double Taxation of Savings, 29 AM. ECON. REV. 16, 16-17 (1939), and SIMONS, TAXATION, supra note 1, at 226.
146. See John Stuart Mill, PRINCIPLES OF POLITICAL ECONOMY bk. V, ch. 2, § 4 (Donald
Winch ed., Pelican Books 1970) (1848), quoted in Fisher, supra note 145, at 16 (arguing
that “[u]nless . . . savings are exempted from income-tax, the contributors are twice taxed
on what they save”).
147. IRVING FISHER, THE NATURE OF CAPITAL AND INCOME 108-09 (1906).
148. Id. at 107.
149. SIMONS, TAXATION, supra note 1, at 89.
150. Id. at 98.
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THE FORGOTTEN HENRY SIMONS
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have been, and must be, without effect upon our courts, legislatures,
accountants, and men of affairs—not to mention the economists.” 151
The disagreement was not just semantic, however. Simons was
fundamentally unsympathetic to the line of thought that had led
Fisher down his semantic blind alley. As Simons notes, the real intellectual value of Fisher’s work on income and capital lay in his development of time-preference theory, which treats saving as merely deferred consumption. 152 Once one accepts this view of saving, it becomes clear that taxing returns to saving means that future consumption is being taxed at a higher rate than current consumption
(all else equal), which may appear unmotivated. And if it is unmotivated, one may conclude that consumption is a better tax base than
income, resulting not just in less economic distortion but also in better measurement of people’s relative “ability” or “ability to pay.” 153
Simons, however, believed that “there is something sadly inadequate about the idea of saving as [merely] postponed consumption.” 154
“Many people save mainly because it is the thing to do, because it is
expected of them.” 155 And—echoing his denunciation of utility-based
theories in other contexts—“[t]o assert that considerations of utility
determine the allocation of consumption funds [over time] explains
nothing at all but merely says, with egregious extravagance of language, that people consume what they consume.” 156 Accordingly, in
his view, two people with the same income make a better horizontal
comparison than two people with the same consumption, and the
former pair is thus the one whose members should presumptively be
equated through the choice of tax base.157
151. Id. (footnote omitted).
152. See id. at 95.
153. See, e.g., DAVID F. BRADFORD & U.S. TREASURY TAX POLICY STAFF, BLUEPRINTS
FOR BASIC TAX REFORM 2, 37 (2d rev. ed. 1984); Joseph Bankman & David A. Weisbach,
The Superiority of an Ideal Consumption Tax Over an Ideal Income Tax, 58 STAN. L. REV.
1413 (2006).
154. SIMONS, TAXATION, supra note 1, at 97.
155. Id. at 96-97.
156. Id. at 95. Although perhaps not germane here, I have explained elsewhere why I
regard Simons’ position on this issue, which is commonly expressed to this day, as itself
fallacious. The value of wealth lies in the fact that it can be used to buy things. Accordingly, under a perpetual flat rate consumption tax, one has already borne the full burden of
the tax with respect to one’s unconsumed wealth. The fact that it can be spent is what
gives it value. “Wealth is worth only what it can buy; otherwise, it might as well be play
money from the board games Monopoly or Life.” Daniel N. Shaviro, Replacing the Income
Tax With a Progressive Consumption Tax, 103 TAX NOTES 91, 105 (2004). Treating saving
as deferred consumption therefore correctly reflects the fact that we have no particular
reason to think savers are better off on a lifetime basis than consumers, unless we mean to
rely on specific empirical theories regarding people’s behavior and welfare.
157. Under a view of saving as deferred consumption, if A and B earn the same wage
this year and the tax base is consumption (with a perpetual flat rate), they pay the same
taxes, in present value over the long run, even if this year one of them consumes less and
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As a matter of logic, then, Simons preferred income taxation to
consumption taxation. Perhaps the most important motivation, however, lay in his underlying distributional concerns. Because economic
income includes, not just current year consumption, but also the
amount of any increase in the market value of one’s assets during the
year, it offers a “more inclusive measure of economic power” 158 than
does consumption. And economic power was the very thing that he
wanted the tax system to equalize. So what, he argued, if—as he expressly agreed—to save the preponderance of a large income was
“moral[ly] superior[]” to engaging in “vulgar and tasteless ostentation
in private consumption”? 159 While “[o]ur private sentiments may
properly distinguish between better and worse uses of great economic
power,”160 tax policy should take no heed of the difference.
[T]here is an urgent social and political problem of preventing excessive and persisting inequality of power. . . . [T]hese distinctions
should not blind us to the need for mitigating inequality or to the
danger that our efforts in this direction will miscarry if we attempt
to differentiate greatly among persons according to the way in
which they use their power.” 161
A last reason for Simons’ preferring the income tax to Fisher’s and
Ogden Mills’ spendings (i.e., progressive consumption) tax was administrative. The income tax was in current use and working reasonably well, albeit susceptible to significant improvement. “Fisher is
urging us to abandon the best part of an established revenue system
and to start anew with an untried form of personal tax.” 162 Departing
radically from existing (and income-based) business accounting and
creating a need, among other challenges, to measure taxpayers’
dissaving (such as from borrowing) was asking for trouble and might
prove unworkable. 163 What is more, while Simons understood that
the spendings tax could achieve “the same degree of progression that
we now have, or the same amount of taxes on persons of great
wealth,” this might require imposing high-end marginal tax rates as
high as 1000%. 164 This seemed likely to be politically unfeasible and
would, in any event, increase compliance problems. 165
saves more. Thus, support for consumption taxation does not rely on the claim that two
people who consume the same amount this year should bear the same tax burden, even if
one of them has greater savings.
158. SIMONS, TAXATION, supra note 1, at 229.
159. Id.
160. Id.
161. Id.
162. Id. at 226.
163. See id. at 227-28.
164. Id. at 230.
165. Id.
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THE FORGOTTEN HENRY SIMONS
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In sum, the picture so far appears clear. Simons was on the income tax side of the long-standing debate and seemingly considered
it important to tax wealth-holders on their returns to saving. The
case is apparently closed, and with a conclusion as unsurprising as
that in the banal headline “Dog Bites Man.” Surely everyone in the
tax community who has heard of Simons already knew that he was a
strong income tax proponent.
A surprise emerges, however, when one turns to the details of his
tax reform views. Simons was actually quite comfortable with letting
savers defer their income tax liabilities without penalty, so long as
the deferral was not potentially permanent, and thereby embraced an
end result that looks very similar to that under consumption taxation, so long as one specifies (as he did) that making gifts and bequests is itself a form of consumption. I show this next by examining
how he dealt with the realization requirement, under which gain and
loss are not taxed prior to the occurrence of a realization event, such
as an asset sale.
2. Simons’ View of Realization and Deferral
As Simons well understood, an income tax in name may not function much like one in practice if taxpayers can take sufficient advantage of a realization-based system. Current law, for example,
might permit a “very wealthy diversifying ‘operator’ . . . [to] show little or no taxable income at all, while living like a king and steadily
increasing his net worth.” 166 All that this required was selectively realizing losses and not gains, while borrowing as needed to fund current consumption. The deferred tax liability would then disappear at
death, given the allowance at that point of a tax-free step-up in basis.167
While realization can turn the income tax into something that
functions more like a consumption tax, in the above scenario we do
not even have that. Blocking exploitation of the scenario may therefore be crucial to the effectiveness of the income tax (in name) as either a true income tax or an effective consumption tax, so far as highend progressivity is concerned. And if one prefers the income tax approach, as Simons emphasized that he did, one might be expected to
emphasize as well the importance of limiting the deferral, not just
the permanent elimination, of the tax on unrealized gain. Our priors
here might therefore lead us to predict that Simons would want to
address and limit taxpayers’ use of realization for deferral, and not
just for permanent elimination of gain. This, however, is not at all
what we find when we look closely at Personal Income Taxation and
Federal Tax Reform.
166. SIMONS, REFORM, supra note 2, at 62.
167. Id.
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Simons is remembered as a foe of realization doctrine for several
reasons. One is that the Haig-Simons income definition gives realization absolutely no place. Changes in the market value of one’s assets
are economic income, as the definition makes clear, whether one sells
the assets or not. Simons also notably called financial accounting’s
reliance on realization a “professional conspiracy against truth,” albeit one that might be expedient “in a world of corruptible accountants
and optimistic directors.” 168 And he famously executed a brutally effective intellectual takedown 169 of Edwin R. A. Seligman of Columbia
University for incoherently arguing that realization is a conceptually
necessary component of income. 170 Seligman was Simons’ elder by
thirty-eight years and arguably had been the preeminent U.S. tax
economist since before Simons was born. 171
168. SIMONS, TAXATION, supra note 1, at 81.
169. See id. at 85-88. Simons’ critique of Seligman is remarkably sarcastic and dismissive. Seligman assumes what he needs to in order to supply the end result he wants,
“then moves merrily to his conclusion.” Id. at 85. “[H]e has evidently no misgivings as to
the finality of his [in Simons’ view, ad hoc and incoherent] contribution.” Id. He starts by
defining income as consumption, but “[b]efore long . . . income becomes something more
familiar—savings being slipped in quite unceremoniously.” Id. At one point in Seligman’s
argument, “income” depends on value, but soon enough this “ceases to be true.” Id. at 86. A
periodicity requirement for income is “essential” at two points in Seligman’s argument, but
at another point “is excluded utterly.” Id. “Seligman’s differentiation between the growth of
a herd and the growth of a forest is one of the less obscure features of his argument.” Id.
Later on, “[i]ncome depends on the number of trees cut—but only provided they do not cut
too many!” Id. at 87. “After an extended parade of dogmatic assertions—put forward as
necessities of logic—the author [adds yet another extraneous argument] . . . rather casually.” Id. “Professor Seligman’s insistence both upon ‘realization’ and upon depreciation deductions seems to involve serious logical difficulties.” Id. at 88. “Of course, it goes without
saying that, after dragging in an amazing variety of income concepts and choosing useful
attributes from different ones at will, Seligman finds little difficulty in throwing out an
item like stock dividends, which was almost defenseless from the start.” Id.
170. The Seligman article to which Simons gave this harsh treatment was Edwin R.A.
Seligman, Are Stock Dividends Income?, 9 AM. ECON. REV. 517 (1919), from which the opinion of the Supreme Court in Eisner v. Macomber, 252 U.S. 189 (1920), holding that stock
dividends cannot constitutionally be taxed because they fail a realization prerequisite for
finding taxable income, had largely been cribbed. Simons was not the only tax academic to
be unimpressed by Seligman’s analysis. See, e.g., Robert Murray Haig, The Concept of Income—Economic and Legal Aspects, in THE FEDERAL INCOME TAX 1 (Robert Murray Haig
ed., 1921) (describing cases such as Eisner as “leading toward a definition of income so
narrow and artificial as to bring about results which from the economic point of view are
certainly eccentric and in certain cases little less than absurd”); Paul H. Wueller, Concepts
of Taxable Income II, 53 POL. SCI. Q. 557, 564 (1938) (Seligman’s “concepts of income are,
in the last analysis, but philological derivatives—without acknowledged social purpose.”).
171. Seligman was born in 1861, started at Columbia in 1885, published two major
books on taxation in the 1890s, was the president of the American Economic Association
from 1902 through 1904, and became a chaired Professor of Political Economy at Columbia
in 1904. He then continued publish regularly through 1932. See Ajay K. Mehrotra, Edwin
R.A. Seligman and the Beginnings of the U.S. Income Tax, 109 TAX NOTES 933, 936-38
(2005). Simons clearly saw no need to pull punches with an eminent senior member of his
field, whose influence he obviously thought had lasted long enough.
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THE FORGOTTEN HENRY SIMONS
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In practice, however, Simons was comfortable with taxpayers’ use
of realization accounting to defer gain. It is not just that he considered realization “indispensable to a feasible income-tax system” 172
and opposed departing from it selectively even where this was most
feasible, such as under an early proposal to require annual mark-tomarket accounting for publicly traded securities.173 What is more, he
considered realization “relatively unobjectionable in principle where
it results only in postponement of assessment” rather than its permanent elimination. 174 Annual accrual of gain, while “implied by the
underlying definition of income . . . is quite unnecessary to effective
application of that definition.” 175 He even called the argument that
income must be allocated to the right period, in order to eliminate the
“interest saving” from deferral, “this mosquito argument,” at which
he had “several times swatted . . . [and] must now swat once more,
[albeit] not to kill the pest.” 176
Part of the reason for Simons’ impatience with arguments that
income must be allocated to the right period, rather than being deferred under the realization rule, was simply his general conviction
that the best should not be the enemy of the good. A reasonably wellfunctioning system should be considered entirely acceptable, even if
along the way it posed insoluble (or, in his words, “hopeless”) dilemmas that could only be given “arbitrary” solutions. 177 However, he did
not consider the time value of deferral—in an era when interest rates
were low, by the standards of more recent decades—as merely something that one would like to eliminate, but that in practice was too
small to worry about. Instead, in many circumstances he was actually affirmatively reluctant to deny it to taxpayers.
Simons recognized, for example, that “long postponement of tax
payment” can have a significant “interest cost to the Treasury.” 178
Nonetheless, allowing such postponement to businesses would yield
“some gains, even to the Treasury, in allowing capital so to ‘fructify.’
The interest loss seems a moderate price to pay, not only for simple
tax procedure but also for stimulation of new enterprise and venturesome investment . . . .” 179 Indeed, there was “very much to be said for
not forcing unproved enterprises to deplete their reinvestable earnings or reserves by forcing them to pay taxes,” even indirectly via a
172. SIMONS, TAXATION, supra note 1, at 162.
173. SIMONS, REFORM, supra note 2, at 74.
174. SIMONS, TAXATION, supra note 1, at 162.
175. Id. at 208.
176. SIMONS, REFORM, supra note 2, at 127.
177. SIMONS, TAXATION, supra note 1, at 53-54 (discussing problems of imputed income
and of drawing a firm boundary between business expenses and personal consumption).
178. SIMONS, REFORM, supra note 2, at 127.
179. Id.
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shareholder-level tax that would lead to increased dividend payouts.180 Simons argued that this “scheme really does derive sound
support from much the same argument which Professor Fisher
has used, persuasively but (I think) improperly, to condemn the
income tax.” 181
This perspective, under which the mere deferral of gain was unobjectionable so long as it did not turn into permanent exclusion, pervasively influences Simons’ actual reform proposals. As Aaron Director noted in his introduction to the posthumously published Federal
Tax Reform, Simons’ “great contribution” to income tax thinking was
to propose what he called “constructive realization.” 182 Under this approach, “[e]very transfer of property by gift, inheritance or bequest
[w]ould be treated as a realization, at the estimated fair market value, by the donor or by the deceased owner’s estate.” 183 This tax would
be levied in addition to treating gifts as taxable income to the donee
while retaining their non-deductibility by the donor—a result that
Simons defended on the ground that gifts constituted consumption by
both parties.184
So long as constructive realization guaranteed a final accounting
when the taxpayer ceased to own appreciated property, Simons not
only could tolerate, but affirmatively supported, eliminating the corporate tax.185 The fact that corporate shareholders could thereby earn
income that was free of any current tax was not a problem, so long as
there was corporate-level dividend withholding plus a guarantee that
any transfer of the underlying stock, including by gift or bequest,
would be treated as a realization by the shareholder, with the gain
being taxed at the ordinary income rate (and preferably subject to
averaging, so taxpayers would not be adversely affected by the
“bunching” problem if annual rates were steeply graduated). 186
How could Simons be so casual, ambivalent, and even selfcontradictory regarding whether income’s broader tax base than consumption (as he saw it) was actually reached in practice? The answer
probably goes back to his underlying motivation for viewing tax reform as a vital part of his “laissez-faire program.” At the time when
180. Id. at 128.
181. Id.
182. Id. at vii.
183. SIMONS, TAXATION, supra note 1, at 167.
184. See id. at 57-58. Simons dismissed the critique that this would result in doublecounting on the ground that this critique “implies . . . the familiar, and disastrous, misconception that personal income is merely a share in some undistributed, separately measurable whole.” Id. at 58. He further argued that a gift exclusion unwisely “distinguish[es]
among an individual’s receipts according to the intentions of second parties.” Id. at 57.
185. See, e.g., SIMONS, REFORM, supra note 2, at 16, 23, 40.
186. Id. at 40, 44.
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THE FORGOTTEN HENRY SIMONS
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he wrote, the U.S. income tax contributed less than 10% of all federal
revenues,187 with the rest coming from tariffs and excise taxes that he
abhorred as both anti-free market and regressive. Replacing them
with a broad-based and relatively neutral levy that reflected individuals’ overall personal circumstances was the big thing, with the
exact details being considerably less important. What is more, Simons’ broader macroeconomic interests (and his experience of the
Great Depression) appear to have encouraged him to focus more on
savings and growth, as opposed to just internal tax policy analysis,
than if he had been purely a tax scholar, and one who lived in less
interesting times.
3. What Might Simons Think Today About the Choice Between
Income and Consumption Taxation?
Given Simons’ surprising degree of comfort with employing an income tax by name that, in practice, often followed timing rules that
were at least as favorable to taxpayers as those under a consumption
tax, it is natural to ask, if only out of curiosity or as a kind of parlor
game, what he might think about the choice of tax base today. Or
more precisely, without speculating about such imponderable questions as whether he would have been swayed by intellectual developments and fashions in the field that he never lived to see, one can
ask what, given his views, he might have made of our many subsequent decades of practical experience. Overall, I see two reasons why
he might have been more fervently pro-income tax in practice today
than he was back then, and two reasons why he might have shifted to
favoring a progressive consumption tax.
(a) More Pro-Income Tax?
(1) Importance of timing. The first reason why Simons might have
become more eager to impose a true income tax, in the sense of limiting interest-free deferral, is that the decades since he published Personal Income Taxation and Federal Tax Reform have taught us how
much timing matters. Perhaps this is simply because we have frequently lived with higher interest rates than those of his era, and
thus have gotten to observe how pervasively timing issues can dominate income tax practice and lead to economic distortions. 188 As William Andrews put it, we have learned that realization is often the
187. SIMONS, TAXATION, supra note 1, at 39.
188. On the other hand, with today’s generally lower tax rates than those in the 1930s,
the distinction between pre-tax and after-tax rates of return may be narrower. One way of
describing the key advantage of deferral is that it enables one to enjoy returns to saving at
the pre-tax rather than the after-tax rate of return.
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“Achilles’ heel” of the income tax, 189 and not just because Simons’
constructive realization approach has never been adopted. Today,
income tax proponents generally recognize that it is quite important
to their goals that deferral issues be addressed more aggressively
than he thought was necessary. Thus, for example, few would argue
today that we can simply eliminate the corporate income tax while
still imposing such a tax at the individual level, serene in the
knowledge that a given shareholder’s slice of corporate income might
often fail to be taxed before that shareholder died.
(2) Greatly increased high-end inequality. Over the last thirty
years, high-end income inequality in the U.S. has vastly increased.
Between 1986 and 2008, for example, under one relevant measure
the share of national income earned by the top 1% of the income distribution almost doubled, while the income share of the top 0.01%
more than tripled.190
Unsurprisingly, and as Simons would have predicted, increased
economic inequality has affected the distribution of political power.
In the last few years, we have seen the greatest and most sustained
collapse of employment levels since the Great Depression prompt
startlingly little concern from Washington policymakers. Instead, the
concern of people in business and finance about forestalling even the
remotest threat of modest inflation appears to matter a lot more politically. Likewise, consider the spectacle in the 2012 presidential
campaign of billionaire donors, set free from campaign finance restrictions by the Supreme Court’s Citizens United decision,191 giving
millions of dollars to support their favored candidates and causes in
apparent exchange for access and at least hoped-for influence.
It is not just anachronistic projection to posit that all this would
have disgusted, and even enraged, the Henry Simons who wrote in
the 1930s and 1940s. He viewed concentrated economic and political
power as ugly and offensive, and he thought no group, profession, or
class should be allowed too much superiority or sway in either realm.
Thus, he presumably would have wanted to take strong measures to
address high-end inequality. At least when he wrote, the income tax,
along with the estate and gift tax, was the main policy tool that he
considered suitable for this purpose. His concern that a spendings tax
would not be progressive enough in practice, even if in principle it
189. See William D. Andrews, The Achilles’ Heel of the Comprehensive Income Tax, in
NEW DIRECTIONS IN FEDERAL TAX POLICY FOR THE 1980S, at 278 (Charles E. Walker &
Mark A. Bloomfield eds., 1983).
190. See Daniel N. Shaviro, 1986-Style Tax Reform: A Good Idea Whose Time Has
Passed, 131 TAX NOTES 817, 834 (2011) (summarizing research by Facundo Alvaredo, Tony
Atkinson, Thomas Piketty, and Emmanuel Saez).
191. Citizens United v. Fed. Election Comm’n, 558 U.S. 310, 365-66 (2010).
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THE FORGOTTEN HENRY SIMONS
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could be, would surely have remained relevant to his analysis of the
choice of policy tool.
(b) Potentially Pro-Consumption Tax?
(1) Political difficulty of addressing inter-asset distortions. I posited above that the clearly demonstrated importance of timing issues
over the last few decades might have motivated Simons to support
fuller implementation of a true Haig-Simons income tax. It also is
possible, however, that it would move him in the opposite direction,
by demonstrating that the income tax could not be as politically pure
and economically neutral as he had fondly hoped. Even by the early
1940s, he was worrying that the federal income tax “reads less
and less like a prescription of taxes on persons according to their incomes, and more and more like an inventory of miscellaneous dispensations” to well-connected interest groups. 192 This introduction of “in
rem elements,” like those in excise taxes, was an instance of “concealed democratic corruption,” exemplified at the time by the oil
depletion allowance. 193
Simons favored tax policy transparency 194 and might reasonably
have concluded (as others have) that an income tax inherently lacks
this virtue with respect to cost-recovery methods that are neutral between assets or industries. By contrast, in a cash-flow tax that applies to businesses (whether incorporated or not) as well as directly to
individuals, expensing achieves inter-asset neutrality by relatively
simple and transparent means. He thus might reasonably have asked
himself the question of whether shifting to a cash-flow consumption
tax might lead to greater neutrality and transparency, thereby reducing industry groups’ capacity to hijack economic and regulatory policy. As I have argued elsewhere,195 it is far from certain that shifting
to a cash-flow consumption tax would actually improve political outcomes, but the possibility that it would (by reason of uniform expensing’s simplicity) would certainly have merited Simons’ consideration.
(2) Administrative complexity of the income tax. A second reason
why Simons might consider giving up on the income tax, if he saw
where we are today, concerns its tax planning, compliance, and administrative costs. The baroque complexities of modern practice,
founded in large part on realization problems that matter much more
192. SIMONS, REFORM, supra note 2, at 96.
193. Id.
194. See id. at 4-5.
195. See, e.g., Daniel Shaviro, Simplifying Assumptions: How Might the Politics of Consumption Tax Reform Affect (Impair) the End Product?, in FUNDAMENTAL TAX REFORM:
ISSUES, CHOICES, AND IMPLICATIONS 75, 75-76 (John W. Diamond & George R. Zodrow eds.,
2008).
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than he had anticipated given the frequent existence of higher interest rates (along with the continuing non-adoption of his constructive
realization idea), might conceivably move him to consider progressive
consumption tax prototypes, even though they remain largely untested.
One set of issues that Simons did not and could not have fully anticipated in the 1930s concerns the extraordinary growth, since that
era, of aggressive tax sheltering transactions and legal responses
thereto, the latter involving both expansive judicial doctrines 196 and
detailed statutory enactments.197 A second set of issues that he did
anticipate, but that arguably has grown worse, concerns entity-level
corporate income taxation, which most analysts now agree (contrary
to his view) is necessary if one taxes income rather than consumption
at the individual level. Simons detested the impact of income tax considerations on companies’ business planning and also on their financial structure. His Federal Tax Reform emphasizes the undesirability
of the corporate income tax system’s bias in favor of debt over equity. 198 And while debt bias is not inevitable under a corporate income
tax, as decades of diverse “corporate integration” proposals have
shown, 199 the very fact that none have been enacted may add to the
appeal of a “Gordian knot” solution, in the form of eliminating the
need to tax income at the entity level.
International tax considerations arguably weigh in this direction
as well. The rise of international business transactions, along with
capital flows that facilitate income-shifting for tax purposes in the
decades since Simons wrote, may cause longstanding problems with
the international tax rules to be ever more damaging to the cause of
taxing individuals on the income they earn through corporate entities. With a corporate income tax, in which residence determinations
must be made at the entity rather than the individual level, these
problems inevitably lack good solutions. 200
196. The economic substance doctrine that lies at the core of judicial responses to aggressive tax planning predates the publication of Simons’ Personal Income Taxation. See
Gregory v. Helvering, 293 U.S. 465 (1935). However, Gregory concerned not the creation of
artificial tax losses, but the use of a tax-free reorganization rule to reduce greatly the tax
imposed on a corporate distribution. Id. at 468-70. Simons noted the “awful complexity” of
the corporate reorganization rules and attributed it to what he considered the mistake of
taxing corporations as if they were natural persons. SIMONS, REFORM, supra note 2, at 89-90.
197. Detailed statutory responses to tax sheltering in the current tax code include, for
example, the investment interest limitation, the at-risk rules, and the passive loss rules.
See I.R.C. §§ 163(d), 465, 469. The economic substance doctrine was also recently codified.
See id. § 7701(o).
198. See SIMONS, REFORM, supra note 2, at 4, 19, 26.
199. On the variety of leading corporate integration proposals, see, for example, DANIEL N. SHAVIRO, DECODING THE U.S. CORPORATE TAX 151-65 (2009).
200. See generally DANIEL N. SHAVIRO, FIXING U.S. INTERNATIONAL TAXATION (2014).
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THE FORGOTTEN HENRY SIMONS
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While income taxation surely looks worse administratively than it
did when Simons was writing, progressive consumption taxation
looks somewhat better. Ogden Mills’ spendings tax was fairly rudimentary in design and in its degree of specification. Its lineal descendant, the “Blueprints” cash flow that David Bradford and the
U.S. Treasury Tax Policy Staff developed in the 1980s,201 goes considerably further in showing how such an approach might work. It also
contains a tax rate-smoothing or income averaging feature 202 that
Simons might conceivably have liked, given his belief that this is important. 203 The decades since Simons wrote have also seen the promulgation of an alternative approach to progressive consumption taxation: Bradford’s X-tax, which builds administratively on the rise
(since the 1950s) of value-added taxes that tax consumption relatively simply and efficiently through broad-based taxes that are collected
at the company level.204 While these progressive consumption tax
models remain largely untested, clearly the consumption tax side of
the administrability debate has gained ground today relative to when
Simons was writing.
Obviously, one cannot, in the end, really say what Simons would
think today about the choice of tax base if he were miraculously revived and apprised of the last few decades’ main developments. He
surely would, however, be disappointed by the trajectory of the income tax in recent decades. It thus is plausible that he would be open
to considering whether a progressive consumption tax could both do
much better administratively and sufficiently match the actual progressivity of the existing income tax. If one had a definite answer to
these questions, not only Simons’ choice, but also ours, would likely
be a lot easier and clearer.
V. CONCLUSION
The Henry Simons who called himself an “extreme conservative”
and foe of economic regulation, and the Henry Simons who favored
“drastic progression” in the income tax, were one and the same intellectually, not just biologically. They shared a dislike for concentrated
economic and political power, and a view of liberty and equality as
not just comparably important, but also highly interdependent in
practice. In his view, unlike that of many of today’s libertarians and
201. See BRADFORD & U.S. TREASURY TAX POLICY STAFF, supra note 153.
202. See id. at 44.
203. See SIMONS, REFORM, supra note 2, at 40, 127.
204. The X-tax combines a value-added tax with allowing businesses to deduct wages,
which are taxed to workers under a progressive rate structure. See ROBERT CARROLL &
ALAN D. VIARD, PROGRESSIVE CONSUMPTION TAXATION: THE X TAX REVISITED (2012); David F. Bradford, The X Tax in the World Economy (Nat’l Bureau Econ. Research, Working
Paper No. w10676, 2004).
38
FLORIDA STATE UNIVERSITY LAW REVIEW
[Vol. 41:1
free market advocates, a plutocratic society would be unappealing
even if everyone’s legal rights were formally inviolate. It is an interesting question—grist for a number of recent studies 205—why his concern about economic as well as political power, and his view that
“[f]reedom without power . . . has no substance or meaning,” 206 have
faded as much as they have among his successors in the classical
liberal tradition.
Intellectual history moves inexorably forward, reflecting not just
fashion but new information and improved understanding. Thus, to
my mind (although others may disagree), neither Simons’ scorn for
theories based on utility and/or ability, nor his analysis of the choice
between income and consumption taxation, is persuasive today. His
hatred of all hierarchies, while appealing to me emotionally, needs a
fuller intellectual foundation than he offers. And his broader economic analysis, such as that concerning the dangers of monopoly power,
may in some respects be more dated still.
Even seventy years down the road, however, much of Simons’
work remains compelling, lucid, and persuasive. This is no small accomplishment. His brilliance, vehemence, and urgent commitment to
improving the world in which he lived helped motivate him to produce, not just a few instances of inspired advocacy, but substantial
contributions both to income tax scholarship and to the intellectual
and institutional foundations of modern law and economics. I only
wish that, in some imaginary place, I could adequately praise and
thank him to his face—perhaps over a beer at Hanley’s tavern in the
twilight zone as Walter Blum looks on with a benign half-smile, and
even Ronald Coase, persuaded at last to accept the value of Simons’
contributions, nods approvingly.
205. See, e.g., DANIEL STEDMAN JONES, MASTERS OF THE UNIVERSE: HAYEK, FRIEDMAN,
BIRTH OF NEOLIBERAL POLITICS (2012); Caldwell, supra note 15; DeLong, supra
note 97; Kasper, supra note 23; Van Horn & Mirowski, supra note 15.
206. SIMONS, Positive Program, supra note 8, at 6.
AND THE
WHEN WE TAXED THE PYRAMIDS
STEVEN A. BANK ∗
I. INTRODUCTION..................................................................................................
II. ORIGINS ............................................................................................................
A. 1909............................................................................................................
B. 1913–1921 ..................................................................................................
C. 1921–1934 ..................................................................................................
D. 1935–1936 ..................................................................................................
III. EVOLUTION .......................................................................................................
IV. FUTURE .............................................................................................................
39
42
42
45
48
53
59
65
I. INTRODUCTION
One of the more anomalous structural features of the corporate
income tax is the dividends received deduction, 1 which permits a corporation to deduct from income an amount equal to some or all of the
dividends it receives in its capacity as a shareholder of another domestic corporation. At first glance, the provision seems to be justified
by the general sentiment against taxing corporate income more than
twice. If this is the explanation, however, the dividends received deduction is underinclusive because some intercorporate dividends are
only partially deductible. As currently drafted, the amount of the deduction is based on the degree of a shareholder’s control. Dividends
are completely (100%) exempt if a corporate shareholder owns at
least 80% of the distributing corporation,2 80% exempt if the ownership interest is less than 80% but at least 20%, and 70% exempt if
the ownership interest is less than 20%. 3 If avoiding triple (or more)
taxation was the rationale, it is not clear why all intercorporate dividends would not be completely exempt from further taxation. Given
partial deductibility and the importance of degree of control, it is
therefore natural to conclude that the dividends received deduction is
less about a concern over multiple layers of taxation and more about
substance-over-form concerns. In other words, it is about differentiating true dividends from distributions that are really just shifts in
money from a corporation’s right pocket to its left pocket. If that is
the explanation, however, the dividends received deduction is overinclusive because it applies to very small investments in another corporation where the distribution really does move money from one tax∗ Paul Hastings Professor of Business Law, UCLA School of Law. Thanks to Joe
Bankman, Mirit Eyal-Cohen, Jim Hines, Sheldon Pollack, Clarissa Potter, Chris Sanchirico, Dan Shaviro, Larry Zelenak, and participants at the FSU Law Review Symposium
commemorating the centennial of the federal income tax and the National Tax Association’s annual meeting for their helpful comments.
1. I.R.C. § 243.
2. See id. §§ 243(a)(3), (b), 1504(a)(2).
3. Id. § 243(a)(1), (c).
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FLORIDA STATE UNIVERSITY LAW REVIEW
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payer to an entirely different taxpayer. Thus, a corporation that owns
a single share of stock in a large public corporation still can exclude
70% of the dividend from income.
The incoherence of the current tax treatment of intercorporate
dividends is a product of its historical development. As described by
the few commentators who have examined the history of intercorporate dividends taxation to any extent, its origins can be traced back
to the New Deal. 4 In the Revenue Act of 1935, 5 corporate income was
for the first time subject to graduated marginal rates. In announcing
the progressive rate scheme, President Franklin Delano Roosevelt
noted that to prevent the evasion of the new graduated rates through
the use of subsidiaries, each of which had income below the thresholds for the application of the higher rates, it would be necessary to
impose a tax on intercorporate dividends. Intercorporate dividends
went from being fully exempt to being only 90% exempt. In theory,
this change was designed to discourage any attempts to evade the
new graduated system. In reality, however, the additional effective
tax burden was too small to be a significant deterrent in most cases
given the alternative of having a corporation’s income subject to the
top corporate rates.
The underlying rationale for taxing intercorporate dividends was
more about discouraging the formation and continued existence of
certain large corporate groups, or “pyramids,” than it was about closing a loophole in the graduated rate scheme. The name for these controversial corporate structures derived from their multilevel corporate chains of ownership in which the investors at the top of the pyramid were able to leverage a relatively small investment in one corporation in order to exercise power and influence over a large group
of subsidiaries at the bottom of the pyramid. As economist Randall
Morck observed, this pyramidal structure was “believed to facilitate
governance problems, tax avoidance, market power, and dangerously
concentrated political influence.”6 Although the resulting tax burden
from the introduction of intercorporate dividend taxation was too
small to force an immediate change in organizational structures,7 it
4. See, e.g., David R. Francis, The Taxation of Intercorporate Dividends: Current
Problems and Proposed Reforms, 64 TAXES 427, 430 (1986); George Mundstock, Taxation of
Intercorporate Dividends Under an Unintegrated Regime, 44 TAX L. REV. 1, 9-10 (1988);
Daniel C. Schaffer, The Income Tax on Intercorporate Dividends, 33 TAX LAW. 161, 163
(1979); Michael J. Maimone & G. Frank Riley III, Note, Taxation of Intercorporate Dividends: A Missed Opportunity for Tax Reform, 7 VA. TAX REV. 777, 779 (1988).
5. Revenue Act of 1935, Pub. L. No. 74-407, 49 Stat. 1014.
6. Randall Morck, How to Eliminate Pyramidal Business Groups: The Double Taxation of Intercorporate Dividends and Other Incisive Uses of Tax Policy, 19 TAX POL’Y &
ECON. 135, 136 (2005).
7. See Steven A. Bank & Brian R. Cheffins, The Corporate Pyramid Fable, 84 BUS.
HIST. REV. 435, 443-45 (2010) (finding in a study of SEC filings between 1936 and 1938 of
2013]
WHEN WE TAXED THE PYRAMIDS
41
was part of a multifaceted campaign against corporate pyramids that
included changes in tax laws, securities laws, and the enactment of
the Public Utility Holding Company Act.8
Not only was the intercorporate dividends tax primarily about this
campaign against pyramids, it was tied as much—or more—to a prior
move to repeal the consolidated return. Formerly a requirement for
corporate groups to prevent evasion of the war profits and excess
profits taxes, 9 the consolidated return had become merely an option
for affiliated corporations as of 1921. By 1932, however, growing concern about the use of holding companies had led Congress to consider
reforms to make such structures less desirable. Initially, corporate
groups had to pay a penalty tax to file a consolidated return, and
then in 1934, the privilege was revoked entirely for most corporations. A companion proposal to tax intercorporate dividends, however, was narrowly defeated. The continued existence of the full exemption for intercorporate dividends after 1934 appeared to be an endrun around at least one aspect of the consolidated return repeal.
In 1935 and 1936, Congress reduced the exemption for intercorporate dividends in order to bolster the concerted action against
holding companies.
This original rationale for the taxation of intercorporate dividends
soon became unnecessary. Starting in the 1940s, concern about pyramidal structures lessened as reorganization began to occur under
the Public Utility Holding Company Act, which had also been enacted in 1935. In 1942, the consolidated return privilege was revived,
and all penalties were eliminated as of 1964. Consequently, Congress
moved away from an intercorporate dividends tax and back toward
the exemption concept that had existed prior to 1935.10 In the time
since, however, the provision has neither returned to its roots nor
fully embraced a scheme based on degree of control. In Part II, this
Article examines the history of the tax treatment of intercorporate
dividends, focusing on both the failed attempt to repeal the dividends
received deduction in 1934 and then its reduction in 1935. Part III
corporate shareholders owning more than 10% of the stock of another corporation that
more than 80% of corporate shareholders remained unchanged, and of the corporate shareholders that changed their holdings, the number of purchases of increased shares virtually
matched the number of sales).
8. Id. at 439, 448; Public Utility Holding Company Act of 1935, Pub. L. No. 74-333,
49 Stat. 803.
9. See infra text accompanying notes 36-40.
10. The use of the word “exemption” is a reference to the effect rather than the means
of accomplishing that end. The partial or full exclusion of intercorporate dividends has
sometimes been accomplished through an exemption, sometimes through a credit, and
more commonly through a dividends received deduction. There is no clear explanation for
the difference, but one commentator has suggested that it was a difference in “nomenclature only.” Mundstock, supra note 4, at 7 n.28.
42
FLORIDA STATE UNIVERSITY LAW REVIEW
[Vol. 41:39
describes the evolution of the dividends received deduction after the
New Deal, taking special note of the changes in circumstances regarding the treatment of consolidated corporate groups. Finally, the
Article concludes by discussing the possible future of the tax treatment of intercorporate dividends and the proposals that have been
raised for its reform.
II. ORIGINS
A. 1909
The idea that a corporation could hold stock in another corporation was a relatively new phenomenon in America at the turn of the
century. New Jersey was the first state to enact a statute broadly
permitting corporate ownership of other corporations in 1889, and
other states were slow to follow. 11 Even as late as 1916, Professor
Maurice Wormser reported in his corporate law treatise that “it is
generally held in this country that a corporation has no power to subscribe for or to purchase stock in another corporation, unless such
power is expressly given in its charter or is reasonably implied in
it.” 12 Otherwise, a corporation could bypass any charter restrictions
on its purpose by purchasing stock in a corporation undertaking an
unauthorized line of business. 13 Perhaps to get around such ultra vires objections, investors created the holding company. Wormser noted:
In recent years there has come into existence a class of corporations known as holding companies. These corporations are organized exclusively for the purpose of acquiring and holding stock in
other corporations. Their validity has been upheld in some states,
including New York, but in others, notably Illinois, they have been
condemned because of their tendency to create monopolies. 14
Critics of excessive business consolidation during the first decade
of the twentieth century were especially concerned about the development of holding companies, which they viewed as an abusive stock
11. CHRISTOPHER GRANDY, NEW JERSEY AND THE FISCAL ORIGINS OF MODERN AMERICORPORATION LAW 42 (1993); CHARLES S. TIPPETTS & SHAW LIVERMORE, BUSINESS
ORGANIZATION AND CONTROL: CORPORATIONS AND TRUSTS IN THE UNITED STATES 213
(1932). Prior to affording general statutory authority, some states permitted corporate
stockholding under special charters or in statutes targeted at specific industries. WM. L.
CLARK, JR., HANDBOOK OF THE LAW OF PRIVATE CORPORATIONS 183 (I. Maurice Wormser
ed., 3d ed. 1916). For example, in 1853 New York granted telegraph companies the authority to own stock in other telegraph companies as part of a program to facilitate interstate
telegraph holding companies. RONALD E. SEAVOY, THE ORIGINS OF THE AMERICAN BUSINESS CORPORATION, 1784-1855, at 198-99 (1982).
12. CLARK, supra note 11, at 183.
13. JAMES WILLARD HURST, THE LEGITIMACY OF THE BUSINESS CORPORATION IN THE
LAW OF THE UNITED STATES 1780-1970, at 45 (1970).
14. CLARK, supra note 11, at 185.
CAN
2013]
WHEN WE TAXED THE PYRAMIDS
43
consolidation technique designed to evade the Sherman Antitrust
Act. 15 By 1912, the Democratic Party platform specifically proposed
to limit the ability of states to permit holding companies and interlocking directorates. 16 After the election, William C. Redfield, the
Secretary of Commerce in President Woodrow Wilson’s new administration, publicly stated that corporations should “not hold stock in
the competing companies, and that neither a person nor a corporation shall at the same time own a controlling interest in two or more
competing corporations.” 17 Eventually, these statements led to a bill
proposing to bar corporate acquisitions of stock in other corporations
whenever “the effect of such acquisition may be to substantially lessen competition between the corporation whose stock is so acquired
and the corporation making the acquisition, or to restrain such commerce . . . or to tend to create a monopoly.” 18 The Clayton Act, as the
bill was called after passage in 1914, 19 was too ambiguously drafted
to be viewed as a substantial impediment to holding companies, but
it did reflect the prevailing sentiment against such structures in the
pre-World War I era. 20
This controversy over corporate holding companies was looming
during the debates over the 1909 corporate excise tax—often considered the forerunner of the modern corporate income tax because the
amount due was a function of the corporation’s income. 21 The original
bill introducing the excise tax included an exemption for dividends
received from another corporation, 22 but this was attacked as a de
facto tax exemption for corporate holding companies. During deliberations over the 1909 corporate excise tax, Insurgent Republican Senator Moses Clapp of Minnesota introduced a motion to repeal the exemption of dividends paid by corporate subsidiaries to their parent
15. HARLAND PRECHEL, BIG BUSINESS AND THE STATE: HISTORICAL TRANSITIONS AND
CORPORATE TRANSFORMATION, 1880S-1990S, at 66 (2000). As Lawrence Mitchell has written, “[t]he trust structure was no longer a subterfuge. The holding company transformed it
into a perfectly legal device.” LAWRENCE E. MITCHELL, THE SPECULATION ECONOMY 31
(2007).
16. PRECHEL, supra note 15, at 66.
17. Id. at 66-67 (citation omitted).
18. Id. at 68.
19. Id.; Clayton Act, Pub. L. No. 63-212, 38 Stat. 730 (1914).
20. PRECHEL, supra note 15, at 68.
21. Payne-Aldrich Tariff Act of Aug. 5, 1909, Pub. L. No. 61-5, § 38, 36 Stat. 11, 112.
22. In a carefully scripted exercise, the corporate excise tax was introduced in the
Senate by Senate Finance Committee Chair Nelson Aldrich as an amendment to Senator
Henry Cabot Lodge’s motion to substitute an inheritance tax for Democrat Joseph Bailey’s
income tax bill. It was drafted by Senator Elihu Root and Attorney General George Wickersham under the close supervision of the President, and it was “carefully scrutinized” by
the Senate Finance Committee as part of a campaign by the President to make the bill
more likely to pass through Congress. ROY G. BLAKEY & GLADYS C. BLAKEY, THE FEDERAL
INCOME TAX 45-47 (1940).
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[Vol. 41:39
holding companies. 23 Clapp complained that the bill “permits the organization of holding companies and exempts such holding companies from any tax where their capital is invested in the stock of subordinate companies.” 24 Senator Nelson Aldrich, a Republican from
Rhode Island, objected:
No holding company or any other company is exempted . . . . This
proposition simply, in the case of corporations which have paid the
tax once and whose stock is held by another corporation, permits
the second holding corporation or the corporation holding the stock
to return an exemption on account of that first payment. In other
words, it does not enforce double taxation upon these various corporations. Every corporation must pay the tax, and if it is paid
once, this act says in effect it shall not from necessity be paid a
second time. 25
Anti-holding company legislators used the words of the bill’s sponsors, which had been carefully drawn to avoid constitutional scrutiny
after the Supreme Court struck down an income tax in Pollock 26 in
response to such argument. New York Senator Elihu Root, one of the
principal drafters of the corporate excise tax bill, had said earlier in
the session that “it is not the profits that would be subject to the tax,
but the privilege or facility of transacting the business through corporate form.” 27 Jonathan Dolliver, an Insurgent Republican from Iowa, recited that quote and went on to say:
If, then, this is not an income tax, if it is not a tax on earnings, if it
makes no difference where the money comes from that flows into
the corporate treasury, on what theory are we, who sit here representing the American people, exempting from the burden of this
tax not little corporations, because they can not afford to pay it,
but great corporations, many of them grown so great that they
trample under foot the laws of the United States, and have in some
instances turned our Government itself into a farce through its
impotency in dealing with their pretensions? 28
Clapp echoed Dolliver’s argument, noting that because this was an
excise tax on the privilege of operating in corporate form, rather than
a true income tax where double taxation might be a valid objection,
“there can be no reason . . . why a great holding corporation, organized to buy a controlling interest in other corporations, should es23. 44 CONG. REC. 3877 (1909).
24. Id. at 4228.
25. Id. at 4231.
26. Pollock v. Farmers’ Loan & Trust Co., 158 U.S. 601, 635-37 (1895) (noting that the
decision striking down the 1894 income tax as unconstitutional would not preclude imposing an excise tax on the privilege of doing business).
27. 44 CONG. REC. 4230 (1909).
28. Id.
2013]
WHEN WE TAXED THE PYRAMIDS
45
cape any taxation for the privilege or right of being a corporation and
engaging in the business of operating and dominating other corporations.” 29 After futile debate between Aldrich and several Insurgent
Republicans over the issue, Aldrich announced he was going to accept
the amendment in order to move on to the rest of the bill. 30 Proponents of Clapp’s proposal to tax intercorporate dividends suspected
that Aldrich expected it “to be sacrificed in conference,” but Aldrich
insisted he would carry forth the views of the majority. 31
As it turns out, the Insurgent Republicans were right to be suspicious of Aldrich’s motives because Clapp’s amendment was stricken
during conference proceedings.32 When Representative Sereno Payne,
a Standpatter Republican from the holding company-friendly state of
New York, reported back to the House regarding the conference proceedings, he was asked why the exemption for intercorporate dividends was reinserted. 33 Payne responded that “[t]here is no reason in
the world why a corporation that owns stock in another company
should pay a double tax upon those holdings. It is not equitable, it is
not right, and it ought not to be exacted. [Applause].” 34 Payne noted:
When it comes to the breaking up or absorption of a company in
order to get rid of competition by another company, I will go to the
full length in preventing it; but I am not in favor of using the taxing power for that purpose, and, of course, a tax of 1 per cent would
not accomplish any purpose in that respect. 35
Critics of the growing influence of holding companies assailed the
result, declaring that “[t]his exemption of the giant concerns that
draw enormous tribute from combinations of lesser companies is regarded by many as the most pernicious feature of the bill.” 36
B. 1913–1921
Notwithstanding the strong repudiation of intercorporate dividend
taxation in 1909, the anti-holding company movement described earlier may have ultimately gotten the upper hand because the exemption for intercorporate dividends was not imported from the corporate
excise tax when the first post-Sixteenth Amendment income tax was
adopted in 1913. 37 Although unpopular among businesses, this was
29.
30.
31.
32.
33.
34.
35.
36.
37.
Id. at 4228.
Id. at 4233.
Id.
BLAKEY & BLAKEY, supra note 22, at 49.
44 CONG. REC. 4696 (1909).
Id.
Id.
Dividend Tax Now in Bill, LAFOLLETTE’S WKLY. MAG., July 31, 1909, at 14.
Revenue Act of 1913, Pub. L. No. 63-16, § II, 38 Stat. 114, 116.
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FLORIDA STATE UNIVERSITY LAW REVIEW
[Vol. 41:39
accepted in part because of the low stakes. As Columbia economist
Edwin Seligman reported to the American Economic Association’s
Committee on War Finances, “[t]his was possible, although unjustifiable, when the rate of the income tax was only 1 or 2 per cent.” 38
Once the U.S. entered World War I, the stakes increased and the
tax treatment of intercorporate dividends became more intolerable
for many businesses. With the corporate income tax rate tripling
from 2% in 1913 to 6% in 1917, coupled with a 1916 levy that imposed a tax of fifty cents per $1000 of capital stock outstanding,
which disproportionately affected corporate groups, some holding
companies even considered reorganizing to lessen their burden. 39 In
response, Congress in the War Revenue Act of 1917 adopted a tax
credit for the receipt of intercorporate dividends. 40 This credit was
merely partial relief, however, because it only covered the 4% surtax
imposed under the Revenue Act of 1917 passed earlier in the year,
and it did not cover the 2% tax that had been adopted in the 1916
Act. The Wall Street Journal noted that the intercorporate dividend
tax credit, “commendable as it was, did not go far enough and resulted in much confusion.” 41 In 1918, Congress went the final step and
permitted corporate shareholders to deduct the full amount of
intercorporate dividends from income. 42 Seligman called it “simple
justice,” with the deduction amounting to a complete exemption of
the dividends. 43
This Congressional focus on the tax treatment of intercorporate
dividends was part of a broader review of the taxation of corporate
groups. Originally, affiliated corporations were not permitted to file a
single, consolidated tax return that combined the profits and losses of
each member of the group.44 All corporations were taxed separately
on their own profits and losses, regardless of their common ownership and control. This may have disadvantaged some companies
seeking to offset the gains of one member of the corporate group with
the losses of another member, but as one businessman later noted,
“[T]he rate of income tax on corporations was very slight, and it
probably did not make very much difference one way or the other
38. Seligman Reports on War Finances, N.Y. TIMES, Dec. 28, 1918, at 14.
39. See, e.g., New Taxation to Spur Corporate Reorganization, WALL ST. J., Oct. 21,
1916, at 5 (describing an announcement by Distillers Securities Corporation that it
planned to merge all of its subsidiaries into its parent company to reduce its capital stock
burden).
40. War Revenue Act of 1917, Pub. L. No. 65-50, § 4, 40 Stat. 300, 302.
41. Justice to Corporations Begins to Appear, WALL ST. J., May 14, 1918, at 10.
42. Revenue Act of 1918, Pub. L. No. 65-254, § 234(a)(6), 40 Stat. 1057, 1078 (1919).
43. Seligman Reports on War Finances, supra note 38, at 14.
44. Walter A. Staub, Consolidated Returns, in THE FEDERAL INCOME TAX 188 (Robert
Murray Haig ed., 1921).
2013]
WHEN WE TAXED THE PYRAMIDS
47
whether there was a consolidated return or a series of returns for the
members of one business family.” 45
In 1917, the introduction of excess profits taxation made the separate entity approach more advantageous for some corporate taxpayers, at least with respect to the excess profits tax. Through intercompany charges between affiliated corporations, such as management
fees or the price paid for items supplied by one company to the other,
a corporate group could manipulate its profits so as to avoid or greatly minimize its exposure to the excess profits tax. Initially, the
Treasury issued regulations authorizing the Commissioner of Internal Revenue to require consolidated excess profits tax returns
“[w]henever necessary to more equitably determine the invested capital or taxable income.” 46 Congress followed up in the Revenue Act of
1918 by requiring consolidated income tax and excess profits tax returns for corporate groups in which at least 95% of the stock of each
of the corporations within the group was owned by one or more of the
other corporations in the group and a common parent corporation
owned at least 95% of the stock of at least one member of the group.47
This was apparently welcomed by the business community, since
even under the Treasury Regulations “most corporations identified
themselves as eligible for consolidated filing and filed the consolidated return, probably because the resulting consolidated return reduced their tax.” 48 According to one report, 75% of all corporate tax
collected in 1917 came from companies voluntarily filing consolidated
returns. 49 Thus, although the move to require consolidated returns
45. Revenue Revision, 1934: Hearings Before the H. Comm. on Ways & Means, 73rd
Cong. 523 (1934) [hereinafter 1934 House Hearings] (statement of John G. Buchanan,
Armstrong Cork Co.).
46. Regs. 41, Art. 78, T.D. 2694, 20 Treas. Dec. Int. Rev. 294, 321 (1918). The authority for issuing this regulation was somewhat tenuous. One contemporary observer identified
the authority as Section 201 of the Act of October 3, 1917, which provided:
For the purpose of this title every corporation or partnership not exempt under
the provisions of this section shall be deemed to be engaged in business, and all
the trades and businesses in which it is engaged shall be treated as a single
trade or business, and all its income from whatever source derived shall be
deemed to be received from such trade or business.
Staub, supra note 44, at 189.
47. Revenue Act of 1918, Pub. L. No. 65-254, § 240, 40 Stat. 1057, 1081-82 (1919).
Although enacted in 1918, it was made retroactive to 1917. Edward H. Green, Aspects of
the Problem of Income Taxation From the Standpoint of Corporations, 10 TAXES 441, 44344 (1932).
48. Jasper L. Cummings, Jr., Consolidating Foreign Affiliates, 11 FLA. TAX REV. 143,
172-73 (2011). Although the regulations were only meant to apply to certain groups of
companies, the instructions to the excess profits tax return asked whether the return was a
consolidated return, which Cummings speculates “may have indicated to taxpayers that
filing a consolidated return was at their option.” Id. at 172.
49. Internal Revenue: Hearing on H.R. 8245 Before the S. Comm. on Fin., 67th Cong.
133 (1921) (statement of Professor T.S. Adams).
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FLORIDA STATE UNIVERSITY LAW REVIEW
[Vol. 41:39
was initially prompted by concerns of excess profits tax evasion, the
push for consolidated returns more generally was ultimately linked
with Congress’ move to exempt intercorporate dividends from tax to
avoid the punishing effects of the high wartime surtax rates. When
the excess profits tax was ended under the Revenue Act of 1921,
Congress made consolidated returns optional rather than mandatory, 50 but the exemption for intercorporate dividends remained.
C. 1921–1934
In 1927, dissatisfaction with the consolidated return led the Joint
Committee on Internal Revenue Taxation to recommend discontinuing consolidated returns. 51 Prompted by this recommendation, the
House voted for the repeal of the privilege in 1928. 52 These moves,
however, were primarily based on administrative rather than substantive concerns. Moreover, the Treasury worried that abolishing
consolidated returns “would be a practical impossibility in view of the
complexity of modern corporate business, and endless confusion in
corporation tax administration would result.” 53 Ultimately, Congress
rejected the repeal option and authorized the Treasury to issue
new regulations to clarify the application and operation of the
consolidated return. 54
Consolidated returns had survived, but not for very long. In 1932,
Congress once again considered the issue of the propriety of permitting consolidated returns. In the House, Representative Clarence
Cannon, a Democrat from Missouri, introduced an amendment to repeal the consolidated return privilege. 55 Rather than simply being a
reprise of the administrative concerns that had prompted a similar
proposal in the late 1920s, however, this repeal proposal was animated by concern about the evils of affiliated corporate groups such as
corporate pyramids. 56
This focus on the evils of corporate pyramids and other affiliated
organizational structures reflected a growing concern that these
practices had played a central role during the 1920s in crowding out
small competitors and concentrating wealth and power in the hands
of a few. 57 The principal feature of the pyramidal structure was that
50. Revenue Act of 1921, Pub. L. No 67-98, §§ 240(a), 301, 42 Stat. 227, 260, 272.
51. Cummings, supra note 48, at 177-78.
52. Id.
53. Senate to Decide Fate of Tax Bill, WALL ST. J., Dec. 21, 1927, at 18.
54. Roy G. Blakey, The Revenue Act of 1928, 18 AM. ECON. REV. 429, 435-36 (1928);
Robert N. Miller, The Taxation of Intercompany Income, 7 LAW & CONTEMP. PROBS. 301,
306 (1940).
55. See, e.g., 75 CONG. REC. 7124 (1932) (statement of Rep. Cannon).
56. See infra text accompanying notes 61-62.
57. See, e.g., FREDERICK LEWIS ALLEN, THE LORDS OF CREATION 248 (1935) (“[I]f it
2013]
WHEN WE TAXED THE PYRAMIDS
49
the owners could use a small investment to exert control over a vast
empire. 58 In 1932, at the same time Congress was considering whether the use of consolidated returns was appropriate, Adolf Berle and
Gardiner Means published their landmark work, The Modern Corporation and Private Property. 59 In this work, they explained that “[t]he
owner of a majority of the stock of the company at the apex of a pyramid can have almost as complete control of the entire property as a
sole owner even though his ownership interest is less than one per
cent of the whole.” 60 One prominent example of this was the Van
Swearingen brothers, who accumulated control of railroad corporations throughout the 1920s via investments by their Allegheny Corporation holding company. 61 According to Berle and Means, “[b]y this
pyramid an investment of less than twenty million dollars has been
able to control eight Class I railroads having combined assets of over
two billion dollars.” 62 The presence of corporate pyramids was particularly pronounced in the public utility sector. One contemporary
study of the period concluded that “[s]o great was the importance of
pyramiding holding companies in the utilities industries in the decade from 1920 to 1930 that the terms ‘holding company’ and ‘public
utility company’ became synonymous in the public mind.” 63
In the presidential campaign of 1932, Roosevelt promised to seek
“[r]egulation and control of holding companies by Federal [P]ower
[C]ommission and the same publicity with regard to such holding
companies as provided for the operating companies.”64 Roosevelt declared that the failure of
[t]he great Insull monstrosity, made up of a group of holding and
investing companies and exercising control over hundreds of operating companies . . . has opened our eyes. It shows us that the development of these financial monstrosities was such as to compel
had not been for the lavish use of this logical extension of the holding-company device,
many of the giants of the economic world would never have got their growth.”).
58. Investors at the top of the pyramid used a variety of means to maintain control,
including cascading holdings of bare majority ownerships, thin capitalization (with funds
provided by preferred stock and debt), and multiple classes of stock (some of which are nonvoting). See JAMES C. BONBRIGHT & GARDINER C. MEANS, THE HOLDING COMPANY: ITS
PUBLIC SIGNIFICANCE AND ITS REGULATION 147-48 (1932); WILLIAM Z. RIPLEY, MAIN
STREET AND WALL STREET 317 (1927).
59. ADOLF A. BERLE, JR. & GARDINER C. MEANS, THE MODERN CORPORATION AND PRIVATE PROPERTY (1932).
60. Id. at 73.
61. See id. at 23; BONBRIGHT & MEANS, supra note 58, at 256, 259; RICHARD SAUNDERS, JR., MERGING LINES: AMERICAN RAILROADS 1900–1970, at 64 (2001).
62. BERLE & MEANS, supra note 59, at 73.
63. CHARLES S. TIPPETTS & SHAW LIVERMORE, BUSINESS ORGANIZATION AND PUBLIC
CONTROL 184 (2d ed. 1941).
64. Text of Governor Roosevelt’s Speech at Portland, Oregon, on Public Utilities, N.Y.
TIMES, Sept. 22, 1932, at 16.
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ultimate ruin, that practices had been indulged in that suggest the
old days of railroad wild-catting, that private manipulation had
outsmarted the slow-moving power of government. 65
The concern was that the consolidated return helped facilitate anticompetitive behavior by holding companies. According to Representative Cannon, the consolidated return “penalizes David and assists Goliath.”66 Cannon went on to note that the consolidated return
is a favorite device of the utilities. An electric company or telephone branch or transportation company pays little attention to
the cost of installing new services. A railroad company can run a
bus line at a loss, a streetcar company can operate a line of taxicabs, or a power company can preempt a new community at a loss.
Through the benevolent provisions of this law they charge these
losses against their profits elsewhere and reduce their taxes while
destroying competition and monopolizing the market. 67
Contemporary observers called the question of whether to repeal
or severely tax consolidated returns “[o]ne of the hardest fought contests” during deliberations over the Revenue Act of 1932. 68 Acknowledging that “[t]he House is divided on this proposition,” Representative Charles Robert Crisp, a Democrat from Georgia, successfully
persuaded his colleagues to adopt a compromise proposal to subject
corporate groups to an additional 1.5% tax for the privilege of filing a
consolidated return. 69 At the urging of Andrew Mellon’s replacement,
Treasury Secretary Ogden Mills, 70 the Senate Finance Committee
removed the penalty tax in the bill it reported on the Senate floor,71
but a compromise was reached in conference. Congress elected to
subject corporate groups filing consolidated returns to an additional
three-fourths of 1% tax for the privilege of filing such a return in
1932 and 1933, and 1% in 1934 and 1935.72 Supporters of repeal consoled themselves by noting that a penalty provision would test
whether supporters of consolidated returns were correct as to their
benefits. As House Speaker John Nance Garner—an advocate for repeal in 1928 and reportedly the behind-the-scenes leader of the 1932
65. James A. Hagerty, Portland Cheers Speech: The Governor Cites ‘Insull Monstrosity’ as He Hits ‘Interests,’ N.Y. TIMES, Sept. 22, 1932, at 1.
66. 75 CONG. REC. 7125 (1932).
67. Id.
68. Roy. G. Blakey & Gladys C. Blakey, The Revenue Act of 1932, 22 AM. ECON. REV.
620, 625 (1932).
69. 75 CONG. REC. 7126 (1932) (statement of Rep. Crisp).
70. Text of Secretary Mills’s Statement to Senate Finance Committee on Tax Bill, N.Y.
TIMES, Apr. 7, 1932, at 20.
71. Blakey & Blakey, supra note 68, at 631; House’s Rates Increased, N.Y. TIMES, Apr.
28, 1932, at 1; Tax Bill Completed; Revised Throughout on Mills’s Pattern, N.Y. TIMES, May
7, 1932, at 1.
72. BLAKEY & BLAKEY, supra note 22, at 345.
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WHEN WE TAXED THE PYRAMIDS
51
repeal effort 73—noted, “[i]f it is advantageous to them to file such returns they will pay the penalty. If there is no advantage in consolidated and affiliated returns, they will submit separate returns.” 74
Thus, as part of a general increase in the corporate income tax rate
from 12% to 13.75%, the rate for affiliated corporations filing a consolidated return was increased to 14.5% for 1932 and 1933. 75
In 1933, the consolidated return issue was revisited. A subcommittee of the Ways and Means Committee issued a report on the prevention of tax avoidance in which it revived the earlier proposals of
the Joint Committee on Taxation and the Ways and Means Committee to repeal the consolidated return. 76 According to the report, the
primary impetus for addressing the consolidated return was the repeal under the National Industrial Recovery Act of the ability to carry forward net operating losses from one year to the next. The Subcommittee noted:
In the past, when any corporation could carry forward a net
loss from one year to another, the consolidated group did not have
such a great advantage over the separate corporation. Now that
this net-loss carry-over has been denied, the advantage of the consolidated return is much greater on a comparative basis. 77
Commentators immediately assailed this recommendation as imprudent and unfairly penalizing most businesses for the abuses of a
few. Godfrey Nelson of the New York Times noted that “[e]xisting law
in respect of the filing of consolidated returns by affiliated corporations is amply justified on the ground of sound business practice and
should be retained.” 78 In hearings held before the House Ways and
Means Committee in the aftermath of the subcommittee report,
a representative from the Standard Oil Company of New Jersey
testified that
[t]here may be arbitrary allocations in consolidated groups to produce that result [of consistent loss offsets], but there are many
other types of consolidations, natural vertical set-ups, as in our
case, where there is every reason to have separate corporations for
73. Garner Will Take Floor Today to Lead Fight for Tax Bill, N.Y. TIMES, Mar. 29,
1932, at 1. In the debates over the 1928 Act, Garner also proposed a graduated corporate
income tax rate scheme. Senate to Decide Fate of Tax Bill, supra note 53 (describing the
graduated tax on corporations as “the brain-child” of Representative Garner). See Barbara
Deckard Sinclair, Party Realignment and the Transformation of the Political Agenda: The
House of Representatives, 1925-1938, 71 AM. POL. SCI. REV. 940, 943 (1977).
74. 75 CONG. REC. 7127 (1932).
75. Blakey & Blakey, supra note 68, at 622.
76. SUBCOMM. ON TAX REVISION, COMM. ON WAYS & MEANS, 73D CONG., PREVENTION
OF TAX AVOIDANCE 10 (Comm. Print 1933).
77. Id.
78. Godfrey N. Nelson, Consolidated Tax Held as Sound Plan, N.Y. TIMES, Dec. 24,
1933, at N5.
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certain operations . . . , and it is not a case of taxation, because
they would continue to exist regardless of the tax penalty, and do
exist regardless of any tax penalty. 79
Railroad representatives were particularly insistent that their business model was necessary, in no small part because of state and federal limits on consolidation. 80 Ben Dey, the general counsel of the
Southern Pacific Co., a railroad company that both operated and
owned the stock of sixty subsidiaries, urged
that if the full committee approves the recommendation of the subcommittee I say to you in all fairness and on behalf of these railroad systems in the United States, only five or six of whom are
making their way or are not on the verge of bankruptcy, that you
should make an exception with respect to the parent company
if it is engaged in interstate commerce as a common carrier, that
it may come in and make a consolidated return for itself and
its subsidiaries. 81
Dey concluded that “it is impossible to put the railroads under this
proposal without committing a terrific public crime. They simply
cannot stand it.” 82
Although the Ways and Means Committee ended up only proposing an increased penalty tax for consolidated returns, repeal was
again proposed in the Senate. Seeking to “strike at the holding company system,” Progressive Senator William Borah introduced
amendments to deny corporate groups the right to file consolidated
returns and to deny any deduction for intercorporate dividends. 83 The
proposal to repeal consolidated returns passed the Senate by a vote of
forty to thirty-seven, albeit with an exception for railroad corporations, but the denial of the dividends received deduction was defeated
by a vote of thirty-nine to thirty-three. 84
The result was that the law was left in a bit of a muddle. Barring
consolidated returns arguably did reduce one advantage of utilizing a
holding company structure by denying a corporation the right to
offset its gains from one subsidiary with the losses of another subsidiary. 85 By preserving the dividends received deduction, however,
79. 1934 House Hearings, supra note 45, at 518 (statement of M.E. McDowell, Standard Oil Co. of New Jersey).
80. See, e.g., id. at 503-04 (statement of Jacob Aronson of the New York Central Lines)
(arguing that the 1920 Transportation Act limited the ability of railroads to consolidate all
of their lines and operations in a single corporation).
81. Id. at 484 (statement of Ben C. Dey, General Counsel, Southern Pacific Co.).
82. Id. at 486.
83. Tax Bill Changes Offered by Borah, N.Y. TIMES, Mar. 2, 1934, at 38.
84. See Estate Tax Levy Raised $92,000,000 by Senate, 65 to 14, N.Y. TIMES, Apr. 13,
1934, at 1.
85. But see Godfrey N. Nelson, Corporations Hit by New Tax Policy, N.Y. TIMES, May
6, 1934, at N9 (“Either because of misunderstanding or by reason of a superficial
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WHEN WE TAXED THE PYRAMIDS
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holding companies could still pass income through multiple tiers
without recognizing additional layers of taxation. Moreover, for those
seeking to attack the Van Swearingen-style corporate pyramid, an
intercorporate dividends tax was far more likely to be important because of the absence of a 95% control requirement as that which existed for consolidated returns. The seeming inconsistency would soon
be resolved.
D. 1935–1936
On June 19, 1935, Roosevelt delivered a special Tax Message to
Congress. 86 Right from the start of his message, it became clear that
his focus was less about revenue and more about using tax to remedy
certain perceived economic ills. According to Roosevelt,
if a government is to be prudent its taxes must produce ample revenues without discouraging enterprise; and if it is to be just it
must distribute the burden of taxes equitably. I do not believe that
our present system of taxation completely meets this test. Our revenue laws have operated in many ways to the unfair advantage of
the few, and they have done little to prevent an unjust concentration of wealth and economic power. 87
After justifying a graduated corporate income tax rate scheme as one
means of addressing the inequities of the concentration of wealth,
Roosevelt went on to revive the tax on intercorporate dividends that
had been defeated in 1934. He contended that it would serve as an
anti-abuse measure for the graduated rates:
Provision should, of course, be made to prevent evasion of such
graduated tax on corporate incomes through the device of numerous subsidiaries or affiliates, each of which might technically qualify as a small concern even though all were in fact operated as a
single organization. The most effective method of preventing such
evasions would be a tax on dividends received by corporations. 88
Business groups swiftly responded to the President’s tax message
and the proposals for reforming corporate taxation. In a report issued
one month later, the Committee on Federal Finance of the U.S.
Chamber of Commerce concluded, “The purpose of the proposed taxes
is obviously to break up large organizations and to compel business
knowledge of the practical use and operation of the consolidated return, this form of accounting has been erroneously associated with the freely denounced holding company or
condemned as a device for the promotion of top-heavy capitalizations.”).
86. Franklin D. Roosevelt, Message to Congress on Tax Revision, AM. PRESIDENCY
PROJECT (June 19, 1935), http:www.presidency.ucsb.edu/ws/?pid=15088.
87. Id.
88. Id.
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to conduct its activities by means of relatively small units.” 89 Similarly, the National Industrial Conference Board observed that “[t]he
Administration desires a program of taxation, the effect of which is
primarily to tax or penalize size or bigness, wherever and in whatever form it may be found.” 90
During the hearings over the ensuing bill, businesses assailed any
notion that the intercorporate dividends tax could be defended as a
revenue or anti-abuse provision. Fred Clausen, Chairman of the
Committee on Federal Finance for the United States Chamber of
Commerce, pointed out that the maximum the proposed tax could
possibly hope to raise at the 85% exemption rate would be $39.7 million, but even that assumed all dividends were taxed regardless of
whether the corporation receiving it had any net income aside from
the dividend. 91 At a 90% exemption, it effectively amounted to a 1.5%
tax on dividends received. 92 Ellsworth Alvord, also of the U.S. Chamber of Commerce, added that “I do not know of anyone who admits
that an intercompany dividend tax is sound. . . . [E]ven as a safeguard [against abuse of the graduated corporate tax rates] it is not
necessary.” 93 Alvord explained that “the hazards—the plain business
financial hazards—of busting up a large corporation into a large
number of subsidiaries far outweigh the gains which might be made
by a saving in the graduated tax.” 94
O.G. Saxon, a Professor of Business Administration at Yale, was
also dubious of the anti-abuse rationale, testifying that “[t]he President’s objective of preventing evasion of the graduated tax could be
obtained by requiring consolidated returns or some similar method.” 95 Moreover, Saxon added that “[t]he proposal that dividends to
corporations on shares of other corporations owned by them be taxed
in order to avoid evasion through subsidiary or holding companies is
so clearly discriminatory against investors in corporations and particularly in large corporations as to require little discussion.” 96 Saxon
predicted that “[i]t would have a deflationary effect on the stocks
owned, for large-scale liquidation would likely ensue. Furthermore,
89. COMM. ON FED. FIN., CHAMBER OF COMMERCE OF THE U.S., FEDERAL TAXATION:
THE SUGGESTIONS IN THE PRESIDENT’S TAX MESSAGE 17 (1935).
90. NAT’L INDUS. CONFERENCE BD., THE NEW FEDERAL TAX PROPOSALS 29 (1935).
91. Proposed Taxation of Individual and Corporate Incomes, Inheritances and Gifts:
Hearing Before the H. Comm. on Ways & Means, 74th Cong. 258-59 (1935) [hereinafter
1935 House Hearings].
92. MARK H. LEFF, THE LIMITS OF SYMBOLIC REFORM: THE NEW DEAL AND TAXATION,
1933-1939, at 143 (1984).
93. Revenue Act of 1935: Hearing on H.R. 8974 Before the S. Comm. on Fin., 74th
Cong. 339-40 (1935).
94. Id. at 340.
95. 1935 House Hearings, supra note 91, at 243.
96. Id.
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WHEN WE TAXED THE PYRAMIDS
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there is no occasion for such a provision. The revenue yield would be
comparatively small and there is adequate control today of stock
ownership in competing corporations through the Clayton Act.” 97
Given the weakness of the tax evasion rationale for the intercorporate dividends tax proposal, it is not surprising that Treasury officials paid mere lip service to it and instead focused on the role the
non-taxation of intercorporate dividends played in contributing to the
growth of corporate pyramids. Robert Jackson, Counsel for the Bureau of Internal Revenue and a future Supreme Court Justice, noted
that even outside of the economic and fairness concerns about pyramidal structures, “their effect on the revenue system is demoralizing
and destructive of good administration.” 98 According to Jackson:
Tax law has for some years encouraged and almost subsidized
the growth of these systems. Stocks of our domestic corporations,
when held by parent corporations, have had almost the same
status as to the tax exempt privilege that the Government has given to its own securities. There was a distinct incentive to corporations to acquire investments in other corporations, and once acquiring investments, there were, of course, the usual incentives to
acquire control. 99
Jackson argued that taxing intercorporate dividends would aid in
the assault against corporate pyramids that had already begun with
the withdrawal of the consolidated return privilege. He indicated
that it “would be desirable as a means of encouraging the simplification of corporate structures. Intercorporate dividends are largely unnecessary transfers brought about and multiplied by complex corporate structures.”100 Jackson explicitly situated the intercorporate dividends tax in the broader campaign against corporate pyramids that
started with the repeal of consolidated returns for most companies:
Up until last year the Federal Government had done little or nothing to discourage such needless complexities. Last year a definite
step was taken in this direction by the abolition of consolidated returns. The partial elimination of the exemption allowed intercorporate dividends would be a further step in this direction and
would have the effect of discouraging the multiplication of intermediate holding companies and of encouraging the creation and
maintenance of straight-forward capital structures that can be understood by the average investor and public official. 101
97. Id.
98. ROBERT H. JACKSON, TREASURY DEP’T, MEMORANDUM AS TO GRADUATED CORPORATION INCOME TAX AND INTERCORPORATE DIVIDEND TAX 30 (1935), available at
http://archive.org/stream/memorandumastogr00jack#page/n5/mode/2up.
99. Id. at 33.
100. Id. at 34.
101. Id. at 35.
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Even the revenue estimates looked better when the intercorporate
dividends tax was viewed as an attack on multitiered corporate
structures. In the context of a corporate pyramid, for instance, the
effective rate might rise if a multitiered corporation actually distributed a dividend up several steps in the chain. According to one estimate, “the tax on intercorporate dividends would vary from 1½ per
cent to 2⅝ per cent, if the tax applied to 15 per cent of such dividends. . . . In the case of pyramided complex holding companies, such
taxes might amount to 8 or 10 per cent.” 102 In specific cases, the tax
burden of the intercorporate dividends tax on corporate pyramids
might be even higher:
In the case of one large public utility holding company with many
subsidiaries, which the Treasury took for illustrative purposes, it
was estimated that this tax would have amounted to 12 cents per
share in 1930; in the case of a certain large industrial company
with many subsidiaries, 5 cents a share in the same year. 103
Not only was the intercorporate dividends tax consistent with the
campaign against corporate pyramids, but it derived from a tax proposal that had been explicitly considered during the debates earlier
in 1935 over the Public Holding Company Act. 104 In the House Committee on Interstate and Foreign Commerce, Representative Samuel
Pettengill, a Democrat from Indiana, had proposed an explicit 2% tax
on intercorporate dividends, 105 which he explained during the House
hearings over the Revenue Act of 1935 as the equivalent of an exemption of 85% on dividends at a time when the corporate rate was
13.75%. 106 Pettengill later explained that he understood the Interstate and Foreign Commerce Committee lacked jurisdiction to consider a tax, but “it was our way of getting it to the attention of the
committee, with the thought of later bringing it to the attention of
the Committee on Ways and Means.” 107 Economist Walter M.W.
Splawn, special counsel to the Committee on Interstate and Foreign
Commerce, had testified to that Committee that “[t]he most effective
means of preventing pyramiding is to eliminate the so-called intermediary companies interposed between the operating company
and the company at the top. Heretofore these intermediary companies have, in effect, been subsidized by the Federal Government
102. Roy G. Blakey & Gladys C. Blakey, The Revenue Act of 1935, 25 AM. ECON. REV.
673, 684 (1935).
103. Id.
104. At least one witness in the House Hearings for the tax bill makes reference to this.
See 1935 House Hearings, supra note 91, at 327 (statement of Rep. Samuel B. Pettengill).
105. See Public Utility Holding Companies: Hearing on H.R. 5423 Before the H. Comm.
on Interstate & Foreign Commerce, 74th Cong. 2214 (1935).
106. 1935 House Hearings, supra note 91, at 329.
107. Id. at 328.
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WHEN WE TAXED THE PYRAMIDS
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through exemption from taxes of dividends on their stock.” 108 Splawn
recommended that “[i]nstead of giving Government encouragement
to intermediate holding companies through exemption from taxation, those companies should be required to pay taxes as though
they were not tied in through stock ownership with a number of
other corporations.” 109
Months before Roosevelt delivered his 1935 tax message proposing
the intercorporate dividends tax as a means of stemming evasion of
the graduated rate scheme, he had endorsed an anti-holding company proposal similar to Pettengill’s for taxing intercorporate dividends. In January of 1935, Representative Sam Rayburn of Texas
reportedly received White House support and approval for a proposed
bill that would regulate and subject public utility holding companies
to a penalty tax not unlike the one imposed on consolidated returns
prior to 1934. 110 The prediction was that “the tax finally decided on
will be such as to permit holding companies which have not weakened their structures through pyramiding to exist, while the public
will be protected largely through the regulation, which will be of a
character to prevent the rise of new holding companies.” 111 Although
the Public Utility Holding Company Act adopted later in 1935 substituted a total ban for the proposed tax penalty, the Administration
remained committed to using taxes more generally as a check against
corporate structures deemed to be abusive. Roosevelt merely made a
strategic decision to subordinate the intercorporate dividends tax to
the graduated corporate income tax rate proposal as part of an effort
to simplify matters for the public by focusing primarily on the “unhealthy and mischievous concentrations of wealth.” 112 Nevertheless,
the connection between intercorporate dividend taxation and the assault on pyramids was already publicly established.
Moreover, there is evidence that Roosevelt was well aware of the
connection between the intercorporate dividends tax and corporate
pyramids when he made his proposal in 1935. In the President’s Secretary’s notes, which contain documents that the White House considered important and confidential, there is a memorandum titled
“Intercorporate Dividend Tax.” 113 The memorandum, which may have
come from Treasury Secretary Henry Morgenthau, explained that
108. Id. at 328 (quoting Dr. Splawn in House Report 827, pt. 2, at 7).
109. Id.
110. White House Backs Holding Unit Taxes, N.Y. TIMES, Jan. 23, 1935, at 25.
111. Id.
112. LEFF, supra note 92, at 136 (quoting a letter from Felix Frankfurter to Roosevelt).
113. Intercorporate Dividend Tax, in Franklin D. Roosevelt, Papers as President: The
President’s Secretary’s File (PSF), 1933-1945, Box 186 – Taxes, at 5 (undated 1935) (on file
with the Franklin D. Roosevelt Presidential Library and Museum), available at
http://www.fdrlibrary.marist.edu/_resources/images/psf/psfc0129.pdf.
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“[t]here has not yet been incorporated in the new tax bill the principle, originated in the tax legislation of last year, of taxing intercorporate dividends so as to discourage holding companies. . . . An
amendment to effect this tax has been carefully drafted in the Department of Justice and is ready for presentation to the Ways and
Means Committee by [Robert] Jackson.” 114
Business leaders assailed this use of the intercorporate dividends
tax as part of the campaign against corporate pyramids that began
with the repeal of consolidated returns. Fred Clausen of the U.S.
Chamber of Commerce noted that if the intercorporate dividends tax
was aimed at breaking up holding companies, it was overinclusive in
its application. As Clausen explained, “the proposal is not limited to
taxing the dividends received by a corporation owning most of . . . the
stock of another but applies to any holding of stock, no matter how
small in percentage.” 115
Business arguments apparently prevailed in the House, which excluded the President’s suggestion for an intercorporate dividends tax
from its bill. 116 The House did indicate a willingness to consider the
measure in a separate bill aimed at “discouraging chains of holding
companies,” 117 however, suggesting that the majority wanted the proposal to be stripped of its thin façade as a tax evasion measure and
discussed in its true context. Nevertheless, the intercorporate dividends tax was reinserted in the Senate bill in the form of an 85% dividends received deduction. 118 In Conference proceedings, the House
agreed to accept the principle of intercorporate dividends taxation as
part of the tax bill, but it successfully reduced the amount of the dividend subject to tax from the 15% proposed in the Senate to 10%. 119
The following year, the question of intercorporate dividends taxation was again on the agenda as part of the consideration of the Revenue Act of 1936. Although much of Congressional attention was focused on a radical proposal to subject undistributed corporate profits
to a penalty tax, 120 the bill reported out by the Ways and Means
Committee to the House contained a provision that would eliminate
the dividends received deduction altogether.121 Ultimately, Congress
114. Id.
115. 1935 House Hearings, supra note 91, at 258.
116. Blakey & Blakey, supra note 102, at 685.
117. Id.
118. Id.
119. BLAKEY & BLAKEY, supra note 22, at 381.
120. See Steven A. Bank, Corporate Managers, Agency Costs, and the Rise of Double
Taxation, 44 WM. & MARY L. REV. 167, 170, 204 (2002).
121. Miller, supra note 54, at 303.
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reduced the deduction from 90% to 85%, but it was changed from a
deduction to a credit. 122
III. EVOLUTION
Although the intercorporate dividends tax was not significant
enough to actually disrupt corporate structures, it continued to loom
large for both proponents and detractors in the years that followed.
As Ellis Hawley observed, “the advocates of decentralization regarded the act as an opening wedge. The small tax on intercorporate dividends might someday evolve into a weapon that would eliminate useless and monopolistic holding companies.” 123 This is precisely what
worried opponents. A tax agent for Sears, Roebuck & Co. noted during a discussion of the issue at the 1938 Annual Meeting of the National Tax Association that
[i]ntercorporate holdings will not be disposed of because of a tax of
2½% on the intercorporate dividends, if the investment is profitable. Therefore, in order to accomplish its stated purpose of forcing
the discontinuance of intercorporate holdings, the government will
be forced to increase the rates. It clearly follows that the trend
of this kind of legislation leads directly to punitive measures,
and regulation. 124
As it turned out, this concern that the tax would continue to loom
large was accurate, even if the prediction of increasing rates was not.
In 1937, Robert Jackson declared that the tax had already succeeded
in breaking up some holding companies, and he predicted that an increase in the tax would finish the job.
[T]he privilege of paying dividends profits free of tax from one corporation to another, operated as a subsidy for the holding companies, one of the most favored forms of creating and operating monopoly. The recent repeal of this privilege and the substitution of
an intercorporate dividend tax has already proved highly effective
in dissolving holding companies, and undoubtedly an increase in
that tax would prove an automatic discouragement of that particular type of antitrust violations. 125
Roosevelt joined Jackson in advocating an increase in the intercorporate dividend taxation as a means of addressing anticompetitive behavior. In his 1938 Message to Congress regarding the Temporary
122. Id.
123. ELLIS W. HAWLEY, THE NEW DEAL AND THE PROBLEM OF MONOPOLY 350 (1966).
124. A.R. Kaiser, NATIONAL TAX ASS’N, Discussion of the Taxation of Intercorporate
Dividends, in PROCEEDINGS OF THE THIRTY-FIRST ANNUAL CONFERENCE ON TAXATION 439,
443 (W.G. Query ed., 1939).
125. Robert H. Jackson, Address, The Struggle Against Monopoly, 1937 GA. B.A. REP.
203, 206, available at http://www.roberthjackson.org/files/theman/speeches-articles/files/
the-struggle-against-monopoly.pdf (last visited Jan. 30, 2014).
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National Economic Committee, Roosevelt noted that “[t]ax policies
should be devised to give affirmative encouragement to competitive
enterprise,” including “increasing the intercorporate dividend tax to
discourage holding companies.” 126
Opponents tried to limit the application of the tax, but to no avail.
In 1937, for example, the Twentieth Century Fund’s Committee on
Taxation proposed a version of the intercorporate dividends tax that
was more narrowly tailored to discouraging corporate pyramids:
The pyramiding of two or more holding companies is rarely necessary for operating purposes, and it facilitates manipulation. Accordingly, the corporation income tax might distinguish between
the first intercorporate payment of dividends, and the second and
subsequent intercorporate payment of dividends. That is, dividends paid to a holding company by the operating company would
be exempt or taxed at a lower rate than dividends paid by one
holding company to another. Such a tax would strongly discourage
the pyramiding of holding companies and would discourage single
holding companies only slightly—if at all. 127
This proposal, however, fell on deaf ears. In 1939, business lobbyists
successfully targeted many aspects of the New Deal tax program for
repeal or revision, but it fell short in securing a reduction in the tax
on intercorporate dividends. 128
The beginning of the end for intercorporate dividend taxation as a
means of attacking corporate pyramids came when the ban on consolidated returns was eased in 1942 and a 2% penalty tax similar to the
one in place between 1932 and 1934 was revived. 129 Much like in
1917, this came on the heels of the adoption of an excess profits tax
with the accompanying concerns about the need for consolidated returns to prevent profit shifting. Contemporary scholars had always
viewed the ban on consolidated returns and the taxation of intercorporate dividends to be inextricably linked as policies against corporate pyramids. In 1940, Gerhard Colm, an economics professor and
fiscal expert for the U.S. Department of Commerce, wrote that
“[i]ntercorporate stockholdings have been used as a means for controlling corporations without necessarily involving full financial responsibility for the controlled corporations. Consolidated balance
126. FRANKLIN D. ROOSEVELT, MESSAGE FROM THE PRESIDENT OF THE UNITED STATES
TRANSMITTING RECOMMENDATIONS RELATIVE TO THE STRENGTHENING AND ENFORCEMENT
OF ANTI-TRUST LAWS, S. DOC. NO. 75-173, at 9 (3d Sess. 1938).
127. COMM. ON TAXATION OF THE TWENTIETH CENTURY FUND, INC., FACING THE TAX
PROBLEM: A SURVEY OF TAXATION IN THE UNITED STATES AND A PROGRAM FOR THE FUTURE
182 (1937).
128. LEFF, supra note 92, at 273.
129. See Maimone & Riley, supra note 4, at 782. Consolidated returns were actually
permitted again starting with the Revenue Act of 1940, but only for purposes of the excess
profits tax. Mundstock, supra note 4, at 10.
2013]
WHEN WE TAXED THE PYRAMIDS
61
sheets and tax exemption for intercorporate dividends permit free
use of this device.” 130 As a consequence, even before the ban on consolidated returns was lifted, one practitioner pointed out that reviving the consolidated return would make the intercorporate dividend
tax incoherent: “if provision for consolidated returns of affiliated corporations should be restored to our taxation system, intercompany
dividends within an affiliated group would be eliminated from tax
consideration along with other intercompany transactions . . . .” 131
With consolidated returns once again permitted, this meant that intercorporate dividends between corporations affiliated by 95% stock
ownership were completely exempt (beyond the 2% tax for the privilege of filing the return), while intercorporate dividends to stockholders owning less than 95% of the stock were only 85% exempt.
In 1964, the additional 2% penalty tax on consolidated returns
was repealed, and consolidated returns once again became fully
available. 132 This was part of a broader program to aid small business. Under the Small Business Investment Act of 1958, dividends
received by small business investment companies were made 100%
exempt.133 In his 1963 tax message, President John F. Kennedy announced a proposal to further advance this policy. 134 Under the existing scheme, corporations were subject to a total rate of 52%, consisting of a 30% normal rate and a 22% surtax rate on earnings in excess
of $25,000. Kennedy proposed to “flip” the normal and surtax rate, so
that the first $25,000 of taxable corporate earnings—“the entire earnings of almost half a million small corporations” according to Kennedy—would realize a 27% rate reduction, while total taxes applicable
to larger corporations would not change. 135 There was concern, however, that the benefit of the lower normal rate and the exemption
from the higher surtax rate for the first $25,000 in income would not
be confined to small businesses. 136 Large corporations already took
advantage of the $25,000 surtax exemption by spreading their in130. Gerhard Colm, Conflicting Theories of Corporate Income Taxation, 7 LAW & CON281, 288 (1940).
131. Miller, supra note 54, at 304.
132. Revenue Act of 1964, Pub. L. No. 88-272, § 234(a), 78 Stat. 19, 113 (1964).
133. Emanuel S. Burstein, The Idiosyncratic Consequences of the Limits in Section
246(b) on the Dividends Received Deduction, 13 TAX NOTES 1019, 1021 (1981). For more
background on small business investment companies, see Mirit Eyal-Cohen, Why Is Small
Business the Chief Business of Congress?, 43 RUTGERS L.J. 1 (2012).
134. John F. Kennedy, Special Message to the Congress on Tax Reduction and Reform,
AM. PRESIDENCY PROJECT (Jan. 24, 1963), http:www.presidency.ucsb.edu/ws/?pid=15088.
135. Id. In 1964, he proposed that the surtax rate “be reduced to 28%, thereby lowering
the combined corporate rate [from 52%] to 50%,” and in 1965, the surtax and total rate
would be reduced further. Id.
136. See Sheldon S. Cohen, Election of Tax Free Intercorporate Dividends Under the
Revenue Act of 1964, 6 WM. & MARY L. REV. 167, 169 (1965).
TEMP. PROBS.
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FLORIDA STATE UNIVERSITY LAW REVIEW
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come among multiple subsidiaries. The flipping of the normal and
surtax rates, with the result that the surtax rate was much higher,
only increased the incentive for abuse. Kennedy therefore explained
that “[s]ince the $25,000 surtax exemption and the new 22% normal
rate are designed to stimulate small business, this reduction should
be accompanied by action designed to eliminate the advantage of the
multiple surtax exemptions now available to large enterprises operating through a chain of separately incorporated units.” 137 He proposed limiting affiliated corporate groups with 80% common control
to one surtax exemption, which would effectively treat them as a single entity.138 As enacted, multiple surtax exemptions were permitted,
but at a cost of a 6% penalty, increasing the normal rate from 22% to
28% in these instances.139 In return, the 2% penalty on consolidated
returns was removed. As Kennedy explained, “if affiliated corporations are treated as an entity for the surtax exemption and other
purposes, they should be permitted to obtain the advantages of filing
consolidated returns without incurring the present tax of 2% on the
net income of all corporations filing such returns.” 140
Much like the shift in attitude toward the consolidated return,
Congress shifted from taxing intercorporate dividends under an antiavoidance and anti-holding company rationale to permitting a more
liberal dividends received deduction under an enterprise rationale,
premised on the notion that the income was earned by a single enterprise. 141 Thus, at the same time that the penalty tax was dropped
from the consolidated return, Congress de-linked the 100% dividends
received deduction from the filing of a consolidated return, making it
an elective stand-alone provision. 142 As enacted, the provision permitted corporations to receive dividends tax-free from a member of the
same affiliated group, which was defined to include an 80% owned
subsidiary. 143 In theory, this equalized the treatment of intercorpo137. Kennedy, supra note 134.
138. Id.
139. Revenue Act of 1964, Pub. L. No. 88-272, § 235(b), 78 Stat. 19, 125 (1964); Thomas
D. Terry, Attorney, Internal Revenue Service, Panel Discussion on Certain Problem Areas
Under the Revenue Act of 1964 at the William & Mary Annual Tax Conference 83-84
(1964),
available
at
http://scholarship.law.wm.edu/cgi/viewcontent.cgi?article=1646
&context=tax. For all affiliated groups but those with aggregate incomes close to $25,000,
it was more advantageous to elect to incur the penalty in order to take multiple surtax
exemptions. Charles L.B. Lowndes, The Revenue Act of 1964: A Critical Analysis, 1964
DUKE L.J. 667, 678.
140. Kennedy, supra note 134.
141. See ANTONY TING, THE TAXATION OF CORPORATE GROUPS UNDER CONSOLIDATION
71-72 (2013). There was some legislation designed to address abuse of the dividends received deduction itself, but the focus on the perceived corporate governance abuse of the
pyramidal structure had disappeared. See Mundstock, supra note 4, at 13-16.
142. See Mundstock, supra note 4, at 13-14.
143. Id.; Revenue Act of 1964, Pub. L. No. 88-272, § 214(a), 78 Stat. 19, 52 (1964) (en-
2013]
WHEN WE TAXED THE PYRAMIDS
63
rate dividends for separate filers and consolidated return filers. In
practice, however, the price for making such an election for separate
filers was high and roughly equivalent to, or higher than, the costs of
filing a consolidated return itself. 144 This led at least one contemporary observer to predict that “[i]t provides for an election to claim the
100% deduction, but the price in terms of disadvantages which must
be accepted is so high that it is doubtful whether the provision will be
used to any substantial extent.” 145 Nevertheless, the move paved the
way for the modern dividends received deduction that is scaled according to size of ownership percentage. Corporations owning 80% or
more of another corporation were eligible for the 100% dividends received deduction, while corporations owning less than 80% of another
corporation were eligible for the pre-1964 Act deduction of 85%.146
In the Tax Reform Act of 1986 and the Omnibus Budget Reconciliation Act of 1987, Congress put the finishing touches on the modern
scheme. In 1986, the general intercorporate dividends received deduction was reduced from 85% to 80% for corporations that owned
less than 80% of a subsidiary. 147 As both the House Ways and Means
and Senate Finance Committee reports to the 1986 Act explained,
the rationale for this change was that it was necessitated by the
broader changes in tax rates under the 1986 Act.148 Prior to 1986, the
top corporate rate was 46%, and corporations eligible for the 85% dividends received deduction (i.e., those owning less than 80% of the
shares of the subsidiary paying the dividend) were therefore subject
to an effective rate of 6.9% (15% of the dividend subject to a 46%
rate). 149 In the 1986 Act, the top rate was lowered to 34%. If instead
the dividends received deduction had been maintained at 85% under
the new lower top corporate rate, the effective rate on intercorporate
dividends would have fallen to 5.1%. 150 The Staff of the Joint Committee on Taxation explained:
Congress did not believe that the reduction in corporate tax rates
generally should result in a significant reduction in this effective
rate. Thus, the dividends received deduction has been reduced to
acting I.R.C. § 243).
144. E. Randolph Dale, 1964 Act: Climate Improved for Multiple Corporations Despite
Penalty Tax, 20 J. TAX’N 264, 266-67 (1964). The price included a limit of only one surtax
exemption for the affiliated group, one accumulated earnings credit, and one $100,000
estimated tax exemption. See id.; Cohen, supra note 136, at 179-80.
145. Dale, supra note 144, at 266.
146. See Burstein, supra note 133, at 1020-21.
147. Tax Reform Act of 1986, Pub. L. No. 99-514, § 611(a)(1), 100 Stat. 2085, 2249.
148. H.R. REP. NO. 99-426, at 244 (1985) [hereinafter 1985 HOUSE REPORT]; S. REP. NO.
99-313, at 221 (2d Sess. 1985) [hereinafter 1985 SENATE REPORT].
149. 1985 SENATE REPORT, supra note 148, at 221.
150. JAMES S. EUSTICE ET AL., THE TAX REFORM ACT OF 1986: ANALYSIS AND COMMENTARY 2-64 (1987).
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FLORIDA STATE UNIVERSITY LAW REVIEW
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80 percent, resulting in a maximum rate of 6.8 percent on dividends subject to the reduced top corporate rate (20 percent of the
top corporate rate of 34 percent). 151
In 1987, Congress completed the reform of intercorporate dividend
taxation when it adopted a new 70% dividends received deduction for
corporations receiving dividends from corporations in which they had
less than a 20% stake. 152 During consideration of the 1986 Act, the
House had considered a bill that created three tiers: 100% for dividends received from affiliates (i.e., 80% owned subsidiaries), 90% for
dividends received from a small business investment company (down
from 100% when the provision was enacted in 1958), and 80%, transitioning to 70% after the phase-in period, for all other intercorporate
dividends.153 In Conference, however, the Senate version was chosen.154
In the fall of 1987, the combination of the federal deficit concerns
and the looming automatic budget cuts that would be triggered in the
absence of new revenue led to a revival of interest in tax increases.155
At first, President Ronald Reagan stood his ground “stumping the
country saying he wants no tax increases.”156 The stock market crash
in October, however, changed his tune.157 Declaring that “I’m putting
everything on the table,” Reagan “abandoned his vow never to raise
taxes and ordered his top aides to work with Congress in developing
a deficit-reduction plan that ‘keeps spending and taxes as low as possible.’ ” 158 Among the revenue raising proposals was to reduce the dividends received deduction from 80% to 75% for dividends from less
than 20%-owned corporations. The House Ways and Means Committee justified the change under the enterprise rationale for the dividends received deduction, explaining that it “believe[d] that the present-law dividends received deduction is too generous for corporations that are not eligible to be treated as the alter ego of the distributing corporation because they do not have a sufficient ownership
151. STAFF OF JOINT COMM. ON TAXATION, 99TH CONG., GENERAL EXPLANATION OF THE
TAX REFORM ACT OF 1986, at 274 (Comm. Print 1987).
152. See Omnibus Budget Reconciliation Act of 1987, Pub. L. No. 100-203,
§ 10221(a)(1), 101 Stat. 1330, 1330-408.
153. 1985 HOUSE REPORT, supra note 148, at 244-45.
154. H.R. REP. NO. 99-841, at II-161 (1986) (Conf. Rep.).
155. Jeffrey H. Birnbaum, Reagan Faces Deficit Showdown with Congress, Hard Choices of Paring Military or Raising Taxes, WALL ST. J., July 16, 1987, at 56.
156. Id.; John H. Cushman, Jr., Fee Rise Suggested to Reduce Deficit, N.Y. TIMES, Sept.
28, 1987, at A1.
157. The Budget Deficit Disgrace, N.Y. TIMES, Nov. 20, 1987, at A38. See generally DIV.
OF MKT. REG., U.S. SEC. & EXCH. COMM’N, THE OCTOBER 1987 MARKET BREAK xi (1988)
(describing the volatility of the market in October 1987).
158. Jack Nelson, Reagan Backs Off His Stand Against Increase in Taxes: Aides Will
Meet with Leaders of Congress on Debt, L.A. TIMES, Oct. 23, 1987, at 16.
2013]
WHEN WE TAXED THE PYRAMIDS
65
interest in that corporation.” 159 The Senate included no such reduction in the rate for intercorporate dividends, but in conference they
agreed to adopt the House provision, with a reduction in the rate
from 75% to 70%.160
IV. FUTURE
The reforms to the taxation of intercorporate dividends in the
1960s and 1980s primarily reflect the move away from the antiholding company rationale of the New Deal and toward an approach
influenced most prominently by a need for revenue. To the extent
that the enterprise rationale continues to buttress the scheme, it does
so in a blunt and largely unsatisfying fashion, with no differentiation
in the percentage exclusion available for 79% corporate owners and
20% corporate owners.
In 2007, the Department of Treasury’s Office of Tax Policy examined the dividends received deduction and found it particularly problematic because of the tax cascading effect.161 This is the problem of
running income up through multiple tiers of corporate ownership,
each of which is only eligible for a partial dividends received deduction. According to the Office of Tax Policy’s report:
By failing to allow a full 100-percent deduction for all intercorporate dividends, the tax system can impose multiple layers of tax
on intercorporate dividends, which leads to distortions in the allocation of investment by discouraging corporations from investments in other corporations that would be profitable in the absence
of the cascading levels of taxes. 162
The Office of Tax Policy calculated that under the 70% dividends received deduction, the additional layer of tax imposes an extra $6.83
burden on every $100 of corporate earnings. 163
The evidence the Office of Tax Policy marshaled regarding intercorporate dividends supports the notion that the partial dividends
received deduction is not all that productive. Of almost $280 billion
in intercorporate dividends issued in 2004, only $51 billion, or less
than 19%, were subject to taxation—and that includes dividends not
eligible for the dividends received deduction at all, such as dividends
from foreign corporations. 164 Of the nearly $100 billion in intercorpo159. H.R. REP. NO. 100-391, pt. 2, at 1094 (1987).
160. See H.R. REP. NO. 100-495, at 965 (1987) (Conf. Rep.).
161. See OFFICE OF TAX POLICY, U.S. DEP’T OF THE TREASURY, APPROACHES TO IMPROVE
THE COMPETITIVENESS OF THE U.S. BUSINESS TAX SYSTEM FOR THE 21ST CENTURY 76-77
(2007).
162. Id. at 76.
163. Id. at 77.
164. Id. at 78.
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[Vol. 41:39
rate dividends eligible for either the 100, 80, or 70% dividends received deduction, only $16.8 billion in intercorporate dividends were
eligible for the 80 and 70% deductions. 165
There appear to be several alternative methods that have been
proposed regarding the taxation of intercorporate dividends. One
possibility is to provide a 100% dividends received deduction for all
intercorporate dividends. This was the system in place prior to 1935.
In 1979, the American Bar Association’s Committee on Affiliated and
Related Corporations proposed returning to this approach, noting
that the original purpose of the move away from a 100% deduction
“was twofold: (1) to prevent the use of graduated corporate income
tax rates by members of a single corporate group, that is, to prevent
the use of multiple surtax allowances; and (2) to discourage the use of
elaborate chains of public utility holding companies.” 166 The Committee explained, “[i]t is highly doubtful whether the slight reduction in
the dividends-received deduction from 100 percent to 85 percent
achieved either purpose.” 167 Moreover, at least in the case of the latter explanation, the culmination of the successful battle to eliminate
public utility holding companies, which coincided with the repeal of
the ban on consolidated returns, effectively shifted the focus away
from anti-bigness. 168
With respect to the concern that an unlimited dividends received
deduction would be abused, several provisions have been enacted
that target such abuse more effectively than the declining dividends
received deduction percentage. In 1969, Congress moved to shut
down one problem with affiliated groups of corporations in a graduated corporate rate scheme—the multiple surtax exemption. 169 The
Revenue Act of 1964 had taken some steps against this practice by
imposing a penalty tax for the privilege of claiming multiple surtax
exemptions,170 but in the Tax Reform Act of 1969, Congress shut it
down altogether by limiting controlled corporations to one surtax ex165. Id.
166. Comm. on Affiliated & Related Corps., Summaries of Proposed Legislative Recommendations to Amend the Internal Revenue Code of 1954 to Apply a 100 Percent Dividends-Received Deduction to All Dividends Received by a Corporation from a Domestic Corporation, 32 TAX LAW. 863, 864 (1979).
167. Id.
168. See Steven A. Bank, Taxing Bigness, 66 TAX L. REV. (forthcoming 2014) (manuscript at 36-37) (on file with author). But see Randall Morck, How to Eliminate Pyramidal
Business Groups: The Double Taxation of Intercorporate Dividends and Other Incisive Uses
of Tax Policy, 19 TAX POL’Y & THE ECON. 135, 169 (2005) (suggesting the taxation of intercorporate dividends might be used in other countries to combat the corporate governance
problems of pyramidal structures).
169. Thomas R. White III, The Tax Reform Act of 1969: Demise of Multiple Surtax Exemptions—When Too Much of a Good Thing Proved Its Own Undoing, 16 WAYNE L. REV.
1353, 1358-60 (1970).
170. See supra text accompanying notes 136-39.
2013]
WHEN WE TAXED THE PYRAMIDS
67
emption.171 Of course, this type of abuse is driven primarily by the
existence of graduated corporate rates that reward the splitting of
income among multiple subsidiaries so none of them have incomes
beyond the lowest rate. 172 Repealing the graduated rate scheme
would reduce the tax incentives for utilizing such a structure. 173
In the 1980s, Congress further strengthened protections against
several other schemes designed to abuse the dividends received deduction, such as extraordinary dividends on stock held for less than
two years. 174 These schemes were called “milking transactions” because the goal is to milk the profits of the subsidiary in a tax-free intercorporate dividend.175 Congress also limited the ability of corporate
parents to extract tax-free intercorporate dividends through debtfinanced subsidiary portfolio stock purchases. 176 These transactions
were concerning because the combination of an interest deduction
and the dividends received deduction appeared to permit the corporation to shelter unrelated income or to subsidize a takeover.177
A second possible reform that has been proposed as an alternative
to the current scheme for taxing intercorporate dividends, which
stands at the opposite end of the spectrum from the first, would eliminate the partial deduction altogether. 178 The partial dividends received deduction was always an awkward combination with the repeal of the consolidated return, since the rhetoric of an intercorporate
dividends tax was, in reality, still a 90% and then 85% dividends received deduction for corporations that were supposed to be considered
separate in the absence of the consolidated return.
A version of this alternative was offered by Harvard professor William Andrews in his Reporter’s Study on Corporate Distributions for
the American Law Institute’s Federal Income Tax Project on Subchapter C. 179 Andrews highlighted the difference between direct investments in controlled subsidiaries and portfolio investments in
171. See Tax Reform Act of 1969, Pub. L. No. 91-172, § 401(a), 83 Stat. 487, 599-604.
172. See Michael Aikins, Note, Common Control and the Delineation of the Taxable
Entity, 121 YALE L.J. 624, 651-52 (2011).
173. See Bank, supra note 168, at 44-45 (suggesting that other incentives, such as
those targeted at small businesses, would remain).
174. See Mundstock, supra note 4, at 15-17.
175. Id. at 12.
176. STAFF OF THE JOINT COMM. ON TAXATION, 98TH CONG., GENERAL EXPLANATION OF
THE REVENUE PROVISIONS OF THE DEFICIT REDUCTION ACT OF 1984, at 128-29 (Comm.
Print 1984).
177. Id.
178. See, e.g., Maimone & Riley, supra note 4, at 778-79 (proposing a repeal of the partial dividends received deduction for non-affiliated corporations, while retaining the 100%
deduction for affiliated corporations).
179. See generally William D. Andrews, Reporter’s Study on Corporate Distributions, in
AM. LAW INST., FEDERAL INCOME TAX PROJECT: SUBCHAPTER C 487 (1982).
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FLORIDA STATE UNIVERSITY LAW REVIEW
[Vol. 41:39
non-controlled corporations, suggesting that a full dividends received
deduction made sense for the former type of investment, while there
was no justification for a dividends received deduction for the latter
type of investment. 180 According to Andrews, the problem with allowing even a partial dividends received deduction for portfolio investments is that it distorted investment decisions by preferring investments in corporate equity over other fully taxable forms of investment. 181 By contrast, for a direct investment, “the dividend-received
deduction is not enough to effect a consistent and uniform elimination of double corporate taxation.” 182 Rather than setting the dividing
line between these two investments at the 80% ownership percentage
under the current rules, however, Andrew proposed a more complicated scheme that would have allowed even a 10% ownership stake to
be classified as a direct investment. 183 The American Law Institute,
however, never adopted the recommendations contained in his
Reporter’s Study. 184
There have been some proposals to tinker with the current partial
dividends received deduction, but much like the 1987 reform they
appear to be revenue-driven rather than based upon any conceptual
notion of the proper tax treatment. In 2007, Charlie Rangel proposed
reducing the 80% deduction to 70%, and reducing the 70% deduction
to 60%. 185 Much like in 1986 and 1987, this was part of a proposal to
reduce the general corporate rate from 35% to 30.5%. 186 In this case,
however, the focus was not on maintaining the same effective tax
rate, but on making the overall reduction in rate revenue-neutral.
Nevertheless, this proposal has never been acted upon. Given the
current push to reduce the corporate income tax rate in a manner
that is either revenue-neutral or is part of a reform of business taxation that produces increased revenue,187 however, Rangel’s proposal
or something similar may soon be revived by politicians seeking to
pay for their own bills.
180. See id.
181. See id. at 494.
182. Id. at 496.
183. Id. at 490. Andrews classified an investment as “direct” if “(i) the investor corporation own[ed] more than 50 percent of the common stock of the issuer for . . . [at least] one
year; or (ii) the investor corporation own[ed] 10 percent or more of the common stock of the
issuer and designat[ed] the holding as a direct investment; or (iii) the investment ha[d]
ever been a direct investment [for at least one year] and ha[d] not been subsequently completely terminated . . . .” Id.
184. Maimone & Riley, supra note 4, at 790 n.46.
185. See H.R. 3970 Tax Reduction and Reform Act of 2007, COMMITTEE ON WAYS &
MEANS (Oct. 29, 2007), http://waysandmeans.house.gov/media/pdf/110/summary%20for%
20distribution.pdf.
186. See id.
187. See Obama’s ‘Grand Bargain’ with Obama, WALL ST. J., July 31, 2013, at A12.
2013]
WHEN WE TAXED THE PYRAMIDS
69
A complicating factor in any proposal for reform of the dividends
received deduction is the globalization of modern corporations. 188 The
basic rules limit the dividends received deduction to taxable domestic
corporations. 189 There are exceptions, however, for dividends from
foreign corporations arising out of earnings and profits accumulated
while the corporation was still a domestic taxable corporation, and
for dividends from a 10% owned foreign corporation with respect to
the portion of the dividends that is U.S.-sourced.190 Some companies
have invoked these exceptions in the context of so-called “sandwich”
structures involving a domestic corporation owning a foreign corporation that owns a domestic corporation. 191 Eventually, the Internal
Revenue Service issued a private letter ruling to provide guidance for
intercorporate dividends in this type of structure. 192 More recently,
however, the Service has had to issue additional guidance to disallow
abusive uses of the dividends received deduction involving controlled
foreign corporations. 193 With reports suggesting that an increasing
number of domestic companies are relocating outside the U.S.
through reincorporation mergers, with either existing companies or
shell companies, 194 these types of structures may become more important. Indeed, if an anti-holding company sentiment prompts a
move to a less generous scheme for taxing intercorporate dividends,
it is likely that multinational holding companies will be the twentyfirst century version of the original corporate pyramids.
188. See Steven A. Bank, The Globalization of Corporate Tax Reform, 40 PEPP. L. REV.
1307, 1308-09 (2013) (describing the growth of multinational corporations and the globalization of corporate profits for domestic corporations).
189. See I.R.C. § 243(a).
190. See id. §§ 243(e), 245.
191. See, e.g., Hal Hicks et al., Sandwich Structures: The IRS Illuminates the Application of the DRD and Other Provisions, INT’L TAX J., July-Aug. 2010, at 61, 61; John D.
McDonald et al., The Dividends-Received Deduction and Sandwich Structures, TAXES, May
2010, at 5, 5.
192. See I.R.S. Priv. Ltr. Rul. 200952031 (Dec. 24, 2009).
193. I.R.S. Chief Couns. Mem. 201320014 (Jan. 18, 2013); see also Jasper L. Cummings, Jr., The Substance of Dividends Received Deductions, 140 TAX NOTES 603 (2013);
Jeffrey L. Rubinger & Nadia E. Kruler, Service Applies Substance Over Form Doctrine to
Disallow Dividends-Received Deduction, 119 J. TAX’N 13 (2013).
194. See Mark Koba, Avoid U.S. Taxes by Forming a Merger Abroad, NBCNEWS.COM
(July 31, 2013, 5:23 PM), http://www.nbcnews.com/business/avoid-us-taxes-formingforeign-merger-6C10810789.
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SOME INCOME TAX SIMPLIFICATION PROPOSALS
JOSEPH M. DODGE *
I.
II.
III.
INTRODUCTION ................................................................................................
SIMPLIFICATION AS AN AGENDA ......................................................................
SIMPLIFICATION WITHOUT REFORM ................................................................
A. Taxpayer Relief from Arithmetic ...............................................................
B. Checklists for Tax-Benefits Eligibility Requirements ................................
C. Tax Credits to be “Off Tax” ........................................................................
D. Rate Schedules ...........................................................................................
E. Subsistence Income ....................................................................................
1. Eliminate the Standard Deduction......................................................
2. The Personal Exemption Amount ........................................................
3. Dependency Exemption Amounts .........................................................
4. The Definition of “Dependent”..............................................................
5. Eliminate the Child Tax Credit ...........................................................
F. The Working Poor ......................................................................................
1. No Separate Rate Schedules for Unmarried Individuals and Heads
of Household ........................................................................................
2. Replace the Child Tax Credit, the Earned Income Tax Credit, and
the Household and Dependent Care Credit with a Single Dependent
Care Allowance ....................................................................................
G. The Taxable Income Computation .............................................................
1. Equal Status Among Deductions .........................................................
2. Personal Deductions Subject to Floors.................................................
3. Deduction Phase-Out Rules .................................................................
4. The Proper Function of the AMT .........................................................
H. Social Security Retirement Benefits...........................................................
I. Educational Tax Benefits ..........................................................................
J. Borderline Personal/Business Deductions ................................................
1. Marginal Business and Investment Deductions Generally .................
2. Business Meal Costs .............................................................................
3. Business Lodging Costs .......................................................................
4. Not-for-Profit Activities ........................................................................
(a) Accounting ....................................................................................
(b) Definition of “Not-for-Profit Activity” ...........................................
5. Rental or Business Use of Personal Residence.....................................
(a) Integrate the Rental Aspect of § 280A with § 183.........................
(b) Disallowance of Deductions for Costs of a Residence Used in a
Business.........................................................................................
(c) Travel Expenses to Maintain a Residence ....................................
6. Tangible Personal Property Available for Personal Use ......................
7. Credit Card Interest .............................................................................
K. Cancellation-of-Debt Income ......................................................................
L. Alimony vs. Child Support ........................................................................
M. Small Business Tax Accounting ................................................................
1. Expand Use of the Cash Method ..........................................................
2. Opting Out of Inventory Accounting ....................................................
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87
87
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98
* Stearns Weaver Miller Weissler Alhadeff & Sitterson Professor of Law, Florida
State University College of Law. The author wishes to thank Norman Stein, Joseph Bankman, Calvin Johnson, and participants of the Symposium on the 100th Anniversary of the
Federal Income Tax, held at Florida State University College of Law on March 1 and 2,
2013.
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FLORIDA STATE UNIVERSITY LAW REVIEW
IV.
[Vol. 41:71
3. Simplified Asset Accounting ................................................................
N. Book-Tax Conformity for Public C Corporations.......................................
O. Gratuitous Transfers .................................................................................
1. What is a “Gift” ....................................................................................
2. Repeal § 274(b) .....................................................................................
3. Repeal the Basis-Disallowance Rule for Gifts of Depreciated-Value
Property ...............................................................................................
4. Repeal the § 691(c) Deduction and the § 1015(d)(6) Basis
Adjustment ..........................................................................................
5. Grantor Trusts .....................................................................................
6. A “Simple Estate” Income Tax Regime ................................................
7. Repeal the Rule that the In-Kind Satisfaction of a Fixed-Sum
Bequest is a Deemed Sale of the Property............................................
P. Transactional Accounting Issues ...............................................................
1. Basis of In-Kind Income Items .............................................................
2. Repeal § 1341 .......................................................................................
Q. Portfolio Accounting for Publicly Traded Securities .................................
1. Mechanics.............................................................................................
2. No Disallowance of Portfolio Net Loss .................................................
3. Partial Repeal of § 1014 .......................................................................
TAX REFORMS CONTRIBUTING TO SIMPLIFICATION .........................................
A. Tax Expenditures .......................................................................................
B. Capital Gains .............................................................................................
1. Plan A: Eliminate Special Rates for Net Capital Gain .......................
2. Plan B: Simplify the Benefits Conferred on Net Capital Gain ............
3. Eliminate the Category of “Collectibles” Gain .....................................
4. Full Depreciation Recapture for Real Estate .......................................
5. Repeal § 1231 .......................................................................................
C. Losses on Sales and Exchanges .................................................................
1. Restrictions on the Current Deductibility of Net Transactional
Losses ...................................................................................................
2. Simplifying the Rules Defining Gains and Losses Subject to the
Anti-Cherry-Picking Rule ....................................................................
D. The Personal Deductions ...........................................................................
1. Residential Mortgage Interest ..............................................................
2. State and Local Taxes ..........................................................................
3. Personal Casualty and Theft Losses ....................................................
4. Charitable Contributions .....................................................................
5. Medical Care ........................................................................................
6. Costs of Tax Planning and Compliance...............................................
E. Personal Injury Recoveries.........................................................................
F. Retirement Savings ....................................................................................
1. Qualified Tax-Deferral Retirement Plans ............................................
(a) Complexity in the Service of an Ineffective Policy Design ............
(b) Plan A: Mandatory Retirement Contributions .............................
(c) Plan B: Tax Subsidies at the Margin ...........................................
(d) Defined Benefit Plans ...................................................................
(e) Mandatory Annuity Pay-Outs Under All Tax-Favored Plans ......
(f) Other Issues ...................................................................................
(g) Roth IRAs .....................................................................................
2. Nonqualified Tax-Deferral Arrangements ...........................................
(a) Restricted Property Transfers and Funded Nonqualified Plans .
(b) Non-Funded Plans .......................................................................
3. Rabbi Trusts ........................................................................................
99
99
100
100
100
101
101
102
103
104
104
104
105
106
106
107
108
108
108
109
109
110
110
110
111
112
112
113
114
114
115
117
118
120
121
122
123
123
123
127
127
129
129
130
130
131
131
133
134
2013]
V.
SIMPLIFICATION PROPOSALS
G. Foreign Income of U.S. Nationals..............................................................
1. Repeal the Exclusion for Foreign-Source Earned Income....................
2. Expand the Simple Version of the Foreign Tax Credit ........................
H. Entity Taxation ..........................................................................................
1. Mandatory Pass-Through Regime for All Non-Publicly Traded
Business Entities .................................................................................
2. A Simplified Pass-Through Regime.....................................................
3. Nondeductibility of C Corporation Interest .........................................
4. Eliminate Capital Gains Treatment of Dividends...............................
5. Repeal the Earnings and Profits Apparatus ........................................
CONCLUSION ...................................................................................................
73
134
134
135
136
136
137
138
138
139
141
I. INTRODUCTION
This Article proposes various moves for simplification of the task
of computing the tax base under the individual income tax, 1 with a
principal view of making the income tax capable of compliance by
“ordinary” individuals without the aid of tax preparation software or
outside assistance. 2
Part II offers a brief overview of the pros and cons of simplification
as a reform agenda or project. Part III deals with simplification
moves that can be carried out independently of conventional tax reform proposals. Part IV considers simplification benefits that are attendant upon plausible tax reform (or revenue-raising) proposals.
Part V offers some concluding remarks.
II. SIMPLIFICATION AS AN AGENDA
An obvious aim of simplifying the federal income tax is to save on
taxpayer compliance costs, especially time spent on filling out tax
returns. It is reported that individual taxpayers spend not insignificant amounts of money and more than twenty-four hours on filing
federal tax returns. 3 Such short-form tax returns as currently exist,
the Form 1040-EZ and the Form 1040-A, do not appear to simplify
matters significantly because taxpayers would still need to consider
1. Simplification of rate structures (such as moving to a flat rate system) is not a
“simplification” issue, since applying a tiered rate structure to the tax base is a simple
arithmetic operation easily performed by a computer, including a program found on a website. Complexity in the rate structure should be equated with lack of transparency (disguised changes in marginal rates), such as occur with the deduction phase-out provisions
found in I.R.C §§ 68 and 151(d)(3), both of which were revived by the American Taxpayer
Relief Act of 2012, Pub. L. No. 112-240, 126 Stat. 2313 (2013).
2. Previous collections of simplification proposals are found in AM. LAW INST. ET AL.,
FEDERAL INCOME TAX SIMPLIFICATION (Charles H. Gustafson ed., 1979); STAFF OF JOINT
COMM. ON TAXATION, 107TH CONG., STUDY OF THE OVERALL STATE OF THE FEDERAL TAX
SYSTEM AND RECOMMENDATIONS FOR SIMPLIFICATION, PURSUANT TO SECTION 8022(3)(B) OF
THE INTERNAL REVENUE CODE OF 1986 (Comm. Print 2001).
3. William Gale & Benjamin Harris, Tax Simplification: How Costly Is Complexity?,
TAX POLICY CTR., http://www.taxpolicycenter.org/briefing-book/improve/simplification/
cost.cfm (last updated Dec. 14, 2007) (reporting and extrapolating from other studies).
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items omitted from these returns in order to determine eligibility to
file them.4 Computerized tax preparation services save on computation time (at a cost), but still require the entering of all relevant data
and (often) the plowing through of checklists relating to numerous
obscure deductions and tax credits. Ownership of rental property (or
property partly devoted to business use) alone adds significantly to
taxpayer burdens.5 Complex and data-heavy tax returns also place
burdens on government enforcement agencies.
A second aim of simplification is to render taxpayers’ perception of
the federal income tax as being internally coherent, and not as a
Christmas tree showering an array of goodies (and baddies) to the
highest (and lowest) bidders. Simplification is offered here as a “good
government” project that would increase taxpayer morale and compliance rates through improved transparency and comprehensibility.
A third aim would be to reduce dispute-resolution costs. The way
to further this aim is to clarify borderlines and reduce (where possible) the necessity for factual inquiries.
The opposite of simplification is complexity, and complexity in
turn partly results from the dynamics of political economy, which
produces a legislative output wherein it is easier to deliver government programs through the tax system (sometimes referred to as
“tax expenditure” provisions) as opposed to the “normal” means of
direct federal subsidies or regulation. Politics also dictates that provisions benefitting political constituencies be numerous (perhaps to
the point of overlap and duplication) and salient,6 whereas provisions
cutting back on taxpayer benefits be obscure and backhanded.7 Addi4. The Form 1040-EZ is for joint and single filers with no dependents, who have no
investment income (other than up to $1500 of interest income), no business, rent, or royalty
income, and who do not itemize. Form 1040EZ: Income Tax Return for Single and Joint
Filers with No Dependents, INTERNAL REVENUE SERVICE (2012), available at
www.irs.gov/pub/irs-pdf/f1040ez.pdf. The Form 1040-EZ includes a line for the earned income credit (EIC), which requires a worksheet computation. Id. The Form 1040-A is a two
page form that resembles the Form 1040 but with no schedules (except possibly Schedule B
and Schedule 8812) and certain deductions and credits omitted. Form 1040A: U.S. Individual Income Tax Return, INTERNAL REVENUE SERVICE (2012), available at
www.irs.gov/pub/irs-pdf/f1040a.pdf. These forms may lull taxpayers into ignoring relevant
items (income, deductions, and credits) that should be reported and which might well reduce net tax liability.
5. Such property entails computation of depreciation, allocation of deductions to
rental or business activity, and disallowance (or limitation) under I.R.C. §§ 183, 280A,
280F, 465, 469.
6. For a public choice theory “take” on tax legislation, see Richard L. Doernberg &
Fred S. McChesney, Doing Good or Doing Well?: Congress and the Tax Reform Act of 1986,
62 N.Y.U. L. REV. 891 (1987) (book review).
7. For example, instead of repealing the itemized deductions, said deductions are
diluted by floors (see I.R.C. §§ 67, 165(h), 213(a)), ceilings (see id. § 170(b)), phase-outs (see
id. § 68), and overlays (the Alternative Minimum Tax, see id. §§ 55(a), 56(b)(1)). See also
statutes cited supra note 5 for provisions diluting deductions with regard to rental or business use of property.
2013]
SIMPLIFICATION PROPOSALS
75
tionally, certain groups possess a vested interest in tax complexity.8
This Article, however, does not address the political obstacles to simplification. Nevertheless, certain simplification measures proposed
herein might be immune from one or more of the political dynamics
just described.
At the technical level, complexity in tax is mostly driven by a faith
in “accuracy.” Accuracy is in part a function of one’s preferred concept
of income. Thus, if one thinks that “income” requires adjustment for
such items as sales taxes, casualty losses, medical expenses, unrealized gains and losses, imputed income, and off-market benefits, then
the computation of the tax base becomes more complex than in the
absence of such adjustments. Many of these adjustments are justified
under the framework of welfare economics (“welfarism”), which posits
that the tax base should be adjusted directly or indirectly (through
proxies) for non-market changes in individual utility or well-being.
However, a comprehensive welfarist tax system is impossible (apart
from political resistance to a welfarist state), because welfarism ultimately refers to individual subjectivity. Determinations of subjective states entail enormous transaction costs and are unreliable.
Proxies for subjective states are crude and insufficient. Finally, welfarist adjustments to the tax base are piecemeal. 9 A partial and
flawed welfarist tax base must be unfair in terms of taxing “likes”
(even in terms of well-being) alike.
Accuracy also entails a belief that even realized changes in wealth
can be accurately accounted for, i.e., that capital expenditures can be
distinguished from expenses, that depreciation and capital recovery
can be accurately measured, that costs of income production can be
distinguished from costs of personal consumption, and that accrual
accounting is more accurate than cash accounting. 10 The mere list of
these issues conjures up complex Code provisions and issues of a factual nature that are frequently disputed and litigated.
8. See Liz Day, How Maker of TurboTax Fought Free, Simple Tax Filing, PROPUBLI(Mar. 26, 2013, 4:00 A.M.), http://www.propublica.org/article/how-the-maker-ofturbotax-fought-free-simple-tax-filing; Evan Halper, Maker of Tax Software Opposes State
Filing Help; The Government’s Offer to Fill Out Forms Is a Hit with Poor and Elderly, but
Not with Intuit, L.A. TIMES, May 5, 2006, at A1.
9. The exclusion for physical personal injuries, I.R.C. § 104(a)(2), is a good example
of a piecemeal welfarist tax provision, tied to the objective fact of a monetary recovery.
Non-compensated injuries do not (and practically could not) give rise to reductions in the
tax base.
10. Accounting for changes in wealth could, in theory, be rendered accurate under a
mark-to-market (“accretion”) income tax, but only if valuation itself is accurate—an unattainable goal. In the case of unique assets, accurate valuation is an illusion: only an actual
sale can reveal what a willing buyer would pay to a willing seller. An accretion income tax
does not exist anywhere on the globe, and the chance that it would be enacted in the United States appears remote.
CA
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At some point, accuracy is not worth the effort. 11 Simplicity requires that the individual income tax base be constituted by objective
outcomes (not estimates or conjectures) that can be attributed to individual taxpayers without government intrusions into personal privacy. That is, market transactions (outcomes) should be the data set
for figuring the tax base of individuals.
Simplicity also possesses a cognitive aspect, as distinguished from
a mechanical aspect. What is desirable is an internally coherent tax
base principle that relates to the taxation function of raising revenue.
The principle should be graspable by non-sophisticated individual
taxpayers. The principle that is most compatible with mechanical
and cognitive simplicity—as well as substantive tax fairness—is
what I call “objective ability to pay” (as distinguished from a “utility”
concept of sacrifice), determinable on an annual basis. This principle
translates into an income tax base constituted by net realized increases in wealth (disregarding realized decreases in wealth that are
not costs of income production). However, the task of justifying and
elaborating upon the concept of an objective ability-to-pay tax base is
a separate project in itself, and accordingly this Article will generally
attempt to maintain a primary focus of simplification without pushing a particular tax reform agenda.
III. SIMPLIFICATION WITHOUT REFORM
The proposals discussed below do not, in the main, entail significant policy or revenue-driven changes. Familiar “tax reform” options
that would advance the simplification agenda are discussed in Part
IV. Items that appear to serve no purpose at all are discussed in
this Part.
A. Taxpayer Relief from Arithmetic
Since the IRS performs the necessary calculations in reviewing
returns, taxpayers should be allowed to forego this task (in whole or
in part), if they so desire. A taxpayer would be allowed to attempt the
calculations herself for informational purposes. 12
11. See generally Louis Kaplow, Accuracy, Complexity, and the Income Tax, 14 J.L.
ECON. & ORG. 61 (1998) (assuming that accuracy entails complexity, and providing framework for a trade-off between simplicity and accuracy).
12. A more comprehensive version of this approach is the pro-forma return; the government itself prepares a tax return, reviewable by the taxpayer, in which all known thirdparty data is entered, with the government performing the tax calculation. See, e.g., Joseph
Bankman, Simple Filing for Average Citizens: The California ReadyReturn, 107 TAX NOTES
1431 (2005).
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SIMPLIFICATION PROPOSALS
77
B. Checklists for Tax-Benefits Eligibility Requirements
Where possible, the eligibility requirements for a tax benefit
should take the form of a checklist allowing a “yes” or “no” answer for
each eligibility requirement. These checklists would mostly be located in the instructions to the Form 1040 and other schedules and
forms, and would render these instructions more user-friendly.
C. Tax Credits to be “Off Tax”
Tax credits for individuals (other than the foreign tax credit and
credits for income taxes already paid by the taxpayer) are government subsidies. As subsidies delivered by the IRS, these credits
should be dealt with on a separate page of the return or otherwise
clearly separated (or even detached) from the tax calculation itself.
Subsidy-type credits should not be labeled as “reductions in tax liability” or “tax credits,” but instead they should be called “federal government payments” that happen to be obtainable as an adjunct to
filing a federal income tax return.
Additions to tax liability can take the form of other federal taxes,
tax-related interest, fines, penalties, and refunds of excessive tax
credits,13 and should be similarly segregated from the computation of
the income tax.
D. Rate Schedules
Since the rates and brackets involve political decisions, no opinion
is advanced herein as to the rate schedules themselves. Nevertheless,
it can be observed that moving to a single rate (or to fewer rate
brackets) is not, by and large, a significant simplification move in itself, especially if taxpayers are not required to perform calculations.
E. Subsistence Income
Subsistence income should not be taxed,14 but exempting subsistence income can be done in a much simpler fashion than under current law. Since subsistence levels appear to vary only with the size of
a household, a simple table could be designed to set out the subsistence allowance per size of household.
13. Additions to tax are labeled “Other Taxes” on page 2 of the Form 1040. Form
1040A: U.S. Individual Income Tax Return, supra note 4, at 2.
14. Income up to the subsistence level is unable to contribute to the government under
liberal political theory. The centerpiece of a super-simplification proposal made in Michael
J. Graetz, Essay, Taxes That Work: A Simple American Plan, 58 FLA. L. REV. 1043 (2006),
is to raise the exemption level of the income tax far above the subsistence level to $100,000
(or more) and to make up the lost revenue through a value-added tax, which is a tax on
business activity. This Article assumes that no significant new federal tax would be enacted, so that simplification would be confined to the individual income tax, where the notion
of off-the-bottom allowances has been widely accepted.
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1. Eliminate the Standard Deduction
The standard deduction (roughly $6000 per individual) 15 serves
two purposes that can be better carried out separately. The first
function is to constitute, along with the personal exemption (roughly
$4000 per individual), 16 a universal low-income allowance; but this
function can be better served by increasing the personal exemption
itself. The second function is to provide a floor under “itemized deductions” as a group,17 which (1) eases accounting burdens and (2)
avoids duplication with the off-the-bottom allowances. However,
this function can be performed better by separate floors under
certain deductions.
2. The Personal Exemption Amount
The personal exemption amount should approximate the subsistence level of income for a household consisting of one individual. A
starting point for calculating subsistence levels is the official poverty
level, but that amount could be rounded up and adjusted to take into
account such universal costs as state, local, and gasoline taxes and
the cost of medical care. A reasonable figure (for 2014) might be
$12,000 for an unmarried individual.
An issue is what the personal exemption amount should be for
married couples under the present system, which allows married
couples to file joint returns for aggregate taxable income. Statistics
indicate that the subsistence level is a function of the number of persons in a common household, and does not depend on the age of
household members or whether the “second” member of the household is married to the “first” member.18 Proceeding on the (optimistic)
assumption that the tax law is to be adapted to the household concept, then, if the personal exemption for an individual is set at
15. The standard deduction for 2013 eliminated tax on the first $12,200 of taxable
income for a married couple filing jointly, $6100 for an unmarried individual (or married
person filing separately), and $8950 for a “head of household.” Rev. Proc. 2013-15, 2013-5
I.R.B. 444, 447-48.
16. In 2013, the personal (and dependency) exemption amount was $3900 per individual. Id. at 448. Both the standard deduction amounts and the personal (and dependency)
exemption amounts are indexed for inflation, resulting in increased amounts from year to
year.
17. An individual takes the greater of (1) the standard deduction, see I.R.C. § 63(c), or
(2) aggregate allowable itemized deductions, but not both. Id. § 63(b). The term “itemized
deductions” means deductions other than (1) the standard deduction, (2) deductions listed
in § 62 that are taken in arriving at adjusted gross income, and (3) the deductions for personal and dependency exemptions allowed by § 151. Id. § 63(d).
18. For 2013, the official (rounded off) poverty level as determined by the U.S. Department of Health and Human Services was $11,490 for an individual, increasing by
roughly $4800 for each additional family member. Annual Update of the HHS Poverty
Guidelines, 78 Fed. Reg. 5182-83 (Jan. 24, 2013).
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SIMPLIFICATION PROPOSALS
79
$12,000, a reasonable figure for a married couple living together
would be $18,000.
The scheme suggested immediately above might be politically “off
the table” on the ground that it would be perceived as reintroducing a
marriage penalty, 19 but this perception would be inaccurate if unmarried, committed couples occupying the same household were
treated as being married. 20 In any event, if it is politically necessary
that the personal exemptions for a married couple be twice that of an
unmarried individual, plausible exemption amounts for 2013 would
be in the neighborhood of $20,000 for a married couple and $10,000
for an unmarried person.
3. Dependency Exemption Amounts
The purpose of the dependency exemption is to allow for the costs
of supporting dependents. Accordingly, the dependency exemption
should be a lesser amount than the augmented personal exemption
for a single-person household, because the dependent is free of having to maintain a household. The current dependency exemption
amount (roughly $4000) is almost the same as what the poverty-level
statistics suggest is appropriate, but (again) the poverty level amount
would only be a starting place for obtaining an appropriate figure. 21
A person claimed as a dependent by another should have a zero
personal exemption. A personal exemption on top of the income exclusion for support received by the dependent entails a double tax
benefit for subsistence to the same taxpayer. The dependency exemption, coupled with the exclusion for support received and the loss of
the dependent’s personal exemption, effectively shifts the dependent’s tax existence to that of the support provider, except for the dependent’s separate economic activity.
4. The Definition of “Dependent”
The tests for determining “dependent” status that involve “support
provided” (by the dependent or the claimant, as the case may be),
relative to total support,22 are unworkable. 23 The relevant distinction
19. Currently, the standard deduction for a married couple is twice that for an unmarried individual. See supra note 15.
20. Two unmarried taxpayers maintaining separate households would have aggregate
personal exemptions of approximately $18,000, but that would presumably be justified by
the fact that separate households are being maintained.
21. Annual Update of the HHS Poverty Guidelines, supra note 18, at 5183.
22. I.R.C. § 152(c)(1)(D) (“qualifying child” must not provide more than one-half of
own support), (d)(1)(C) (“qualifying relative” must receive more than one-half of support
from claimant).
23. Support for this purpose includes economic resources that are not gross income
and that often take the form of in-kind room, board, and other items, and exclude items
that are not spent on living costs. These facts are intrinsically hard to ascertain, are not
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should be between dependents living in the taxpayer’s household
(“household dependents”) and those that are not (“other dependents”). A person living in the taxpayer’s household should be deemed
to be a household dependent 24 unless she (a) is not within a specified
degree of relationship (or registered domestic partner), 25 or (b) has
“income” above a certain threshold amount. 26 For this purpose, the
income threshold amount should be an amount greater than the dependency exemption amount, but certainly not greater than the personal exemption amount.
To be an “other dependent,” the person should be required to satisfy a somewhat stringent “relationship” test. Additionally, the claimant must have provided, by cash transfers or payments,27 an amount
that exceeds the greater of the exemption amount or the putative dependent’s “income.” Finally, the person would be disqualified if (a)
she is an owner of her place of abode or (b) her “income” exceeds the
personal exemption amount.
An issue is how “income” should be defined for each category of
dependent. A possible construct would be “adjusted gross income”
(AGI), plus the untaxed portion of Social Security retirement benefits
and excluded interest, personal injury recoveries, non-taxable distributions from trusts and estates, and amounts received on account
of disability.
5. Eliminate the Child Tax Credit
This ($1000 per qualifying child) tax credit, 28 which appears to be
simple on its face, is complicated by phase-out rules, the linking of
refundability to the taxpayer’s earned income over $3000, and its interaction with other tax credits. The purported rationale is to augment the dependency exemptions (but only for children under the age
of seventeen living in the taxpayer’s household), 29 but circumstantial
public, and cannot be provided by disinterested third parties.
24. The idea is that the claimant should be deemed to have supplied value at least
equal to the dependency exemption amount.
25. The purpose here is to weed out persons who cohabit for convenience or pleasure.
26. The purpose here is to weed out persons who are basically self-supporting.
27. If the taxpayer allows the putative dependent to live in a dwelling owned by the
taxpayer (other than the taxpayer’s residence), the taxpayer can be deemed to have spent
cash on the dependent at the rate of, say, 5% of the dwelling’s cost.
28. I.R.C. § 24(c).
29. The legislative history states only:
The Committee believes that the individual income tax structure does not reduce tax liability by enough to reflect a family’s reduced ability to pay taxes as
family size increases. In part, this is because over the last 50 years the value of
the dependent personal exemption has declined in real terms by over one-third.
The Committee believes that a tax credit for families with dependent children
will reduce the individual income tax burden of those families, will better recognize the financial responsibilities of raising dependent children, and will
2013]
SIMPLIFICATION PROPOSALS
81
evidence suggests that this credit is a kind of federal “workfare” supplement for the working poor with dependent children. 30 The credit is
a wasteful squandering of government revenues to the extent that it
does not allow for, or subsidize, incremental costs of child care. The
aims of this credit can better be accomplished by (1) aligning the dependency exemption amount with the amount necessary to support a
household dependent 31 and (2) providing tax credit(s) for the working
poor with children. 32
F. The Working Poor
1. No Separate Rate Schedules for Unmarried Individuals and
Heads of Household
The existing system providing for four categories of filing status
can be easily reduced to two, namely, married couples filing jointly
and everyone else.
The current rate schedule for an unmarried individual is the same
as for a married person filing separately up to a taxable income of
about $75,000, but, above that level, two unmarried persons with
evenly split incomes (and living together) pay less tax than a married
couple filing jointly having the same aggregate income.33 This disparity could influence marriage decisions of high-income couples. The
disparity is presumably based on economies of scale available to married couples. However, marriage status is an extremely crude indicator of economies of scale. Moreover, it is hard to justify implicit (incremental) cost-of-living allowances at high-income levels. Indeed,
cost-of-living differentials that result from taxpayer choice, apart
from being inscrutable to being measured on a case-by-case basis,
promote family values.
H.R. REP. NO. 105-148, at 310 (1997). The stated rationale suggests a deduction rather
than a credit. The credit has since been liberalized so as to be available for a “qualifying
child” (the taxpayer’s descendant, sibling, or sibling’s descendant) living in the taxpayer’s
household but under the age of seventeen. See I.R.C. § 24(c)(1) (referencing id. § 152(c)).
30. The existing federal cash-transfer program for families with dependent children is
Temporary Assistance for Needy Families (TANF), which replaced the Aid for Dependent
Children (AFDC) program in 1997, the same year that the child tax credit was enacted. See
Personal Responsibility and Work Opportunity Reconciliation Act of 1996, Pub. L. No. 104193, 110 Stat. 2105. TANF is designed to encourage welfare recipients to enter the workforce, and the child tax credit is refundable only if (and as) earned income (wages) exceeds
$3000. See 42 U.S.C. § 601 (2006); I.R.C. § 24(d)(1), (d)(4). Since the benefit level of TANF
is largely decided by the states, the child tax credit amounts to a federal supplement to
TANF.
31. See supra pp. 6-7.
32. See infra pp. 8-11.
33. See I.R.C. § 1(c), (d), (f)(8), and the rate tables for 2013, published in Rev. Proc.
2013-15, 2013-5 I.R.B. 444, 445 (showing a divergence above a taxable income amount of
$73,200).
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should (arguably) not be taken into account at all.34 Certainly, any
adjustments of this sort would complicate the system. Thus, the rate
schedule for unmarried persons—which has already been partially
repealed—should be wholly eliminated, so that the same rate schedule would apply both to unmarried individuals and to married individuals filing separately.
A head of household is an unmarried individual with one or more
dependents living at home. 35 Both the head-of-household rate schedule 36 and the head-of-household standard deduction 37 are more favorable than that of an unmarried individual (but not as favorable as for
a married couple filing jointly). No reason exists for taxing uppermiddle-class (and wealthy) individuals at favorable rates just because
they have one or more live-at-home dependents, or for why the first
dependency exemption should (in effect) be significantly greater for
an unmarried person with a live-at-home-dependent relative to other
taxpayers with a dependent. 38 The legitimate aim of the special rate
schedule to account for incremental work and child-care costs can be
better accomplished by some increase in the dependency exemptions
and a tax allowance for working taxpayers with live-at-home dependents (see item 3 below).
2. Replace the Child Tax Credit, the Earned Income Tax Credit,
and the Household and Dependent Care Credit with a Single Dependent Care Allowance
The child tax credit is not linked to any costs of child care over
and above the routine support that is already deducted by reason of
the dependency exemptions.39 The earned income credit (EIC) 40 is
extremely complex and serves two goals—refunding part of the payroll tax and subsidizing the working poor with dependents—that can
better be accomplished separately. The household and dependent
care credit 41 has a clear enough purpose, but it (uniquely) requires
34. See Calvin H. Johnson, The Inequities in Cost of Living Adjustments, 28 A.B.A.
SECT. TAX’N NEWS Q. 24 (2009); Michael J. McIntyre & Oliver Oldman, Taxation of the
Family in a Comprehensive and Simplified Income Tax, 90 HARV. L. REV. 1573 (1977). In
welfarist terms, adjustments for higher costs of living are incoherent, because the incremental monetary costs are incurred voluntarily to obtain higher non-monetary benefits.
35. I.R.C. § 2(b).
36. Id. § 1(b).
37. The head-of-household standard deduction is $8950 for 2013, compared to $6100
for other individuals. Rev. Proc. 2013-15, 2013-5 I.R.B. 444, 448 (2013).
38. A non-itemizing head of household with one dependent effectively obtains approximately an extra $3000 of allowance off the bottom relative to other taxpayers (for 2013,
the precise amount is $2850, the difference between standard deductions of $8950 and
$6100). See id.
39. Thus, single-earner couples obtain a windfall: a subsidy for non-existent (or wholly
discretionary) expenses, such as private schooling.
40. I.R.C. § 32.
41. Id. § 21.
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accounting for eligible costs, confers an unwarranted subsidy for
high-income taxpayers while (as a nonrefundable credit) being useless for low income individuals, and is overly broad in allowing tax
benefits for discretionary personal household expenses (e.g., housekeeping costs). All of these credits are keyed to wage income while
being subject to phase-out or cut-back rules, indicating that they are
aimed at those low-to-moderate income households with a wageearner and live-at-home dependents. The phase-out rules for the EIC
are especially complex and kick in at low amounts of earned income
(or AGI), rendering compliance difficult for that portion of the population that is likely to be poorly educated.
First, a refundable credit should be available for wage earners
equal to the Social Security tax rate (currently 6.2%) times earned
income up to, say, $10,000, for a maximum credit of $620.42 This credit (the Wage Earner Credit, or WEC) would not be conditioned on
having household dependents, but would be subject to the same
phase-out rule as the Household Dependent Allowance (HDA),
described below.
Since dependency exemptions would already allow for the “normal” cost of supporting dependents, any additional tax benefits
should be keyed to the incremental costs of caring for household dependents where the taxpayer is unable to provide the care herself by
reason of being disabled or employed. 43 Thus, to be eligible for this
allowance (the HDA), the taxpayer must be disabled or a full-time
student, or must have worked more than, say, 1200 hours during the
year. If the eligible taxpayer is married (broadly defined), the spouse
must be disabled, a full-time student, or must also have worked the
same minimum total hours. Additionally, the taxpayer must have at
least one dependent living at home for more than, say, half the year.
The live-at-home dependent should occupy a specified degree of relationship to the taxpayer and be under a certain age, disabled, or over
a certain age.
Design issues for the HDA abound. First, should the allowance
take the form of a deduction or a tax credit? In internal-to-tax terms,
any allowance off the bottom or cost of earning income should take
the form of a deduction. The opposing view is that the allowance
should be viewed as a government subsidy for part of the costs of in42. Topic 751 – Social Security and Medicare Withholding Rates, IRS.GOV,
http://www.irs.gov/taxtopics/tc751.html (last updated Oct. 23, 2013). This is similar to the
Making Work Pay credit of I.R.C. § 36A, which has expired. Also, the credit should not
exceed the Social Security taxes actually paid.
43. THE PRESIDENT’S ADVISORY PANEL ON FED. TAX REFORM, SIMPLE, FAIR, AND PROGROWTH: PROPOSALS TO FIX AMERICA’S TAX SYSTEM 60 (2005), available at
http://govinfo.library.unt.edu/taxreformpanel/final-report/TaxPanel_5-7.pdf, proposed a
Family Credit (without phase-out) for taxpayers with certain amounts or types of income
and a separate Work Credit (with phase-out).
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cremental dependent care and that a refundable tax credit delivers a
uniform subsidy that is not a function of the taxpayer’s marginal tax
rate. Indeed, a deduction is worthless to a taxpayer having a net income below the “standard” low-income allowances. On the other
hand, a refundable tax credit requires the filing of a tax return where
one would not otherwise be required.44 Since the HDA would replace
tax credits, the HDA would also presumably take the form of a
tax credit.
The eligibility requirements would be a virtual guarantee that eligible costs are incurred. Therefore, it would not be necessary to account for actual costs of incremental dependent care. Accordingly, an
eligible taxpayer would be entitled to a refundable tax credit of, say,
$6000 (40% of $15,000) for the first eligible dependent, with decreasing amounts for a second dependent (say, $4000), and third dependent (say, $2000). A credit of $6000 compares with the sum of: (1) a
child tax credit of $1000, (2) a household and dependent care credit of
$3000, 45 and (3) a $3250 (in 2013) credit for the first dependent under
the EIC.46
Both the HDA and the WEC should be phased out at a uniform
rate above, say, $50,000 of AGI. 47
G. The Taxable Income Computation
The task of calculating the taxable income of individual taxpayers
is unnecessarily convoluted and can be simplified under the proposals set forth below.
1. Equal Status Among Deductions
The distinctions among various categories of deductions (§ 62 deductions, itemized deductions, and miscellaneous itemized deductions) 48 pose unnecessary (and confusing) line-drawing issues, complicate the taxable income computation, 49 and obfuscate the simple
notion that taxable income equals gross income less deductions.
44. An individual income tax return is required only if gross income exceeds the sum
of the personal exemption amount and the standard deduction amount. I.R.C. § 6012.
45. Id. § 21(c). This credit cannot exceed $6000 in the aggregate, however.
46. Id. § 32(b). In 2013, the maximum incremental credit for a second dependent was
$2122 and for a third dependent was $672, but no additional amounts were allowed for
additional dependents. See Rev. Proc. 2013-15, 2013-5 I.R.B. 444, 445 (maximum EIC for a
taxpayer with one, two, or three qualified children).
47. Taxpayers with substantial income have the option of providing home care themselves. Stated differently, above a certain income level, paying for dependent care becomes
a lifestyle choice. Finally, if the allowance takes the form of a tax credit, then it is wasteful
to subsidize taxpayers with substantial incomes.
48. I.R.C. §§ 62(a), 63(d) (itemized deductions), 67(b) (miscellaneous itemized
deductions).
49. Aggregate miscellaneous itemized deductions are subject to a 2% floor, id. § 67(a),
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As noted above, the standard deduction would be removed, eliminating a major reason for having a separate category of itemized deductions. All deductions (including the personal and dependency exemptions) would be allowed in full, without phase-out rules. Floors
and ceilings would attach only to certain specified deductions. Such
floors and ceilings would be computed with reference to “net income,”
meaning gross income reduced by the deductions (other than the personal and dependency exemptions) not subject to any floor.
2. Personal Deductions Subject to Floors
The purpose of the floors under the personal deductions is to eliminate duplication with costs already deemed to be covered by the personal and dependency exemptions, so that only extraordinary costs
within a certain category are eligible for additional deduction. Floors
already exist under the deductions for personal casualty losses 50 and
for medical expenses.51 It is appropriate to consider a floor under
each of the remaining personal deductions, but the issues of repeal of
and/or floors under the personal deductions are deferred to Part IV.
3. Deduction Phase-Out Rules
Deduction phase-outs create hidden tax rate bubbles that lack
transparency and cannot be justified under any theory of progressivity. 52 Deduction phase-outs require the filling out of a worksheet. In
contrast, tax credits that are subsidies for the non-wealthy are appropriately circumscribed by phase-outs. It is not inappropriate to
require a taxpayer eligible for a government subsidy to expend some
effort to obtain it.
4. The Proper Function of the AMT
The Alternative Minimum Tax (AMT) was originally designed to
reach high-income taxpayers who paid no or little tax on account of
“excess” deductions. 53 The current AMT appears to be a kind of ad
hoc revenue raiser that bears no relationship to any normative concept of income, but instead, for most individual taxpayers, operates
as a sort of “stealth” partial repeal of certain itemized deductions.54
and itemized deductions are subject to a phase-out rule (up to 80% thereof), id. § 68, as well
as being effectively disallowed unless the aggregate amount thereof exceeds the standard
deduction. See Form 1040A: U.S. Individual Income Tax Return, supra note 4.
50. I.R.C. § 165(c)(3), (h).
51. Id. § 213.
52. The American Taxpayer Relief Act of 2012, Pub. L. No. 112–240, 126 Stat. 2313
(2013), revived phase-out rules for the personal and dependency exemptions, I.R.C.
§ 151(d)(3), and for aggregate itemized deductions, id. § 68.
53. See H.R. REP. NO. 91-413, at 4628 (1969).
54. The AMT disallows, inter alia, the standard deduction, personal and dependency
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On the merits, if a deduction is justified in the first place—
particularly as it records a reduction in a taxpayer’s ability to pay—
no justification exists for reducing or eliminating the deduction explicitly or implicitly. The same end can be attained by other (and
more transparent) means, such as the repeal of unwarranted deductions, the imposition of floors, and the foreclosing of avenues of
abuse, as is considered in Part IV. Ceilings appear to be appropriate
only in the case of wholly “discretionary” personal deductions, but the
only such deduction that is truly discretionary appears to be the
charitable deduction,55 which is already subject to a ceiling.56
The AMT could be reformed to better accord with its original purpose, 57 but that is not a simplification issue.
H. Social Security Retirement Benefits
The existing rules governing the inclusion in income of Social Security retirement benefits 58 are so complex that a worksheet is
required to figure out the taxable amount. 59 Also, the rules appear
to be disconnected from any theory of partial exclusion. Yet a
taxable amount can be figured by viewing the benefits as entailing
a recovery of (all or a portion of) 60 nondeductible contributions (Social
Security taxes). 61 A person’s contribution history is contained in computerized records of the Social Security Administration (SSA), and
this history is periodically mailed to individuals eligible to receive
retirement benefits.
exemptions, state and local taxes, allowable miscellaneous itemized deductions, interest on
home equity loans, and a portion of the medical expense deduction. See I.R.C. § 56(b). The
first two of these are a trade-off for the generous AMT exemption amounts (in 2013,
$80,800 for married couples filing jointly and $51,900 for unmarried individuals), I.R.S.
News Release IR-2013-4 (Jan. 11, 2013); but perhaps the exemption amounts should be
raised somewhat. For a critique of the AMT, see Linda M. Beale, Congress Fiddles While
Middle America Burns: Amending the AMT (and Regular Tax), 6 FLA. TAX REV. 811 (2004).
55. I.R.C. § 170. Self-inflicted casualty losses are not deductible at all, id. § 165(h)(4),
the mortgage interest deduction is limited to two residences (and contains ceilings on principal debt), id. §§ 67(b), 163(h)(4), and the medical expense deduction excludes costs of
most cosmetic surgery, id. § 213(d)(9). Nevertheless, further restrictions on abuse of these
deductions are considered infra Part IV.
56. Id. § 170(b).
57. The current AMT disallows the exclusion for the exercise of “incentive stock options” but leaves out of account the capital gains preference (which currently is neither an
exclusion nor a deduction), as well as § 103 (tax-exempt) interest (except with respect to
private activity bonds). Id. § 56(b)(3).
58. Id. § 86.
59. Form 1040: Social Security Benefits Worksheet—Lines 20a and 20b, IRS.GOV
(2013), http://apps.irs.gov/app/vita/content/globalmedia/social_security_benefits_worksheet
_1040i.pdf.
60. An issue is whether such basis should be reduced to account for the share of Social
Security taxes used to fund the Social Security disability program.
61. An alternative simplification/reform option would be to allow a deduction for taxes
paid, with inclusion of the full amount of benefits. This approach would presumably be off
the table on account of current revenue considerations.
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The basis recovery system can be modeled on (a) a recovery-ofbasis-first system, (b) the annuity rules of I.R.C. § 72, or (c) the tax
treatment accorded to mortgage loans.62 Since the SSA has all the
requisite information, it would be able to send a computer-generated
tax information return to both the IRS and the taxpayer indicating
the taxable portion of benefits.
I. Educational Tax Benefits
The multiple tax benefits for higher educational expenses variously take the form of deduction, exclusion, tax credit, and exempt
trust.63 All these provisions contain overlapping definitions of qualified educational expenses, 64 and most of them contain needs tests and
maximum benefit limitations. Those that do not contain needs tests
and limitations on benefits (the scholarship exclusion and state tuition programs) essentially amount to exclusions for higher education
obtained at a bargain price. Gift-financed education is tax-free by
reason of § 102(a). 65
At a minimum, a universal definition of qualified higher education
costs should apply for all purposes. Similarly, a universal needs test
(phase-out for high income taxpayers) should apply in all cases in
which the tax benefit is contingent on need.
J. Borderline Personal/Business Deductions
Categorical rules for sorting out borderline tax issues are preferable, in administrative-efficiency terms, to fact-intensive case-by-case
determinations.
1. Marginal Business and Investment Deductions Generally
Current § 67 disallows “miscellaneous itemized deductions”
(MIDs) to the extent of 2% of AGI.66 An MID is an “itemized deduction” that is not listed in § 67(b). 67 This “anything not on the approved list” rule has deprived taxpayers of rightful deductions in unanticipated circumstances, such as plaintiff transaction costs in ob62. Any unused basis of a deceased individual would carry over to persons receiving
Social Security survivor benefits. Unused basis would simply expire.
63. See I.R.C. §§ 25A (Hope and Lifetime Learning Credits), 117(a) (qualified scholarships), 221 (interest on education loans), 222 (qualified tuition and related expenses), 529
(qualified tuition plans, known as QTPs), and 530 (Coverdale education savings accounts,
known as ESAs). Additionally, educational employee fringe benefits are provided for by
§§ 117(d) and 127.
64. QTPs can uniquely provide for room and board costs. Id. § 529(e)(3)(B). ESAs can
uniquely provide for pre-college education. Id. § 530(b)(2)(A)(ii). These features are hard to
justify on policy grounds.
65. Id. § 102(a).
66. Id. § 67(b).
67. Id.
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taining includible damages recoveries and deductions allowed under
§ 183(b)(2), discussed immediately below. 68 Recall that, under the
proposal offered above, the category of “itemized deduction” would
be eliminated.
Instead, the floor should apply only to those specified deductions
(as a group) for which Congress deems that the connection of the expense to income production is tenuous. Leading candidates are unreimbursed employee deductions and “investment” deductions that are
only indirectly connected to income production and that typically involve small amounts. Indeed, to supplement such a percentage-ofAGI disallowance rule, consideration could be given to simply disallowing small-amount (say, under $200) borderline items, such as
subscription costs to the Wall Street Journal. 69
2. Business Meal Costs
Costs of consuming food and beverages are inherently personal
and should be disallowed in full, except where the consumption is
directly related to an active business of the taxpayer (such as being a
food critic or a professional food preparer). 70
In the case of employer-reimbursed business meals, the employer
is the real spender, and, since it is not consuming the meals itself,
should not be subject to the existing 50% disallowance rule,71 which
is meaningless in the case of employers that are exempt from income
tax. Any perceived abuse in this area can be dealt with by deeming
reimbursed employee meal costs (perhaps in excess of a specified per
diem amount) as additional compensation income of the employee.
3. Business Lodging Costs
Section 162(a)(2) currently allows a deduction for business-related
“away from home” lodging costs. 72 However, the doctrine relating to
the “away from home” requirement is confused and arbitrary.73 As
with food and beverage costs, costs of lodging are inherently personal
and should generally be denied unless clearly justified. One such exception would be reimbursement by an employer. (However, compensation that is disguised as a reimbursement should be treated as
68. See Jeffrey H. Kahn, Beyond the Little Dutch Boy: An Argument for Structural
Change in Tax Deduction Classification, 80 WASH. L. REV. 1 (2005).
69. Cf. I.R.C. § 165(h)(1) (allowing casualty losses only to the extent they exceed $100
per casualty).
70. Under current law, 50% of business meal costs are disallowed. Id. § 274(n)(1).
71. In an employer-reimbursement situation, the 50% disallowance rule falls on the
employer, not the employee. See id. § 274(n)(2)(A) (cross-referencing id. § 274(e)(3)).
72. Id. §162(a)(2).
73. E.g., JOSEPH M. DODGE ET AL., FEDERAL INCOME TAX: DOCTRINE, STRUCTURE, AND
POLICY 256-68 (4th ed. 2012) (describing this doctrine).
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compensation.) Another would be for core-of-the-business lodging
costs (say, of a travel writer). 74
Apart from the foregoing, a business deduction for lodging costs is
justified insofar as (1) a plausible business reason exists for maintaining at least one residence at the base location (such as being near
a place of work that is used for, say, at least sixty days a year), and
(2) a clear business reason also exists for the away-from-base-location
lodging. Spouses should be treated as separate taxpayers for this
purpose. The “second” lodging should be “away from home” in an objective sense, such as more than 100 miles from both the taxpayer’s
residence and her business office. These principles should operate to
ensure that only incremental (or duplicative) business-driven lodging
costs are deductible.
Using these criteria, the outcomes of certain recurring scenarios
would be resolved as follows:
(1) Husband and wife maintain homes in different locations to be
close to their respective business locations. No deduction would be
allowed for either residence because no business reason exists for one
spouse to reside in the other spouse’s residence.
(2) Itinerant business (salespersons, pro golfers and tennis players, entertainers). In most of these cases no business reason exists to
maintain a “base” home in any particular location, and therefore the
deduction for lodging costs would be denied.
(3) Two business locations of the same taxpayer (ongoing). Here a
business reason should exist for having separate residential locations. A ski instructor in Lake Placid should not be able to deduct
lodging costs in Naples, Florida, with respect to a computer consulting business that could be based anywhere.
(4) Non-recurring extended leaves and reassignments. No deduction should be allowed if the taxpayer’s family accompanies the taxpayer to the temporary job location, because in that case the taxpayer
can avoid duplicative housing costs by renting out the first home.
Otherwise, lodging deductions would be allowed only if (and so long
as) (1) the taxpayer has not changed employers (or has not been terminated), (2) has not purchased a home in the temporary location,
and (3) could reasonably expect to return to her base home location at
the end of the “away” period. However, “away from home” status
would expire at the end of the first full calendar year following the
year of taking up residence at the second location.
74. Such a business might be a not-for-profit activity under I.R.C. § 183, however.
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On no account should depreciation be allowed on a taxpayer’s
principal residence as defined in § 121, 75 because depreciation (by reducing basis) creates tax-favored gain.76
4. Not-for-Profit Activities
Section 183(a) disallows all deductions from “not-for-profit activities,” but § 183(b)(2) allows deductions to the extent of the income
from any such activity.77
(a) Accounting
Under present law, it is necessary to account for the costs giving
rise to the deductions that initially are allowed by § 183(b)(2), because at least some § 183(b)(2) deductions are then subject to disallowance as miscellaneous itemized deductions, and depreciation allowed under § 183(b)(2) reduces the basis of taxpayer-owned assets.78
Accordingly, depreciation must be calculated (and perhaps pro-rated
between personal and not-for-profit use), and then it needs to be determined what portion of the depreciation is allowed under
§ 183(b)(2) after considering other deductions allowable under
§ 183(b)(2). 79 Accounting for such depreciation and attendant basis
reductions is not worth the effort, especially in instances such as
hunting, fishing, prospecting, amateur artistic ventures, amateur
inventing, and sporadic renting of personal-use property.
Therefore, § 183 should be reconstituted so as to disallow depreciation (and other cost-recovery deductions) completely with respect to
any asset used in a not-for-profit activity. It follows that no basis adjustments would be required for such assets on account of depreciation (and cost recovery) deductions. Other income-production costs
would be allowed under § 183(b)(2) up to the amount of gross income
75. I.R.C. § 121(a) generally excludes up to $500,000 of gain on a taxpayer’s personal
residence, defined as a residence that the taxpayer has used as her primary residence for
730 days (“periods aggregating two years or more”) out of the last five years of ownership.
However, only gain attributable to principal residence use (after 2008) qualifies for the
exclusion. See id. § 121(b)(4). This rule renders it difficult to obtain full exclusions for more
than one residence of a taxpayer.
76. Under present law, the depreciation is allowed and the gain resulting from such
depreciation is included as unrecaptured § 1250 capital gain, subject to a maximum rate of
25% under § 1(h)(1)(D), rather than as excluded gain. Id. § 121(d)(6). It would be easier to
disallow the depreciation and forego the basis adjustments.
77. Actually, § 183(b)(2) allows deductions that would otherwise require a business or
investment nexus to the extent that the gross income from the activity exceeds deductions
(such as property taxes, mortgage interest, and casualty losses allocable to the activity)
that do not require a business or investment nexus. Id. § 183(b)(2). The principal effect of
this rule is to remove the personal deductions from the possibility of § 183(a) disallowance.
The secondary effect is to (possibly) reduce the deductions allowed by § 183(b)(2).
78. Id. § 1016(a)(2).
79. See Treas. Reg. § 1.183-1(b).
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from the activity (reduced by allowable personal deductions). Loss
carryovers should continue to be disallowed. The net effect of these
changes would be to simplify accounting greatly under § 183(b). In
most cases, § 183 would operate to allow the taxpayer simply to ignore income and deductions with respect to not-for-profit activities.
(b) Definition of “Not-for-Profit Activity”
The category of “not-for-profit activity”—which triggers § 183—
has been often narrowly construed by the courts to allow marginal
activities to operate as tax shelters.80 The factual nature of the § 183
inquiry encourages taxpayers to frequently litigate the matter 81 with
the knowledge that penalties are unlikely. The multi-factor test contained in the regulations 82 invites unpredictable judging. The
worst abuses in this area involve real estate used in farming and
ranching activities. 83
If the multi-factor approach is retained, § 183 should be amended
so that the possibility of appreciation in property used in, or which is
the location of, an activity shall not be taken into account as indicating a profit motive for the activity being scrutinized. Treating the appreciation potential of an asset used in a marginal activity as indicating that the activity itself is for profit is to let the tail wag the dog.84
Additionally, a stronger standard could be imposed for overriding
the presumption that an activity generating a series of losses is a
not-for-profit activity, such as one of “clear and convincing evidence.”
An alternative to the “factor” approach would be, as a default rule,
to treat any activity as a not-for-profit activity if (a) the activity is not
carried on through a C corporation, 85 (b) the activity involves any
meaningful element of what people normally consider to be pleasure
or recreation for the taxpayer, or (c) the activity involves use of a
taxpayer’s residence (a topic separately considered immediately below). Exceptions could be carved out, e.g., for activities that become
profitable for a certain period, that exceed a certain gross revenue
amount, that generate losses only because of favorable tax account80. See, e.g., Engdahl v. Commissioner, 72 T.C. 659 (1979), acq., 1979-2 C.B. 1; Fields
v. Commissioner, 1981 T.C.M. (P-H) 1981-550, at 2114 (1981).
81. Annotations of reported § 183 cases occupy seventy-four pages of Standard Federal Tax Reports. See 2013-4 Stand. Fed. Tax Rep. (CCH) ¶ 12,170 at 26,896-969.
82. See Treas. Reg. § 1.183-2(b) (listing nine factors).
83. Discussions of I.R.C. § 183 are found in ROBERT W. WOOD, 548-2ND TAX MANAGEMENT PORTFOLIOS: HOBBY LOSSES (2d ed. 2012); PAUL R. MCDANIEL ET AL., FEDERAL INCOME TAXATION 595-609 (6th ed. 2008).
84. Personal use of an appreciation-potential asset has always defeated loss and expense deductions apart from I.R.C. § 183. See, e.g., Austin v. Commissioner, 298 F.2d 583
(2d Cir. 1962). Section 183 was not intended to reverse prior law on this point. See I.R.C.
§ 183(c).
85. Losses of a C corporation are confined to the corporation and do not pass through
to individual shareholders.
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ing rules (such as expensing research costs), or that present other
objective indicators of a serious profit-making intention (such as acquiring technical expertise and serious marketing efforts).
5. Rental or Business Use of Personal Residence
Section 280A, dealing with business and rental use of a taxpayer’s
residence, not only potentially overlaps with § 183, 86 but it also resembles § 183 as to its operation, 87 save for the following variances:
(1) instead of a for-profit fact test, the triggering mechanism is the
objective one of non-residential (commercial) use of a taxpayer’s residence; 88 (2) for uses other than certain specified exclusive business
uses or rental use (for more than fourteen days), deductions (other
than personal deductions) are wholly disallowed; 89 (3) in the case of
the specified exclusive business uses or rental use, the allowed
amount is computed in the same way as under § 183 but with further
disallowance in an amount equal to activity deductions not attributable to such use, but with carry-forward of disallowed losses; 90 (4) certain rentals of a principal residence escape § 280A;91 and (5), if the
residence is rented for less than fifteen days, the gross rental income
is excluded and for-profit deductions disallowed. 92 Apart from the
statutory complexity of § 280A and its overlap with § 183, accounting
under § 280A is burdensome, and the “exclusive business use” test of
§ 280A(c)(1) cannot be enforced without governmental intrusions into
privacy. Residential property subject to significant personal use is
unlikely to depreciate on account of wear and tear, as the owner will
be strongly motivated to keep the property in good condition.
(a) Integrate the Rental Aspect of § 280A with § 183
In the case of a rental of a residence, the likelihood is that the
rental is a device to pay some of the costs of carrying property that
was primarily acquired for personal use, or to extract some cash for
what is basically a house-sitting function of the tenant. Under such
86. Not-for-profit rental or other activity in a personal residence could fall under both
provisions. Section 280A(f)(3) appears to say that the operating rules of § 280A take precedence but that non-profit years can count for purposes of the § 183 presumption. See I.R.C.
§ 280A(f)(3). Section 280A also potentially overlaps with § 469 (dealing with losses from
passive activities, including rental activities), and here again § 280A takes precedence. See
id. § 469(j)(10).
87. Personal deductions are not disallowed, id. § 280A(b), but they reduce the amount
that can be deducted (if at all) with respect to the use, id. § 280A(c)(5).
88. Id. § 280A(a).
89. See id.
90. See id. § 280A(c).
91. Id.
92. Id. § 280A(g).
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circumstances, it cannot be assumed that the rental is at arm’s
length for a market-rate rental.
Accordingly, the rental use of a residence of the taxpayer should
be treated as a per se not-for-profit activity, subject to the mechanical
rules of § 183(b), including the no-carryover rule and disallowance of
depreciation on buildings and furnishings.
The § 183 approach should not apply in cases where the personal
use is insignificant or a for-profit motive is likely to exist. Possible
scenarios deserving of an exception include: (1) rental for more than,
say, 300 days in a year at a fair rental, 93 and (2) personal use for less
than fifteen days a year coupled with at least 185 days of rental use
under management by a professional rental agent.
The existing rule that ignores both rental income and deductions
if rental use is less than fifteen days a year 94 is overly generous, as
very high daily rentals can be obtained in desirable locations and for
special events (such as the Olympic Games, bowl games, football
weekends, and the Santa Fe Indian Market). In the case of de minimis rental use, none of the costs of owning or maintaining the residence are truly related to the obtaining of rents, and therefore the
rents should be included with no offsetting deductions. Rents (and
deductions) should be ignored only if the rents are less than, say,
$500 a year.
(b) Disallowance of Deductions for Costs of a Residence Used in a
Business
Non-residential uses of a residence are likely undertaken out of
personal convenience, not business necessity, and (in most cases) it
could not be shown that the business-use space within the residence
would not have been acquired for personal reasons. The “exclusive
business use” test is unenforceable, as the typical home office can also serve as a media room, a den, a library, an extra bedroom, and a
place for personal computing and bill paying. However, the mechanical rule of § 183(b) does not make sense here because costs allocable
to the residence do not generate any income directly. Therefore, the
appropriate solution in this scenario is simply to disallow not only
depreciation but also general residence-related costs (such as utility
costs and general house repairs). Total disallowance is consistent
with the general tax approach to dual-purpose costs generally.95 This
93. Websites such as Zillow.com post estimated rental values of virtually all properties in the United States.
94. I.R.C. § 280A(g).
95. See, e.g., Commissioner v. Flowers, 326 U.S. 465 (1946) (commuting to work);
Welch v. Helvering, 290 U.S. 111 (1933) (costs of acquiring human capital); Wrightsman v.
United States, 428 F.2d 1316 (Ct. Cl. 1970) (costs relating to personal-use property with
high appreciation potential); Smith v. Commissioner, 40 B.T.A. 1038 (B.T.A. 1939) (child
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approach would obviate the need for allocations of gross income and
deductions to the business use of the home.
Here, the deduction-disallowance rule would be waived for: (1) deductions not related to the residence but related to the business activity, (2) deductions relating to in-residence non-transportable business property and supplies not adaptable for personal use (such as
technical equipment and chemicals), and (3) separate structures (or
attached structures that are not adaptable to personal use, such as
art studios) used exclusively in the taxpayer’s trade or business. Of
course, the “business” in question could itself be a not-for-profit activity subject to § 183.
(c) Travel Expenses to Maintain a Residence
Independently of the foregoing, the Code should be amended to
disallow travel expenses relating to property used as a personal residence by the taxpayer for more than, say, fourteen days a year. Such
property’s location reflects the taxpayer’s desire to visit that location, and travel expenses thereto can be assumed to be personal
recreational expenses.
6. Tangible Personal Property Available for Personal Use
The IRS is in no position to monitor the bona fide (non-rental)
business use of items such as computers, printers, cell phones, tablets, vehicles, and other (movable) tangible property that (a) is not
permanently located on the taxpayer’s business premises and (2) is
available for personal use. Some of these items are currently treated
as “listed property” subject to § 280F, but that section still allows deductions for depreciation and other deductions with respect to certain
listed property with more than 50% of personal use.
Given that even employers have difficulty in enforcing a businessuse-only rule for employees using employer property of this nature
(even property located on the employer’s premises), it is wholly unreasonable to expect the IRS to enforce the distinction between business and personal use where the taxpayer receives no rental income
from the property. Accordingly, deductions with respect to these
items should simply be disallowed, period. The Treasury should be
authorized to issue regulations allowing exceptions for situations
where the IRS is confident that the property is subject to no more
than de minimis personal use.
care to enable one to work); Rev. Rul. 70-474, 1970-2 C.B. 35 (work clothing adaptable to
personal use).
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7. Credit Card Interest
The IRS cannot reasonably be expected to monitor a taxpayer’s
allocation of interest on credit card debt among the various categories
of interest. Accordingly, such interest should be wholly disallowed
unless the card is exclusively devoted to business use.
K. Cancellation-of-Debt Income
The courts and IRS appear to be extending the concept of cancellation-of-debt (COD) income to situations where the individual has no
real increase in wealth or ability to pay. 96 Reigning in the concept of
COD income to an appropriate extent can be viewed as being in the
nature of “clarification of doctrine,” which would advance the cause of
taxpayer comprehension and reduce unexpected (and unpleasant)
taxpayer involvement with the system. 97
For purposes of this discussion, “COD income” refers to a situation
where a debt disappears by operation of law (such as the running of
the statute of limitations), action of the creditor, or agreement between the debtor and creditor. 98 COD income should exist only where
the taxpayer is enriched by the borrowing (or credit) transaction as a
whole.99 The paradigm COD scenario is where the taxpayer borrows
cash and is relieved of having to pay it back.
COD income should not arise in cases where a mere liability, unrelated to the taxpayer’s obtaining cash or property on credit, is cancelled or forgiven. 100 Examples are fines, penalties, tax liabilities,
child support obligations, and charges for money, goods, or services
never obtained by the taxpayer. In these cases, the “liability” is a
mere prediction of a future expense or loss, and the avoidance of even
an anticipated future decrease in wealth is not income.
Second, COD income should not arise on the forgiveness of purchase money debt in cases where the taxpayer still owns the acquired
property. Such a rule already exists in § 108(e)(5) for two-party pur96. See Payne v. Commissioner, 95 T.C.M. (CCH) 1253 (2008), aff’d, 357 F. App’x 734
(8th Cir. 2009) (per curiam), cert. denied, 131 S. Ct. 151 (2010); Hahn v. Commissioner, 93
T.C.M. (CCH) 1055 (2007) (forgiveness of earned interest).
97. I.R.C. § 108(a) avoids current inclusion of COD income in certain cases, but at the
cost of reducing such favorable tax attributes as net operating losses carryovers and basis.
See id. § 108(b). It is doubtful that an ordinary individual taxpayer would be able to comprehend or comply with this approach.
98. The term does not refer to satisfaction of a taxpayer’s debt or liability by the taxpayer or by a third party, debt cancellations that are means of paying for goods or services
provided by the debtor to the creditor, or erroneous deduction accruals by accrual method
taxpayers (or other scenarios that involve application of the tax benefit rule).
99. For other commentary along similar lines, see generally Richard C.E. Beck, Cancellation of Debt and Other Incidental Items of Income: Puritan Tax Rules in the U.S., 49
N.Y.L. SCH. L. REV. 695 (2004).
100. Older cases support this view. See, e.g., Commissioner v. Rail Joint Co., 61 F.2d
751 (2d Cir. 1932).
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chase money debt, and it should be extended to three-party purchase
money debt.101 In this type of case, the taxpayer never received cash
to spend freely. Rather, the taxpayer is committing herself to pay the
purchase price in future installments. Instead of the taxpayer having
COD income, the basis of the property should be reduced with recapture of excessive depreciation deductions. Here, the taxpayer is
merely paying a reduced amount for the property. The typical application of this approach would be to a renegotiation downwards of a
residential mortgage.
Taking the foregoing a step further, COD income should not arise
by reason of avoiding consumer debt, including unpaid interest or
rental obligations. The rationale (again) is that the taxpayer is paying a reduced price for consumption and that arm’s length bargain
purchases of consumption do not give rise to income. 102
However, third-party credit card debt is distinguishable, because
it essentially entails a loan of cash to the cardholder followed by an
immediate cash payment to the merchant. 103 Thus, a reduction in
bank credit card debt is true COD income because the taxpayer has
been enriched in tax terms.
L. Alimony vs. Child Support
Current law allows a transactional election between two tax regimes concerning the payment of cash from one divorced spouse to
another: (1) if several statutory requirements are complied with to
constitute the payments as “tax alimony,” the payments are deductible by the payor and includible by the payee, or (2) otherwise, as the
default rule, the payments are ignored by both payor and payee.
These alternatives are supposed to be independent of state law. However, the requirement for tax alimony that the payments must
terminate on the death of the payee spouse has resulted in entanglement with state law,104 as has the rule that a label of “child support” (possibly imposed by a court regardless of the parties’ intentions) also negates characterization as tax alimony. Additionally, unsophisticated divorce lawyers are often ignorant of the tax rules and
their implications.
101. The IRS views this scenario as giving rise to COD income. See Rev. Rul. 91-31,
1991-1 C.B. 19.
102. In some cases, COD income is avoided under the disputed-debt doctrine of current
law. See Preslar v. Commissioner, 167 F.3d 1323 (10th Cir. 1999) (holding there is no COD
income where dispute is over value received).
103. Rev. Rul. 78-38, 1978-1 C.B. 68. It would be virtually impossible to allocate any
reduction in bank credit card debt to particular purchases.
104. See, e.g., Preston v. Commissioner, 209 F.3d 1281 (11th Cir. 2000); Ribera v.
Commissioner, 73 T.C.M. (CCH) 1807 (1997).
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The default rule should be that cash payments from one ex-spouse
to another pursuant to an instrument of divorce or separation should
be deductible by the payor and includible by the payee, regardless of
state law, what the payments are called, or whether they can survive
the payee spouse’s death. 105 A deduction/inclusion scheme would accord with the ability-to-pay principle. The payor spouse is typically in
a higher tax bracket than the payee spouse, meaning that larger
payments (than otherwise) can be made, leaving both parties better
off after tax. Economically, there is virtually no difference between
cash transfers labeled as alimony or as child support, as only rarely
is the payee spouse held to account for misuse of the funds. The payee spouse would be entitled to any available dependency exemption.
The spouses could jointly make an election into a no-deduction/noinclusion rule, in which case the payor would have superior rights to
the dependency exemption.
Exceptions to the deduction/inclusion scheme could lie for frontloaded payments, payments that look like they are in lieu of a property transfer, or payments that have the effect of a property purchase
(which are to be disregarded under § 1041).
M. Small Business Tax Accounting
This proposal would allow certain small business taxpayers (however defined) to elect to use cash accounting for inventory and other
items, thereby giving them the opportunity to fill out their tax returns without resorting to accountants and tax return preparers.
1. Expand Use of the Cash Method
A business is currently required to use the accrual method if it (a)
keeps its books according to financial accounting principles,106 (b)
carries inventories, 107 or (c) is required by statute to do so. 108 Whatever might be said for accrual accounting for purposes of financial
statements, it is hard to see how cash accounting can misstate income for tax purposes, as a general matter. 109 The tax base is an an105. If the payee is not the ex-spouse, the same rules should apply unless the payee is
an exempt entity or non-U.S. taxpayer, in which case the payor would forego the deduction
but be eligible to claim the dependency exemption.
106. I.R.C. § 446(a), (c)(2).
107. Treas. Reg. § 1.446-1(c)(2)(i).
108. See I.R.C. §§ 447, 448.
109. The legislative history to § 448 lamely states that the accrual method better conforms to financial accounting principles (especially the “matching principle”) than the cash
method. No abuses of the cash method are cited. See STAFF OF JOINT COMM. ON TAXATION,
99TH CONG., GENERAL EXPLANATION OF THE TAX REFORM ACT OF 1986 474-75 (Comm.
Print 1987). On the merits, it might be said that trade receivables received on the sale of
goods and services are an “accession to wealth,” but the current income tax is a realization
income tax, and receivables represent unrealized income. Where the receivables are highly
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nual construct, and matching is not a tax norm. 110 The cash method
should be allowed, at the taxpayer’s option, unless a good reason exists to the contrary.
2. Opting Out of Inventory Accounting
Under present law, the purchase (or production) and sale of inventories is required to follow inventory accounting, which entails treating inventory costs (when accrued) as capital expenditures and following a recognized convention, such as FIFO, for allocating such
costs to the taxable year. However, some exceptions already exist to
this approach.111
Although capitalization is a hard norm of income taxation, reasons
to relax it exist in the case of small business generally. The link between any particular cost and any particular sold item is already
severed by the existence of inventory-accounting conventions. The
gain from inventories is not compensation for the use of money or
property, nor is it in the nature of market appreciation. Sellers of inventory have a natural incentive to sell it as promptly as is feasible.
Essentially, inventory gains are the product of services (buying in
one market and selling in another, plus servicing customers). Noncapitalization is simpler than the approach of current law, and there
appears to be little potential for tax avoidance, especially if the taxpayer is on the cash method of accounting.112 In other words,
it is proposed that inventory costs be generally treated as
business expenses.
The option to forego capitalization should not be available to small
businesses that are required to capitalize inventory costs under regulatory law or Generally Accepted Accounting Principles (GAAP) to
assets that are depreciable, to inventories of investments (land and
securities), to inventories of unique assets (art and collectibles), to
liquid, the merchant possesses an incentive to sell the receivables. Many receivables of
service providers will never be collected, as the sellers of services have no security.
110. See Burnet v. Sanford & Brooks Co., 282 U.S. 359 (1931); Deborah A. Geier, The
Myth of the Matching Principle as a Tax Value, 15 AM. J. TAX POL’Y 17 (1998).
111. See Treas. Reg. § 1.162-3T (allowing expensing of materials and supplies), § 1.1626 (expensing of outlays of professionals), § 1.162-12 (farming costs). Additionally, small
resellers of goods, farmers, and artists are not required to capitalize direct and indirect
costs relating to inventories. See I.R.C. § 263A(b)(2)(B), (d), (h). Similarly, businesses that
perform services on a “project” basis (such as architects and plaintiffs’ lawyers) do not capitalize costs to such projects. See Treas. Reg. § 1.263(a)-4 (2004) (service projects to obtain
future fees from clients generally not treated as “intangibles”). Certain costs of extracting
natural resources are likewise not capitalized. See id. §§ 263(c), 616, 617.
112. In the bad old days, expense deductions could be accrued by an accrual method
taxpayer simply by entering into a contract for the purchase of goods to be delivered in the
future. Under current § 461(h)(2)(A)(ii), the deduction cannot be accrued any earlier than
the goods are provided to the taxpayer. See I.R.C. § 461(h)(2)(A)(ii).
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taxpayers using long-term contract accounting, or to other businesses
or items for which expensing is not appropriate (as listed in regulations).
3. Simplified Asset Accounting
Except for capital expenditures currently deducted under “expensing” rules, all capital expenditures of a “small business” incurred during the year (that relate to wasting assets) would be collected into a
single vintage account and depreciated on a straight line basis over,
say, four years, with all assets being deemed to have been put in service on January 1 of the vintage year. No depreciation deduction
would be allowed in the year of the asset’s disposal. The asset’s basis
(for purposes of figuring gain or loss) would be its cost less 25%
thereof for any year of depreciation.
N. Book-Tax Conformity for Public C Corporations
C corporations, as a general matter, compute taxable income in
the same way as do individuals for purposes of the corporate income
tax. 113 However, a corporation is a tax entity separate from its shareholders, and the corporate income tax is, at its core, an excise tax
that takes the form of an income tax in order to accommodate marginally profitable businesses. C corporation tax accounting would be
simplified if it conformed to GAAP rather than the tax accounting
rules for individuals, at least if the corporation follows GAAP accounting. It might be thought that individual/corporate tax accounting uniformity (1) eliminates tax incentives as to form of business
entity, (2) avoids tax disparities that would exist with respect to similarly-situated GAAP-reporting businesses (because GAAP involves
principles rather than a comprehensive set of rules), and (3) avoids
the tax-driven race to the bottom within the accounting profession
that might occur if GAAP were followed for tax purposes.
I do not find these arguments to be persuasive on their face. A
strong tax incentive already exists not to incorporate: the double
shareholder/corporation tax. 114 Additionally, corporate tax reform
may include other features, such as lower rates and rules mandating
the form of business organization, that could affect evaluation of how
corporate tax accounting should work. For publicly traded C corporations, book-tax conformity would balance client demand for higher
113. See id. § 63(a). The gross income computation is the same for individuals and C
corporations; some deductions are only allowed for individuals and some are only allowed
for corporations, but most are allowed for both. See §§ 63(b), 151(a), and the captions to
I.R.C. Subtitle A, Ch. 1, Subch. B, Parts VI, VII, and VIII (Income Taxes).
114. It should be noted that, if the C corporation tax rate is lower than the individual
tax rate, and if capital gains (and dividends) are also subject to lower-than-normal individual rates, then corporate accumulations and delayed distributions can save taxes relative
to a pass-through system.
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earnings against the client demand for lower taxes. Book-tax conformity should itself create a demand for greater uniformity in the
application of accounting standards among businesses. I conclude
that this simplification option at least deserves serious study as a
component of a broader package of business-entity tax reform.
O. Gratuitous Transfers
Various tax rules relating to the income taxation of gratuitous
transfers can be simplified or eliminated.
1. What is a “Gift”
Under current law, the test for the § 102(a) exclusion for “gifts”
and “bequests” is whether the donor’s motive is one of “ ‘disinterested
generosity.’ ”115 A test keyed to motive of a person other than the taxpayer is unworkable. Taxpayers are free to take aggressive positions
on this issue without incurring a significant risk of penalties
and/or tax fraud prosecution.116 The existing rule breeds costly factbound litigation.
A subjective test is unnecessary and should be replaced by the objective test adopted by the gift tax (as well as the charitable contribution deduction), namely, whether a transfer of wealth has not been
made for full and adequate consideration in money or money’s worth,
or in an ordinary commercial transaction.117 Additionally, any receipt
of money or property from a business entity should not be excludible
as a gift for income tax purposes.
2. Repeal § 274(b)
Section 274(b) disallows business deductions for certain items that
are excluded solely as gifts. This section is badly drafted insofar as it
assumes that certain items are excluded as gifts where really they
are not. Additionally, this provision would be rendered moot by the
change mentioned immediately above. Third, deductibility as a business deduction should not hinge on the tax treatment of another party. The tests for deductibility under § 162 are independent of the
test for exclusion under § 102(a). Accordingly, this section should
be repealed.
115. Commissioner v. Duberstein, 363 U.S. 278, 285-86 (1960) (quoting Commissioner
v. LoBue, 351 U.S. 243, 246 (1956)).
116. See, e.g., United States v. Harris, 942 F.2d 1125 (7th Cir. 1991).
117. See Treas. Reg. § 25.2512-8.
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3. Repeal the Basis-Disallowance Rule for Gifts of DepreciatedValue Property
Section 1015 generally provides a carryover basis rule for inter
vivos gifts, but a complex exception lies for gifts of depreciated-value
property, under which the basis can “float” until the property is sold
by the donee. The only conceivable purpose of this rule is to prevent
the assignment of built-in losses from a lower-bracket donor to a
higher-bracket donee. This scenario would appear to be uncommon,
since lower-bracket donors rarely have unrealized-loss property to
give away. Yet § 1015 allows the assignment of built-in gains by
higher-bracket donors to lower-bracket donees, which is a much more
serious problem as far as income-shifting strategems are concerned.
Thus, the exception should be repealed.
4. Repeal the § 691(c) Deduction and the § 1015(d)(6) Basis Adjustment
The § 691(c) deduction is available to a person acquiring a right to
“income in respect of a decedent” (IRD) of an amount equal to the estate tax (if any) “on” the IRD right, when the IRD is included in income. (IRD rights, which are rights to earned but unpaid income of a
decedent, do not obtain a step-up in basis under § 1014.)118 The theory of the deduction is that, if the decedent had included the income
on her final return, the estate tax base would have been reduced by
the income tax paid or owed by the decedent. If the income and estate
tax rates are the same, the § 691(c) deduction is equal to the hypothetical estate tax savings that would have resulted from the hypothetical inclusion of the IRD in the decedent’s income.
The § 691(c) deduction is not only complex, but it is also so obscure
(being unrelated to any cost) as to be susceptible of being overlooked
except by the cognoscenti. Moreover, it is based on a false assumption, namely that the IRD was subject to income tax of the decedent.
In fact, the IRD is income of the recipient of the IRD right, not the
decedent. 119 Equal treatment between estate transfers of IRD rights
and ordinary cash is not appropriate, because the situations are not
the same. The current rules for IRD have the effect of deferring income and of attributing the income to a person who may well occupy
a lower tax bracket than that of the decedent. The income tax paid by
the IRD recipient will appropriately reduce the IRD recipient’s potential transfer tax base. The § 691 deduction serves no legitimate purpose and should be repealed.
118. See I.R.C. § 1014(c).
119. See id. § 691(a).
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Section 1015(d)(6) gives a donee of appreciated property an income
tax basis increase equal to the gift tax (if any) on the unrealized appreciation in the gift property. Apparently, the adjustment is “for” a
hypothetical income tax of the donor that would have hypothetically
reduced the gift amount. 120 If so, the rationale for § 1015(d)(6) is at
least as flimsy as that for the § 691(c) deduction. Not only is this scenario purely hypothetical, but no donor would realize gain that would
otherwise be wiped out by the stepped-up basis rule of § 1014.
5. Grantor Trusts
The rules as to what trusts are deemed to be owned by the grantor
are forbiddingly complex. 121 Proposals range from treating all inter
vivos trusts as grantor trusts to that of treating no such trusts as
grantor trusts. 122 Here I’ll offer an intermediate proposal: a grantor
trust would be a disregarded entity123 if income or corpus could be (or
is required to be) distributed to the grantor or the grantor’s spouse. 124
The identity and status of the person holding such power would be
irrelevant, 125 and limitations (standards) on any such distributive
power would be disregarded.
Because of the fact that a grantor trust is a disregarded entity for
income attribution purposes, a grantor trust should not be treated as
a separate taxpayer for any other income tax purpose. 126 It follows
that transactions between a grantor and a grantor trust would be
120. The gift tax on the unrealized appreciation is not an acquisition cost of the donee,
because the donor is liable for the gift tax. Id. § 2502(c). Even so, acquisition costs are not
added to the § 1015 basis, but subsumed within it. See Treas. Reg. § 1.1015-4 (basis to the
donee is the greater of the § 1015 basis or any cost of acquiring the gift).
121. See I.R.C. §§ 671-677. Section 678, treating certain trusts as owned by a beneficiary, would also be repealed.
122. See, e.g., Mark L. Ascher, The Grantor Trust Rules Should be Repealed, 96 IOWA L.
REV. 885 (2011). Grantor trusts can be used to avoid the highly compressed rate schedule
of § 1(e) applicable to trust and estate net income, but trusts can still be used to shift income from the grantor’s higher marginal rates to the lower marginal rates of distributees.
It should be noted that the “kiddie tax,” see I.R.C. § 1(g), curbs the use of trusts to shift
income to minors, but this renders § 677(b) (trust income used to discharge grantor’s support obligation) largely pointless.
123. The grantor continues to be taxed on the trust’s income, because the grantor is
deemed to be the owner of the trust property. I.R.C. § 671.
124. Sections 674 and 675 (the most technical of the grantor trust rules) would be repealed, and §§ 673, 676, and 677(a) would be combined. Professor Ascher concedes that
§ 676 (power to re-vest corpus in grantor or grantor’s spouse) should be retained. Ascher,
supra note 122, at 930. Section 677(a) extends the principle expressed in § 676 to income.
Section 673 (retained reversions worth more than 5%) should be retained because nontrust retained-reversion transfers are ineffective to shift income.
125. The concept of “adverse party”—an artificial construct—would cease to play a role
in this area.
126. Cf. Rothstein v. United States, 735 F.2d 704 (2d Cir. 1984) (recognizing an installment sale from a grantor trust to a grantor), nonacq., Rev. Rul. 85-13, 1985-1 C.B. 184.
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disregarded. The model for such a rule is § 1041, dealing with property transfers between husband and wife.127
6. A “Simple Estate” Income Tax Regime
Under current law, estates are taxed as Subchapter J trusts,128
but special rules come into play only for estates. 129 The system is
complex, and its rules are often skipped over in the basic income tax
and estate and gift tax courses, so that estate attorneys may be insufficiently aware of them, with the resulting incurrence of unnecessary
taxes. 130 There is no policy reason to tax estate net income at the
highest marginal rate (as can easily occur under present law), as estates (which result from a transferor’s death) are not illegitimate income shifting devices.
A simpler income tax regime should be available for any estate
that (1) possesses a net value under a certain amount (perhaps $2
million), (2) does not provide for a successive interest transfer (in
trust or otherwise), and (3) is not a trust in disguise (i.e., is wound up
within a reasonable time after the decedent’s death).
Specific-bequest property, and the income therefrom, would be
deemed to be owned by the legatee (and not the estate) for income
attribution purposes starting on the day following the decedent’s
death. All other estate income and deductions would be aggregated at
the entity level and attributed to the residual legatees (and/or heirs)
in proportion to their interests. (No estate net income would be allocated to fixed-sum legatees. 131) The estate would pay a withholding
tax at the highest individual marginal rate on all estate net income,
including net capital gains. (The withholding tax would be charged
pro rata against the estate distributions to residual legatees or heirs.)
These estate beneficiaries would, in addition to reporting their ratable share of estate net income, obtain a tax credit for their share of
127. Section 1041 treats a “sale” between marital partners as a non-realization event,
and the transferor’s basis carries over to the transferee. I.R.C. § 1041(a), (b).
128. See id. § 641(a).
129. See id. §§ 642(b)(1), 663(a)(1).
130. Under current law, if the estate net income is greater than distributions to residuary legatees (and heirs), the excess is taxed to the trust under the highly compressed rate
schedule of I.R.C. § 1(e).
131. A “specific property” bequest is one where the legatee is to receive specifically
identified property under the will. A “fixed-sum” (or “pecuniary”) bequest is of a fixeddollar amount under a will. See Treas. Reg. § 1.663(a)-1(b). Under the law of estates, fixedsum legatees (unlike other legatees and heirs) are not entitled to a share of estate income,
but they may be entitled to interest payments. See RICHARD B. COVEY, MARITAL DEDUCTION AND CREDIT SHELTER DISPOSITIONS AND THE USE OF FORMULA PROVISIONS, App. B
(4th ed. 1997) (compilation of state rules on this issue). Any interest payable by the estate
on account of a delayed distribution of a fixed-sum bequest would be deductible to the estate in arriving at estate net income for income tax purposes and would be gross income to
the fixed-sum legatee.
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the withholding tax. 132 The executor would file an information return
to the IRS and the estate distributees stating the gross income
amounts and the tax credit amounts for each residual beneficiary
or heir.
7. Repeal the rule that the in-kind satisfaction of a fixed-sum bequest is a deemed sale of the property
Under current law, the satisfaction of a fixed-sum bequest with inkind property is treated as a sale by the estate (or trust) of the asset
to the legatee at its fair market value, 133 but other estate distributions entail a different set of income tax consequences. 134 These rules
add unneeded complexity to the system and may be overlooked by
fiduciaries. The rule as to fixed-sum bequests is conceptually misguided, because the distributee has not given any consideration in
money or money’s worth for the right to the bequest. Whatever purpose might be served under probate law for treating the pecuniary
obligation as a “debt”135 has no relevance for income tax purposes.136
Accordingly, all in-kind distributions should be treated alike: the
distribution would not constitute a realization event, and the estate’s
basis would carry over to the distributee. 137
P. Transactional Accounting Issues
1. Basis of In-Kind Income Items
Under current law, some confusion exists as to whether the “tax
cost” basis of in-kind property receipts should be the amount actually
included in gross income or, instead, the amount includible (although
not in fact included). Often this issue is dealt with by applying the
complex “mitigation provisions” 138 or fact-intensive equitable doctrines, such as equitable estoppel, equitable recoupment, or the duty
of consistency. 139 Resort to these provisions and doctrines assumes
132. The suggested system would do away with the distribution deduction and the
computation of estate distributable net income. See I.R.C. §§ 643(a), 661, 662. Net tax exempt income would also be passed through.
133. See Kenan v. Commissioner, 114 F.2d 217 (2d Cir. 1940); Rev. Rul. 67-74, 1967-1
C.B. 194; see also I.R.C. § 267(a)(1), (b)(13) (allowance of loss to estate in this scenario).
134. See I.R.C. § 643(e) (default rule is that distribution is not a realization event).
135. Treating pecuniary bequests as “debts” is what results in the estate’s obligation to
pay interest if the distribution of the bequest is unreasonably delayed. See supra note 131.
136. The proposed change is in line with that for “false” COD income, involving the
forgiveness of debts not incurred for value received. See supra text accompanying notes
100-01.
137. Section 643(e) would be modified to accord with this proposal. If the distribution
deduction/inclusion system of present §§ 661 and 662 continues in force for trusts (and
large estates), the distribution would be “at” the trust’s basis.
138. I.R.C. §§ 1311-1314.
139. The various doctrinal strands in this area are discussed in JOSEPH M. DODGE ET
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that the statute of limitations applies to basis determinations, a position that is contrary to the Supreme Court’s decision in Dobson v.
Commissioner, 140 as well as the position of all courts of appeals in
cases involving recoveries of amounts erroneously deducted in prior
years.141 Since basis is not subject to the statute of limitations, linking basis to what the taxpayer actually reported does not involve the
re-opening of barred issues. As a policy matter, taxpayers should not
obtain collateral tax benefits for their own errors and omissions.
Accordingly, the “tax cost” basis of any in-kind property receipt (or
of any claim to a right to recovery of an item previously expended)
should depend on the taxpayer’s actual prior tax treatment of the item.
2. Repeal § 1341
Section 1341 gives a taxpayer that refunds or repays a previously
included item the choice between the deduction that would be allowed as a matter of course and a credit equal to the incremental
taxes “caused” by the prior income inclusion of the refunded amount.
This provision has bred a good deal of litigation concerning its imprecisely worded prerequisites. If applicable, § 1341 involves recalculating the tax for a year possibly closed by the statute of limitations.
Section 1341 was enacted in 1954 in the wake of a Supreme Court
case where the original inclusion was subject to very high marginal
rates in 1944 that had decreased by the year of repayment. 142 The
correct tax treatment in theory is to allow a deduction (as a matter of
right) in the year of repayment, because the taxpayer has had the use
of the money until then. Accordingly, § 1341 should be repealed.
Section 67(b)(9) provides that the deduction “allowed by” § 1341 is
not a “miscellaneous itemized deduction.” 143 However, § 1341 does not
allow any deduction whatsoever. 144 Presumably, the intent here was
to list the deduction referred to in § 1341, but it appears (on account
of the reference to “claim of right”) that this reference applies only
where the § 1341 requirements for electing into the credit are satisfied. This technical glitch becomes moot if, as suggested above, § 67 is
amended to cover only enumerated borderline expense deductions
AL., supra
note 73, at 654-60.
140. Dobson v. Commissioner, 320 U.S. 489 (1943).
141. Federal appeals courts that have considered the issue have uniformly held that
recoveries of erroneously deducted amounts are fully includible. See, e.g., Hughes & Luce,
L.L.P. v. Commissioner, 70 F.3d 16 (5th Cir. 1995). In other words, a taxpayer’s basis in
the right of recovery hinges on the actual prior tax treatment, not the correct prior tax
treatment.
142. See United States v. Lewis, 340 U.S. 590 (1951); H.R. REP. NO. 83-1337, at A29495 (2d Sess. 1954), reprinted in 1954 U.S.C.C.A.N. 4017, 4436.
143. I.R.C. § 67(b)(9).
144. See id. § 1341. Curiously, the deduction for the refund or repayment is viewed as a
deductible “loss” under § 165(c)(2), rather than an “expense.”
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and the distinction between above-the-line and itemized deductions
is eliminated. Otherwise, given that the “claim of right” notion has
been abandoned in the doctrinal substratum, 145 § 67(b)(9) should be
amended to refer to “the deduction arising from the repayment or
refund of a previously included amount.”
Q. Portfolio Accounting for Publicly Traded Securities
Even with brokers being required to supply basis information for
securities transactions,146 accounting for basis on an item-by-item
basis is onerous. 147 Consideration should be given to allowing taxpayers to use an average basis in a portfolio of publicly traded securities.
An average-basis approach is conceptually correct for shares of a given stock, since all such shares are fungible. The proposed system
would simply extend this concept to the taxpayer’s entire portfolio of
publicly traded securities, for which a year-end valuation of the portfolio would be required.
1. Mechanics
The system would operate somewhat like inventory accounting,
but without a physical “closing inventory.” Thus, “portfolio security
gains” for a year would be “receipts from security dispositions” less
“cost of securities sold.” The cost-of-securities-sold amount would be
“cost of opening securities inventory” plus “cost of new securities inventory” 148 (equaling total portfolio basis) multiplied by a fraction,
the numerator of which is “gross receipts from securities dispositions”
and the denominator of which is the sum of (1) such gross receipts
and (2) the sum of the market quotes for all securities on hand at the
end of the year.149 Conceptually, this formula produces a basis offset
(against sales receipts) equal to that percentage of the aggregate
year-end securities basis that reflects the decrease in value of the
portfolio caused by the sales. The “opening inventory” for the next
year would be “cost of opening securities inventory” plus “cost of new
securities inventory,” less “cost of securities sold,” all for the prior
145. See United States v. James, 366 U.S. 213 (1961) (overruling Commissioner v. Wilcox, 327 U.S. 404 (1946), a case that had held that embezzled cash was not gross income
because not obtained under a claim of right).
146. See I.R.C. § 6045(g).
147. Under current law, where shares of the same stock are purchased at different
times, the taxpayer has to either identify the particular securities sold or else use the firstin, first-out convention. Treas. Reg. § 1.1012-1(c)(1). Since shares of the same stock are
fungible, an average-basis approach is conceptually preferable to either of the methods
sanctioned by the regulations. An average-basis approach is currently allowed only for
certain mutual fund shares. See id. § 1.1012-1(e)(1).
148. “Cost of new securities inventory” would include any current-year basis adjustments attributable to tax-free exchanges, gifts, bequests, OID accruals, and so on.
149. Thus, if there is no closing inventory of securities, the basis would be 100% (gross
receipts/gross receipts) of the aggregate basis.
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year. Securities that have become worthless during the year would
not produce transactional losses. Instead, worthlessness would
have the effect of increasing aggregate basis relative to aggregate
portfolio value.
The existing distinction between long-term gains and losses and
short-term gains and losses would, if retained, complicate the system,
because separate pools of short-term and long-term publicly traded
securities would need to be kept, with securities passing from a
short-term pool to a long-term pool. The problem can be managed if
securities are deemed to move from a short-term pool to a long-term
pool only on January 1 of the taxable year that is the second taxable
year following the year of purchase. Thus, securities purchased at
any time in 2013 would reside in a short-term pool in 2013 and
2014,150 and any remaining security cost in this pool would shift to
the long-term pool in 2015. It would still be necessary to match sales
receipts to the correct vintage pool. This problem would disappear if
the distinction between long-term and short-term were to be abolished.
2. No Disallowance of Portfolio Net Loss
If the taxpayer elects to use this system, all publicly traded securities would be required to be accounted for within it. In that case, the
system would operate in a manner that would preclude the cherry
picking of losses, because the proceeds from the sale of any security
would trigger the same basis recovery amount, regardless of whether
that particular security had appreciated or depreciated. Sales would
produce losses only where the portfolio as a whole (inclusive of the
year’s transactions) is in a loss position.
Since the cherry picking of losses would not be a major concern
under the portfolio approach, consideration could be given to allowing
any portfolio loss for the year as a current deduction, without any
carry forward of losses (except for negative taxable income caused by
such losses). If losses were allowed in full, the losses should carry
symmetrical tax treatment to any favorable tax treatment conferred
upon portfolio gain. Thus, if 30% of portfolio gain were excluded by
reason of being long-term capital gain, then 30% of portfolio losses
would be disallowed.
150. Securities purchased in 2013 would reside in a “vintage 2013” pool, and sales of
2013 securities would be offset by the average basis of sold 2013 securities. The 2013 pool
would continue for the year 2014, and any remaining basis at the end of 2014 would pass
into the long-term pool on January 1, 2015. Another pool, for securities purchased in 2014,
would continue through 2015, and pass to the long-term pool in 2016.
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3. Partial Repeal of § 1014
Transitioning to the next part concerning simplification aspects of
certain tax reform measures, it is fair to say that academic tax commentators are unanimous in their condemnation of the rule that
death wipes out unrealized asset gains and losses. 151 Repeal of this
rule would also generate substantial revenue.
The portfolio-basis system described above could, if mandatory, be
used as a vehicle for partial repeal of § 1014 (really, of the rule that
death is not a realization event for tax purposes). The usual objection
to such a repeal, i.e., that historic basis is too hard to ascertain,
would carry no weight, as portfolio basis would have been adjusted
annually. The net portfolio gain or loss would be deemed realized in
the year of the taxpayer’s death. The fair market value of the portfolio assets at the decedent’s death would fix both the amount realized
by the decedent at death and the basis of the decedent’s successors in
such assets.
IV. TAX REFORMS CONTRIBUTING TO SIMPLIFICATION
This Part deals with tax reform options that also offer simplification potential. Since this Article is not being used as a vehicle for
pushing my personal tax reform agenda, the emphasis herein is on
the simplification potential offered by what might be called the “usual suspects” in the vast array of possible tax reform proposals.
A. Tax Expenditures
It might be obvious that the place to start is with wholesale elimination of those numerous Code provisions that can be called “tax expenditures,” in the narrow sense of having been enacted to serve a
programmatic goal, such as investment in a certain type of business,
the creation of domestic jobs, or the subsidization of child care. (The
broader issue of defining a tax expenditure as any deviation from
some tax-base norm—such as Haig-Simons income—would not serve
the purposes of the present discussion, which is not focused on
norms. 152) All such programmatic tax expenditures must contain
qualification rules that distinguish the favored activity from nonfavored activity. These qualification rules are typically detailed and
151. See Joseph M. Dodge, Why a Deemed-Realization Rule for Gratuitous Transfers Is
Superior to Carryover Basis and Avoids Most of the Problems of the Present Estate and Gift
Tax, 54 TAX L. REV. 421 (2001), and authorities cited therein.
152. For example, from a consumption tax perspective, capital expenditures should be
expensed; from an accretion income tax perspective, capital expenditures should not be
expensed, and depreciation should equal the annual decline in an asset’s value; from a
realization income tax perspective, it is questionable whether depreciation should be allowed at all.
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complex. 153 But, although their wholesale elimination from the tax
Code would advance the cause of tax simplicity, the same programs,
now “off tax,” would entail non-tax complexity and attendant compliance costs. Abolishing the programs altogether might advance the
cause of “government program simplicity,” but simplicity at that level
has to be weighed in the larger context of policy, which is beyond the
scope of this Article. Of course, where these “programs” are not
justified in policy terms, repealing them would advance the cause
of simplification.
In the name of transparency, I would only suggest that programmatic tax expenditures take the form of tax credits rather than deductions. Since some of the deduction provisions that are generally
thought of as tax expenditures (such as accelerated depreciation154
and expensing of research and experimentation outlays 155) occupy a
gray zone of accounting uncertainty, these provisions might even be
justified in the name of simplification. However, simplification in this
context only argues that rules are preferable to case-by-case determinations. Simplification alone does not justify one set of rules
over another.
B. Capital Gains
The arguments for and against special rates for capital gains are
well rehearsed and will not be repeated here.156 Without doubt, vast
simplification of the income tax can be obtained by eliminating (to
the extent possible) the apparatus regarding capital gains. Some of
this apparatus, however, might be needed to cope with the problem of
cherry picking capital losses, which (although tangentially considered
above in connection with investment portfolio accounting) is systematically addressed here.
1. Plan A: Eliminate Special Rates for Net Capital Gain
Section 1(h), providing special (low) rates for various categories of
net capital gains, is so complex that its details probably cannot be
grasped by even a very intelligent tax expert, so that a lengthy worksheet (or computer program) is required. Additionally, Schedule D of
the Individual Income Tax Return (Form 1040) requires the entry of
extensive data broken down into numerous categories.
An obvious option is to provide no tax benefit for net capital gains
in any form.
153. See, e.g., I.R.C. 179(d).
154. Id. §§ 168(b)(1), (k), 179.
155. Id. § 174.
156. See generally TAX ANALYSTS, THE CAPITAL GAINS CONTROVERSY (J. Andrew Hoerner ed., 1992).
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2. Plan B: Simplify the Benefits Conferred on Net Capital Gain
A secondary option is to replace the present “rate” approach by a
“partial exclusion” approach for net capital gains. For example, some
percentage of net capital gains, say, 30%, would be excluded from
gross income. The existing approach essentially eliminates any progressivity in the capital gains system at the upper end of the income
scale (where virtually all net capital gains are concentrated) and
therefore disproportionately favors taxpayers in the very highest rate
bracket.157 The exclusion approach also better accords with an “inflation adjustment” rationale for favorable treatment. Finally, the exclusion approach is compatible with the structure of the Alternative
Minimum Tax (AMT), because the exclusion can (and should) be added back in computing AMT taxable income.
3. Eliminate the Category of “Collectibles” Gain
Net collectibles gain is currently subject to a maximum tax rate of
28%. 158 Either net collectibles gain deserves treatment on a par with
other investments in the capital gains system or it does not. In my
view it does not, since collectibles are usually held for personal use or
could be held for personal use without the knowledge of the IRS.
Hence, it can be presumed that the acquisition and disposition of collectibles is driven more by personal taste than economic considerations. Indeed, losses on such assets are (usually) subject to disallowance as personal losses, and the activity of collecting is likely to be
held to be a not-for-profit activity. 159
If any collectibles are to obtain a full capital gains benefit, strict
“investment” requirements should be imposed. For example, the collectible should have been purchased for a substantial sum (say,
$40,000, or perhaps more) and should be required to be stored in a
vault or warehouse and barred from any personal use.
4. Full Depreciation Recapture for Real Estate
The argument against recapture (as ordinary gain) of gain caused
by depreciation of real estate is not convincing. 160 The argument is
157. To illustrate this point, assume that taxpayers X and Y are in the 25% and 40%
marginal rate brackets, respectively, without regard to capital gains, and that each has net
capital gains of $10,000. Under the rate approach of current law, both X and Y pay incremental tax of $1500 on this $10,000. Under a system in which 40% of net capital gains are
excluded, X and Y would have incremental income of $6000. X, taxed at a 25% rate, would
have the same $1500 incremental tax as before. However, Y would have an incremental tax
of $2400.
158. I.R.C. § 1(h)(4)-(5). Actually, matters are more complicated than that, but the
complications are not germane to the discussion.
159. See, e.g., Barcus v. Commissioner, 1973 T.C.M. (P-H) 1973-138, at 643 (1973),
aff’d, 492 F.2d 1237 (2d Cir. 1974) (per curiam).
160. Existing § 1250 recaptures only the excess of accelerated over straight-line depre-
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that real estate can appreciate and depreciate at the same time, so
that the gain might result from true unrealized appreciation deserving of capital gain treatment. However, the argument is based on the
derivation of depreciation from a mathematical model (changes in
present values of future yields that are fixed ab initio) that inevitably
shows “losses” with the passage of time. The mathematical model is
only a proxy for expected mark-to-market depreciation. 161 If the asset
did not in fact depreciate in value, then the asset was not a wasting
asset in the taxpayer’s hands over the period it was held, and depreciation should not have been allowed in the first place. Appreciation
is an “inconsistent event” relative to the depreciation deductions.162
Only one asset exists, and any gain should be attributed first to depreciation (a certain tax fact), which, by causing the basis to be reduced, directly produces gain. Gain that is clearly “caused” by ordinary deductions (that reduce basis) should always be ordinary gain.
Recapture already exists under § 1245 as to equivalent gain on
personal property. The less-favorable capital gains tax rate for
“unrecaptured § 1250 gain”163 already amounts to a partial move in
this direction.
Accordingly, § 1250 should be repealed, and § 1245 should be expanded to encompass all gain attributable to depreciation (and expensing). This simplification move can also be made without any other change in the capital gains system.
Elimination of the categories of “collectibles gain” and “unrecaptured § 1250 gain” would greatly facilitate a move back to a partialexclusion system.
5. Repeal § 1231
Section 1231 is a complicated provision, the main feature of which
provides that net unrecaptured long-term gain from property used in
a trade or business is net capital gain (but that net loss is ordinary
loss). Expansion of depreciation recapture to real estate would greatly reduce the impact of this provision, so that it would only affect
land and other nondepreciable property used in a business. In general, business-use property should generate ordinary gain (and loss),
as is the case with other business income (and loss).
ciation, but exceptions exist. Accelerated depreciation has not been allowed on real estate
since 1986. Thus, virtually all gain on depreciable real property is treated as capital gain or
§ 1231 gain.
161. This much is evident from what many consider to be the seminal work on depreciation: Paul A. Samuelson, Tax Deductibility of Economic Depreciation to Insure Invariant
Valuations, 72 J. POL. ECON. 604 (1964).
162. In the absence of Congressional preemption of depreciation rules, the inconsistentevents doctrine would probably result in ordinary gain to the extent of depreciation. See
Hillsboro Nat’l Bank v. Commissioner, 460 U.S. 370 (1983).
163. I.R.C. § 1(h)(1)(D), (h)(6).
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Another aspect of § 1231 is to provide that net unrecaptured involuntary-conversion gains on business and investment property can,
when combined with other § 1231 gains and losses, end up as net
capital gains despite the absence of a sale or exchange. 164 There is no
reason that unrecaptured gains should be treated as capital gains
just because the property is disposed of in an involuntary conversion,
because the taxpayer in such cases can avoid the recognition of involuntary-conversion gain under § 1033 by reinvesting the proceeds
of conversion in similar-use property. Unreinvested gains of an individual are available for consumption. Finally, if the purpose of capital gains benefits is to unlock investments, then involuntary conversions are not an inappropriate occasion to confer capital gains treatment, because the disposition was beyond the taxpayer’s control. 165 In
general, the appropriate remedy for unexpected income or gains is a
tax deferral rule, which already exists in the form of § 1033. Thus,
this aspect of § 1231 also merits repeal.
A provision parallel to § 1231 (as far as the “character” of gain or
loss is concerned) exists under § 165(h)(2)(B) with regard to involuntary conversions of personal-use assets. The same arguments for repeal as noted above apply here as well. (Other aspects of personal
casualty losses and gains will be discussed below.)
What remains of § 1231 after repealing the foregoing is a tax expenditure provision that taxes income from certain extractive and
agricultural enterprises at lower rates. 166
C. Losses on Sales and Exchanges
Even if lower rates for net capital gains are eliminated, the problem of capital losses would remain. Under current law, a taxpayer’s
aggregate capital losses for the year can only be deducted to the extent of the sum of (1) taxpayer aggregate capital gains for the year, or
(2) $3000 (in the case of non-corporate taxpayers). 167
1. Restrictions on the Current Deductibility of Net Transactional
Losses
The restrictions on the current deductibility of net capital losses
are designed to prevent the cherry picking of investment losses while
allowing gains to go unrealized. The theoretically proper anti-cherrypicking rule would be to allow realized losses to be allowed to the ex164. Id. § 1231(a)(3)(A)(ii), (a)(4)(B), (a)(4)(C).
165. This point was the basis for the decision in Pounds v. United States, 372 F.2d 342,
348 (5th Cir. 1967).
166. I.R.C. § 1231(b)(2)-(4).
167. Id. § 1211. Capital losses that are disallowed are carried over to future years under § 1212.
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tent of realized gains plus an amount equal to the excess (if any) of
net realized losses over unrealized gains.168 However, accounting for
unrealized gains would entail a valuation of appreciated assets at
the end of the year, 169 and the income tax avoids valuations as a
general rule.
The “portfolio method” of accounting for securities transactions
set forth in Part III.Q above is one way to deal with the problem.
A less radical approach would be to allow taxpayers to elect to treat
unrealized gains on publicly traded investments as having been realized (at the end of the taxable year) to the extent of such realized net
losses, and such gains (although not actually resulting from a sale)
would absorb the realized net losses. Realized losses on publicly traded investments in excess of realized and deemed-realized gains would
be allowed to the extent that such excess exceeds gains that
are neither realized nor deemed realized. Since the assets in the
deemed-realized-gain category are still owned by the taxpayer, an
amount equal to the deemed-realized gain would be added to basis,
bringing the basis of such assets up to their fair market values at
the end of the year, effectively reducing future gains (as would occur
with carryovers). 170
2. Simplifying the Rules Defining Gains and Losses Subject to the
Anti-Cherry-Picking Rule
If lower rates for capital gains are eliminated, the existing terminology and definitions of capital gains and losses could be scrapped
and a new system put in place that is designed solely to implement
the anti-cherry-picking rules in an appropriate fashion. The anticherry-picking rule should be limited, roughly speaking, to “voluntary” realized losses from investments and from those business assets
that are not routinely disposed of at the end of a normal business cycle (such as land and assets having an indefinite or very long useful
168. Thus, if realized losses are $10,000, realized gains are $2000, and unrealized gains
are $5000, the amount currently deductible should be limited to $5000: $2000 + [($10,000 $2000) - $5000]. Stated differently, the deduction for net realized losses would be reduced
by the amount of unrealized (“unpicked”) gains.
169. Since all figures in the formula are determined as of the end of the year, a loss
that was not truly “cherry-picked” at the time realized could be disallowed and carried over
because of appreciation that occurred later in the year. Of course, the reverse could happen
as well.
170. Again, assume that a taxpayer has realized losses of $10,000 during the year, has
realized gains of $2000 during the year, and has unrealized gains at the end of the year of
$5000, all involving publicly traded investments. The taxpayer would report $2000 of realized gains and could elect to report an additional $5000 of deemed-realized gains (excess of
end-of-year fair market value of appreciated assets over their then adjusted basis). In that
case, all $10,000 of the realized losses would be allowable, because no cherry picking would
exist in this scenario. Additionally, $5000 would be added to the basis of the unrealized
gain assets, bringing the basis of each such asset up to the fair market value at the end of
the year.
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life). Thus, inventory and business equipment would normally be excluded from the loss-limitation system, as would be involuntaryevent losses, losses that were realized by reason of another party’s
action, losses incurred by the lapse of a time period, and losses occasioned by worthlessness. Various “deemed sale or exchange” rules,
such as §§ 165(g), 166(d)(1)(B), and 1271(a)(1), could be consolidated
into one Code section treating certain losses as falling without the
anti-cherry-picking rule. At the same time, all transactional gains
(not from inventory, business equipment, receivables, etc.), whether
voluntary or not, should be allowed to offset losses subject to the anticherry-picking rule.
The existing distinction between short-term and long-term would
be meaningless under the anti-cherry-picking rule. If no favorable
treatment for net capital gains is available, the holding period concept could be dropped entirely.
D. The Personal Deductions
Proposals abound to eliminate, cut back, or restrict all or some of
the personal deductions, sometimes in the name of raising revenue,171
and sometimes in the name of conforming to a normative tax base. 172
The deductions (in various degrees) have already been seriously
eroded by floors, ceilings, phase-out rules, and indirect disallowance
or deferral under the Alternative Minimum Tax. These backhanded
approaches were critiqued in Part III as contributing to complexity and
lack of transparency. Here, the focus is on the deductions themselves.
1. Residential Mortgage Interest
Although defended by politicians as essential to preserving middle
class homeownership, this deduction for qualified residence interest 173 is criticized by a broad spectrum of tax academics. 174 Plausible
proposals include: (1) eliminating the deduction entirely, (2) eliminating the deduction for interest on home equity debt (as opposed to acquisition or improvement debt), 175 (3) restricting the deduction to in171. See, e.g., Edward D. Kleinbard, The Role of Tax Reform in Deficit Reduction, 133
TAX NOTES 1105, 1106-07 (2011).
172. Numerous articles discuss the issue of whether any of the personal deductions
conform to the concept of Haig-Simons income. See, e.g., William D. Andrews, Personal
Deductions in an Ideal Income Tax, 86 HARV. L. REV. 309 (1972); Mark G. Kelman, Personal Deductions Revisited: Why They Fit Poorly in an “Ideal” Income Tax and Why They Fit
Worse in a Far from Ideal World, 31 STAN. L. REV. 831 (1979); William J. Turnier, Evaluating Personal Deductions in an Income Tax—The Ideal, 66 CORNELL L. REV. 262, 270-76
(1981).
173. I.R.C. § 163(h)(3).
174. See, e.g., Dennis J. Ventry, Jr., The Accidental Deduction: A History and Critique
of the Tax Subsidy for Mortgage Interest, L. & CONTEMP. PROBS., Winter 2010, at 233.
175. Interest on home equity debt (as opposed to acquisition debt) is allowed on up to
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terest on (acquisition) debt for the taxpayer’s principal residence only, 176 and (4) reducing the dollar figures for deduction-generating
mortgage principal. The invocation of middle-class values is not a
plausible defense of the deduction insofar as it relates to home equity
debt and mortgages on second (vacation) homes.
This deduction is neither particularly complex nor hard to administer. Nevertheless, if a deduction for home equity indebtedness is
retained, the “net equity” limitation found in § 163(h)(c)(1) should be
removed, because it entails annual valuations of the property and
annual determinations of acquisition-debt principal. 177 Alternatively,
this net equity rule could be retained but only applied as of the date
of borrowing. A third possibility would be to require that the home
equity loan come from an unrelated commercial lender.
Since the personal exemptions already include an allowance for
housing costs, consideration should be given to imposing a floor under the residential interest deduction (if it is retained) in order to
prevent redundant deduction of the same costs. Since persons tend to
spend at least 30% of their income on housing costs,178 and since
mortgage interest would often be the largest such cost for homeowners, a plausible floor would be $6000 (one-third of the low-income allowance for a family of two as suggested earlier).179 However, such a
floor—although perhaps a revenue raiser—would not eliminate much
data from the system.
2. State and Local Taxes
The deduction for nonfederal taxes (unrelated to business or investment) is also controversial. Plausible proposals include (1) abolishing the deduction entirely, (2) eliminating the deduction for property taxes (or possibly only foreign property taxes), and (3) eliminating the deduction for sales taxes.
Accounting for state and local sales taxes is impractical. Additionally, sales taxes are naturally viewed (rightly or wrongly) as a cost of
whatever is purchased. The case for eliminating the deduction for
$100,000 of home equity debt principal. I.R.C. § 163(h)(3)(C)(ii).
176. The deduction is available for interest on the taxpayer’s personal residence and
one other residence. Id. § 163(h)(4)(A)(i).
177. Id. § 163(h)(c)(1).
178. See Mary Schwartz & Ellen Wilson, Who Can Afford to Live in a Home?: A Look at
Data from the 2006 American Community Survey, U.S. CENSUS BUREAU,
http://www.census.gov/housing/census/publications/who-can-afford.pdf (last visited Jan. 25,
2014).
179. Off-the-bottom allowances are discussed in the text supra Part III.E–F. However,
a fixed-dollar floor is probably a political non-starter, since it appears to favor high-income
taxpayers whose mortgage interest expense would exceed the floor. The conventional approach in response to this problem is to express floors as a percentage of net income. However, that kind of floor appears to be out of synch with fixed-dollar subsistence deductions.
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sales taxes on personal-consumption items is compelling from both a
theoretical and practical perspective. In sum, sales taxes should be
treated as part of the cost of whatever is purchased and not as a
separate expense.
Property taxes are viewed as a cost of maintaining property, and
costs of maintaining personal-use property should not be deducted.
Moreover, property taxes on personal-use property can be avoided by
renting rather than owning. Hence, it cannot be persuasively argued
that these expenses are involuntary or are forced. Thus, the deduction for taxes on personal-use property is also a good candidate for
repeal. Certainly, real property taxes on second homes should be disallowed as being highly discretionary. Since it is sometimes hard to
tell whether a tax on tangible personal-use personal property is really a tax, and since such taxes typically are small in amount, the deduction for such taxes should also be eliminated.
State and local income taxes cannot be avoided except by the extreme measures of moving or cheating. Hence, a plausible case exists
for deducting only these taxes. Moreover, since state and local income
taxes are not universal in the United States, a deduction only for this
category of nonfederal taxes is not a proper scenario for a floor under
the deduction.
Taxes on real property are universal, all but five states impose
sales taxes,180 and all but seven (or nine) states impose income taxes.181
Aggregate state and local taxes as a percentage of income ranged (in
2010) from about 7.0% to 12.8%, 182 which is a fairly narrow spread.
Since the tax base is supposed to be a “difference principle,” costs
that all persons bear equally (or proportionately to income) can well
be ignored. Although a floor under a deduction is usually appropriate
to weed out commonly incurred expenses of a certain type, allowing a
deduction in excess of a floor is indicated only where extraordinary
expenses of the category in question is possible. In the case of state
and local taxes, it is hard to see how such extraordinary payments
can occur. Therefore, even if it is thought that one or more of the categories of state and local taxes should be deducted under a normative
180. Alaska, Delaware, Montana, New Hampshire, and Oregon do not have comprehensive state sales taxes, but most have taxes that are partial substitutes for sales taxes.
State Sales Tax Rates, SALES TAX INST., http://www.salestaxinstitute.com/resources/rates
(last updated Nov. 1, 2013).
181. States without income taxes are Alaska, Florida, Nevada, New Hampshire, South
Dakota, Tennessee, Texas, Washington, and Wyoming. States Without a State Income Tax,
IRS.GOV, http://www.irs.gov/uac/States-Without-a-State-Income-Tax (last updated Apr. 11,
2013). Nevertheless, New Hampshire and Tennessee tax dividends and interest. See Taxes
by State, RET. LIVING INFO. CTR., https://www.retirementliving.com/taxes-by-state (last
updated Jan. 2013).
182. State and Local Tax Burdens: All States, One Year, 1977 – 2010, TAX FOUND. (Oct.
23, 2012), http://taxfoundation.org/article/state-and-local-tax-burdens-all-states-one-year1977-2010.
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theory of income, a case can be made that none of them should be deductible in practice.
Under current law, refunds of deductible taxes must be run
through the machinery of § 111 in order to determine the portion of
them that is includible by reason of having actually reduced taxable
income in a prior year. This calculation is required where: (a) the deduction is subject to a floor, (b) the deduction falls within a class of
deductions that is subject to a floor, or (c) the taxpayer’s taxable income is reduced to a negative number by the deduction. Refunds occur mainly with respect to income taxes. If taxes (including income
taxes) are not deductible at all, then refunds of such taxes would be
wholly excludible and would not have to be included subject to the
machinery of § 111.
3. Personal Casualty and Theft Losses
The standard rationale for this deduction is that personal casualty
and theft losses constitute a decrease in wealth that is not “consumption.” 183 However, in fact consumption under an income tax is viewed
as occurring when a personal-use asset is purchased, not as and
when it is used.184 Moreover, the tax system does not otherwise take
into account deviations of consumption value from cost.
As a matter of broader policy, the deduction operates as taxpayersubsidized insurance for uninsured losses. The deduction is more
valuable to high-bracket taxpayers who can best afford to purchase
property-loss insurance.
It is tempting, therefore, to repeal this deduction entirely, and for
most taxpayers the deduction has already been repealed by reason of
the floor under the deduction equal to 10% of adjusted gross income.
Nevertheless, in some cases casualty and theft losses reduce ability
to pay, and the system should make appropriate allowance in that
event. Any reduction in ability to pay occurs by reason of having to
prematurely replace “essential” property. (Such a rationale is the
same as the “duplicative cost” rationale for deducting business lodging costs.) Thus, the deduction should be triggered only by the unexpected destruction of certain property. The deduction would be the
lesser of the cost of replacement or the cost of the items being replaced, reduced by the sum of net salvage proceeds, insurance proceeds, and government cash benefits, but not to exceed a specified
183. Turnier, supra note 172, at 272.
184. Consumption costs, whether expenses or capital expenditures, are taxed by being
nondeductible. The nondeductible (and non-depreciable) cost of a personal-use asset represents the present value of its future estimated consumption value. Actual consumption
with respect to such assets is not taxed as it occurs.
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fixed-dollar figure. “Replacement cost” would include unreimbursed
costs of lodging for a maximum period of, say, one year.
If the deduction is not repealed or further cut back, the following
simplification reforms are suggested.
First, valuation “after” the casualty should not play any role in
cases where the item is not disposed of and is repaired or rehabilitated. The valuation of, say, a wrecked automobile is pointless, because
a wrecked automobile has no economic use, except as salvage. In such
a case, the repair costs (not to exceed the cost of the property), reduced by recoveries, should be treated conclusively as the tentatively
deductible amount. Of course, if the item is abandoned or sold
for scrap, the loss amount is the adjusted basis reduced by any
monetary recovery.
Second, no deduction should be allowed for losses attributable to
unrealized appreciation. Hence, the tentatively deductible amount
should be reduced by the excess, if any, of the pre-loss value over the
adjusted basis of the item.
Third, it is not clear why casualty and theft losses are allowed to
avoid the existing floor by first being netted against recognized casualty and theft gains. 185 Personal consumption losses should not offset
recognized gains that are essentially investment gains (other avenues exist for nonrecognition of personal casualty and theft gains,
namely, §§ 121 and 1033). This netting rule echoes that of § 1231, but
§ 1231 would be eliminated under a proposal made above. Also, no
good reason exists why recognized personal casualty gains should
obtain capital gains treatment, as occurs under § 165(h) when such
gains exceed such losses. The issue of loss deductibility should have
priority over that of character. The portion of § 165(h) relating to
whether the casualty and theft deduction is an itemized deduction or
an above-the-line deduction would be rendered moot by the abolition
of that distinction. Accordingly, § 165(h) should be mostly repealed,
leaving only the floor under the deduction (if retained) in place.
4. Charitable Contributions
The charitable deduction has been critiqued (and defended) from
many angles, but the only consensus reform proposal is to limit the
deduction with respect to donations of appreciated property to the
taxpayer’s basis across the board. (As to depreciated-value property,
presumably the deduction should be limited to value.) Certainly it is
185. The 1982 Act revised § 165 so that the 10% floor applied to all casualty and theft
losses. Tax Equity and Fiscal Responsibility Act of 1982, Pub. L. No. 97-248, 96 Stat. 324.
The 1984 Act introduced the complex rules of § 165(h) as a technical correction, apparently
designed to cull personal casualty theft and casualty gains and losses out of § 1231. Deficit
Reduction Act of 1984, Pub. L. No. 98-369, 98 Stat. 494.
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hard to justify the various distinctions found in § 170(e), which limits
the deduction to basis in some cases but not others.186 This reform
would advance the cause of simplification of the income tax.
Apart from the issue of appreciated-property contributions, the
charitable deduction should be subject to a floor, equal to, say, 2% of
net income. 187 Viewed instrumentally, the charitable deduction is an
incentive to give, but nontax incentives also exist, and it is likely that
people would give modest amounts to charity without a tax incentive.
A modest floor should actually increase incentives to give at the margin. Moreover, a floor would also eliminate a good deal of trivia (and
potential valuation disputes) from the system.
Valuation of utilitarian tangible personal property imposes a considerable administrative burden on the tax system. Such property is
virtually certain to have depreciated greatly in value and is likely to
be slated for abandonment in any event. The donor is hardly incurring any kind of sacrifice by giving these items to a charity, because
such items have already been consumed by the donor. Thus, the rationale for any deduction at all in this scenario is very weak and can
only survive by supposing both that it is socially better that these
items end up in the hands of charity rather than a waste disposal site
and that potential donors would prefer (in the absence of a tax incentive) to destroy rather than give. Consideration should be given to
authorizing the IRS to issue a valuation table that confers a small (or
zero) per item value on such property. 188 Alternatively, the deduction
could simply be disallowed for donations of tangible personal property worth less than, say, $200 per item.189
For items of utilitarian tangible personal property that possess
significant value and that could either be sold or used by the charity
(such as cars, boats, furniture, and computers), a deemedconsignment approach is appropriate: the donor would simply obtain
a deduction in the year of sale by the charity in an amount equal to
186. Roughly speaking, the deduction equals basis for (1) property held for less than
one year, (2) property given to a private (non-operating) foundation, and (3) tangible personal property not to be used by the donee for its exempt function. The latter category was
sufficiently abused that Congress was forced to enact § 170(e)(7) in 2006.
187. That is, only aggregate contributions in excess of 2% would be deductible. Higher
(10% of AGI) floors already exist under the medical expense deduction, I.R.C. § 213(a), and
the deduction for personal casualty losses, id. § 165(h)(2)(A). Additionally, a 2%-of-AGI
floor exists under aggregate “miscellaneous itemized deductions.” Id. § 67(a).
188. Section 170(f)(16), added in 2006, disallows a deduction for clothing and certain
household items that are in “good used condition or better.” Id. § 170(f)(16). However, this
standard is imprecise and probably unenforceable. The same section allows the IRS to issue a regulation that treats contributed clothing or certain household items of “minimal
monetary value” as being worth zero, but no such regulation has been issued, and, again,
the standard is vague. Id.
189. Cf. id. § 165(h)(1) (throwing out the first $100 of losses per casualty or theft
event).
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the charity’s net sales proceeds.190 It might be objected that the donee
might actually use the property, in which case the sales price might
turn out to be much lower than the value at the time of contribution.
However, since charities have a long history of accommodating donors at the expense of the IRS, a charity’s representations to a donor
as to its intentions are unreliable (and unenforceable by the IRS).
Hence, the donation rule should induce the charity to sell the donated item in the market and spend the cash on whatever it desires.
Another possible reform proposal (possessing a simplification angle) would be to eliminate any income tax deduction for a contribution that will benefit the charity only at or after the donor’s death,
generically referred to as a “charitable remainder transfer.” 191 The
income tax is an annual tax, and there is no reason why a donor
should obtain an income tax deduction in the current year for a
transfer not reduced to possession or use by the charity during the
year in question, especially if the donor (or the natural object of the
donor’s bounty) is enjoying the property in the meantime. The charity
really receives no useable value until the retained interest expires.
The income tax is not bound to follow the law of future interests.
Charitable remainder interests are hard to value, and techniques exist to overvalue the charitable remainder interest relative to the nondeductible retained interest.
The ceilings on the charitable deduction are complex and overlapping. Additionally, concern exists that the charitable deduction can
be combined with other personal deductions (as well as the personal
and dependency exemptions) to virtually zero-out the donor’s tax liability. This problem can be eliminated by imposing a single ceiling as
a percentage of taxable income (without regard to the charitable deduction itself). In other words, other deductions would operate to
lower the ceiling on the charitable deduction.
5. Medical Care
The deduction for medical care, subject to a 10% floor of adjusted
gross income, is for uninsured medical costs paid by an individual for
herself, her spouse, and her dependents. 192 The floor can effectively
190. A rule of this type already exists in § 170(f)(12), added in 2006, but only for vehicles, boats, and airplanes, and it does not apply to vehicles or airplanes if the donee undertakes “significant intervening use or material improvement.” Id. § 170(f)(12)(A)(ii). This
provision is unnecessarily complex, requires paperwork to be provided to the donee and the
IRS, and appears to contemplate the possible amendment of the donor’s tax returns. Moreover, it is not clear why it is limited to vehicles, boats, and airplanes.
191. A cognate device is the “direct charitable annuity,” in which a contribution is
made in return for an annuity payable by the charity. A unique problem with this device is
that the “donor” benefits from the charitable tax exemption in the form of increased annuity payments (relative to the commercial norm).
192. See Patient Protection and Affordable Care Act, Pub. L. No. 111-148, § 9013, 124
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be avoided through medical savings accounts, employer health plans,
self-employment health insurance, and (to some extent) selfpurchased insurance. 193 The floor renders the deduction useless for
most of those taxpayers unable to avoid it.
The Code section allowing the deduction, § 213, has become something of a Christmas tree by reason of being worded in such a way
that allows the scope of the deduction to expand endlessly to include
borderline items that have more to do with desires than objective
health needs. 194 The problem is aggravated by the fact that no political constituency appears to favor the elimination or containment of
this deduction. Nevertheless, the deduction (if retained) should be
limited to costs for, say, the prevention or cure of disease, the alleviation (other than by over-the-counter drugs) of chronic or abnormal
pain, or the correction of a non-self-inflicted work-disabling physical
defect or condition.
Current health policy favors near-universal coverage through private insurance. It is surprising that the Patient Protection and Affordable Care Act of 2010 did not enact an above-the-line deduction
for self-purchased health insurance, a move that would have further
eroded the significance of § 213. Instead, what the Act gave us was a
tax subsidy, effective starting in 2014, for persons (above the eligibility level for Medicaid but below an amount that is four times the applicable poverty level) who purchase health insurance through “exchanges” in the form of a refundable tax credit found in § 36B.195
The credit is extremely complex, and it will undoubtedly require
a worksheet.
6. Costs of Tax Planning and Compliance
A good case can be made for eliminating the deduction conferred
by § 212(3) for costs relating to taxes. This deduction has already
been partially repealed by virtue of having been categorized as a mis-
Stat. 119, 868 (2010) (amending I.R.C. § 213).
193. All except the last have the effect of allowing a deduction for the insurance premium, I.R.C. §§ 106, 162(l), 223, plus a tax-free reimbursement for health care costs. The last
scenario entails a nondeductible premium combined with such tax-free reimbursement.
Reimbursements are tax-free under § 104(a)(3) or § 223(f). Id. §§ 104(a)(3), 223(f).
194. The deduction is overbroad in defining medical care to entail costs relating not to
only diseases, but also to costs “affecting any structure or function of the body.” Id.
§ 213(d)(1)(A). The over-broadness is compounded by the tendency of the medical and, especially, the mental health professions to expand the definition of “disease” to encompass
virtually any biological or mental condition that inhibits the attainment of an individual’s
personal goals. See O’Donnabhain v. Commissioner, 134 T.C. 34 (2010), acq., 2011-47 I.R.B.
789 (Nov. 21, 2011) (allowing deduction for sex change surgery because “gender identity
disorder” is now a “disease” recognized by the mental health profession).
195. Premiums (up to the credit amount) will not also be deductible as medical expenses. I.R.C. § 280C(g).
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cellaneous itemized deduction, 196 and it now chiefly operates to subsidize tax litigation (including criminal tax fraud defense) and tax
planning for the wealthy. Despite the fact that tax planning costs are
not within the language of the existing statute, the IRS has decided
otherwise, without satisfactory explanation.197 Other costs of nonbusiness litigation are not deductible.
As a matter of income tax theory, a cost incurred to reduce a nondeductible cost (such as a federal tax) should not be deducted. 198
E. Personal Injury Recoveries
Under current law, recoveries for personal physical injuries are
excluded under § 104(a)(2). 199 Other tort and tort-like recoveries (including punitive damages and compensatory damages for nonphysical injuries) are included. No persuasive rationale exists for the exclusion. 200 If the exclusion is based upon solicitude for plaintiffs, taxing damages can be overcome by grossing up tort recoveries. The exclusion for plaintiffs can be captured (in whole or in part) by defendants, resulting in failure to internalize fully the social costs of the tort.
The distinction between included and excluded damages in turn
determines the deductibility of attorney fees and other costs of obtaining recoveries, because only costs allocable to included recoveries
are deductible. 201 Since most tort claims are settled, and since private
settlement allocations cannot be trusted (no party desires an allocation to punitive damages), it devolves upon tax trial courts to undertake the onerous and costly task of adjudicating the tort claim in order to make an allocation.
These issues can be solved in a fashion that simplifies the tax law
by making all personal injury recoveries includible. In that case, all
costs of obtaining such recoveries (which are really capital expenditures)202 would be deductible.
196. Also, if the deduction reduces taxable income, it is added back to AMT taxable
income.
197. See Merians v. Commissioner, 60 T.C. 187 (1973) (noting IRS concession of this
issue), acq., 1973-2 C.B. 1 (Dec. 31, 1973).
198. A refund of federal income taxes is excluded from income on account of the fact
that the overpaid tax was not deductible. Costs of obtaining excluded income (or nonincome) are not deductible. See I.R.C. § 265(a)(1). Any deduction here can only offset unrelated income. Planning strategies resulting in a reduction of nondeductible federal taxes
have the same effect as a refund of overpaid nondeductible federal taxes.
199. Id. § 104(a).
200. See generally Joseph M. Dodge, Taxes and Torts, 77 CORNELL L. REV. 143 (1992).
201. I.R.C. § 265(a)(1) (disallowing expenses of obtaining excluded income).
202. See Joseph M. Dodge, The Netting of Costs Against Income Receipts (Including
Damage Recoveries) Produced by Such Costs, Without Barring Congress from Disallowing
Such Costs, 27 VA. TAX REV. 297 (2007).
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F. Retirement Savings
Explicit statutory tax favoritism for savings vehicles exists for certain funded qualified retirement vehicles, herein referred to as “qualified plans,” but the benefit of tax deferral is also obtainable under
certain nonqualified (funded and non-funded) arrangements.
1. Qualified Tax-Deferral Retirement Plans
Except for Roth IRAs, 203 the basic pattern for qualified retirement
savings vehicles under current law is to allow tax-free contributions
to an account to be excluded (or included and deducted) by the account owner, the earnings on the account to be tax free, and for the
payouts to be fully taxed.204
(a) Complexity in the Service of an Ineffective Policy Design
At the individual taxpayer level, the “complexity problem” with
current law is the proliferation of tax-favored plan types with assorted requirements pertaining to qualification, taxpayer eligibility, maximum contributions, minimum and maximum distributions, and more.205
Simplification could begin by consolidation of the various existing
plan types,206 especially those used by small business owners and
self-employed individuals. But tinkering with the existing system is
not ambitious enough and may result in further complications.207
203. Roth IRAs generate tax-exempt income from nondeductible contributions, I.R.C.
§ 408A, and therefore do not fall within the category of “tax-deferral plans.”
204. The tax favoritism consists of a deduction for worker contributions to the plan,
contrary to the capitalization principle. Alternatively, an employer’s contribution to a
funded plan benefitting the employee is excludible by the employee, but exclusion is the
equivalent of inclusion (as compensation for services) and full offsetting deductibility.
205. A good introduction to the system, along with reform proposals, is found in Norman P. Stein, An Alphabet Soup Agenda for Reform of the Internal Revenue Code and
ERISA Provisions Applicable to Qualified Deferred Compensation Plans, 56 SMU L. REV.
627 (2003).
206. Qualified plans can be classified according to method of contribution, calculation
of benefits, or unique qualification rules, and various categories often overlap or hybridize.
Besides Roth IRAs, the following types of plans can be qualified: regular IRAs, “SIMPLE”
IRAs, cash or deferred § 401(k) plans, regular pension plans, cash-balance defined benefit
plans, pension equity plans, simplified employee pension plans (SEPs), salary-reduction
pension plans, profit-sharing defined contribution plans, target-benefit (defined contribution) plans, age-weighted profit-sharing (defined contribution) plans, money purchase (defined contribution) plans, employee stock ownership plans (ESOPs), non-ESOP stock bonus
plans, top-heavy plans, annuity § 403(a) plans, exempt-organization annuity § 403(b)
plans, and state and local government § 457 plans. See I.R.C. §§ 219, 401(k), 403(b), 408(k),
408(p), 457. The rules pertaining (mostly) to plan qualification occupy 338 pages in the
Code alone (the 2012 CCH edition).
207. A retirement income simplification/reform proposal submitted by the American
Bar Association Tax Section was released on October 3, 2012. Letter from Rudolph R.
Ramelli, Chair of the A.B.A. Section of Taxation, & Charles H. Egerton, Former Chair of
the A.B.A. Section of Taxation, to Chairmen and Ranking Members of the S. Comm. on Fin. &
H. Comm. on Ways & Means (Oct. 3, 2012), available at http://www.americanbar.org/content/
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The task of meaningful simplification can be approached by way of
focusing on the underlying policy rationale for the existing system,
which is explicitly that of retirement security. 208 The existing system,
overall, is currently embodied in both the Social Security retirement
system and the law that governs privately funded retirement plans
(the Employee Retirement Income Security Act of 1974 as amended,
known as ERISA). 209 Non-workers, ranging from the chronically unemployed to wealthy investors, lie beyond the scope of retirement income security policy.210
A possible approach is to eliminate tax-favored plans entirely and
to expand the Social Security retirement system so that it provides
an adequate level of wage replacement in retirement for all or most of
the workforce.211 Nevertheless, the discussion herein will proceed on
the twin assumptions that the Social Security program will continue
and that retirement security in excess of Social Security will be privately funded.212
In the context of a privately funded system that supplements Social Security, the concept of retirement income security has two
prongs. One is financial security through funding, vesting, nonalienability, plan insurance (for defined benefit plans), and portability,
dam/aba/administrative/taxation/100312letter.authcheckdam.pdf.
208. An alternative means of simplification would be to allow universal tax-free savings accounts, but that move would not only entail a major shift towards a cash-flow consumption tax, but would also undermine the goal of income security, as described infra in
the text accompanying notes 250-51.
209. The non-tax provisions of ERISA are located at 29 U.S.C. §§ 1001-1461 (2006). The
historical evolution of the pension system in the U.S. is recounted in JOHN H. LANGBEIN ET
AL., PENSION AND EMPLOYEE BENEFIT LAW 44-63 (5th ed. 2010).
210. It should be noted here that a federal needs-based program, Supplemental Security Income (SSI), provides benefits to low-income persons over age sixty-five, as well as to
the disabled and blind. 42 U.S.C. § 1382(a)(1) (2006). In contrast, Social Security retirement benefits are not conditioned on need. Id. § 402(a).
211. It appears that many affluent countries provide a more extensive governmentfunded pension system than does the United States, where the wage replacement rate
provided by Social Security appears to be fairly modest. Specifically, the wage replacement
rate has been roughly 45% for lowest-quintile wage earners and about 33% for middlequintile workers, with further declines in the two highest quintiles. See Alan Fox, Earnings
Replacement Rates and Total Income: Results from the Retirement History Study, 45 SOC.
SEC. BULL., Oct. 1982, at 3, 13 (mid-1970s data), available at http://www.ssa.gov/policy/
docs/ssb/v45n10/v45n10p3.pdf; see also LANGBEIN ET AL., supra note 209, at 38-39. The
Social Security retirement income program (which is not really contingent on retirement as
such) is part of the Old Age, Survivors, and Disability Insurance (OASDI) federal program.
To be eligible, a person must contribute to the program for a specified period. Contributions
are withheld by employers for employees. See I.R.C. §§ 3101, 3111. Self-employed persons
contribute by way of the self-employment tax. See id. §§ 1401-1403. Current contributions
fund current benefits, so that the program operates on a pay-as-you go basis, as opposed to
an investment basis.
212. Under current demographic assumptions, the Social Security program is, if unchanged, expected to run a large deficit in the future, and, in any event, benefits are estimated to represent a lower rate of return on contributions than would be the case with
privately-funded plans. See LANGBEIN ET AL., supra note 209, at 41-43.
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many of which can be (and are) achieved simply by federal government mandates under ERISA, as amended, but which are also incorporated into the tax qualification rules. 213 The second prong of the
policy is that of covering virtually the entire workforce. This second
aim is merely touched upon by legal mandate.214 Instead, it is almost
exclusively the aim of the tax rules, 215 which is to incentivize employers to offer broad-coverage retirement plans (which, inside the firm,
are often mandatory for covered employees), with a secondary purpose to incentivize non-covered workers to save for retirement. 216 Unfortunately, the present system of qualified plans has only brought
retirement plan coverage up to about half of the workforce, and this
coverage is heavily weighted towards high-income employees.217 The
reasons for the ineffectiveness of the present system are legion, but
the root of the problem is that employers are not required to adopt
qualified plans, nor are non-covered workers required to create their
own plan. Employers willing to adopt a plan can (and do) effectively
avoid covering large portions of their workforce by hiring workers as
independent contractors or less-than-half-time workers.218 Additionally, unionized workers can be excluded,219 and benefits and contributions for employees under qualified plans can be integrated with Social Security, thereby effectively reducing plan coverage for low-paid
workers.220 Also, the qualification rules themselves contain loopholes
213. See I.R.C. § 401(a)(1), (2), (7).
214. Basically, the legal mandate is that an employer adopting a plan can exclude only
part-time employees, employees under the age of twenty-one, or employees with less than
one year of service. 29 U.S.C. § 1052 (2006). The same rule appears (in substance) as
§ 410(a) of the tax Code. See I.R.C. § 410(a).
215. A “minimum coverage” nondiscrimination rule is located at I.R.C. § 410(b). Additionally, contributions or benefits must not discriminate in favor of highly compensated
employees. Id. § 401(a)(4). Finally, caps exist on contributions and benefits, id. § 415(b)-(c),
which operate mainly to the detriment of high-salary employees.
216. See Bruce Wolk, Discrimination Rules for Qualified Retirement Plans: Good Intentions Confront Economic Reality, in PENSION AND EMPLOYEE BENEFIT LAW, supra note 209,
at 402, 402-05. For an account of the enactment of ERISA that stresses the political motivations, see S. SPEC. COMM. ON AGING, 98TH CONG., THE EMPLOYEE RETIREMENT INCOME
SECURITY ACT OF 1974: THE FIRST DECADE 1-25 (Comm. Print 1984) (Chapter 1, Overview:
Why Was ERISA Enacted? written by Michael S. Gordon). For a more cynical view, see
John H. Langbein, Social Security and the Private Pension System, in IN SEARCH OF RETIREMENT SECURITY 109 (Teresa Ghilarducci et al. eds., 2004) (describing the effect of the
system as being a stealth program to allow high-income earners to accumulate wealth at
low tax rates).
217. See LANGBEIN ET AL., supra note 209, at 25-30.
218. The term “employee” is not actually defined in ERISA, but in Nationwide Mutual
Insurance Co. v. Darden, 503 U.S. 318 (1992), the Supreme Court held that independent
contractors are excluded. See also Treas. Reg. § 31.3121(c)-(d); Rev. Rul. 87-41, 1987-1 C.B.
296. Employees who work less than twenty hours per week are effectively not considered to
be employees. See I.R.C. § 410(a)(3). For a comprehensive discussion of excludible employees, see LANGBEIN ET AL., supra note 209, at 412-15.
219. I.R.C. § 410(b)(3)(A).
220. See generally Keith A. Bender, Characteristics of Individuals with Integrated Pensions, 62 SOC. SEC. BULL., no. 3, 1999, at 28 (noting that integration is allowed in part so
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that allow non-coverage of (especially) low-compensation employees. 221 Finally, the most widely used plan type for self-employed persons is the § 401(k) type of defined contribution plan, which itself is
elective on an annual basis.
Technicalities aside, the tax incentives for employers and noncovered workers are too feeble. The only current tax inducement to
the employer is a current deduction for cash transfers to qualified
employee trusts, 222 but a current deduction for cash transfers already
accords with income tax norms, and such treatment operates as an
incentive only because Congress has imposed an artificial tax disincentive for nonqualified funded plans. 223 The more salient employer
tax incentive consists of offering the tax benefits attendant upon
qualified plans to highly compensated employees (who presumably
control company policy) on condition, by way of nondiscrimination
rules, that they offer qualified plans to rank-and-file employees. This
indirect, trickle-down, approach is wasteful for several reasons. First,
employer-maintained retirement plans for employees below the top
tier would exist to a fair degree without tax benefits on account of the
dynamics of employee recruitment and collective bargaining. 224 Second, the cost—lost tax revenue—attendant on bribing high-level employees is high, whereas the incentive is weak, because highly-paid
employees—who already have the capacity to save—can achieve
equivalent or better tax results through other forms of deferred compensation, such as nonqualified arrangements, incentive stock options, and carried interests. 225 Third, the net cost of covering lowerincome employees may outweigh the net tax benefits for high-salary
employees. 226 Fourth, workers at the bottom may oppose coverage
solely on the ground of a perception (perhaps accurate) that contributions reduce current cash wages dollar for dollar. Fifth, various actors (non-covered employees, self-employed workers, small business
owners, and unprofitable businesses) may under-appreciate the benefits of wage-deferral. 227
that the sum of Social Security and qualified plan benefits do not exceed the worker’s wages).
221. Qualification for tax benefits is conditioned on compliance with nondiscrimination
rules, I.R.C. §§ 401(a)(4), 410(b), the ineffectiveness of which is critiqued in Peter Orszag &
Norman Stein, Cross-Tested Defined Contribution Plans: A Response to Professor Zelinsky,
49 BUFF. L. REV. 629 (2001).
222. I.R.C. § 404(a)(1)-(4) (providing limits on such current deductions).
223. See id. § 404(a)(5) (deferring the employer deduction for nonqualified plans until
employee inclusion).
224. Unions that obtain pension plans can justify their existence, while the employer
can pass all or a portion of the cost thereof on its workforce and other parties.
225. These devices achieve not only income deferral but also result in capital gains
treatment for gain that is essentially compensation for services.
226. See Wolk, supra note 216, at 402-05.
227. A worker without other income at retirement will benefit from shifting income
from higher current rate brackets into lower tax rate brackets after retirement. Additionally, under certain assumptions (including one of constant tax rates over time), deducting the
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The foregoing calls into question whether employers should be the
focal point of retirement income policy. It is certainly the case that
employers are not needed as administrators of funded plans; financial institutions are better positioned to perform this function, as well
as that of investment guidance.
(b) Plan A: Mandatory Retirement Contributions
One simple alternative to the present system is that of mandatory
contributions 228 by employers and self-employed persons to privately
run individual-account annuity plans that satisfy the essential conditions of retirement income security. 229 Some sweeteners might be required to induce Congress to adopt such an approach, such as waivers for employees covered by existing plans, tax credits to employers
to cover a portion of incremental administrative costs, government
subsidies for low-wage contributors, and opt-out provisions for highincome workers. 230
The simplification advantage of this approach is obvious: taxdeferral incentives would be unnecessary,231 although tax deferral
could still be conferred as a way of increasing the amount of future
retirement distributions.
(c) Plan B: Tax Subsidies at the Margin
The other option is to design more effective tax (or other) mechanisms to achieve the goal of near-universal retirement income securiinvestment and including distributions in full—the paradigm for qualified plans—produces
the same after-tax amount as not deducting the investment but fully exempting the net
economic return.
228. The contribution would be a specified percentage of a worker’s wages. The percentage could vary with the hourly wage rate, but design issues such as this are beyond the
scope of a piece on income tax simplification.
229. See generally PRESIDENT’S COMM’N ON PENSION POLICY, COMING OF AGE: TOWARD
A NATIONAL RETIREMENT INCOME POLICY (1981); Tax Analysts, Clinton Details Universal
Savings Accounts, Including 401(k) Matches, 1999 TAX NOTES TODAY 72-1; Daniel
Halperin, Retirement Income Security After the Fall, in 2009 N.Y.U. REVIEW OF EMPLOYEE
BENEFITS AND EXECUTIVE COMPENSATION ch. 11, § 11.09 (2009) (calling for direct government contributions to accounts for low-income workers, to make up for the fact that mandatory contributions would be likely to result in a reduction in wages).
230. A proposal loosely based on these premises, known as the “Universal, Secure, and
Adaptable (“USA”) Retirement Funds,” is set out in TOM HARKIN, U.S. S. COMM. ON
HEALTH, EDUC., LABOR & PENSIONS, THE RETIREMENT CRISIS AND A PLAN TO SOLVE IT
(2012), available at http://www.harkin.senate.gov/documents/pdf/5011b69191eb4.pdf. A
similar proposal was made in the 2013 Obama Administration Budget Proposal, see OFFICE
OF MGMT. & BUDGET, FISCAL YEAR 2013 BUDGET OF THE U.S. GOVERNMENT 147 (2012),
available at http://www.gpa.gov/fdsyspkg/BUDGET-2013-BUD/pdf/BUDGET-2013-BUD.pdf.
A feature of these proposals is to transfer investment decisions from individual account
holders to professional fiduciaries.
231. Social Security contributions (taxes) paid by an employee are not deductible,
I.R.C. § 275(a)(1), and distributions are mostly includible under a complex formula, see id.
§ 85, that is critiqued supra notes 58-62 and accompanying text.
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ty. Simplification could be obtained by positing a single vehicle for
providing such security, which would be the worker-owned Qualified
Retirement Account (QRA). Any person having compensation income
during the year would be eligible to contribute to such an account,
managed by an independent administrator. The QRA would automatically possess the attributes of funding, vesting, and portability. The
tax treatment of such accounts would generally follow the present
model of tax deferral. Aggregate additions to a worker’s QRA (by the
worker’s employers and/or the worker herself) for a given year would
be a specified percentage of salary, say, 6%, subject to a fixed-dollar
cap.232 Excess additions would not be deductible or excludible (as the
case may be), but would create a tax basis in the account.
However, if the QRA approach were solely dependent on voluntary
worker contributions, the broad-coverage aspect of retirementincome-security policy would essentially be blown off. Tax provisions
designed to incentivize broad coverage would reintroduce complexities into the system, but it is hoped that these complexities can be
minimized. Perhaps the most effective means of broadening coverage
within a QRA system would be to induce employers to provide mandatory QRAs for all of its employees, under which employers would
directly transfer cash to the worker QRAs. 233 The optimal tax mechanisms for accomplishing this goal are not self-evident, but some suggestions follow. Some tax benefits should be aimed at employers directly. Among possibilities to be considered are: (1) a modest tax credit to “compensate” the employer for its trouble, 234 (2) a current employer deduction, as under current law, along with a deductionequivalent credit for non-profitable employers. Additionally, a possible “stick” would be to wholly disallow deferred compensation tax deductions for employers failing to adopt a mandatory QRA plan. A
possible tax incentive for highly-compensated management to support an employer-sponsored QRA plan would be to provide that adoption of such a plan would result in replacement of the normal fixeddollar cap on annual QRA contributions by a gradual decrease (above
the cap amount) in the specified contribution percentage as compensation increases. Thus, if the basic annual contribution limit is 8% of
compensation (up to $400,000) not to exceed $32,000 (8% of
$400,000), then top management of a company adopting a mandatory
plan would be allowed to make additional contributions to their indi232. Under current law, the maximum contribution to an employer-sponsored defined
contribution plan is the lesser of 100% of “compensation” or $40,000 (as indexed for inflation). See I.R.C. § 415(c) (the limit was $51,000 in 2013).
233. Amounts within the limitation would be excluded by the worker if provided by the
employer and deductible if provided by the employee. Presumably employer contributions,
if any, would count first in applying the limitation.
234. Cf. I.R.C. § 45E (credit for small employer pension start-up costs).
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vidual QRAs at a rate of, say, 6% on the next $200,000 of compensation, 4% on the next $200,000, and so on.
The foregoing may be insufficient to bring employees of small
businesses, moderate-to-low income business owners, and other selfemployed persons into the fold. For non-covered low-income workers,
an additional refundable credit might be offered for voluntary worker
contributions to a QRA, somewhat along the lines of that provided by
§ 25B.235 The credit can be expressed as a percentage of contributions
to a QRA, not to exceed a fixed dollar amount. 236
(d) Defined Benefit Plans
Not to be overlooked are employer-funded defined benefit pension
plans, 237 as opposed to the individual account plans discussed above.
Defined benefit plans are particularly attractive in terms of retirement-income-security policy insofar as benefits are typically expressed as a percentage of wages, and investment risk is borne by the
employer instead of the worker. 238 Such plans essentially constitute
in-house non-profit annuity companies that require a large actuarial
pool. Qualified defined benefit (pension) plans should continue to exist, 239 but tax simplification does not appear to be a significant concern here for individual taxpayers.
(e) Mandatory Annuity Pay-Outs Under All Tax-Favored Plans
By definition, retirement security entails a funded individual annuity that serves to continue wages (or a portion thereof) after retirement or a specified age until a worker’s death, to protect against
the risk of longevity. It follows that annuity pay-outs should be mandatory for all subsidized retirement vehicles.
235. The § 25B credit, however, is nonrefundable, meaning that it has no effect on lowincome workers. Id. § 25B.
236. A tax credit proposal was provided by a group known as Retirement USA. See
Proposals for a New Retirement System, RETIREMENT USA (Oct. 21, 2009),
http://www.retirement-usa.org/proposals-new-retirement-system. A prominent academic
commentator favoring this approach is Halperin, supra note 229, § 11.06.
237. Such plans, which require a large pool of participants, provide salary-replacement
payments based on a formula relating to salary history and years of participation.
238. However, portability (avoiding the loss of benefits by reason of changing employers), which is also an aspect of retirement security, is hard to achieve in the case of defined
benefit plans except by converting an accrued benefit right into a lump-sum amount that
can be rolled over into a defined-contribution plan.
239. As under present law, I.R.C. § 415(b)(1), annual annuity distributions should be
capped at a specified amount.
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Additionally, and contrary to present law, 240 a beneficiary of any
qualified plan should not be able to withdraw amounts from a QRA
before retirement age, except perhaps for permanent disability. 241
(f) Other Issues
Numerous other issues would need to be dealt with, including the
definition of “employee” for purposes of the ERISA tax rules, 242 possible provision for non-working spouses of working spouses,243 surviving spouses and dependents of workers both before and after the
commencement of annuity pay-outs, 244 and divorced spouses.
(g) Roth IRAs
The Roth IRA, instead of deferral, gives a tax-free return on an
after-tax investment.245 Roth IRAs do not conform to the retirementincome-security paradigm because tax-exemption after retirement (as
opposed to claiming deductions while working) is preferable to tax
deferral only if the owner already has post-retirement taxable income
in significant amounts. Additionally, Roth IRAs do not require annuities or even minimal distribution rules, and they allow contributions
even after retirement age. 246 In short, Roth IRAs do not advance the
policy of retirement income security and function mainly to allow the
240. An annuity is not required for defined contribution plans (including IRAs, § 401(k)
plans, and § 403(b) plans), which currently outweigh defined benefit plans in terms of
coverage.
241. The current system imposes a 10% penalty on pre-retirement distributions but
allows for numerous exceptions. I.R.C. § 72(t). The only exception should lie for permanent
disability (premature forced retirement), which can be monitored by the Social Security
Administration and can trigger conversion into an individual annuity. Insurance problems
(such as a medical emergency) should be dealt with, if at all, by other mechanisms.
242. Currently, “employee” is defined in Treas. Reg. § 31.3121(c)-1(d), which also serves
as the definition for income tax withholding and payroll tax purposes. The definition
adopts a modified common-law fact-based “control” test. Perhaps the test could itself be
simplified. See Calvin H. Johnson, Settle Withholding by the Dollars, Not Control, 136 TAX
NOTES 949 (2012).
243. A large percentage of spouses will be employed on their own and will thereby be
eligible to contribute to their own qualified plans. It is appropriate that a non-working
spouse of a working spouse should be able to contribute to her own QRA on the ground that
she is being implicitly paid for domestic labor.
244. The qualified annuity of a person who is married on the annuity starting date
could be required to be a self-and-survivor annuity for the annuitant and the annuitant’s
spouse, unless the spouse waives the survivorship right. Such a rule exists for certain qualified plans under current law. See I.R.C. §§ 401(a)(11), 417. Of course, a longer expected
annuity period results in lower periodic payments. Moreover, a surviving spouse should not
receive a greater aggregate annuity than the largest of her own annuity or the deceased
spouse’s annuity. Since the purpose of an annuity is the exact reverse of that of life insurance, a QRA should not provide survivorship benefits (or a refund to the deceased worker’s
estate) in cases where the QRA owner dies before the annuity starting date. A refund feature would reduce annuity payments.
245. Id. § 408A(c)(1), (d)(1).
246. Id. § 408A(c)(4), (5).
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well-off to augment the amount of their bequests. Accordingly, the
Roth IRA should be repealed. 247
2. Nonqualified Tax-Deferral Arrangements
For non-qualified employer-provided deferred compensation arrangements, tax deferral can be obtained either if the arrangement is
unfunded or if the employee’s interest in the plan is funded but subject to a substantial risk of forfeiture.248 On the other hand, if an employer confers upon an employee the right and power to obtain current cash income, the employee would be in constructive receipt of
the income (even if the cash is not actually taken) unless a meaningful restriction or penalty would attach to the taking. 249 In other
words, the employee is not currently taxed unless she (a) is in constructive receipt of income or (b) receives property (or is a beneficiary
of an employer-funded trust that receives cash) that is not subject to
a substantial risk of forfeiture. In general, the readily available opportunities for deferral through nonqualified arrangements undermine incentives to create qualified plans 250 and fail to satisfy the policy of retirement income security. 251
(a) Restricted Property Transfers and Funded Nonqualified Plans
The general rule is that receipts of cash income are currently included, notwithstanding a risk of forfeiture, and any actual forfeiture
gives rise to a deduction in the year of loss. 252 Current § 83(a), which
provides otherwise for compensation-related receipts of property interests (including funded deferred compensation), 253 came into existence to
accommodate court decisions that failed to treat receipts of property
247. If they are retained, Roth IRAs should be subjected to similar requireddistribution rules as are applicable to tax-deferral plans.
248. Section 83(a) states that the transfer of property to a service provider is current
income unless the property is “subject to a substantial risk of forfeiture.” I.R.C. § 83(a).
Section 402(b) states that the transfer of cash by an employer to a nonqualified deferred
compensation trust is deemed to be a transfer of property to the employee subject to
§ 83(a). Id. § 402(b). This provision codifies the tax common law rule known as the economic benefit doctrine. John F. Cooper, The Economic Benefit Doctrine: How an Unconditional
Right to a Future Benefit can Cause a Current Tax Detriment, 71 MARQ. L. REV. 270, 273
(1988).
249. Treas. Reg. § 1.451-2(a).
250. Nonqualified deferral plans are, by reason of not being subject to a nondiscrimination requirement, usually limited to highly compensated service providers. Thus, availability of such plans undermines the goal of retirement security for most of the workforce.
251. An arrangement that is unfunded and/or subject to a substantial risk of forfeiture—and is not annuitized—hardly provides for retirement income security.
252. See James v. United States, 366 U.S. 213 (1961); N. Am. Oil Consol. v. Burnet, 286
U.S. 417, 424 (1932).
253. Section 402(b) provides that transfers of cash to a deferred compensation plan
shall be treated as transfers of property subject to § 83. I.R.C. § 402(b).
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subject to a significant risk of forfeiture the same as receipts of cash.254
This differing tax treatment of forfeitable cash and forfeitable property is hard to justify as a matter of policy, 255 especially where the
“property” is nothing more than a right to future cash. 256 Moreover,
restrictions on property given as compensation can be viewed as selfimposed (or at least willingly accepted) by virtue of the benefit of tax
deferral, and tax deferral for nonqualified arrangements conflicts
with the overriding policy of retirement income security through
qualified plans. 257
The cleanest solution would be to alter § 83 so as to be in accord
with the treatment of “restricted” cash. Accordingly, the property
should be included at the time of receipt and valued without regard
to the restrictions.258 Such a revised § 83 should provide that the
service provider obtains an ordinary loss deduction upon any
actual forfeiture.
Property that has no ascertainable fair market value on receipt,
such as nontransferable (and not-in-the-money) stock options and pure
profits interests, are subject to a different default rule, namely: no inclusion until cash receipt (or until the property can be reasonably valued, such as upon the exercise of the option or the obtaining of liquidation rights).259 Current rules generally accord with this principle,260 but
the principle should be made into a universal rule, which means eliminating the special tax breaks given to incentive stock options (ISOs)
254. The doctrinal problem was the notion that the receipt of property as compensation, although normally an income realization event, avoided current inclusion because the
forfeiture condition rendered the property incapable of valuation when received (assuming
that any transferee would also be subject to the forfeiture condition). See Kuchman v.
Commissioner, 18 T.C. 154 (1952) (holding forfeitable property not currently included). Not
so justifiable in terms of doctrine was Lehman v. Commissioner, 17 T.C. 652 (1951), where
it was held that no income arose upon the lapse of such a restriction, resulting in deferral
(and capital gains treatment) until the property was sold. The IRS acquiesced in these
cases in Rev. Rul. 68-86, 1968-1 C.B. 184. Section 83(a), enacted in 1969, deferring compensation until the lapse of the forfeiture restriction, can be described as a compromise
between this case law and the tax rules for cash. See I.R.C. § 83(a).
255. The difference in tax results channels transactions of this sort into the property
mode.
256. The rationale of Kuchman, 18 T.C. at 163, was that forfeitable property was not
capable of valuation and therefore not currently realized income. See supra the doctrine
and text accompanying note 254. However, the courts could have treated the restriction as
being personal and not an aspect of the property itself. However, the restriction can be
made to be on the property by a provision that all transferees are subject to the restriction.
In any event, Congress can do what the courts fail to do.
257. The argument in favor of § 83 is that forfeiture conditions (usually, leaving the
firm) align the interests of employee and employer, but this is not a concern of tax policy.
Moreover, the proposed change in tax treatment does not prohibit such forfeiture
conditions.
258. Current § 83(a) states that non-forfeiture restrictions are to be ignored in valuing
in-kind compensation. I.R.C. § 83(a).
259. See Commissioner v. LoBue, 351 U.S. 243, 248 (1956); Treas. Reg. § 1.83-7.
260. See I.R.C. § 83(e)(3)-(4).
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and employee stock purchase plans.261 Additionally, any income realized under this type of arrangement should be ordinary income.262
(b) Non-Funded Plans
The core principle for non-funded, purely contractual deferred
compensation arrangements is that deferral is obtainable in the absence of the constructive receipt of cash income, but, as already noted, constructive receipt is easily avoided by imposing a more-than-deminimis penalty on demanding current cash.
Section 409A, which was enacted in 2004 to deal with certain
problems relating to nonqualified deferred compensation, is framed
in these terms: “The [House] Committee believes that certain arrangements that allow participants inappropriate levels of control or
access to amounts deferred should not result in deferral of income
inclusion.” 263 Section 409A requires current inclusion in gross income,
with interest and penalties, of nonqualified rights to future compensation (funded or non-funded), unless various anti-abuse rules are
complied with. 264 With regard to non-funded arrangements, § 409A
has effectively expanded the constructive receipt doctrine by requiring immediate inclusion of rights to future cash unless the arrangement (1) prohibits last-minute deferral decisions and elective accelerations of deferred benefits and (2) requires deferred amounts to be
distributed only upon objectively determinable occurrences. 265
Section 409A is considered to be an excessively complex and openended response to the stated abuses.266 The governing concept here
should be that tax deferral of salary is essentially not justified at all
for tax reasons unless pursuant to a government mandate or under a
funded qualified plan, while acknowledging that certain rights to future cash cannot be currently taxed due to future contingencies. Accordingly, deferral should be “allowed” for non-funded arrangements
only if (a) no short-term cash-or-deferral elections are available and
(b) the plan prohibits—and does not in fact make—distributions on
261. See id. §§ 83(e)(1), 421-424 (providing for no taxation until the sale of the stock,
with any gain being capital gain).
262. Deferred compensation that is tied to changes in stock prices is apparently within
the scope of § 409A. Id. § 409A. Under Treas. Reg. § 1.409A-1(b)(5)(i)(A), (C), a nonqualified
stock option may be exempt if it (a) is not in the money when granted or (b) is “service recipient stock” (common stock of the employer). Section 409A, if it is retained in any form,
should not apply to nonqualified stock options, since the exercise of an option is not a distribution, nor does it represent an ability to obtain the employer’s cash.
263. See H.R. REP. NO. 108-548, pt. 1, at 343 (2d Sess. 2004).
264. See I.R.C. § 409A(a)(1)(A)(i).
265. See id. § 409A(a)(2)-(4). These rules also apply to funded arrangements, but in that
context they would be irrelevant if forfeiture conditions could no longer achieve deferral.
266. The proposed regulations under § 409A take up 103 pages in the 2013 CCH Federal Tax Reporter. Section 409A apparently applies to nonqualified stock options and splitdollar life insurance arrangements.
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any occasion other than reaching a certain age or long-term disability. In cases where current inclusion would occur except for future
contingencies that render the right to future cash incapable of valuation, a penalty tax, say, 10%, would be imposed on actual pay-outs.
3. Rabbi Trusts
The IRS has held that a Rabbi trust (a funded deferred compensation trust that is reachable by the employer’s creditors) is not truly
“funded” for tax purposes, 267 and therefore falls into the category of
contractual deferred compensation. Section 409A(b) taxes to the employee employer contributions to a Rabbi trust that is offshore and
any nonqualified deferred compensation amount subject to an employer’s financial-health contingency. 268 These rules partially overlap,
and it should suffice to provide that financial contingencies of an employer should not be taken into account in determining that a contribution has been made by an employer to a deferred compensation
arrangement (i.e., that the trust is funded). 269 At this point, deferral
would be impossible if Congress repeals the rule pertaining to forfeiture conditions.270 If the risk-of-forfeiture rule is retained, it should
be provided that financial and investment risks should themselves
not be viewed as substantial risks of forfeiture.
G. Foreign Income of U.S. Nationals
The United States generally taxes U.S. citizens and residents
(“U.S. nationals”) on worldwide income. If another country happens
to tax foreign-source income of a U.S. national, the United States
generally allows a tax credit against the U.S. tax on the same income
(but not to exceed the average U.S. tax on the same income). 271
1. Repeal the Exclusion for Foreign-Source Earned Income
Current § 911 allows an exclusion from U.S. tax for foreign-source
personal services (i.e., “earned”) income up to $80,000, as adjusted for
inflation ($97,600 in 2013), of a U.S. national if the U.S. national has
267. See Rev. Proc. 92-64, 1992-2 C.B. 422; I.R.S. Priv. Ltr. Rul. 81-13-107 (Dec. 31,
1980).
268. I.R.C. § 409A(b).
269. Since the underlying rule—that funded rights to future cash are current property
rights—is indifferent to the relationship between the parties (or the nature of the income),
the rule proposed here should be made applicable to trusts benefitting independent contractors as well as employees.
270. However, a funded (defined contribution) nonqualified plan must (generally) fully
vest within five years. See Employee Retirement Income Security Act, 29 U.S.C.
§ 1053(a)(2)(A)(ii) (2006). Full vesting removes conditions of forfeiture and would require
income inclusion under § 83(a). I.R.C. § 83(a).
271. I.R.C. §§ 901, 904(a).
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a “tax” home outside of the U.S. and meets a foreign residency test. 272
The calculation of the exclusion is complicated by a deduction for the
“foreign housing cost amount,” determined under a formula. 273 The
exclusion is hotly contested in tax policy circles and is the only significant exception to U.S. taxation of its own nationals.
Earned income is foreign-source if the taxpayer performs the services abroad.274 The exclusion allows creative talents, consultants,
and any person who can perform technical services from a non-U.S.
location to avoid U.S. tax, even if there is no business reason to perform these services abroad (or in the country of residence). The income can be earned in a tax haven country that imposes little or no
tax on the income, or perhaps in a non-tax-haven country that exempts certain types of services income by statute or under an income
tax treaty with the United States.
The argument for the foreign-income exclusion is no stronger than
that for excluding all foreign-source income (or perhaps foreignsource business income) of a U.S. individual taxpayer from U.S.
tax. 275 But, if the United States were to move wholesale to a territorial system that applied to individual taxpayers, source rules would
come under scrutiny. The source rule for services is mechanical and
bears little relationship to U.S. policy interests.276 In the context of
the prevailing U.S. norm of taxing U.S. nationals on world-wide income, it is hard to see what purpose the § 911 exclusion serves. In the
current world economic climate, it has little to do with exploiting foreign markets or tapping into foreign labor supplies.277 Removing the
exemption would do no real harm, because the foreign tax credit
would be available to avoid double taxation of foreign-source earned
income. Also, income tax treaty provisions can be negotiated with a
view of curbing host country taxation of temporary visitors. 278
2. Expand the Simple Version of the Foreign Tax Credit
The operation of the foreign tax credit is normally quite complex,
as it involves the application of “basket limitations” for foreign pas272. Id. § 911 (citizens or residents of the United States living abroad).
273. See id. § 911(a)(2), (c).
274. Id. § 861(a)(3).
275. The tax systems of some prominent trading partners of the United States have a
territorial slant, especially where corporations are involved. See HUGH J. AULT & BRIAN J.
ARNOLD, COMPARATIVE INCOME TAXATION 446-52, 467-71 (3d ed. 2010).
276. The income is sourced where the services are performed, not, say, where the benefit of the services are obtained. See I.R.C. § 861(a)(3).
277. The exclusion is critiqued in CHARLES H. GUSTAFSON ET AL., TAXATION OF INTERNATIONAL TRANSACTIONS 454-57 (4th ed. 2011).
278. See INTERNAL REVENUE SERVICE, UNITED STATES MODEL INCOME TAX CONVENTION OF NOVEMBER 15, 2006, arts. 14, 16 (2006), available at http://www.irs.gov/pub/irstrty/model006.pdf.
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sive income and for other foreign income. 279 Individual taxpayers paying modest amounts of foreign tax should not be involved with these
complications. Under § 904(k), the foreign tax credit limitations do
not apply if the taxpayer’s foreign income is entirely passive and the
creditable foreign taxes do not exceed $300. This provision should be
liberalized by eliminating the passive income requirement and increasing the maximum foreign tax amount to, say, $1000.
H. Entity Taxation
The taxation of family business enterprise impacts the taxation of
individual taxpayers. The discussion below assumes the implementation of a corporate tax “reform” that includes a reduction in tax rates
for C corporations relative to individual tax rates. 280 Interestingly,
such a “reform” would create several opportunities for simplification.
1. Mandatory Pass-Through Regime for All Non-Publicly Traded
Business Entities
If C corporation tax rates are less than individual tax rates, and if
the present system is otherwise unchanged, the accumulation/bailout
game would be revived for closely held entities that elect to do business as a C corporation.281 This opportunity can be foreclosed by requiring all non-public business entities and their equity holders to be
subject to pass-through taxation. 282 The liquidity premium incident to
public trading is what perhaps justifies a separate business entity
tax to begin with. Accordingly, only publicly traded entities would be
subject to the (reduced) C corporation tax. No reason exists to condition pass-through treatment of corporations on having no more
than a specified number of shareholders, as currently exists with
S corporations.283
279. See I.R.C. § 904(d).
280. The American Taxpayer Relief Act of 2012, Pub. L. No. 112-240, 126 Stat 2313
(2013), raised the highest individual rate to 39.6%, leaving the highest corporate rate at
35%.
281. The game consists of accumulating corporate earnings at a relatively low tax rate,
deferring or abstaining from dividend payments, and realizing on the value of the appreciated stock at low individual capital gains rates (with basis offset). Anti-bailout provisions
were salient features of corporate taxation during periods when the game was being
played. See, e.g., I.R.C. §§ 531-537 (accumulated earnings tax); id. §§ 541-547 (personal
holding company tax); id. § 341 (repealed) (collapsible corporation provision); id. §§ 302,
304, 306, 355, 1248 (current Code).
282. “Pass-through taxation” means that profits and losses are attributed (passed
through) to the equity holders, with no tax at the entity level.
283. See I.R.C. § 1361(b)(1)(A), (c) (S corporation cannot have more than 100 shareholders). A study by the American Law Institute proposes removal of this feature. See
GEORGE K. YIN & DAVID J. SHAKOW, AM. LAW INST., TAXATION OF PRIVATE BUSINESS ENTERPRISES 170-72 (1999).
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It might be argued that pass-through treatment is not appropriate
for non-public corporations with complex capital structures, because
here the burden of losses is not settled by contract or organizational
structure, as it is with a partnership or LLC. The difficulty of profit
and loss allocation is perhaps overrated. For example, holders of preferred interests can be taxed like debt-holders, 284 and the profit
shares of other equity interests would be spelled out. The issue of loss
shares in multi-tier pass-through corporations has been addressed by
me elsewhere. 285
Pass-through treatment of non-public corporations would render
pointless the personal holding company tax and the accumulated
earnings tax, which could be repealed. The proposed change would
also simplify the task of entity classification for tax purposes and reduce the factors entering into choice of tax entity decisions into
one, namely, whether equity interests in the entity are to be
publicly traded, which is a decision that would normally be made
on nontax grounds.
2. A Simplified Pass-Through Regime
Under a mandatory pass-through system for non-public entities, it
might be desirable to offer separate pass-through regimes, as exists
under current law: (a) the relatively simple S corporation regime,
elective for a corporation meeting certain eligibility requirements
(such as the one-class-of-stock rule), and (b) the complex passthrough regime for tax partnerships. 286 However, an S corporation
cannot currently elect into Subchapter K, and a partnership (or other
entity, such as an LLC, that is eligible to be taxed as a partnership)
cannot elect subchapter S status.
It is proposed that non-public business entities be allowed to
choose between a simple and a complex pass-through regime, or,
more modestly, that a tax partnership be allowed to elect into Subchapter S (as modified to accommodate partnerships). 287
284. That is, holders of preferred interests would be taxed on dividends paid (and possibly dividends accrued), which would be deducted by the entity, thereby reducing passthrough income.
285. See Joseph M. Dodge, A Combined Mark-To-Market and Pass-Through CorporateShareholder Integration Proposal, 50 TAX L. REV. 265, 319-23 (1995).
286. See I.R.C. §§ 1366-1377 (operative rules for S corporations); id. §§ 702-761 (operative rules for entities taxed as partnerships). The differences are explained in Walter D.
Schwidetzky, Integrating Subchapters K and S—Just Do It, 62 TAX LAW. 749 (2009).
287. Compare YIN & SHAKOW, supra note 283, at 131-272 (proposing a simplified version of conduit taxation for eligible private business organizations that so elect), with
Schwidetzky, supra note 286 (essentially proposing elimination of Subchapter S).
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3. Nondeductibility of C Corporation Interest
Under present law, the distinction between corporate debt and
equity is salient, because interest and dividends carry different tax
treatment to both the corporate entity 288 and the equity holders,289
resulting in a distortive incentive to use debt. 290 Additionally, the distinction is often difficult to apply in practice, and, being highly factintensive, is costly to administer and uncertain in result. 291 From the
policy angle, the interest deduction can combine with business tax
preferences to generate a very low, zero, or even negative income tax
on business earnings derived from capital, resulting in the misallocation of capital to marginal or bad investments. 292
These problems can be solved by disallowing interest deductions
for C corporations—at least those in which capital is a material income-producing factor. This disallowance would be a fair trade-off for
reducing the corporate tax rate. Indeed, it should generate sufficient
revenue to enable Congress to enact a truly significant reduction in
the corporate tax rate. 293
4. Eliminate Capital Gains Treatment of Dividends
Under current law, most dividends received from corporations are
treated as long-term capital gains.294 This special treatment (along
with the capital gains preference) operates, as far as corporate equity
is concerned, as a form of “partial” corporate/shareholder integration
by significantly reducing the shareholder-level tax. However, it is
better (in theory) to tax corporate profits at the level of individuals
receiving distributions, not the entity, because, although it is easy to
collect tax at the corporate level, the incidence of the corporate tax is
unknown and could vary among industries and firms. 295 Moreover, a
288. Interest is generally deductible, I.R.C. § 163(a), whereas dividends are not.
289. Interest is ordinary income, whereas “qualified dividend income” is currently
treated as “net capital gain.” Id. § 1(h)(11)(A).
290. The tax incentive to use debt financing often overwhelms nontax factors in choosing finance mechanisms. Additionally, interest can be used to shift income away from U.S.
debtors to related foreign parties. See I.R.C. § 163(j).
291. Section 385 was enacted in 1969 to deal with this issue, but that section is contingent on the issue of regulations, and final regulations have never been issued.
292. Expensing of capital expenditures results in “single” taxation of investment returns, whereas the exclusion of borrowing and deduction of interest yield “double” deduction of interest, viewing both phenomena in present value terms.
293. Limiting the current interest deduction to business or investment income, see id.
§§ 163(d), 469, would fail to solve the arbitrage problem of combining the current treatment of debt with consumption-tax treatment of investments. It might be contended that
certain interest (e.g., on purchase-money loans used to purchase real estate) should be
exempt from any disallowance rule, but if borrowed money is truly fungible, then such a
contention loses force.
294. See id. § 1(h)(11).
295. See Forum: Incidence of the Corporate Income Tax, 66 NAT’L TAX J. 149-262 (2013)
(introduction and four articles).
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139
significant reduction in the C corporation rate itself operates as a
form of partial integration. Many of the leading trading partners of
the U.S. have moved to partial integration systems of various types.
Accordingly, a significant reduction in the corporate tax rate
should be accompanied by restoration of the status of dividends as
ordinary income. Also, insofar as a capital gains preference for stock
gains and dividends is justified as a partial integration measure, such
preference would become redundant to the low corporate tax rate.296
5. Repeal the Earnings and Profits Apparatus
Under current law, a non-liquidation distribution from a C corporation is gross income only to the extent it is deemed to come out of
the corporation’s post-1913 earnings and profits (E & P). 297 E & P is a
financial accounting construct, and one has to make numerous adjustments to taxable income to calculate it. Additionally, rules are
required to determine what distributions reduce E & P. 298 These
rules, which are wholly arbitrary, operate so that a few corporations
still are deemed to possess pre-1913 E & P.299 The entire E & P system is much ado about practically nothing, as the E & P system rarely
prevents non-liquidation distributions from being taxable dividends.
From another angle, the taxation of equity investments should be
separated from any taxation of the underlying entity. The E & P
mechanism operates inappropriately as a capital recovery for corporate equity. Shares of stock are correctly not subject to depreciation,
because corporate equity has an indefinite useful life. Additionally,
partial loss deductions are not generally allowed under the income
tax. 300 Thus, recovery of capital under a realization income tax should
not be allowed unless there is a true disposition of all or a physical
portion of an asset. Stated in abstract terms, taxation of an investment should depend only on the investment and its economic return,
296. A 1982 study estimated that corporate stocks and bonds accounted for almost 37%
of total assets for all top wealthholders, closely followed by real estate (gains on which are
already largely exempt under § 121), with other categories being relatively insignificant.
See Marvin Schwartz, Estimates of Personal Wealth, 1982: A Second Look, SOI BULL.,
Spring 1988, at 31, 32. Thus, the capital gains (and dividends) tax preference could be
wholly eliminated, or at least targeted to individuals investing in family-owned businesses.
297. Corporate distributions in excess of E & P are tax free due to the shareholder’s
stock basis offsetting the cash received, and distributions in excess of basis are treated as
gains from the sale of the stock. See I.R.C. §§ 301(c)(1), 316(a).
298. See id. § 312.
299. The general rule is that distributions are deemed to come out of the most-recentlyacquired E & P. See id. § 316(a)(2). This last-in, first-out (LIFO) convention is the opposite
of the most commonly used convention for inventory, which is first-in, first-out (FIFO).
300. See Citizens Bank of Weston v. Commissioner, 252 F.2d 425 (4th Cir. 1958);
Lakewood Assocs. v. Commissioner, 109 T.C. 450 (1997); Pulvers v. Commissioner, 48 T.C.
245 (1967), aff’d, 407 F.2d 838 (9th Cir. 1969).
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not on the remote source of the return. 301 The fact that dividends are
not deductible represents the decision that corporate taxable income
is a tax base independent from the tax base of the shareholders. (In
contrast, the net income of a trust or estate is viewed as a pool of income that can only be taxed once.) A (pro rata) non-liquidation distribution is not a disposition of an investment or a portion thereof, but
only a cash return thereon: the shareholder retains the same right to
future distributions and same degree of control as existed before. The
fact that the corporate assets have shrunk in size is immaterial. Such
shrinking would cause the value of the stock to decrease, but that
decrease is simply unrealized depreciation, and unrealized depreciation is not deductible under a realization income tax. The E & P
mechanism, in short, is contrary to both the realization principle and
the separation of the corporate and individual income taxes.
Accordingly, the E & P apparatus should be jettisoned, and all prorata non-liquidation distributions should be treated as gross income.302
The notion of a “partial liquidation” distribution, resulting in a
basis offset without an actual surrender of stock, could be retained.303
However, since the same basis offset as is desired in a partial liquidation can be obtained by (1) dropping assets into a newly-created
controlled corporation, (2) distributing the stock of that corporation to
the shareholders of the distributing corporation, and (3) liquidating
the corporation whose stock was distributed, 304 the qualification requirements for obtaining a basis offset in a partial liquidation should
be essentially the same as would qualify a distribution of stock in a
controlled corporation for tax-free treatment under § 355. 305
301. Basis recovery in the case of an annuity or a level-payment debt obligation is
based on the notion that each cash receipt marks the disposition of a component of the
asset.
302. For other critiques of the current system, see William D. Andrews, “Out of Its
Earnings and Profits”: Some Reflections on the Taxation of Dividends, 69 HARV. L. REV.
1403 (1956), and Walter J. Blum, The Earnings and Profits Limitation on Dividend Income: A Reappraisal, 53 TAXES 68 (1975).
303. See I.R.C. § 302(e) (qualified partial liquidation treated as sale of portion of shareholder’s stock).
304. The assets of the terminal business can be placed in a separate corporation tax
free, id. § 368(a)(1)(D), the stock of which is distributed to the existing shareholders tax
free, id. § 355, and that corporation can be liquidated in a transaction treated as a sale
with basis offset, id. § 331(a).
305. The three-step transaction described at the beginning of this text sentence
achieves the same result as a partial liquidation under § 302(e) only if step (2) thereof—the
distribution of controlled corporation stock—qualifies as a tax-free distribution under
§ 355. Current § 355, in turn, has various qualification requirements, including (1) the
distributed corporation must contain assets of an active business that has been carried on
for at least five years, (2) that business must be carried on immediately after the distribution, and (3) the transaction must not be a disguised dividend (which would be indicated by
a prior agreement to sell or liquidate the distributed corporation). See id. § 355(a)(1)(B), (b).
The requirements of current § 302(e) are more lax, requiring either that a business (carried
on for five years) be terminated or that the transaction not be essentially the equivalent of
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141
An issue is whether, as a transitional rule, existing corporations
would be allowed to declare pre-1913 E & P and apply it against the
first post-enactment dividends until pre-1913 E & P is exhausted.
However, all current distributions with respect to stock are income to
the shareholder when received and cannot be pre-1913 income of the
shareholder. There is no constitutional requirement that dividends
out of pre-1913 E & P must be exempt, especially since the accounting convention that has the effect of preserving pre-1913 E & P is
arbitrary. 306 In fact, Lynch v. Hornby 307 held precisely that a post1913 dividend paid out of profits accumulated before 1913 could be
constitutionally taxed. 308 Therefore, any such transition rule would be
unnecessary and, in my view, unwarranted.
V. CONCLUSION
The emphasis here has been on proposals that fit into a realization income tax, which would simplify compliance and administration
for the bulk of individual taxpayers. The proposals made herein
(some original, some not) advance only some simplification moves
among the many that are possible. Other kinds of proposals can be
imagined, such as simplifying depreciation accounting (or eliminating depreciation altogether). International taxation is another area
that is only lightly considered herein.
Tax academics are often skeptical of a simplification agenda. Tax
law, as well as life itself, is complex, and tax professionals thrive on
complexity. Thus, we tax professionals have a vested interest in the
fact that we have mastered the intricacies of the tax law, which is a
major component of our human capital. But we tend to overlook the
fact that tax law is not self-executing. Accordingly, we tend to overestimate the ability of the IRS and the general population to follow
what we have wrought. In any event, the simplification agenda is not
necessarily bad news for tax professionals. The reader will have undoubtedly noted that many of the proposals made herein are not fully
developed and would require further working out. Some may even
turn out to be non-viable from the simplification angle itself. Tax professionals should be as good at creating simple, workable solutions to
a dividend at the corporate level (meaning, in effect, that a meaningful contraction of the
corporation’s business occurred).
306. Doyle v. Mitchell Bros. Co., 247 U.S. 179 (1918), construed the 1909 corporate
income tax to exclude pre-enactment appreciation. However, since a tax on gross receipts
(without basis offset) is constitutional as an indirect tax, basis recovery cannot be constitutionally required. See Joseph M. Dodge, Murphy and the Sixteenth Amendment in Relation
to the Taxation of Non-Excludable Personal Injury Awards, 8 FLA. TAX REV. 369, 401-07
(2007).
307. Lynch v. Hornby, 247 U.S. 339 (1918).
308. I.R.C. § 316(a)(1), excluding distributions from pre-1913 E & P, is, therefore, not
constitutionally required.
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existing complexities as they are at mastering existing ones. It is certainly a lot more enjoyable.
A PROPOSED REPLACEMENT OF THE TAX
EXPENDITURE CONCEPT AND A DIFFERENT
PERSPECTIVE ON ACCELERATED DEPRECIATION
DOUGLAS A. KAHN*
I.
II.
III.
IV.
INTRODUCTION ......................................................................................................
REPLACEMENT OF THE TAX EXPENDITURE CONCEPT .........................................
DEPRECIATION DEDUCTIONS ................................................................................
A. Economic Depreciation ....................................................................................
B. Proper Method of Depreciation ........................................................................
C. Illustration of a Flaw in the Tax Expenditure Concept .................................
CONCLUSION..........................................................................................................
143
145
153
154
155
157
158
I. INTRODUCTION
The concept of tax expenditures has been widely accepted1 and has
even been adopted into federal law, which requires the annual promulgation of tax expenditure budgets.2 Pursuant to that mandate, several
federal governmental offices publish lists of what they deem to be tax
expenditures. One such budget is published by the Department of
Treasury,3 and a different budget is published by the Staff of the Joint
Committee on Taxation.4 While there is considerable overlap in those
two budgets, they are not identical, and they utilize different norms
and baselines for determining what constitutes a tax expenditure.5
In addition, forty-five states publish their own versions of a tax
expenditure budget.6
The theme of the tax expenditure concept is that some tax provisions
are not elements of a normal or ideal system of income taxation and that
such provisions are designed indirectly to finance a program that Congress has chosen to support.7 The listed tax provisions are designated as
* Paul G. Kauper Professor, University of Michigan Law School. The author thanks Justin Hoag for his assistance in the preparation of this Essay.
1. Professor Zelinsky observed in a recent article that the advocates of the tax
expenditure concept have prevailed and that the federal government and the governments of
forty-five states
publish tax expenditure budgets. See Edward A. Zelinsky, The
Counterproductive Nature of Tax Expenditure Budgets, 137 TAX NOTES 1317 (2012).
2. 2 U.S.C. § 622(3) (2012) defines the terms “tax expenditures” and “tax expenditures
budget.” Section 632(e)(1) requires the Committee on the Budget of both houses of Congress to
publish a report each fiscal year, and the report must contain a tax expenditure budget. Id.
§ 632(e)(2)(E). 31 U.S.C. § 1105(a)(16) (2006) requires the president to submit a budget each
year, which must include a tax expenditure budget.
3. OFFICE OF MGMT. & BUDGET, EXEC. OFFICE OF THE PRESIDENT, ANALYTICAL
PERSPECTIVES: BUDGET OF THE U.S. GOVERNMENT, FISCAL YEAR 2014, at 241-77 (2013).
4. STAFF OF JOINT COMM. ON TAXATION, 113TH CONG., ESTIMATES OF FEDERAL TAX
EXPENDITURES FOR FISCAL YEARS 2012–2017 (Joint Comm. Print 2013).
5. Id. at 1, 20-22.
6. Frank Shafroth, Tax Expenditures: A Most Taxing Challenge, 64 ST. TAX NOTES 327
(2012).
7. STAFF OF JOINT COMM. ON TAXATION, supra note 4, at 2 (“Special income tax provisions
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disguised expenditures of the government that should be subjected to
the same scrutiny as are direct expenditures.8 While there is considerable overlap in the items listed in the two federal tax expenditure budgets, there are differences because they do not utilize the same baseline.
The budgets also provide an estimate of the amount of revenue that
the government loses because of the inclusion in tax law of each such
designated provision.9
There are several questions concerning the premise on which the various tax expenditure budgets rest. First, is there a “pure” or “ideal” income tax system? Second, even if there is one, was there any intention
by the legislators to adopt a system that would accord with a pure income tax system? Third, as a matter of policy, would it be desirable to
adopt a tax system that comports with a pure income tax system? I will
explore these questions in this Essay.
In prior articles, I have expressed my view that the tax expenditure
concept is flawed and misleading.10 In this Essay, I will set forth a view
of the structure of the federal income tax system that is different from,
and in contravention of, the view underlying the tax expenditure concept. I propose an entirely different standard for measuring the appropriateness of a tax provision. The tax expenditure concept is based on a
binary approach in categorizing tax provisions. Under that system, an
item either is consistent with normal tax provisions or is inconsistent
with them. There are no shades of consistency. Instead, I propose a multivariate standard for evaluating tax provisions.
Over 32 years ago, I published an article on accelerated depreciation
in which I concluded that some amount of acceleration was consistent
with normal tax principles and should not be classified as a tax expenditure.11 Over the intervening years, from time to time, I have exchanged
comments with authors who have questioned that conclusion.12 It is time
are referred to as tax expenditures because they may be analogous to direct outlay programs
and may be considered alternative means of accomplishing similar budget policy objectives.”).
8. There are reasons to question just how much scrutiny is given to direct expenditures.
Many governmental programs, such as Social Security, Medicare, and Medicaid dispense large
amounts of money without any congressional oversight of the programs. See AARON
WILDAVSKY, THE POLITICS OF THE BUDGETARY PROCESS 213-16 (2d ed. 1974) (explaining that
members of Congress have increasingly become “negligent guardians” of the purse).
9. The two budgets utilize different methodologies in determining the amount of revenue
that is lost. STAFF OF JOINT COMM. ON TAXATION, supra note 4, at 20-22.
10. See, e.g., Douglas A. Kahn & Jeffrey S. Lehman, Tax Expenditure Budgets: A Critical
View, 54 TAX NOTES 1661 (1992) (criticizing the tax expenditure concept’s assumption of “[a]n
ideal Internal Revenue Code”).
11. Douglas A. Kahn, Accelerated Depreciation—Tax Expenditure or Proper Allowance for
Measuring Net Income?, 78 MICH. L. REV. 1 (1979).
12. See, e.g., Walter J. Blum, Accelerated Depreciation: A Proper Allowance for Measuring
Net Income?!!, Comment, 78 MICH. L. REV. 1172 (1980); Douglas A. Kahn, Accelerated
Depreciation Revisited—A Reply to Professor Blum, 78 MICH. L. REV. 1185 (1980).
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A PROPOSED REPLACEMENT
145
to revisit that topic and renew the consideration of how tax depreciation
may properly operate.
This Essay’s analysis of depreciation provides one example of how the
tax expenditure budgets are flawed. The treatment of some accelerated
depreciation as a tax expenditure is based on a view that any acceleration conflicts with normal tax principles.13 I will show in this Essay that
when the structure of depreciation is examined, it becomes clear that
there is more than one way to determine what allowance for depreciation should be made. Furthermore, allowing acceleration does not contravene any established tax principles.
It is not the thesis of this Essay that acceleration is the only proper
method of tax depreciation. To the contrary, it is my view that many
forms of depreciation are proper and comply with normal tax principles,
and that accelerated depreciation is merely one of the appropriate methods that can be authorized.
II. REPLACEMENT OF THE TAX EXPENDITURE CONCEPT
Even those that admire the tax expenditure concept acknowledge
that there is a problem in identifying many of the items that constitute
expenditures because there is not universal agreement as to what constitutes a pure income tax system. Such a system is the base against
which tax provisions are measured to determine whether they are
“pure” tax provisions or tax expenditures.14 Nevertheless, these commentators note that there are many clear examples of what are and are
not tax expenditures, so they approve of the concept and regard any
questionable inclusions in the budgets as minor discrepencies.15 It is
noteworthy that some of the items that are regarded by the concept’s
proponents as clearly constituting expenditures are not so regarded by
some other commentators. For example, Professors Chirelstein and
Zelenak state that all personal deductions, such as charitable contributions and medical expenses, are clearly tax expenditures.16 On the other
hand, a number of commentators have concluded that some personal
deductions are consistent with a normal tax system.17 That conflict of
13. The commentary in the budget promulgated by the Staff of the Joint Committee states
that any depreciation provision that allows for a deduction in excess of what would be permitted
under straight-line recovery using the recovery periods set forth in the alternative depreciation
system established in I.R.C. § 168(g) will be treated as a tax expenditure. STAFF OF JOINT
COMM. ON TAXATION, supra note 4, at 6. The commentary indicates that economic depreciation
is deemed to be the model. Economic depreciation is explained infra Part III.A.
14. See, e.g., MARVIN A. CHIRELSTEIN & LAWRENCE A. ZELENAK, FEDERAL INCOME
TAXATION 206 (12th ed. 2012).
15. Id.
16. Id.; see also Gregg D. Polsky, Rationally Cutting Tax Expenditures, 50 U. LOUISVILLE
L. REV. 643 (2012) (arguing that charitable deductions, certain retirement accounts, child tax
credits, and the home mortgage interest deduction are all types of tax expenditures).
17. See, e.g., William D. Andrews, Personal Deductions in an Ideal Income Tax, 86 HARV.
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views illustrates that even if the premise of the expenditure concept
were correct, the classification of many such tax items as expenditures
is controversial.
To quarrel with the inclusion of some of the items in the budgets may
not be sufficient to justify abandoning the expenditure concept. While
such commentary casts doubt on the reliability of parts of the budgets, it
leaves open the question of whether the concept itself is viable. The
more items that are questioned, the greater the skepticism over the
reliability of the budgets; but the flaw in the concept is more fundamental than the difficulty encountered in identifying those items that
are expenditures.
It is the thesis of this Essay that the controversial aspect of some of
the items listed in the budgets is a symptom of the fact that the underlying premise of the expenditure concept is unsound. The failure of the
expenditure concept is not merely that many of the inclusions in the
budget are questionable. Rather, its failure lies in the fact that the entire concept is based on an erroneous view of the income tax system. It is
not sufficient to correct individual items of the budget; the entire tax
expenditure concept should be discarded. I discuss below the view of the
tax system on which the expenditure concept is based and describe a
different view of the tax system that more accurately comports with how
tax law actually operates and should operate.
The tax expenditure concept rests on the view that an ideal or normal
tax system exists. Tax provisions are then compared to that ideal or
normal system to see if they conform or not. The ideal system is usually
described as one that assesses taxes on some modified version of the
Haig-Simons definition of income—i.e., that income is equal to the sum
of a person’s accumulation of wealth and the market value of that person’s personal consumption during a specified period.18 Whatever may be
said about that definition as an ideal, it does not take into account the
administrative practicalities of overseeing an income tax system for millions of people engaged in a great variety of economic activities. The various tax expenditure budgets, however, do exclude provisions that serve
administrative functions.19
L. REV. 309 (1972); Jeffrey H. Kahn, Personal Deductions – A Tax “Ideal” or Just Another
“Deal”?, 2002 L. REV. M.S.U.-D.C.L. 1; Joel S. Newman, Commentary, Of Taxes and Other
Casualties, 34 HASTINGS L.J. 941 (1983); William J. Turnier, Personal Deductions and Tax
Reform: The High Road and the Low Road, 31 VILL. L. REV. 1703 (1986).
18. HENRY C. SIMONS, PERSONAL INCOME TAXATION: THE DEFINITION OF INCOME AS A
PROBLEM OF FISCAL POLICY 50 (1938). Treasury’s tax budget expressly adopts the Haig-Simons
definition as its model. OFFICE OF MGMT. & BUDGET, supra note 3, at 242.
19. The Staff of the Joint Committee’s budget expressely states that it excludes provisions
that serve administrative feasability. STAFF OF JOINT COMM. ON TAXATION, supra note 4, at 5.
Treasury’s budget excludes some items because of their administrative function. For example, it
excludes unrealized income from its budget. OFFICE OF MGMT. & BUDGET, supra note 3, at 242.
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147
The two governmental budgets apply different standards for determining the baseline against which tax items are measured.20 The drafters of one budget create what they consider to be an ideal system for
their baseline, and the drafters of the other budget determine what
principles they consider to be normal in the current tax system and then
characterize some of the current tax provisions as out of place with
those principles and, therefore, as tax expenditures.21 However, both
budgets recognize that some basic tax principles are appropriate and do
not create an expenditure. For example, the doctrine of realization is
treated as a normal and appropriate part of a tax system, and so adherence to that doctrine does not create a tax expenditure for either budget.22 For accounting purposes, the Joint Committee’s budget treats the
accrual method as normal except where it is not feasible to use it.23 The
budgets acknowledge that administrative convenience is a proper goal of
a tax system, and that is why they generally accept the realization doctrine.24 In recognition of the importance of administrative convenience to
the operation of a tax system, the budgets accept a number of other tax
principles, including the measuring of gain without regard to the effect
of inflation.25 The Joint Committee’s budget does not treat the failure to
tax the imputed income from one’s own services or from home ownership
as a tax expenditure because the Committee considers them to be excluded from income out of administrative necessity.26
The tax expenditure system is based on a binary view of tax provisions. They either conform to normal principles or they do not. There are
no degrees of compliance; every tax provision is either black or white.
That is an inaccurate picture of how a tax system is actually structured
and how it should be structured.
The proponents of the tax expenditure concept are correct in asserting that there is a core of provisions that clearly are part of the structure of an income tax system. The deduction of the expenses of producing income is a necessary part of a tax system if one seeks to tax net in-
20. STAFF OF JOINT COMM. ON TAXATION, supra note 4, at 1, 20-22.
21. Id.
22. Id. at 5; OFFICE OF MGMT. & BUDGET, supra note 3, at 241-42. In a recent article, Professor Calvin Johnson proposes a different baseline for tax expenditures that would include the
failure to tax unrealized appreciation as a tax expenditure. See Calvin H. Johnson, Measure Tax
Expenditures by Internal Rate of Return, 137 TAX NOTES 273 (2013). If the tax expenditure concept were to adopt all of Professor Johnson’s recommendations, the budget would have very
little significance because relatively few tax provisions would be omitted.
23. STAFF OF JOINT COMM. ON TAXATION, supra note 4, at 7.
24. See supra note 19 and accompanying text.
25. STAFF OF JOINT COMM. ON TAXATION, supra note 4, at 7; OFFICE OF MGMT. & BUDGET,
supra note 3, at 257.
26. Id. at 5. However, Treasury’s budget does classify some imputed income as a tax
expenditure. Id. at 5 n.11.
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come as contrasted to gross receipts.27 The number of provisions that fit
within that core may be fewer than some imagine, but there is no doubt
that there is a core of such provisions. However, it is an error to treat
tax provisions as either within that core or outside of it. In reality, most
provisions lie on a continuum of varying distances from that core. For
example, the expenses of daycare for an infant may be necessary for the
parent to work and earn income, but the personal elements of having a
child cause that expense to lie further from the core than the expenses of
paying an employee to sell the taxpayer’s products. Medical expenses
may be an appropriate deduction,28 but they are further from the core
than are ordinary business expenses. One of the flaws of the tax expenditure concept is that it ignores the proximity of a provision to the core.
Tax law does not operate in a vacuum. Tax laws affect behavior and
can have societal and economic consequences that may be desirable or
may be undesirable. For example, the failure to tax imputed income may
influence one spouse to stay home to care for a child rather than to earn
taxable wages and pay someone else to care for the child. The tax law
will have an influence on the parent’s decision. The likelihood of the tax
system skewing that decision is enhanced by the fact that the secondary
spouse’s wages may be taxed at a higher rate because of the income
earned by the other spouse. If no deduction is allowed for child care, the
tax law will create an incentive for one spouse to not be employed. The
decision for one spouse to stay home and care for the child may be regarded as desirable or undesirable depending upon one’s views on both
societal and economic issues. If it were concluded that that decision
should be made by the parents, insulated from any outside influence by
the government, the tax law’s influence could be neutralized by providing a tax deduction for the expense of child care. The parent’s decision
could then be made independently of tax considerations. Instead of
providing a deduction, current tax law gives a tax credit for such expenses.29 That works less efficiently than would a deduction, but it
serves the same function.
The child care example is one where a tax provision could be adopted
to prevent another tax position (the failure to tax imputed income) from
influencing behavior when it is determined that such influence is undesirable. It seems to me that a provision designed to negate a negative
influence of the tax law should not be regarded as a tax expenditure
27. There are good reasons not to base a tax system on gross receipts. Such a tax would
impose greater taxes on businesses with high costs than on those with low costs. That would
violate the doctrine of horizontal and vertical equity.
28. To the contrary, as previously noted, there are those who conclude that medical
expenses should not be deductible. The issue is controversial. See supra note 16 and
accompanying text.
29. I.R.C. § 21(a)(1), (b)(2)(a).
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even if the provision is deemed to differ from an ideal tax. Provisions of
that nature should be classified differently.
In contrast to neutralizing tax influences, a tax provision could be
adopted in order to induce or deter certain behavior. Some provisions
clearly were designed to further a non-tax objective. For example,
providing tax benefits for the purchase of anti-pollution devices has programmatic goals. The tax expenditure proponents would claim that a
tax provision that is designed to induce behavior is a subsidy and should
be characterized as an expenditure.30 That view is too simplistic.
As noted above, relatively few tax provisions fit within the core of
measuring and taxing net income. Instead, most lie on a continuum in
which some are close to that core and some are far from it. Legislators
take into account the effect that a proposed tax provision will have on
behavior and consider whether that behavior will have societal or economic consequences that are desirable or undesirable. It would be foolish to ignore the influence of taxation on the economy and on societal
decisions and simply to allow good and bad consequences to occur in any
way they happen to arise. That is not what occurs.
The considerations that go into the adoption of tax provisions are
multifaceted. The proximity of the provision to the core of a tax system
is one factor, but only one factor. The further a provision is from the
core, the greater the policy considerations must be to justify its retention. The closer the provision is to the core, the less relative weight that
is accorded to policy considerations. However, policy considerations are
never entirely absent from the equation. Even a core provision may be
removed from the tax law because of the prominence of adverse policy
considerations. For example, a deduction for an expense that directly
produces income is a core provision. But, there are circumstances where
no deduction is allowed for such expenses because they contravene nontax policies. One such exception is for illegal expenses, which are denied
deductibility by I.R.C. § 162(c). While, for several reasons, I think that §
162(c) is a bad provision, its legislative purpose obviously rests on nontax considerations. A fine that arises out of an activity conducted in operating a business is nondeductible because of I.R.C. § 162(f). Another
example is unreimbursed employee business expenses, which are treated as miscellaneous itemized deductions and so are subjected to limitations on their deductibility31 or even disallowed entirely if the AMT applies.32 There is no aspect of accurate income measurement that would
30. The thesis of the tax expenditure concept is that tax provisions that are designed to
implement a program, as contrasted to a measurement of net income, are equivalent to a direct
expenditure of governent funds and should be accorded the same treatment. See STAFF OF
JOINT COMM. ON TAXATION, supra note 4, at 2; STANLEY S. SURREY & PAUL R. MCDANIEL, TAX
EXPENDITURES 1 (1985).
31. Id. §§ 67-68.
32. Id. § 56(b)(1)(A)(i) (disallowing a deduction for miscellaneous itemized deductions in
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justify that treatment of business expenses, the full deductibility of
which is clearly within the core of proper tax provisions.
This picture of taxation explains one of the reasons why tax provisions need to be altered from time to time. The consequences of a provision can change as societal and economic conditions change. The values
that society holds can change so that consequences that once were
thought desirable are now viewed as undesirable, or vice versa.
There is another fundamental flaw in the tax expenditure concept.
Not only does it posit that there is a pure income tax system, it is based
on the assumption that the current tax law is designed generally to conform to that system so that variances from it can be seen as departures
that often represent disguised expenditures.33 To the contrary, the current system is not designed to be purely a taxation of net income nor did
its drafters aspire to that exclusive goal. The current system is far more
pragmatic. It is designed to be a combination of taxation of income and
consumption.34 In their excellent casebook, Professors Bankman, Shaviro, and Stark state, “it is often said that our system is as much a consumption tax as an income tax, or more precisely some sort of impure
hybrid of the two.”35 More broadly, the tax system can be seen as a hybrid of income tax and consumption tax systems infused with a pragmatism that takes into account various policies and values.
The pragmatic approach that Congress has adopted in enacting the
tax law is illustrated in Subchapter K, which contains the principal provisions dealing with the taxation of partnerships and partners.36 There
are two very different views of the nature of a partnership. It can be
viewed as a separate entity distinct from its partners. Alternatively, it
can be regarded as a mere convenient representative of the aggregate of
interests of the partners. The exclusive adoption of either view would
result in a quite different tax system from the one that would be applied
if the other view were taken. Congress chose not to adopt either view
determining the alternative minimum taxable income of an individual); see also id. § 67(b)
(outlining what constitutes a “miscellaneous itemized deduction”).
33. The only plausible justification for characterizing some tax provisions as falling
outside of pure income measurement is that the legislative purpose for having an income tax
system is to measure and tax income, such that any actual tax provisions that fail to measure
income accurately and that further a non-tax policy objective constitute a utilization of the tax
system to finance a program that the legislature desires.
34. For example, the tax law does not apply to some significant accessions to wealth such
as imputed income and unrealized appreciation of the value of assets, and the tax law’s view of
consumption appears to be different from the one contemplated in the Haig-Simons definition.
For example, commentators have questioned whether the deduction for medical expenses and
charitable contributions conflict with Haig-Simons because they should be treated as
consumption expenses. See supra note 16 and accompanying text.
35. JOSEPH BANKMAN, DANIEL N. SHAVIRO & KIRK J. STARK, FEDERAL INCOME TAXATION
14 (16th ed. 2012).
36. LAURA E. CUNNINGHAM & NOEL B. CUNNINGHAM, THE LOGIC OF SUBCHAPTER K 1 (4th
ed. 2010).
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exclusively. Instead, Congress adopted a hybrid view that treats a partnership as a separate entity for some purposes and as an aggregate of
interests for others.37 Rather than adhering to a fixed model, Congress
chose a more flexible and nuanced approach. When the tax law operated
better by treating the partnership as an entity, Congress did so; and
when the tax law operated better by treating the partnership as an aggregate of the partners’ interests, it did so.
The pragmatism of the tax system is reflected throughout the Code.
Another example is the treatment of spouses. For some purposes, they
are treated as two separate individuals.38 For other purposes, they are
treated as a single unit.39 Repeatedly, Congress shows that it is not seeking to adopt some idealized system, but rather seeks to have a system
that carries out its policies and goals. The discussion in Part III.B of this
Essay notes that Congress has shown that same pragmatism in its
treatment of depreciation. In some circumstances, Congress has chosen
to ignore unrealized appreciation in measuring the amount of an asset’s
depreciation.40 In other circumstances, it has disallowed any depreciation deductions because it has taken unrealized appreciation into account.41 In other words, in some circumstances, Congress has adhered to
the realization doctrine in determining depreciation, and in other circumstances it has rejected the realization doctrine.
Given the hybrid and pragmatic nature of the country’s income tax
system, it is folly to speak of provisions departing from some fixed, ideal
view of income. Such so-called departures can be as much a proper part
of the system as those that are seen as core provisions. There are numerous factors to be considered in determining whether any tax provision should be retained, but its relationship to some ideal tax system is
not one of them.
Once it is accepted that the tax law does not seek to adhere to a single view of taxation, it seems clear that any purported departures from
an ideal system cannot be characterized as impure. A provision that
does not conform to an imagined ideal tax system could be a provision
that complements other provisions that do not conform. Once a variance
37. See, e.g., KAREN C. BURKE, FEDERAL INCOME TAXATION OF PARTNERS AND
PARTNERSHIPS 1-2 (4th ed. 2013).
38. For example, spouses are not required to file a joint income tax return under I.R.C.
§ 6013, but they can each file separately, reporting his or her own income and deductions.
39. See, e.g., I.R.C. § 318(a)(1)(A)(i) (treating a taxpayer as owning stock owned by the
taxpayer’s spouse); id. § 469(h)(5) (treating the participation of a taxpayer’s spouse as
participation of the taxpayer).
40. As noted in Part III.B infra, the allowance of accelerated depreciation effectively
ignores the unrealized appreciation in the remaining life of the asset.
41. No depreciation is allowable for a non-wasting asset (such as land) because the
appreciation of the value of the remaining life of the asset offsets the value that was exhausted
in the year in which the asset was used.
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from a system has been adopted, there can be good reasons not to follow
that system when adopting other provisions.
The proponents of the tax expenditure concept do not contend that
the items listed in the budgets necessarily should be repealed or
changed. They contend that since the items do not conform to established tax principles, each should be repealed unless a convincing case
can be made for its retention on the basis of serving some valuable societal or economic purpose whose benefit justifies the amount of revenue
that is lost because of that provision.42 In other words, because of their
equivalence to a direct expenditure, they should meet the same process
of review that is applied to determine whether to continue making a
direct expenditure.43
By singling out some tax provisions because they serve non-tax policy
functions, the concept obscures the fact that non-tax policy considerations have a role in the question of the adoption or retention of virtually
all tax provisions.44 The inclusion of some items on the list suggests that
the items that are not on the list are free of policy considerations. Also,
by placing all so-called tax expenditures in a single category of nonneutral, the concept ignores the different status of provisions that lie on
different points of the continuum. Since the adoption or retention of virtually all tax provisions is influenced by non-tax considerations, the selection of some such provisions to be designated as having a programmatic function is misleading because it suggests those provisions are
significantly different from the many other provisions that also serve a
programmatic function.
The expenditure concept serves more of a political purpose than it
does provide any useful information. By classifying some provisions as
tax expenditures, it suggests that they do not belong in the tax system
and makes them prominent targets for repeal whenever Congress needs
to increase revenue.45 This labeling could alter the debate on listed items
by marking them with a scarlet letter. Moreover, the question of where
the items belong on the continuum, which should be a factor, might be
42. SURREY & MCDANIEL, supra note 30, at 26-27.
43. As previously noted, some authors have questioned the extent to which direct
expenditures are scrutinized. See, e.g., Zelinsky, supra note 1, at 1320.
44. As previously noted, even core provisions, such as business expenses, are subject to
non-tax considerations. See supra notes 27-32 and accompanying text. In that case, as
contrasted to inducing the adoption of a provision, the presence of undesirable non-tax
consequences can lead to eliminating or limiting the item.
45. Despite the promulgation of tax expenditure budgets, the number of items that are
classified as expenditures has continued to grow. Some have concluded, therefore, that the tax
expenditure budgets have been ineffective. Indeed, Professor Zelinsky contends that the
budgets have been counterproductive and have actually stimulated the increase in tax
expenditures. Zelinsky, supra note 1, at 1317. While that seems an unlikely consequence and
other explanations are available, I make a different point in this Essay. My thesis is that the
expenditure concept is based on a false premise and should be discarded regardless of its
efficacy.
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overlooked. The following discussion of accelerated depreciation provides
an example of a designated expenditure provision that can be seen to be
within the core itself. The characterization of accelerated depreciation as
an expenditure reflects the rigidity of the expenditure concept and its
failure to reflect the flexibility of the tax system, which accommodates a
variety of approaches for the determination of income.
III. DEPRECIATION DEDUCTIONS
The cost of acquiring an asset that will be used in a trade or business
or for the production of income is deductible.46 However, if the asset is to
be used by the taxpayer for more than one year, the entire cost generally
cannot be deducted currently, but instead it must be capitalized.47 The
capitalized cost can be allocated among the years of the asset’s useful
life, and a portion of the cost can be deducted in each year.48 Certain
types of amortization of cost are referred to as depreciation.49 If an aliquot amount is allocated equally to each year of the recovery period, the
depreciation is referred to as “straight-line” depreciation.50 Some methods of depreciation allocate a greater amount of cost to the earlier years
of the recovery period than to the later years. Those types are called “accelerated depreciation.” The most commonly used accelerated depreciation method authorized by the Code is the “declining balance method.”51
While there is little dispute as to the appropriateness of allowing depreciation deductions, there are issues as to the methods of depreciation
that should be available and as to the choice of a recovery period. In
general, the tax expenditure budgets treat accelerated methods as expenditures to the extent that the amount of deduction in a year exceeds
what would be allowed under either straight-line or economic depreciation.52 The source of the view that accelerated depreciation is excessive
is an approach to depreciation called “economic depreciation” or “sinking-fund depreciation.”
46. I.R.C. §§ 162(a), 212(1).
47. Id. § 263; see Indopco v. Commissioner, 503 U.S. 79 (1992). The one-year standard is a
rule of thumb that has been adopted by the Service. See Rev. Rul. 73-357, 1973-2 C.B. 40; Rev.
Rul. 69-560, 1969-2 C.B. 25.
48. I.R.C. §§ 167-168.
49. Id.
50. Treas. Reg. § 1.167(b)-1(a).
51. I.R.C. § 168(b).
52. STAFF OF JOINT COMM. ON TAXATION, supra note 4, at 6; OFFICE OF MGMT. & BUDGET,
supra note 3, at 258 (utilizing economic depreciation, a decelerated method, as the normal tax
baseline).
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A. Economic Depreciation
Economic depreciation is based on the premise that the correct
amount of depreciation allowable for a year is the amount by which the
asset declined in value by the end of the year.53 It is not based on the
actual decline in the asset’s value, which would require appraisals to be
made. Rather, it is based on the decline that occurs because of the passage of time without regard to changes that may have taken place in
market conditions. Apart from the administrative difficulty in measuring market changes, tax law has firmly established that changes in market value do not affect the amount of depreciation that is allowable.54
Economic depreciation concludes (quite reasonably) that the value of
an asset is the sum of the present values of the income stream that it is
assumed the asset will produce. The calculation of economic depreciation
is illustrated in an example in the treatise on federal income taxation
that is co-authored by Professors Chirelstein and Zelenak.55 I will use
their example since it provides such a clear explanation of that approach
to depreciation.
In that illustration, a machine is purchased for $4000 to be used in a
business. The machine is expected to last for 5 years and to produce (after maintenance expenses) income of $1200 each year. While it is unrealistic to assume an equal amount of income production each year, that
assumption makes the calculations easier. I will also assume, unrealistically, that the entire $1200 is received at the end of each year, rather
than being earned throughout the year.
To calculate the value of each year’s income stream to a purchaser,
the market will discount the $1200 for that year by a figure that represents the rate of income that the market deems appropriate for the risk
involved in purchasing the machine. The discount rate that is used to
establish the price of an asset is set by the market. Since the purchaser
paid $4000 for a machine that will produce $6000 over a 5-year period,
the discount rate was about 15%.
The value of the machine will decrease by the end of each year since
the remaining life of the machine will be one year less. But, simultaneously, the value of the remaining years of use will increase because they
are one year nearer to occurring. The latter increase in value will offset
some of the reduction in value caused by the expiration of one year’s life.
Chirelstein and Zelenak illustrate this effect by setting forth the
following schedule:56
53.
54.
55.
56.
CHIRELSTEIN & ZELENAK, supra note 14, at 187.
Fribourg Navigation Co. v. Commissioner, 383 U.S. 272, 277 (1966).
CHIRELSTEIN & ZELENAK, supra note 14, at 187-88.
Id. at 188.
2013]
Present
Value
of
Investment
Start Year 1
End Year 1
End Year 2
End Year 3
End Year 4
End Year 5
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A PROPOSED REPLACEMENT
$4000
$3427
$2740
$1950
$1045
$0
Present Value of Remaining Payments
1
$1045
2
$905
$1045
3
$790
$905
$1045
4
$687
$790
$905
$1045
5
$573
$687
$790
$905
$1045
Total
Annual
Loss
in
Present
Value
$573
$687
$790
$905
$1045
$4000
As you can see from that schedule, the decline in value of the machine at the end of Year 1 was $573. In the next year, the machine declined in value by $687. The decline in value was larger in each subsequent year until the fifth year when the decline was $1045. If depreciation deductions were to follow that schedule, there would be only $573 of
depreciation in the first year and increasing amounts each year until the
last year would have $1045 of depreciation. Instead of straight line or
accelerated depreciation, there would be decelerated depreciation. In a
nutshell, that is economic or sinking-fund depreciation.
Because economic or sinking-fund depreciation is based on several
unrealistic assumptions, no one advocates the adoption of that system.
Indeed, Chirelstein and Zelenak themselves acknowledge that the assumptions are unrealistic for the depreciation of tangible assets, and
they note that if more realistic assumptions were made, “the proper depreciation method would be less decelerated than sinking fund, or possibly even straight-line or accelerated.”57 While the tax expenditure budget proposed by the Joint Committee on Taxation considers economic depreciation to be the model, they treat straight-line depreciation as the
normal baseline for their budget.58
B. Proper Method of Depreciation
Let us ignore the unrealistic assumptions that go into economic depreciation and focus on whether it is the only proper view of depreciation when accepting those assumptions.
Referring to the schedule above for the machine that was purchased
for $4000, we can see that of the $4000 that the purchaser paid for the
machine, $1045 of it was attributable to the income he expected to earn
in the first year of using the machine. If he paid $1045 for the first
57. Id. at 189.
58. See STAFF OF JOINT COMM. ON TAXATION, supra note 4, at 6.
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year’s use of the machine, why doesn’t economic depreciation allow him
to deduct that amount for the use of the machine in that year? Why does
economic depreciation allow him to deduct only $573? The answer is
that while he used up the first year of the machine’s life for which he
paid $1045, the value of the remaining four years of the machine’s life
increased due to the fact that they are all one year closer in time to being earned. So, we can see that economic depreciation is based on offsetting the exhaustion of the $1045 paid for the first year’s use of the machine by the increase in value of the remaining life of the machine due to
the passage of time.
The increase in the value of the remaining life of the machine is unrealized appreciation. The doctrine of realization is a basic element of
the federal income tax system, and the tax expenditure budgets do not
treat the application of that doctrine as creating an expenditure.59 If the
increase in value of the remaining life were not taken into account in
determining depreciation because of the realization doctrine, the machine would be depreciated on an accelerated method. The first year’s
depreciation would be $1040, the second year’s would be $905, and so on,
until the fifth year’s depreciation would be $573.
Does that accelerated method violate normal principles of federal income taxation? It is the thesis of this Essay that it does not. It rests on
an application of the realization doctrine that is widely used in the federal income tax system and clearly is part of the normal tax system.
As previously noted, it is not my position that accelerated depreciation is the only permissible method under normal taxation rules. While
the realization doctrine is generally applied in the tax system, there are
a few circumstances when Congress has chosen not to apply it.60 If Congress chose not to take the unrealized appreciation of the remaining life
of an asset into account when determining depreciation deductions, that
would not violate any neutral principles of taxation. Similarly, if Congress chose to calculate depreciation by offsetting the appreciation of the
remaining life of an asset against the amount paid for one year’s use,
even though that would not comport with the realization doctrine, that
treatment also would be consistent with normal tax principles. While
the realization doctrine is a normal part of tax law, there is no requirement that it be used. Ignoring the realization doctrine is just as “normal”
as following it. There is no “correct” method; either one is permissible.
Indeed, Congress has rejected the realization doctrine for purposes of
determining depreciation in certain circumstances. Generally, no depreciation deduction is allowable for assets that are not subject to wear and
59. See supra note 22 and accompanying text.
60. See, e.g., I.R.C. §§ 336, 1272 (treating “debt instruments having original issue
discount[s]” and property acquired during corporate liquidation as a gain/loss of income).
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tear.61 Consequently, no depreciation deduction is allowable for land and
for stocks. While such assets do not deteriorate due to wear and tear,
the present value of each year’s income declines the further the years
are from the present. At some point in time, the present value of the remaining years of income will be de minimis. Why then is no depreciation
allowable for such assets? The apparent answer is that in those cases,
Congress has chosen to reject the realization doctrine and to take into
account the appreciation in value of the remaining life of those assets.
Once again, Congress has displayed its pragmatism by refusing to be
restricted to a single approach.62
C. Illustration of a Flaw in the Tax Expenditure Concept
The tax expenditure budgets’ treatment of accelerated depreciation
illustrates the basic flaw in that concept. The budgets rest on the notion
that there is a single correct or perfect system of federal income taxation
that has no relationship to policy considerations. The error in that view
is much more than the great difficulty that exists in determining just
what constitutes a perfect system. The error is to assume that such a
system exists and that it would be desirable to adopt it. The budget’s
rigid approach to depreciation illustrates how wrong it is to hold that
there is a single correct approach to measuring income. The tax law is
and should be far more flexible and pragmatic than that. It should accommodate the needs of the time. Policy considerations are a normal
part of the tax system and should not be classified as aberrations.
If accelerated depreciation is more desirable at one point in time, it
should be employed. If it is not desirable at another point in time, it
should be abandoned. There is no reason to skew that decision by categorizing one of the choices as being inconsistent with normal tax principles. Accelerated depreciation is consistent with normal tax principles,
and the decision whether to retain or repeal it should not be influenced
by a false characterization that it is not.
61. Treas. Reg. § 1.167(a)-2.
62. In a recent article, Professor Calvin Johnson contends that accelerated depreciation
does not comport with a new baseline that he urges should be adopted in determining tax
expenditures in lieu of the baselines that are used currently. See Johnson, supra note 22, at
273-74. In essence, his contention is that a policy analysis of depreciation would reject
accelerated depreciation. As noted above, I do not contend that accelerated depreciation should
be adopted; I merely contend that its adoption does not contravene normal current tax
principles. Professor Johnson’s position that economic policy supports eliminating accelerated
depreciation rests on a single consideration (on the merits of which I express no opinion in this
Essay) and ignores some of the other factors that might properly be taken into account. For
example, the likely effect of inflation on measuring depreciation might be considered. The fact
that the value of many personal property items does decline more in the earlier years of the
asset’s use might be weighed. In any event, it is not my intention to take a side on the question
of whether accelerated depreciation is desirable as a matter of policy. I leave that question for
others to resolve, but I suspect that answers will differ at different points in time depending
upon the needs of that period.
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IV. CONCLUSION
I maintain that the tax expenditure concept is grounded on a basic
error in its view of the income tax system. There is no “perfect” or “ideal”
tax system. The tax system is not divorced from every political, societal,
and economic condition that exists, nor is it independent of the values
that society holds at given points in time. The tax expenditure concept
views the ideal tax system as one that is insulated from non-tax factors
rather than being a part of and responsive to them. It is wrong to treat
tax as isolated from everything else. The adoption of that view can distort the proper consideration of the passage or repeal of tax provisions.
The advocates of the tax expenditure concept recognize that non-tax
policies can properly induce Congress to adopt specific tax provisions.
Their contention is that such provisions should be scrutinized as they
would if they were direct expenditures. However, by characterizing some
provisions as inconsistent with neutral tax principles, they attempt to
make it more difficult to defend the listed items. More importantly, by
adopting a binary approach in characterizing provisions as either within
normal tax principles or outside of them, the concept fails to take into
account the greater variety that exists in a properly structured tax system. Provisions that are outside of the core of proper tax provisions are
not all distanced from that core to the same extent. Some provisions lie
closer to the core than others, and some are far removed from it. The
expenditure concept obscures that fact and describes the tax world
as containing only two categories—those within the system and those
outside of it.
It has been pointed out that while the tax expenditure concept has
been widely accepted, it has been notoriously ineffective in changing the
tax law.63 While there has been some speculation as to why that is so,
the most obvious reason seems to have been ignored. The likely reason
that the concept has not had a greater impact on tax legislation is that
even though people purport to approve of the concept, they intuitively
realize that it is flawed and should not have any influence.
Some have suggested that even if the tax expenditure concept is
flawed, it would be useful to have a list of tax items that might be scrutinized by Congress when it seems appropriate to do so. I have no quarrel with the promulgation of such a list. My quarrel is with the characterization of certain tax items as “impure” because they do not comport
with a supposed ideal tax system. It is the stigmatization of certain tax
items that is the source of the mischief with which I find fault.
63. See, e.g., Zelinsky, supra note 1, at 1317 (explaining how “tax expenditure budgets . . .
have not curbed tax expenditures, as the proponents of those budgets promised”).
THE END OF CASH, THE INCOME TAX,
AND THE NEXT 100 YEARS
JEFFREY H. KAHN * & GREGG D. POLSKY **
I. INTRODUCTION..................................................................................................
II. CASH AND THE INCOME TAX GAP ......................................................................
III. WILL PAYMENT SYSTEMS TECHNOLOGY EASE TRANSITION TO A
CONSUMPTION TAX? ..........................................................................................
IV. CONCLUSION .....................................................................................................
159
161
166
171
I. INTRODUCTION
One theme of this symposium, which celebrates the 100th anniversary of the federal income tax, is “The Next 100 Years.” What will
the next hundred years have in store for the federal income tax? We
suspect that technological innovations will play a very significant
role. Technology has dramatically affected life in the United States
over the past century in many areas, perhaps most notably in communications. 1 On the other hand, the income tax is technologically
very similar to the way it was in its early years, and technological
developments have been at the margins of the income tax and have
not affected its core elements.
This is not to imply that technology has had no effect on the income tax. Technological improvements have made third-party reporting and withholding more efficient, which has allowed these mechanisms to become more pervasively used.2 Tax compliance software
has made it easier for professional tax preparers and taxpayers alike
to prepare and file tax returns and information statements. 3 Technology has also made it easier for taxpayers to substantiate their activities; the proverbial shoebox full of receipts is disappearing. All of
these changes have undoubtedly facilitated the evolution of the in* Charles W. Ehrhardt Professor & Associate Dean for Academic Affairs, Florida
State University College of Law.
** Willie Person Mangum Professor of Law, University of North Carolina School of
Law. The authors thank Joshua Eagle, Brant Hellwig, Douglas Kahn, Kathleen Delaney
Thomas, Lawrence Zelenak, and the participants at Duke Law School’s tax colloquium and
at the Florida State College of Law’s tax symposium for comments, suggestions, and discussions on this topic. They would also like to thank Mary McCormick for her research
assistance.
1. Wesley MacNeil Oliver, Western Union, the American Federation of Labor, Google,
and the Changing Face of Privacy Advocates, 81 MISS. L.J. 971, 972 (2012).
2. Ruth Mason, Delegating Up: State Conformity with the Federal Tax Base, 62
DUKE L.J. 1267, 1280-81 (2013).
3. See id.; see also Jay A. Soled, Homage to Information Returns, 27 VA. TAX REV.
371, 372-73 (2007).
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come tax from its original class tax to the mass tax it is today. These
changes have also facilitated the exponential growth of the tax expenditure budget, which is now the primary way in which the federal
government engages in non-military discretionary spending.4 And
both of these developments—the transition to a mass tax and
the growth of tax expenditures—have resulted in the federal income
tax becoming the most salient and controversial tax in the
United States. 5
But while technology has certainly affected the income tax, it has
not affected its core elements. The income tax remains a selfreported, annually calculated tax. And the tax problems resulting
from the cash economy—namely, that cash income is rarely reported
accurately—continue to plague the income tax. 6 The income tax is
thus analogous to the transportation industry; while technology has
made car and plane travel more efficient and accessible to the masses, the traveling experience has not changed fundamentally over the
past century. However, recent news reports suggest that driverless
cars may be available on a widespread basis within the next ten
years.7 Driverless cars would fundamentally alter traffic control systems, parking, and even the way that cities are structured.8 Perhaps
the same fundamental technology-driven changes are in store for the
income tax.
While technology might improve the federal income tax, it could
have the opposite effect by paving the way towards the elimination of
the income tax. One particular type of technology—payment systems—has the potential either to fortify the income tax or to destroy
it. Payment systems technology (e.g., electronic payment systems)
could eventually shrink the cash economy down to an immaterial size
and perhaps even make cash as obsolete as payphones. These developments would fortify the income tax by reducing the large part of
the “tax gap” 9 attributable to unreported cash income, which would
result in increased fairness and efficiency, greater confidence in the
tax system, and improved taxpayer morale. But payment systems
technology, instead, could destroy the income tax by easing the transition from the income tax to a consumption tax.
4. See LAWRENCE ZELENAK, LEARNING TO LOVE FORM 1040: TWO CHEERS FOR THE
RETURN-BASED MASS INCOME TAX 56-60 (2013) (describing the tax expenditure explosion
and its relationship to the income tax becoming a mass tax).
5. See id.
6. Susan Cleary Morse, Stewart Karlinsky & Joseph Bankman, Cash Businesses and
Tax Evasion, 20 STAN. L. & POL’Y REV. 37, 39-40 (2009).
7. Nick Bilton, How Driverless Cars Could Reshape Cities, N.Y. TIMES, July 8, 2013,
at B5.
8. See id.
9. See infra Part II (defining “cash tax gap”).
2013]
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161
In Part II, we explain how the end of the use of cash would
strengthen the income tax system by eliminating the very large portion of the tax gap that results from the inability of the Internal Revenue Service to ensure that cash transactions are properly reported.
In Part III, we describe some of the advantages of a consumption tax
over the income tax that have been asserted by many economists and
policymakers. 10 We then explain how the end of cash makes the transition to that type of system more realistic. We also briefly address
some of the possible transitional and permanent concerns that such a
move would entail. In Part IV, we conclude.
II. CASH AND THE INCOME TAX GAP
A large portion of the income tax gap—the difference between the
amount of income tax revenue that is by law supposed to be paid and
the amount of income tax revenue actually collected—is attributable
to cash income that is not reported. This “cash tax gap,” which has
recently been estimated at over $100 billion per year, 11 has many
troubling policy implications. First, the lost tax revenue means that
tax rates are higher than they otherwise would need to be to raise
the same amount of revenue. The higher tax rates result in greater
tax-induced distortions, including the adoption of tax planning strategies to reduce the tax burden.12 Second, the unintentional tax preference for cash transactions results in the cash economy being larger
than it otherwise would be. Businesses that routinely accept cash
(such as those that provide household and other personal services 13)
are tax-preferred relative to other businesses, which results in overinvestment in those types of businesses. In other words, the after-tax
return from cash businesses is greater because of underreporting.14
10. DANIEL S. GOLDBERG, THE DEATH OF THE INCOME TAX: A PROGRESSIVE CONSUMPTAX AND THE PATH TO FISCAL REFORM 5 (2013) (“[A] consumption tax, that is, a tax
based on what individuals consume rather than on what they earn as under an income tax,
is viewed by most economists as superior to an income tax.”).
11. See Kathleen DeLaney Thomas, Presumptive Collection: A Prospect Theory Approach to Increasing Small Business Tax Compliance, 67 TAX L. REV. (forthcoming 2013)
(manuscript at 5) (on file with authors).
12. JOEL SLEMROD & JON BAKIJA, TAXING OURSELVES 144 (4th ed. 2008) (“On all the
margins of choice, taxpayers will undertake behavior that reduces tax liability up to the
point that the marginal cost equals the marginal tax saving.”).
13. For tax avoidance reasons (both income and employment taxes), homeowners
often pay domestic help in cash. Catherine B. Haskins, Household Employer Payroll Tax
Evasion: An Exploration Based on IRS Data and on Interviews with Employers and Domestic Workers 5 (Feb. 1, 2010) (unpublished Ph.D. dissertation, Univ. of Massachusetts –
Amherst), available at http://scholarworks.umass.edu/cgi/viewcontent.cgi?article=1171&
context=open_access_dissertations.
14. See Thomas, supra note 11, at 5 n.21; see also U.S. GOV’T ACCOUNTABILITY OFFICE, GAO-07-1014, TAX GAP: A STRATEGY FOR REDUCING THE TAX GAP SHOULD INCLUDE
OPTIONS FOR ADDRESSING SOLE PROPRIETOR NONCOMPLIANCE (2007), available at
http://www.gao.gov/new.items/d071014.pdf.
TION
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Third, to avoid detection by the IRS, taxpayers who do not report
cash income typically do not deposit the cash they receive in bank
accounts or make other investments (e.g., in stocks, bonds, or CDs)
with that cash. As a result, the cash is suboptimally invested, and
cash recipients are unable to borrow funds to grow their businesses.15
Fourth, the cash tax gap hurts taxpayer morale and encourages other
types of tax cheating. Open and obvious cheating by failing to declare
cash income and offering “cash discounts” can make even taxpayers
who are inclined towards honest reporting doubt the integrity of
the system. 16
Fifth, the tax preference for cash encourages the use of cash over
other mediums of money payment. In fact, the tax preference for cash
probably plays a key role in the persistence of cash in the economy.
Considering the readily available alternatives to cash (debit card,
credit card, or e-payment transactions) and the problems inherent in
dealing with cash, it is a wonder that cash transactions remain as
common as they are. The problems with cash are legion. 17 Cash is
subject to counterfeit, and counterfeiters are becoming increasingly
sophisticated. Cash is more easily stolen than electronic money.18
Cash must be secured during transit and where stored. Cash must be
physically delivered to where it will be stored, resulting in transportation costs.19 Once a transaction in cash is consummated, it may be
impossible to find and collect against the seller if the product or service is not delivered or is defective. 20 Cash transactions do not spontaneously and immediately leave a record of what has transpired,
which allows for disputes as to whether payments have been made
and makes it more difficult for parties to keep track of what they
have purchased or sold.21 Cash is easier for sellers’ or buyers’ agents
to misappropriate. Cash transactions require change to be physically
provided if exact cash is not paid, which requires sellers to keep
change on hand and slows down transactions. Cash generally must
be accounted for manually. Electronic cashiers cannot process cash
15. Morse et al., supra note 6, at 49-54; see also Ilan Benshalom, Taxing Cash, 4 COL65, 74 (2012).
16. See Leandra Lederman, Reducing Information Gaps to Reduce the Tax Gap: When
Is Information Reporting Warranted?, 78 FORDHAM L. REV. 1733, 1755 (2010).
17. See generally DAVID WOLMAN, THE END OF MONEY (2012) (describing the problems of cash and predicting an eventual cashless society).
18. Id. at 45.
19. JACK WEATHERFORD, THE HISTORY OF MONEY 238 (1997).
20. Other payment systems make recourse against the seller much easier. Credit and
debit card companies allow buyers to challenge charges, and e-payment sellers generally
leave a footprint that would allow a claim to be made against them. Arnold S. Rosenberg,
Better than Cash? Global Proliferation of Payment Cards and Consumer Protection Policy,
44 COLUM. J. TRANSNAT’L L. 520, 524 (2006).
21. Id. at 534.
UM. J. TAX L.
2013]
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163
transactions efficiently, which means that sellers that accept cash
usually will hire human cashiers. The list goes on and on.
This is not to say that cash does not sometimes have its virtues.
Cash is currently very useful for small, ad hoc transactions, such as
tipping service providers. 22 But this advantage too will soon wither
away, as e-payment technologies through, for example, mobile phone
applications, become commonplace.23 Nevertheless, there are certain
advantages of cash that will likely persist. Most significantly, cash
easily allows for anonymous purchases. 24 In addition, cognitive biases
may have a salutary effect on spending behavior when cash is used
as the medium of payment. 25 People tend to be more frugal paying in
cash rather than in other media; casinos seem to bank (no pun intended) on this principle by requiring gamblers to bet with tokens.
Personal finance experts likewise encourage the use of cash to tamp
down excessive spending. 26 But even this advantage may be ephemeral as electronic commitment devices (perhaps electric shocks from
your cell phone if you spend too much 27) eventually develop.
Overall, the benefits of non-cash payment media substantially
outweigh the benefit of cash, leaving aside tax consequences. This
explains the exponential growth of non-cash payment media and its
emerging dominance in the economy. 28 Eventually, it is likely that
nearly all remaining cash-transaction outliers will involve tax evaders and crime participants.
Given the critical role of cash in tax evasion and criminal activity
more generally, it is not surprising that governments have begun to
discourage the use of cash, sometimes subtly and other times in
heavy-handed ways. Italy and Greece recently banned the use of cash
22. See Benshalom, supra note 15, at 71 (explaining that cash is “especially efficient
for small retail purchases”).
23. Cf. DAVID W. SCHROPFER, THE SMARTPHONE WALLET: UNDERSTANDING THE DISRUPTION AHEAD (2010) (predicting the eventual dominance of the smartphone wallet).
24. See Benshalom, supra note 15, at 92 (describing the privacy benefits of using
cash). Even the end of cash may not completely eliminate anonymous purchases. See Omri
Marian, Are Cryptocurrencies Super Tax Havens?, 112 MICH. L. REV. FIRST IMPRESSION 38,
39 (2013).
25. See Benshalom, supra note 15, at 71 (noting that cash “allows some people to better manage their personal budgets”).
26. See WOLMAN, supra note 17, at 88.
27. In all seriousness, electronic devices allow users to check their balances anywhere
at any time and should also make it easier to create (and perhaps stick to) a budget.
28. Some might point to the earning of points and miles through credit/debit card use
as a reason for the emerging dominance of non-cash media. Certainly this may have been a
factor in discouraging the use of cash (because points and miles operate as an effective tax
on cash users), but the convenience and other benefits of non-cash media would outweigh
the benefits of cash, leaving aside points and miles, except in a very small subset of purchasing activity.
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in transactions exceeding a threshold amount. 29 Other countries have
taken large currencies out of production, making large cash transfers
more onerous. 30 Still others have subsidized the cost of electronic
payment terminals for small retailers or provided tax rebates when a
taxpayer’s electronic payments reach threshold amounts. 31
In addition to these legal changes, some governments have engaged in campaigns criticizing the use of cash in an attempt to
change social norms. For example, Britain’s Treasury Minister recently remarked that paying tradesmen such as plumbers in cash is
“morally wrong” because it facilitates tax evasion.32 Other governments have run advertising campaigns that, while not specifically targeting cash transactions, emphasize the social cost of tax evasion. 33
Academic commentators have argued that governments should
discourage cash transactions. 34 For example, Ilan Benshalom would
impose a Pigovian tax on cash withdrawals from financial institutions to cause cash users to internalize the societal costs of tax evasion and criminal activity facilitated by cash transactions. 35
As these legal and social attacks on cash proceed, technology continues to make e-payments easier, more secure, and more ubiquitous.
For example, Starbucks recently started selling the Square card
reader, which easily converts any cell phone into a credit or debit
card reader. 36 Square and other companies have also created technology allowing for “mobile payment” through cell phones without the
29. Joe Weisenthal, Italy is Taking a Draconian New Measure to Avoid Tax Evasion,
BUSINESS INSIDER (Dec. 4, 2011, 4:48 PM), http://www.businessinsider.com/italy-banningcash-transactions-above-1000-euros-2011-12; Greek FinMin Unveils Tax Reform, Wage
Policy, REUTERS (Feb. 9, 2010, 11:37 AM), http://www.reuters.com/article/2010/02/09/
greece-finmin-highlights-idUSLDE61824V20100209.
30. REBECCA HELLERSTEIN & WILLIAM RYAN, FEDERAL RESERVE BANK OF NEW YORK,
STAFF REPORT NO. 400, CASH DOLLARS ABROAD 2 (rev. ed. 2011), available at
http://www.newyorkfed.org/research/staff_reports/sr400.pdf.
31. See FRIEDRICH SCHNEIDER, A.T. KEARNEY, THE SHADOW ECONOMY IN EUROPE,
2011: USING ELECTRONIC PAYMENT SYSTEMS TO COMBAT THE SHADOW ECONOMY 7-8 (describing subsidies paid by Mexico, Columbia, Argentina, and South Korea for retailers who
accept electronic payments).
32. Nicholas Watt, Paying a Plumber Cash in Hand is Morally Wrong, Says Tory
Minister, THE GUARDIAN (July 23, 2012), http://www.theguardian.com/politics/2012/jul/23/
taxandspending-hmrc.
33. Elisabetta Povoledo, Italy Tries to Get Tax Cheats to Pay Up, N.Y. TIMES (Aug. 8,
2011), http://www.nytimes.com/2011/08/09/business/global/italy-tries-to-get-tax-cheats-topay-up.html.
34. See, e.g., Jay A. Soled, To Close the Tax Gap, Eliminate Cash, 115 TAX NOTES 379
(2007).
35. See generally Benshalom, supra note 15.
36. Brian X. Chen, Now on Sale at Starbucks: Square’s Credit Card Reader, N.Y.
TIMES BITS BLOG (Jan. 3, 2013, 2:20 PM), http://bits.blogs.nytimes.com/2013/01/
03/starbucks-square-mobile-credit-card-reader/.
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use of a credit or debit card.37 Biometric payment, through, for example, a touch of the finger, is also reportedly on the horizon.38
The demise of cash should have positive ramifications for the income tax. E-payments automatically leave an electronic trail for every transaction, which decreases the risk of non-reporting of income.
More importantly, e-payments must be made through a third-party
intermediary who could become subject to third-party reporting obligations. The recently enacted section 6050W of the Internal Revenue
Code expanded third-party reporting obligations to credit/debit card
issuers and to “third party settlement organizations,” such as PayPal,
who must now generally issue Forms 1099-K to their payees who
both receive more than $20,000 in payments in a calendar year and
engage in more than 200 transactions during the year. 39 Section
6050W could easily be expanded to cover the information-reporting
regime; the $20,000/200 transaction floor could be lowered to cover
nearly all e-payment transactions.
Closing the cash tax gap would raise revenues, which could allow
for reduced rates, which would in turn reduce tax-induced behavioral
distortions. Closing the gap would also improve taxpayer morale and
confidence in the tax system by buttressing the view that everyone is
paying their fair share. Traditional cash businesses, which tend to be
smaller, more informal, and have a business-to-consumer orientation,
would no longer be tax-advantaged relative to other businesses, resulting in more efficient investment decisions overall.40 Second-order
problems associated with the storing of cash proceeds, such as the
suboptimal investment and borrowing activities by tax evaders,
would be alleviated. 41
A major drawback of this electronic utopia is that financial companies will have information concerning our private as well as our
commercial activities, but society may have no choice other than to
accept that consequence. However, especially in light of recent NSA
scandals, the public may object to the government obtaining that information. 42 Of course, the government already obtains a great deal
of information (through third-party reporting), but individuals might
37. Jenna Wortham, I’m Still Waiting for My Phone to Become My Wallet, N.Y. TIMES
(July 27, 2013), www.nytimes.com/2013/07/28/technology/im-still-waiting-for-my-phone-tobecome-my-wallet.html.
38. Ellen McCarthy, Cash, Charge or Fingerprint?, WASH. POST (June 9, 2005),
http://www.washingtonpost.com/wp-dyn/content/article/2005/06/08/AR2005060802335.html.
39. See I.R.C. § 6050W.
40. Joel Slemrod, Small Business and the Tax System, in THE CRISIS IN TAX ADMINISTRATION 69, 96 (Henry J. Aaron & Joel Slemrod, eds., 2004).
41. See Benshalom, supra note 15, at 73-74.
42. See Goldberg, supra note 10, at 118.
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be unwilling to have the government know every single transaction
in which they engage.
III. WILL PAYMENT SYSTEMS TECHNOLOGY EASE TRANSITION
TO A CONSUMPTION TAX?
The previous part explained that technological innovations in
payment systems should fortify the income tax by dramatically reducing the income tax gap as well as cash-induced distortions. This
part considers whether those same technological innovations might
eventually doom the income tax as we know it by paving the way towards a retail-sales-based consumption tax. It should be noted that it
is possible to adopt a consumption tax system and still retain an income tax for high income taxpayers. A number of countries have done
that. 43 However, retention of an income tax system forgoes some of
the benefits that are obtained from adopting a consumption tax as a
complete substitution for the income tax.
For a variety of reasons, many tax experts and policymakers advocate for the federal tax system to transition from a (mostly) income
base to a pure consumption base. 44 In addition, moving from the current return-based system (in which taxpayers must file annual income tax returns) to a retail-transaction-based system (in which retailers charge and collect taxes on transactions) would probably have
political traction because of the public distaste for filing tax returns.45
One argument in favor of a consumption tax is the philosophical
one that the private withdrawal of goods and services from the economy ought to be taxed, rather than the production of goods and services.46 Another is that an income tax discourages saving (i.e., future
consumption) in favor of immediate consumption, while a consumption tax is neutral as to the timing of consumption. 47 Yet another ar43. For example, the United Kingdom, France, and Germany each have both an income tax and a value added tax (VAT).
44. See, e.g., EDWARD J. MCCAFFERY, FAIR NOT FLAT: HOW TO MAKE THE TAX SYSTEM
BETTER AND SIMPLER (2002); LAURENCE S. SEIDMAN, THE USA TAX: A PROGRESSIVE CONSUMPTION TAX (1997) (each proposing transition to a consumption tax).
45. See NEAL BOORTZ & JOHN LINDER, THE FAIRTAX BOOK: SAYING GOODBYE TO THE
INCOME TAX AND THE IRS 40-41 (2005) (describing public dissatisfaction with the filing of
income tax returns).
46. See, e.g., N. Gregory Mankiw, A Better Tax System (Assembly Instructions Included), N.Y. TIMES (Jan. 21, 2012), http://www.nytimes.com/2012/01/22/business/four-keys-toa-better-tax-system-economic-view.html?_r=0.
47. To illustrate this point, Chirelstein and Zelenak use the following example. Consumer (C) and Saver (S) each earn $1,000 in wages in Year 1. In a tax-free, 10% interest
world, C will consume $1,000 in Year 1, while S could consume $1,100 ($1,000 x 1.1) in
Year 2. Under a 40% consumption tax, C would consume $600 ($1,000 – 40%) in Year 1,
while S consumes $660 ($1,000 x 1.1 – 40%) in Year 2. Under a 40% income tax, C would
again consume $600 in Year 1, while S could only consume $636 ([$1,000 – 40%] + [10% x
($1,000 – 40%)]). The 1:1.1 ratio between immediate and delayed consumption holds for
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gument is that taxing income is much more difficult and complicated
than taxing consumption. The realization rule—that gains and losses
from property are generally taken into account only upon a sale or
exchange of the property—is a necessary fixture of the income tax;
yet it can be circumvented through hedging.48 More importantly, the
realization rule creates incentives to hold onto appreciated property
(to avoid income recognition) and to dispose of depreciated property
(to trigger losses); the capital gains preference and limitations on
capital losses are responses to these incentives. 49 In addition, capitalization and cost recovery issues (e.g., repairs versus improvements,
capitalization and amortization of intangibles) can be immensely difficult to administer. The taxation of undistributed income of flowthrough business entities is also difficult. All of these problems would
disappear under a consumption tax. 50 Under a consumption tax, realization of gains or losses would be a non-event because mere realizations do not represent consumption. Likewise, the amount that a
taxpayer consumes is unaffected by whether a business expenditure
results in long-term or short-term benefit, which means that the capitalization doctrine would be rendered irrelevant. 51 And reinvested
profits of a business likewise do not result in consumption, which
means that business entity taxation would no longer be necessary. 52
Despite the purported benefits of moving to a consumption tax
imposed on transactions, two principal obstacles are thought to be
the most significant deterrents. First, and most important, it is impossible, with current technology and prevailing political attitudes, to
impart much progressivity into a retail sales tax (or into its close
cousin, the VAT). Everyone must pay the same tax rate because the
the tax-free world and the consumption tax but it is reduced to 1:1.06 for the income tax.
See MARVIN A. CHIRELSTEIN & LAWRENCE ZELENAK, FEDERAL INCOME TAXATION 486 (12th
ed. 2012). Note that in this example it is assumed that the tax base for both the income tax
and the consumption tax is tax-inclusive.
48. David M. Schizer, Frictions as a Constraint on Tax Planning, 101 COLUM. L. REV.
1312, 1340-44 (2001).
49. David A. Weisbach, The (Non)Taxation of Risk, 58 TAX L. REV. 1 (2004).
50. This is not to say that tax complexity would altogether disappear. There still
would remain disputes about whether something represents consumption (e.g., gifts or
fringe benefits versus non-taxable perks) and valuation of in-kind consumption. See John
K. McNulty, Flat Tax, Consumption Tax, Consumption-Type Income Tax Proposals in the
United States: A Tax Policy Discussion of Fundamental Tax Reform, 88 CALIF. L. REV.
2095, 2178 (2000). But disputes falling under the “increase in net worth” side of the HaigSimons equation would disappear since the focus is on consumption, not on the value of
one’s net worth.
51. Under a pure consumption tax, all expenditures would be immediately deductible,
thereby eliminating the need for capitalization. See SLEMROD & BAKIJA, supra note 12, at
238.
52. However, it is politically unlikely in the extreme that there would be no taxes
imposed on corporate entities. It is a virtual certainty that the corporate income tax would
be retained or would be replaced by some other tax.
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cash register cannot distinguish between Bill Gates and Joe the
Plumber. 53 To alleviate those concerns, retail sales tax advocates often propose that the government pay a “prebate,” which is a fixed
cash transfer to every taxpayer to offset the sales tax paid on a specified amount of consumption.54
A prebate would effectively create a single zero-bracket but would
not result in different marginal tax rates above the zero-bracket
amount. Thus, once a taxpayer consumes above the zero-bracket
amount, the taxpayer would be taxed at the same marginal rate regardless of whether he was Joe the Plumber or Bill Gates. 55 Widespread government cash disbursements also seem to be, at this point,
a political non-starter. Prebates involve the transfer of cash to every
citizen, which (it is claimed) makes voters uncomfortable 56 and has
the potential for fraud. 57 “Tax coupons,” which would exempt from
tax a specified amount of spending each year, would avoid the politically unattractive cash transfers, but would also impart only very
limited progressivity.58 Tax coupons would also likely face similar
fraud issues.
Another version of a consumption tax—the so-called cash-flow
tax—could easily impart a good deal of progressivity in a politically
acceptable way. The income tax could be turned into a cash-flow tax
quite easily. By allowing for unlimited individual retirement account
(IRA) contributions and also getting rid of any penalty taxes on
premature IRA distributions, only income that is consumed during
the year is taxed.59 The “consumed income” could then be subject to a
53. Another way to attempt to add progressivity is to have different rates for different
types of items (food could be taxed at a low rate while yachts could be taxed at a high rate).
This, however, is an imperfect tool and leads to administrative difficulties of how to label
certain items for tax purposes. See Catherine Rampell, Value-Added Taxes: A Primer, N.Y.
TIMES ECONOMIX BLOG (Apr. 19, 2010, 1:38 PM), http://economix.blogs.nytimes.com/2010/
04/19/value-added-taxes-a-primer/.
54. See, e.g., BOORTZ & LINDER, supra note 45, at 84-85.
55. Note, however, that the use of a zero-bracket amount does provide some progressivity to the effective tax rate applied to consumers. For example, take a consumption tax
system with a prebate amount of $1000, and a consumption tax rate of 20%. X spends
$10,000 in year one, X pays a tax of $2000 (20% times $10,000). Taking into account the
$1000 prebate, X’s effective tax rate is 10%: $2000 minus the $1000 prebate, or $1000,
divided by $10,000. Y spends $20,000, and pays a tax of $4000 (20% times $20,000). Y’s
effective tax rate is 15%: $4000 minus the $1000 prebate, or $3000, divided by $20,000. So,
the effective rate paid by Y is greater than the effective rate paid by X, even though the
marginal tax rates are the same.
56. Daniel N. Shaviro, Welfare, Cash Grants, and Marginal Rates, 59 SMU L. REV.
835, 839 (2006).
57. See, e.g., HANK ADLER & HUGH HEWITT, THE FAIRTAX FANTASY 46 (2009).
58. Cf. ZELENAK, supra note 4, at 76-77 (describing a 1943 proposal by Treasury Secretary Henry Morgenthau, Jr. for a national sales tax combined with tax coupons to impart
progressivity).
59. See MCCAFFREY, supra note 44, at 57-58; SEIDMAN, supra note 44, at 6-7.
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progressive tax rate schedule, so that as the taxpayer’s consumption
increases during the year, the consumption is taxed at higher rates.60
This method of taxing consumption would probably be palatable to
the public, as it would superficially look very much like the current
income tax. On the other hand, a cash-flow tax would still require
taxpayers to file annual returns, 61 which would take away the
attractiveness of the proposal for those who wish to do away with
individual returns.
Futuristic “smart” e-payment systems could be able to track how
much every taxpayer spends each year and to adjust the rate of tax
(as calculated and collected by the retailer or by an e-payment middleman) as the taxpayer’s spending increases. Thus, for example, the
first $10,000 of consumption spending could be tax free, with the next
$10,000 taxable at a 5% rate, the next $10,000 at a 10% rate, and so
on. To avoid liquidity issues for both taxpayers and the government,
the amount of tax paid on a particular transaction would be a blended rate based on estimated annual consumption, and true-up adjustments would be made towards the end of the year if actual consumption during the year differed from projected consumption. 62 However,
one problem with that approach is that it is vulnerable to tax evasion
by the simple scheme of having purchases made for someone by a
person with low consumption. 63
A second obstacle to moving to a consumption tax is the transition
problem. Money already taxed under the outgoing income tax, as represented by the taxpayer’s aggregate basis in her assets or cash on
hand, should not be taxed again under the new consumption tax.64
Absent any transition relief, under any of the consumption tax systems—retail sales tax, VAT, and cash-flow tax—double taxation of
pre-enactment basis would result. 65 While there are ways to mitigate
60. See MCCAFFREY, supra note 44, at 57-58; SEIDMAN, supra note 44, at 6-7.
61. See MCCAFFREY, supra note 44, at 57.
62. For example, assume that a taxpayer, based on her prior year’s consumption (or
income, if this is the first year of the consumption tax), is expected to spend $100,000 on
consumption, which would (after taking account of any exemption amount) be taxed at an
effective rate of 20%. At the beginning of the year, the tax would be imposed at that 20%. If
the taxpayer’s spending during the year is less than expected, such that the expected effective tax rate is now 15%, the tax rate on future purchases would be adjusted. After the end
of the year, when the proper tax rate is known with precision, a refund would be issued to
the taxpayer for any excess tax paid. This system is much like the wage withholding system we have today.
63. Of course, if cash is completely eliminated, then the government should be able to
track transactions between the evaders.
64. See MCCAFFERY, supra note 44, at 108-10 (discussing transition problem of preenactment basis).
65. While it is easy to see how double taxation would result under retail sales tax and
VAT, double taxation may be harder to see under the cash-flow model, but it nevertheless
exists there too. Under the cash-flow model, taxpayers would be required to put all of their
investment assets into their IRA, and distributions therefrom would subsequently be taxed
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the transition burden on existing wealth even under current technology, smart e-payment systems would make it easier to provide transition relief. Smart e-payment systems could take account of the taxpayer’s basis and cash at the time of transition and allow for that
amount to purchase tax-free consumption to the extent legislators
determine transition relief is warranted. The amount of such exclusion from the consumption tax could be amortized over the anticipated consumption of the taxpayer during the taxpayer’s life expectancy.
Payment systems technology could make a progressive retail sales
tax that includes such transition relief for pre-enactment basis a realistic possibility. E-payment technology would allow third-party intermediaries (or, more rarely, retailers) to adjust the tax rate imposed on purchases to take account of both the taxpayer’s consumption level and the taxpayer’s previously taxed assets. The technology
could also allow a taxpayer’s pre-enactment basis to be amortized
against future consumption, preventing or at least ameliorating the
double taxation problem.
As a political matter, a progressive retail sales tax would have a
number of benefits to make it attractive. It would remove the inconvenience of taxpayers having to file annual tax returns, which is
something that voters claim to hate.66 Because the tax would be paid
in small increments, like traditional retail sales taxes imposed by
states, it would be less salient than the current income tax. 67 And the
tax would be progressive without requiring the government to make
direct wealth transfers to its citizens.
Once the requisite technology is eventually developed, the major
impediment to implementing a progressive retail sales tax would
probably be privacy concerns. To impose the correct tax rate at the
point of retail sale, the third-party intermediary (or, perhaps, the retail seller) would need to know the amount of the buyer’s previous
consumption. This could be troubling to some people, though they
might be comforted by the fact that machines, not people, will be aggregating and processing the consumption data. Unfortunately, we
have seen that people can farm information out of the machines that
collect it. 68 We also must keep in mind that attitudes towards privacy
regardless of whether the distributions represent amounts previously taxed under the
former income tax, thereby resulting in double taxation.
66. A Third of Americans Say They Like Doing Their Income Taxes, PEW RESEARCH
CTR. (Apr. 11, 2013), http://www.people-press.org/2013/04/11/a-third-of-americans-saythey-like-doing-their-income-taxes/.
67. The salience of the income tax is reduced by the withholding mechanism. However, since taxpayers must file an income tax return each year, they will see their ultimate
tax bill even if they do not have to pay it all at once.
68. Amir M. Hormozi & Stacy Giles, Data Mining: A Competitive Weapon for Banking
and Retail Industries, INFO. SYS. MGMT., Spring 2004, at 62, 69.
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and technology will certainly evolve as we inevitably move towards a
paperless society. For example, the idea of electronic stock registration (in lieu of physical shares) would surely have been a non-starter
over much of the stock market’s history, yet physical shares are now
nearly obsolete. And the information now voluntarily shared by Facebook users would have been considered extremely private in years
past. 69 So while current prevailing attitudes towards privacy might
preclude the enactment of a progressive retail sales tax now, it is
quite possible that privacy concerns will eventually diminish to the
point where such a tax is politically feasible.
Privacy concerns might also ensure that at least some cash transactions will continue to occur. People who place a high value on
anonymous purchasing may continue to use cash.70 Other people
might choose to use cash only when they are making purchases that
they consider particularly private or sensitive. The persistence of
cash transactions would pose a problem for a progressive retail sales
tax. Ideally, the same amount of tax ought to be imposed whether
payments are made in cash or electronically. But only electronic
payments can be tracked, and such tracking is necessary in order to
determine the correct tax rate. It seems to us that the best solution
would be to impose the highest statutory tax rate on cash purchases
and require the retail seller to collect the tax. This would treat all
cash purchases as if persons with large amounts of consumption
made them. In many cases, this would overtax cash purchases and,
in effect, act as a penalty on anonymous purchasing. This would be
an unintended by-product of a progressive retail sales tax, but given
the expected evolution in attitudes regarding privacy, it is possible that
this penalty might not impede the eventual enactment of such a tax.
IV. CONCLUSION
In this Symposium Essay, we have argued that technological innovation will be critical during the next 100 years of the income tax.
On the one hand, the increasing prevalence of electronic payment
systems should bolster the income tax by substantially reducing the
tax gap and mitigating the distortions caused by the cash economy.
On the other hand, technological innovation and the corresponding
evolution of attitudes towards privacy could make a progressive
retail sales tax quite feasible, which might spell the end of the
income tax.
69. Natasha Singer, Your Online Attention, Bought in an Instant, N.Y. TIMES (Nov.
17, 2012), http://www.nytimes.com/2012/11/18/technology/your-online-attention-bought-inan-instant-by-advertisers.html?pagewanted=1&_r=0.
70. Even without cash, anonymous electronic currencies, such as bit coins, may be
available. See Marian, supra note 24, at 39.
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ON THE FUTURE OF TAX SALIENCE SCHOLARSHIP:
OPERATIVE MECHANISMS AND LIMITING FACTORS
DAVID GAMAGE ∗
I. INTRODUCTION..................................................................................................
II. BACKGROUND....................................................................................................
A. Market Salience .........................................................................................
1. Spotlighting .........................................................................................
2. Ironing .................................................................................................
B. Political Salience .......................................................................................
1. Indirect taxes ........................................................................................
2. Tax-system complexity .........................................................................
3. Withholding .........................................................................................
4. Deficit financing...................................................................................
5. Sticky baselines ....................................................................................
6. Tax-label aversion ................................................................................
III. OPERATIVE MECHANISMS .................................................................................
A. Bounded Rationality ..................................................................................
B. Time Inconsistency.....................................................................................
C. Framing Effects .........................................................................................
IV. LIMITING FACTORS............................................................................................
A. Size of the Tax Liability .............................................................................
B. Learning from Experience..........................................................................
C. Aversion to Being Manipulated .................................................................
V. CONCLUSION .....................................................................................................
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I. INTRODUCTION
As we celebrate the centennial anniversary of the U.S. federal income tax and look forward to the next hundred years, it is worth reflecting on the nature of tax scholarship. The U.S. tax system is incomprehensibly complex. Any attempt to assess the U.S. tax system
must therefore rely on applying some theoretical frame. Which
frames are chosen, and how they are applied, potentially has firstorder consequences for how we understand the role of the income tax
as a central component of the U.S. system of governance.
The two most important frames that have been used to assess the
income tax over the past hundred years are comprehensive tax base
theory1 and optimal tax theory.2 Both of these approaches have
∗ Assistant Professor of Law, University of California, Berkeley (Boalt Hall). Many
thanks to Joe Dodge, Brian Galle, Jacob Goldin, Andrew Hayashi, James Hines, Doug
Kahn, Jeff Kahn, Stacie Kinser, Shruti Rana, Chris Sanchirico, Darien Shanske, Larry
Zelenak, and other participants of the “One-Hundred Years of the Federal Income Tax”
Symposium at Florida State University.
1. See, e.g., Boris I. Bittker, A “Comprehensive Tax Base” as a Goal of Income Tax
Reform, 80 HARV. L. REV. 925 (1967) (discussing comprehensive tax base theory); Joseph A.
Pechman, Comprehensive Income Taxation: A Comment, 81 HARV. L. REV. 63 (1967) (same).
2. See, e.g., LOUIS KAPLOW, THE THEORY OF TAXATION AND PUBLIC ECONOMICS (2008)
(providing an overview of optimal tax theory); BERNARD SALANIÉ, THE ECONOMICS OF TAX-
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generated powerful insights. Yet both of these approaches also have
serious limitations. 3
Over the past few decades, optimal tax theory has come to dominate tax scholarship in both economics departments and elite law
schools. A number of strands of recent scholarship have thus attempted to address some of the limitations of optimal tax theory as it
has traditionally been employed. One of the most prominent of
these recent scholarly trends is the study of questions related to
tax salience. 4
In a recent Article, Darien Shanske and I reviewed the developing
literature on tax salience. 5 When we began the project that led to
that article, we were hopeful that the literature on tax salience could
be applied to illuminate a number of conundrums plaguing both federal and state and local tax policy. However, we ultimately concluded
that the literature on tax salience is not yet sufficiently developed to
be applied in making concrete recommendations for practical tax
policy problems.
Building on that article, this Essay—written for Florida State
University’s symposium on the 100th anniversary of the federal income tax—evaluates how the literature on tax salience should be advanced in order for it to guide more effectively tax policy over the
coming decades. In particular, this Essay analyzes potential limiting
factors to the operation of observed tax salience effects.
To date, most of the empirical literature on tax salience has focused on demonstrating the existence of specific tax salience effects
within particular contexts. Building on these empirical studies, most
of the normative scholarship engaging with tax salience has been
based on extrapolating from the discrete instances of tax salience ef(2d ed. 2011) (same).
3. For discussions of the limitations of optimal tax theory (as it has traditionally
been employed), see, for example, James Alm, What is an “Optimal” Tax System?, in TAX
POLICY IN THE REAL WORLD 363 (Joel Slemrod ed., 1999); Christopher Heady, Optimal
Taxation as a Guide to Tax Policy: A Survey, 14 FISCAL STUD. 15 (1993); Alex Raskolnikov,
Accepting the Limits of Tax Law and Economics, 98 CORNELL L. REV. 523 (2013).
4. For a definition of tax salience, see David Gamage & Darien Shanske, Three Essays on Tax Salience: Market Salience and Political Salience, 65 TAX L. REV. 19, 23 (2011)
(“As we use the term, ‘tax salience’ refers to the extent to which taxpayers account for the
costs imposed by taxation when the taxpayers make decisions or judgments. The concept of
tax salience is thus meant to abstract from taxpayers’ values or preferences with respect to
taxation—from how the taxpayers might wish to account for tax costs were they not subject
to cognitive limitations. Our concept of tax salience would be meaningless in a world of
complete information in which taxpayers had unlimited time and resources and were not
subject to any cognitive biases. Thus, our concept of tax salience is meant to capture any
systematic differences between how taxpayers would perceive the costs of taxation in this
hypothetical world of perfect economic rationality and how taxpayers actually perceive the
costs of taxation in the real world.” (footnote omitted)).
5. Id.
ATION
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fects observed in these empirical studies. Only a handful of scholars
have attempted to develop more systematic theories for how tax salience might operate. 6 Yet in the absence of more systematic theories,
we cannot predict with any confidence how tax salience effects might
operate outside of the specific empirical contexts in which they have
been observed. Only after analyzing potential operative mechanisms
and limiting factors should we apply the developing literature on tax
salience to broad questions of tax policy.
I should note at the outset that the purpose of this Essay is not to
critique the existing scholarship on tax salience. Conducting empirical studies to demonstrate the existence of tax salience effects within
specific contexts is a necessary first step for developing more general
theories.7 Rather, the intent of this Essay is to point out that more is
needed before the tax salience literature can offer a useful guide with
respect to the complexities of real-world policy.
Most importantly, normative scholars should not assume that a
tax salience effect that is demonstrated to occur within one set of
particular circumstances will necessarily manifest when circumstances differ. This Essay evaluates potential limiting factors to the
operation of tax salience effects, such as the size of the tax liability,
taxpayers learning from experience, and taxpayers’ aversion to being
manipulated. These limiting factors have the potential to prevent tax
salience effects that are shown to occur in one set of circumstances
from manifesting in scenarios where these limiting factors are
strongly present.
Ultimately, in order to develop a broader theory capable of predicting the conditions under which tax salience effects are likely to
prove important, we must develop a better understanding of the operative mechanisms underlying tax salience. To this end, the literature on tax salience must move beyond offering a list of biases and
must seek instead to provide a theory of cognition (or of social reasoning or of whatever else might underlie observed tax salience effects).
This Essay proceeds as follows. Part II provides background by
briefly summarizing the portions of my previous article with Darien
Shanske upon which this Essay builds. Following that background,
Part III evaluates three potential operative mechanisms that might
underlie observed tax salience effects. Part IV then analyzes three
potential limiting factors that might prevent tax salience effects from
6. And these attempts have been limited to applications of the bounded rationality
paradigm. See infra Part III.A.
7. Indeed, I have conducted research of this sort myself; see Andrew T. Hayashi,
Brent K. Nakamura & David Gamage, Experimental Evidence of Tax Salience and the Labor-Leisure Decision: Anchoring, Tax Aversion, or Complexity?, 41 PUB. FIN. REV. 203
(2013).
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occurring in circumstances under which these limiting factors are
strongly present. Part V concludes.
II. BACKGROUND
One of the central contributions of my prior article with Darien
Shanske was to argue that market salience and political salience
should be considered distinct concepts.8 In our terminology, “market
salience” refers to when tax salience effects occur with respect to
market decisionmaking (for example, consumer purchasing), and “political salience” refers to when tax salience effects occur with respect
to political judgment formation (for example, individual voting). 9 We
argued that market salience and political salience often work in opposite directions.10 Factors capable of “reduc[ing] market salience
may increase political salience, and vice versa.” 11
Much of our article was devoted to evaluating normative arguments that have been made about the policy implications of tax salience.12 This Essay does not primarily build on that discussion of
normative arguments, but rather seeks to further develop our conclusion that “the existing empirical findings on both forms of tax salience are tentative. . . . [W]e cannot currently predict with any confidence how tax-design techniques affect tax salience within realworld environments.” 13
Yet before proceeding to develop this conclusion by evaluating
possible operative mechanisms and limiting factors, it is necessary to
first briefly summarize the overview we provided in that article of
hypotheses about tax salience in the existing literature. 14 Readers
8. Gamage & Shanske, supra note 4, at 54-59.
9. For further discussion, see id. at 24-25.
10. Id. at 54-58.
11. Id. at 54.
12. Id. at 60-98.
13. Id. at 22-23.
14. The remainder of this Part summarizes portions of my prior article with Darien
Shanske. Elaboration on and support for all of the statements made in the remainder of
this Part can be found in that prior article, id. at 22-54. Since its publication, there have
been a number of important developments in the literature on tax salience. Due to space
and scope constraints, I will not review those developments in this Essay. Particularly
noteworthy recent additions to the literature include: STEVEN M. SHEFFRIN, TAX FAIRNESS
AND FOLK JUSTICE (2013); Lilian V. Faulhaber, The Hidden Limits of the Charitable Deduction: An Introduction to Hypersalience, 92 B.U. L. REV. 1307 (2012); Brian Galle,
Carrots, Sticks, and Salience, 66 TAX L. REV. (forthcoming 2013), available at
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2224160; Jacob Goldin & Tatiana
Homonoff, Smoke Gets in Your Eyes: Cigarette Tax Salience and Regressivity, 5 AM. ECON.
J.: ECON. POL’Y 302 (2013); Jacob Goldin, Note, Sales Tax Not Included: Designing Commodity Taxes for Inattentive Consumers, 122 YALE L.J. 258 (2012); Andrew T. Hayashi, The
Legal Salience of Taxation (Sept. 14, 2012) (unpublished manuscript), available at
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2151867; Daniel Reck, Taxes and Mistakes: What's in a Sufficient Statistic? (July 29, 2013) (unpublished manuscript), available
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who are already familiar with the empirical literature on tax salience
may wish to skip the remainder of this Part, so as to begin reading
with this Essay’s contributions to the literature in Parts III and IV.
A. Market Salience
Taxpayers do not always fully factor the price effects of taxation
into their market decisions.15 Two categories of market salience—
spotlighting and ironing—examine two different hypotheses for how
taxpayers may respond to complicated or obscured tax prices.
1. Spotlighting
Spotlighting involves taxpayers focusing only on certain components of an aggregate price and thereby underestimating the aggregate price. 16 Most observed spotlighting behavior results from a separation of the tax assessment from the market decision. 17 In particular, a number of empirical studies suggest that taxpayers often discount taxes that are not assessed until after a market decision has
been made. 18 In other words, taxpayers appear often to spotlight on
the prices displayed at the time of market decisionmaking.
2. Ironing
Ironing occurs when taxpayers incorrectly use their average tax
rates when making market decisions rather than their marginal tax
rates. 19 In essence, ironing is a form of spotlighting behavior wherein
taxpayers spotlight on their average tax rates when it would be more
economically rational for the taxpayers to make decisions based on
their marginal tax rates.
B. Political Salience
Political salience refers to how the presentation of taxes affects political decisionmaking. For instance, certain tax instruments may
have low political salience if voters discount tax costs imposed
through these instruments when making voting decisions. A number
of factors have been hypothesized to influence the political salience of
taxation, including: indirect taxes, tax-system complexity, withholding, deficit financing, sticky baselines, and tax-label aversion. 20
at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2268617.
15. Gamage & Shanske, supra note 4, at 26.
16. Id. at 27.
17. Id.
18. Id. at 27-31.
19. Id. at 31.
20. Id. at 34-54.
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1. Indirect taxes
Indirect taxes refer to tax instruments for which the statutory incidence falls on businesses or other intermediaries rather than on
individual taxpayers. 21 Even though at least a portion of the economic burden of indirect taxes falls on consumers in the form of higher
prices, because voters do not personally remit these taxes they are
alleged to have low political salience. 22 In other words, according to
the indirect-taxes hypothesis, the public may often ascribe the burden of indirect taxes to the nominal payors, thus failing to account
fully for taxes that the voting public does not explicitly pay.
2. Tax-system complexity
The tax-system complexity hypothesis holds that the voting public
may discount tax prices for which determining the overall tax price
requires more complex calculations.23 For instance, many have alleged that breaking a tax price into a series of smaller payments assessed over a period of time may reduce political salience as compared to assessing a single aggregate tax price.24 It is also sometimes
alleged that reducing the compliance costs of tax instruments may
lower the political salience of those tax instruments. 25
3. Withholding
It is frequently alleged that the use of withholding mechanisms
may lower the political salience of the withheld taxes.26 However, the
existing literature is not entirely clear as to what it is about withholding that is thought to reduce political salience. 27 It has been posited that breaking tax remittances into smaller regular payments
may reduce the political salience of the tax liabilities. 28 To the extent
this is so, the withholding hypothesis can be thought of as a subfactor of the tax-system-complexity hypothesis. Alternatively, if tax
liabilities subject to withholding are viewed more like money that is
never received rather than a coercive extraction from the taxpayer’s
income, then the withholding hypothesis may operate similar to the
indirect-taxes hypothesis. 29
21.
22.
23.
24.
25.
26.
27.
28.
29.
Id. at 35.
Id. at 35-38.
Id. at 39-41.
Id.
Id.
Id. at 41-43.
Id.
Id.
Id.
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4. Deficit financing
The costs of deficit financing may be less politically salient than
the costs of financing through current taxes. 30 In a sense, the deficitfinancing hypothesis may operate like the market-salience hypothesis for spotlighting, to the extent that the deficit-financing hypothesis
operates through the separation in time between voting decisions and
when the future tax liabilities are imposed.31
5. Sticky baselines
The sticky-baselines hypothesis groups several sub-hypotheses
that all stand for the principle that foregone tax cuts are less politically salient than are actual tax hikes.32 These sub-hypotheses include the flypaper effect, bracket creep, income elasticity, and the
fiscal-volatility effect. 33
6. Tax-label aversion
The final political salience hypothesis is based on the notion that
the mere labeling of a policy as a “tax” can reduce voter support for
the policy. This general notion can be grouped into a number of related sub-hypotheses, including: taxes versus other extractions, taxfinanced spending versus tax expenditures, and tax-financed spending versus regulation.34
III. OPERATIVE MECHANISMS
There is considerable evidence that tax salience effects are real
and that they are potentially important. However, the existing literature cannot yet offer clear predictions about how tax salience operates with respect to real-world tax instruments. In particular, the
existing literature does not sufficiently analyze potential limiting factors to the hypotheses advanced about tax salience, and the literature thus cannot determine whether increased use of techniques for
reducing tax salience would have the intended effect. 35 Ultimately,
our current understanding of both market salience and political salience remains largely speculative.
30. See id. at 43-45.
31. Id.
32. See id. at 45-49.
33. Id.
34. See id. at 49-54.
35. A key paper—Raj Chetty, Adam Looney & Kory Kroft, Salience and Taxation:
Theory and Evidence, 99 AM. ECON. REV. 1145 (2009)—does analyze limiting factors, but
only within a bounded rationality model. See infra Part III.A.
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One method for improving our understanding of tax salience is
through empirical testing of discrete tax salience hypotheses—such
as the research reviewed in my prior article with Darien Shanske
and summarized in Part II of this Essay. I am hopeful that this approach will yield further insights, and I applaud scholars engaged in
this form of research. 36 However, testing of discrete hypotheses must
be complemented with bigger-picture theorizing. An empirical study
can only evaluate the predictions of a hypothesis as it relates to the
particular circumstances giving rise to the experimental data. Without proper theoretical contextualizing, policy-minded scholars may
inappropriately extrapolate the results of an empirical study to circumstances in which the results are unlikely to hold.37
I continue to believe that tax salience has multiple dimensions
and that market salience and political salience should be considered
distinct concepts. Nevertheless, both market salience and political
salience are likely to result from similar operative mechanisms. Both
refer to how taxpayers perceive their tax burdens with respect to either their market or political decisionmaking. Over the last couple
decades, behavioral economists and decision-theory psychologists
have developed a rich literature analyzing how consumers respond to
price-shrouding techniques as employed by private-sector firms. This
Part attempts to apply that consumer behavior literature to analyze
potential operative mechanisms underlying both the market salience
and political salience of taxation. 38
A strong finding of the consumer behavior literature is that misperceiving prices does not necessarily imply underestimating prices.39
When consumers are faced with convoluted price calculations in the
private sector, they do not always underestimate the final price. Indeed, depending on the details of how a price is made convoluted,
consumers may overestimate the final price rather than underestimating it.40 Consequently, it is naive to assume that taxpayers will
36. As noted earlier, supra note 7, I have engaged in this form of research myself.
37. Arguably, a primary goal of empirical research is to test hypotheses, so that the
supported hypotheses can yield predictions outside of the contexts directly studied. Theorizing about operative mechanisms and limiting factors can help refine hypotheses and
generate new predictions to be tested through future empirical work.
38. My discussion here builds on similar work by others, including: Aradhna Krishna
& Joel Slemrod, Behavioral Public Finance: Tax Design as Price Presentation, 10 INT’L TAX
& PUB. FIN. 189 (2003); Edward J. McCaffery & Jonathan Baron, Thinking About Tax, 12
PSYCHOL. PUB. POL’Y & L. 106 (2006).
39. Hyeong Min Kim & Luke Kachersky, Dimensions of Price Salience: A Conceptual
Framework for Perceptions of Multi-Dimensional Prices, 15 J. PRODUCT & BRAND MGMT.
139, 139-40 (2006).
40. Vicki G. Morwitz, Eric A. Greenleaf, Edith Shalev & Eric J. Johnson, The Price
Does Not Include Additional Taxes, Fees, and Surcharges: A Review of Research on Partitioned Pricing 36 (July 26, 2011) (unpublished manuscript), available at
http://ssrn.com/abstract=1350004 (“[F]irms need to understand that partitioned pricing
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necessarily underestimate their tax liabilities when faced with difficult tax calculations. If a taxpayer is aware of the existence of a tax
instrument but has trouble calculating her tax liabilities, should she
not just estimate her tax liability and use this estimate when making
market and political decisions?
This Part posits three potential explanations for what might cause
taxpayers to (at least sometimes) underestimate their tax burdens. I
label these mechanisms as: bounded rationality, time inconsistency,
and framing effects. These mechanisms are not mutually exclusive.
Methods for attempting to reduce tax salience may function through
multiple or even all of these mechanisms. Nevertheless, determining
which operative mechanisms potentially underlie empirical findings
of tax salience is important both for generating hypotheses to be tested through future empirical research and for predicting the robustness of the empirical findings to limiting factors. Moreover, determining which operative mechanisms underlie observed tax salience effects
may also be important for assessing their normative implications.
A. Bounded Rationality
Bounded rationality refers to explanations wherein taxpayers rationally allocate scarce cognitive resources. 41 Once we recognize that
taxpayers have limited time, energy, willpower, or other cognitive
resources, it becomes manifestly obvious that taxpayers will not always perform all of the calculations needed to accurately assess the
tax implications of their decisions. In their seminal paper on the
market salience of taxation, Chetty, Looney, and Kroft presented an
influential model of bounded rationality. 42 Their model predicts that
taxpayers will be more likely to spotlight on immediately available
price components (e.g., ignoring taxes that are not assessed until after the time of market decisionmaking) when making small, repeated
purchases, and when tax rates are low. 43 Conversely, their model
predicts that consumers will be more likely to calculate aggregate
(post-tax) prices when making large, one-time purchases, or when tax
rates are high. 44 The underlying notion is that consumers are more
likely to expend the time and effort to calculate post-tax prices when
more is at stake in their doing so. Effectively, Chetty, Looney, and
benefits firms in many situations, but certainly not in all situations. . . . If some or all of
these factors are absent, however, partitioned pricing can have no positive impact, or even
a negative one.”).
41. See generally Matthew D. Adler, Bounded Rationality and Legal Scholarship
(Univ. of Pa. Law Sch. Inst. for Law & Econ., Research Paper No. 08-03, 2008), available at
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1095874.
42. Chetty et al., supra note 35.
43. See id. at 1149-64.
44. See id. at 1175-76.
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Kroft’s bounded-rationality approach models consumers as trading
off between making tax-efficient purchasing decisions and expending
the cognitive effort required to calculate post-tax prices.
Within a bounded-rationality framework, the more complicated a
tax calculation becomes, the less likely it becomes that taxpayers will
accurately assess their tax liabilities. This dynamic can affect political salience as well as market salience. The more difficult it becomes
to accurately assess tax burdens, as compared to how much the taxpayer cares about making accurate political judgments, the less likely that the taxpayer will expend effort to incorporate accurately tax
information into her voting decisions.45 However, as I noted earlier,
taxpayers do not necessarily respond to complicated tax calculations
by underestimating their tax liabilities.46 If a taxpayer makes a
rough estimate of the post-tax price of a market decision, or of the tax
liability associated with a political decision, the taxpayer may well
overestimate (rather than underestimate) the tax consequences. 47
Hence, to reduce tax salience under a bounded-rationality framework requires doing more than just increasing complexity; a common
strategy involves offering taxpayers a reference price that is lower
than the total price. 48 If the reference price is close enough to the total price and is significantly more available, taxpayers may be induced to focus solely on the reference price rather than expending the
effort to calculate the total price. 49 Reference-price strategies can be
45. If voters care little about accurately incorporating tax information into their voting decisions, voting behavior may be especially prone to manipulation.
46. See supra text accompanying notes 39-40.
47. See Kim et al., supra note 39, at 139-40.
48. Id. at 140.
49. See id. at 139-40 (“This stream of research contends that consumers trade-off the
benefits of accuracy with the costs of time and effort to process MDPs, and therefore they
often underestimate total prices.”). In the consumer behavior literature, price-presentation
strategies that involve making price calculations more complicated and then offering a
reference price that is lower than the final price are called “price-partitioning strategies,”
“reference-price strategies,” or “multi-dimensional-pricing strategies.” See, e.g., ChienHuang Lin, Shih-Chieh Chuang & Chaang-Yung Kung, The Presence of Reference Price:
How Value Can Appear Convergent to Buyers and Sellers, 33 ADVANCES IN CONSUMER RES.
237 (2006); Kim et al., supra note 39; Richard L. Ott & David M. Andrus, The Effect of Personal Property Taxes on Consumer Vehicle Purchasing Decisions: A PartitionedPrice/Mental Accounting Theory Analysis, 28 PUB. FIN. REV. 134 (2000). There are many
variations to this basic strategic approach. For instance, one variation involves offering a
discount and then trying to make the discount appear as salient and large as possible, rather than trying to make surcharges to the reference price less salient. For a couple other
variations: “bundling” consists of charging a single combined price for multiple distinct
goods, while “options pricing” involves creating additional features that can be added to a
base product for additional charge. Marco Bertini & Luc Wathieu, Research Note, Attention
Arousal Through Price Partitioning, 27 MARKETING SCI. 236, 237 (2008). These variations
may also have tax-salience analogs, particularly in the state and local government context
where it is common to assess fees and user charges for various publically provided services
as an alternative to taxation.
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especially effective when there is a temporal gap between when the
reference price is assessed and when the final price is charged. 50 As
DellaVigna notes, “[h]olding constant the informativeness, information
that is further into the future (or past) is less likely to be salient.” 51
With regard to market salience, studies of the spotlighting hypothesis found that taxpayers often discount taxes that are not assessed until after market decisions are made. 52 In other words, the
price components available at the time of market decisionmaking
may function as a reference price.53 The reference-price dynamic also
provides a potential explanation for the ironing hypothesis. Nonlinear price schedules can be difficult to understand, and boundedly
rational taxpayers may prefer to use a reference price rather than
calculating their actual marginal tax rates when faced with a nonlinear price schedule. If taxpayers sometimes use their average tax
burdens from prior time periods as a reference price for predicting
their future tax liabilities, then this would result in ironing behavior.54
With respect to political salience, the basic reference-pricing dynamic supports the indirect-taxes and deficit-financing hypotheses.55
For indirect taxes, voters may use their direct tax burdens as a reference price, discounting the burdens of indirect taxes when reaching
political judgments. 56 Similarly, for deficit financing, voters may use
their current tax burdens as a reference price, discounting the increased future tax burdens needed to repay accrued debt. 57
50. Stefano DellaVigna, Psychology and Economics: Evidence from the Field, 47 J.
ECON. LITERATURE 315, 352 (2009).
51. Id.
52. See supra Part II.A.
53. For example, pre-sales-tax prices are close enough to aggregate post-sales-tax
prices (as most states’ sales taxes have rates below ten percent) and are significantly more
available due to their being posted on the store aisles such that boundedly rational consumers may well decide it is not worth their time and effort to incorporate sales taxes into
their purchasing decisions. See Chetty et al., supra note 35, at 1165-75. As another potential example, the time gap between when many income-tax-related decisions need to be
made (December 31st) and when income taxes are calculated (April 15th) may reduce the
market salience of decisions related to claiming income tax deductions and credits.
54. This explanation for ironing behavior is empirically supported by Feldman and
Katuščák’s finding that taxpayers make market decisions partially based on their average
income-tax rates from prior years, even controlling for the relationship between prior and
current year tax status. See Naomi E. Feldman & Peter Katuščák, Should the Average Tax
Rate Be Marginalized? (Charles Univ. Ctr. For Econ. Research & Graduate Educ., Acad. of
Scis. of the Czech, Econ. Inst., Working Paper No. 304, 2006), available at
http://www.cerge-ei.cz/pdf/wp/Wp304.pdf.
55. For political salience, scholars have typically used the terms “isolation effect” or
“focusing effect” in place of “spotlighting” or “reference pricing,” but the underlying idea is
the same. See, e.g., Edward J. McCaffery & Jonathan Baron, Isolation Effects and the Neglect of Indirect Effects of Fiscal Policies, 19 J. BEHAV. DECISION MAKING 289, 290 (2006).
56. See id.
57. See id. at 297-300.
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Within the consumer behavior literature, a potentially important
variation on the basic reference-pricing strategy is sometimes called
“pennies-a-day.” 58 The idea is that if a total price can be divided into
a series of smaller sub-prices assessed over a prolonged period of
time, then it can become more difficult to calculate the aggregate final price, and consumers may be induced to focus on the smaller periodic payments as a reference price. The pennies-a-day concept thus
supports the tax-system-complexity hypothesis that tax instruments
which levy many smaller payments over a period of time (e.g., sales
taxes) may have lower political salience than tax instruments which
levy fewer larger tax payments (e.g., property taxes). Krishna and
Slemrod have speculated that this mechanism also supports the view
that withholding reduces the political salience of the income tax.59
Another potentially important variation on the reference-pricing
strategy has been called the “metric effect.” 60 Research has demonstrated that individuals may react differently to prices depending on
whether the prices are presented in dollar values or as percentages.61
This metric effect manifests for both market salience and political
salience. For market salience, displaying prices as percentages—
instead of in dollar values—appears to make prices seem lower when
the percentages are small and to make prices seem higher when the
percentages are large. 62 When base prices are displayed in one format
(either in dollar values or as percentages) and tax surcharges in another format, this can increase the cognitive effort needed to calculate aggregate prices and thereby make taxpayers more likely to
spotlight on the reference price.
For political salience, voters’ attitudes toward progressivity and
other tax-policy topics appear to differ dramatically depending on
whether tax liabilities are displayed in dollar amounts or as percentages.63 Many voters appear to support progressivity “without having
a strong sense about what progressivity means or about how much
58. Krishna & Slemrod, supra note 38, at 193. The pennies-a-day strategy may also
function via the mechanisms of time-inconsistency and/or framing effects, as I will discuss
further infra Part III.B–C.
59. Id. at 193-94.
60. McCaffery & Baron, supra note 38, at 113.
61. Id. at 114.
62. See, e.g., Timothy B. Heath, Subimal Chatterjee & Karen Russo France, Mental
Accounting and Changes in Price: The Frame Dependence of Reference Dependence, 22 J.
CONSUMER RES. 90, 96 (1995) (“A $50 savings probably sounds smaller when framed as a 1
percent discount, and a $100 savings probably sounds larger when framed as a 50 percent
discount.”); Morwitz et al., supra note 40, at 37.
63. See, e.g., McCaffery & Baron, supra note 38, at 113-14 (“Most strikingly, subjects
gave systematically different answers on the basis of whether the question was asked using dollars or percentages . . . .”).
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progressivity they favor.” 64 For instance, “[u]nder the standard definitions, a ‘flat tax’ is defined as when all taxpayers pay the same percentage of their incomes in taxation, and a ‘progressive tax’ as when
higher-income taxpayers pay a greater percentage of their incomes in
taxation than do lower-income taxpayers.”65 But when tax liabilities
are displayed in dollar values rather than as percentages, higherincome taxpayers are shown as paying more in taxes than lowerincome taxpayers even under a flat tax. Ed McCaffery and Jon
Baron have thus demonstrated that displaying tax distribution
information in dollar values can dramatically reduce voters’ support
for progressivity.66
Overall, then, the bounded rationality framework provides a potential operative mechanism for the hypotheses that have been forwarded regarding both market salience and political salience, as discussed in Part II. However, alternative operational mechanisms may
also explain and support these hypotheses. This Part thus proceeds
to discuss two alternative operational mechanisms: time inconsistency and framing effects.
B. Time Inconsistency
Within a bounded-rationality framework, temporal gaps can decrease tax salience by making it more difficult to calculate post-tax
prices. Temporal gaps are also key to the time-inconsistency framework, but the mechanism is not due to increasing the complexity of
tax calculations. Instead, the time-inconsistency framework operates
when taxpayers mispredict their future behavior or irrationally overdiscount the effects of a present decision on their future selves.
More specifically, numerous laboratory and field experiments have
demonstrated that individuals do not always discount the future implications of their decisions as predicted by standard economic models.67 Individuals frequently engage in what is often called “hyperbolic discounting” and apply a much higher discount rate when comparing the present to the near future than when comparing two time periods in the future.68 As DellaVigna elaborates:
[E]vidence suggests that discounting is steeper in the immediate
future than in the further future. For example, the median subject
in Thaler (1981) is indifferent between $15 now and $20 in one
64. Gamage & Shanske, supra note 4, at 83.
65. Id. at 83-84.
66. McCaffery & Baron, supra note 38, at 113-14.
67. See DellaVigna, supra note 50, at 318-23; Lee Anne Fennell & Kirk J. Stark, Taxation Over Time, 59 TAX L. REV. 1, 13-15 (2005).
68. David Laibson, Golden Eggs and Hyperbolic Discounting, 112 Q.J. ECON. 443, 449
(1997).
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month (for an annual discount rate of 345 percent) and between
$15 now and $100 in ten years (for an annual discount rate of
19 percent). 69
Three related hypotheses have been forwarded to explain this hyperbolic-discounting behavior. First, taxpayers may simply not value
the welfare of their future selves in the same fashion as they do the
welfare of their present selves. 70 An important philosophical approach associated with Derek Parfit argues that personal identity is
not stable over time. 71 The implications of this view are far from
straightforward, and I will not attempt to do them justice in this Essay. Nevertheless, it is worth noting that if taxpayers care more
about their present selves than their future selves, then a taxpayer
operating at any specific moment in time may view the gap between
her present self and her near-future self as considerably more important than the gap between her more-distant-future self and her
self in a time period following that more-distant future.72 Hence, hyperbolic-discounting behavior may be caused by taxpayers valuing
their present selves over their future selves.
A second explanation for hyperbolic-discounting behavior is “selfcontrol problems.” Self-control problems operate when taxpayers
make decisions inconsistent with their own judgments about welfare
over time because they lack the willpower to refrain from immediately satisfying their present desires.73 Anyone who has consciously
over-eaten when faced with a good meal or who has been unable to
resist the in-the-moment temptations of candy, alcohol, or gambling,
should understand what is meant by self-control problems.
Finally, hyperbolic discounting may be due to an “optimism bias”
wherein individuals make unrealistic predictions about their likely
future behavior or about likely future conditions. For example, consumers appear to regularly over-predict the amount they will exercise in the future when purchasing health club memberships 74 and to
69. DellaVigna, supra note 50, at 318.
70. See Lawrence Zelenak, Tax Policy and Personal Identity over Time, 62 TAX L. REV.
333 (2009).
71. See DEREK PARFIT, REASONS AND PERSONS (1984).
72. If taxpayers limit their conception of self to their present self but have partialaltruistic preferences toward all of their future selves, they might well strongly prioritize
the welfare of their present self over all future selves, but they might not strongly prioritize
the welfare of a near-future self over a more-distant-future self. For further discussion
more generally, see Daniel M. Bartels & Oleg Urminsky, On Intertemporal Selfishness:
How the Perceived Instability of Identity Underlies Impatient Consumption, 38 J. CONSUMER RES. 182 (2011).
73. DellaVigna, supra note 50, at 318-24.
74. Stefano DellaVigna & Ulrike Malmendier, Contract Design and Self-Control: Theory and Evidence, 119 Q.J. ECON. 353, 373-77 (2004).
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under-predict the amount they will borrow in the future when deciding whether to open credit-card accounts. 75
Under all three explanations, hyperbolic discounting can lead taxpayers to make choices in the moment that do not correspond with
the taxpayers’ long-term preferences. If tax instruments are designed
so as to create a temporal gap between when decisions regarding taxation are made and when tax liabilities are imposed, the impact of
the tax liabilities may become less salient. In effect, taxes can be designed so as to facilitate present-oriented taxpayers exporting the tax
consequences of their current decisions to their future selves.
In regard to market salience, the time-inconsistency framework
offers an alternative explanation for spotlighting behavior. Since
most of the major empirical studies of spotlighting involved a temporal gap between when the tax liabilities were assessed and when
the market decisions were made, observed spotlighting behavior
could be a result of taxpayers’ hyperbolically discounting their future
tax liabilities. In contrast, the time-inconsistency framework on its
own probably does not explain ironing behavior; the difficulty in assessing non-linear price schedules probably does not result from temporal gaps. 76 With respect to political salience, the time-inconsistency
framework offers clear support for the deficit-financing hypothesis.
The deficit-financing hypothesis predicts that taxpayers tend to discount the future tax liabilities that result from accrued debt. If taxpayers engage in hyperbolic discounting with respect to future tax
liabilities, then deficit financing should reduce the political salience
of taxation. The time-inconsistency framework on its own probably
does not support the other political salience hypotheses, which do not
function based on time delays. 77
75. Id. at 377-79.
76. Although time inconsistency on its own does not explain ironing behavior, time
inconsistency may work in tandem with bounded rationality to jointly cause ironing behavior. A boundedly rational taxpayer may be tempted to use her average tax rates rather
than her marginal tax rates in order to avoid expending the cognitive resources necessary
to calculate marginal tax rates. If there is a temporal gap between when tax rates are calculated and when tax liabilities are imposed, then time inconsistency may exacerbate the
temptation to avoid calculating marginal tax rates. For instance, taxpayers make market
decisions that affect their income-tax liabilities throughout the year; many important income-tax-relevant decisions must be made by December 31st, but income-tax forms are not
due until April 15th. If bounded rationality tempts taxpayers to make income-tax-relevant
decisions based on their average tax rates, time inconsistency can exacerbate these temptations since the tax consequences will not be felt until after the decisions are made.
77. However, time inconsistency may magnify the effects of bounded rationality. If
bounded rationality tempts taxpayers to focus on reference prices when making voting
decisions, to avoid expending the cognitive resources needed to more accurately assess
their tax liabilities, time inconsistency can increase these temptations to the extent that
the fiscal consequences of voting decisions seem remote in time from the voting.
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Determining whether a tax salience effect results from time inconsistency or from bounded rationality can be important because the
two operative mechanisms may respond differently to limiting factors, such as the size of a tax liability. 78 As with bounded rationality,
there are limits to the operation of time inconsistency. Taxpayers
who realize that they are prone to hyperbolic-discounting behavior
may take steps to prevent their future selves from making decisions
at the expense of their even-more-distant-future selves. 79 Such taxpayers might go so far as to sign contracts with third parties to bind
the taxpayers’ future behavior. 80 Or taxpayers may use cognitive
mechanisms to restrict the present-focused desires of their future
selves, in a sense forming contracts between the taxpayers’ selves at
various points in time.81 We might hypothesize that the more frequent and important a time-inconsistency scenario becomes, the
more likely it becomes that taxpayers will take steps to prevent their
future selves from engaging in hyperbolic-discounting behavior.
However, many of the mechanisms taxpayers can use to overcome
time-inconsistent behavior require the taxpayers to know in advance
that they are subject to time inconsistency.82 When tax salience effects result from time inconsistency, the limiting factor of whether
taxpayers can learn from experience may rise to central importance.83
C. Framing Effects
The third potential operative mechanism, framing effects, might
be thought of as a catch-all category for biases that do not operate
78. See infra Part IV.
79. See Roland Bénabou & Jean Tirole, Self-Knowledge and Self-Regulation: An Economic Approach, in 1 THE PSYCHOLOGY OF ECONOMIC DECISIONS 137, 137 (Isabelle Brocas
& Juan D. Carrillo eds., 2003) (describing research on a variety of tools individuals can use
to overcome time-inconsistent behavior).
80. See Nava Ashraf, Dean Karlan & Wesley Yin, Tying Odysseus to the Mast: Evidence from a Commitment Savings Product in the Philippines, 121 Q.J. ECON. 635, 635-38
(2006) (describing research on financial products that enable consumers to limit the discretion of their future selves); Richard H. Thaler & Shlomo Benartzi, Save More Tomorrow™:
Using Behavioral Economics to Increase Employee Saving, 112 J. POL. ECON. 164, 168-69
(Supp. 2004) (explaining that employer-sponsored automatic-enrollment savings plans
have been “remarkably successful”).
81. See Jess Benhabib & Alberto Bisin, Modeling Internal Commitment Mechanisms
and Self-Control: A Neuroeconomics Approach to Consumption-Saving Decisions, 52 GAMES
& ECON. BEHAV. 460, 462 (2005) (describing a model based on research in cognitive neuroscience wherein individuals “have the ability to either invoke automatic processes that are
susceptible to impulses or temptations, or alternative control processes which are immune
to such temptations.”); see also Bénabou & Tirole, supra note 79.
82. See, e.g., Ashraf et al., supra note 80, at 636 (“If individuals with time-inconsistent
preferences are sophisticated enough to realize it, we should observe them engaging in
various forms of commitment (much like Odysseus tying himself to the mast to avoid the
tempting song of the sirens).”).
83. See infra Part IV.B.
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based on bounded rationality or time inconsistency. Looking back to
our discussion of reference-price strategies under the boundedrationality paradigm, the hypothesis was that partitioning an aggregate price into a lower reference price plus a tax surcharge makes it
more difficult for consumers to calculate aggregate prices and thus
tempts the consumers to instead make judgments using a reference
price that is lower than the aggregate price. Yet the empirical findings on reference pricing have also been analyzed using a framingeffects approach. To the extent that framing effects is the operative
mechanism, consumers form initial judgments and expectations
based on the reference price and then allow these initial judgments
and expectations to influence their perceptions of the aggregate
price—even when the consumers do later fully calculate the aggregate price. Several studies have found that reference-price strategies
can bias value judgments even when consumers do calculate aggregate (post-tax) prices.84 Biases that operate through individuals making preliminary judgments based on incomplete information, and
then allowing these preliminary judgments to color their final evaluations even when they later receive complete information, are often
called “anchoring biases.” 85
Anchoring may function as an alternative operative mechanism
for all of the hypotheses that can be explained by the boundedrationality form of reference pricing. Consider first the market salience hypothesis of spotlighting. If taxpayers anchor on the spotlighted reference price, even later showing the taxpayers their aggregate
tax liabilities may not counteract the market salience effects of spotlighting. Similarly, if taxpayers first consider their historic average
tax rates when making market decisions—following the ironing hypothesis—they may anchor on this reference price such that later exposure to marginal tax rates may not counteract the initial anchoring.
Anchoring can likewise potentially explain all of the political salience hypotheses. If voters use their direct tax burdens or current tax
burdens as reference-price proxies, then anchoring can produce political salience effects even if the voters are later exposed to their indirect or future tax burdens. Similarly, if voters use politicians’ votes
as a form of reference-price proxy, anchoring may influence voting
behavior even if the voters also note the impact on their tax burdens
of the phenomena underlying the sticky-baselines hypotheses. Simi84. See, e.g., Gretchen B. Chapman & Eric J. Johnson, Anchoring, Activation, and the
Construction of Values, 79 ORGANIZATIONAL BEHAV. & HUM. DECISION PROCESSES 115
(1999); Robin M. Hogarth & Hillel J. Einhorn, Order Effects in Belief Updating: The BeliefAdjustment Model, 24 COGNITIVE PSYCHOL. 1 (1992); Thomas Mussweiler & Fritz Strack,
The Semantics of Anchoring, 86 ORGANIZATIONAL BEHAV. & HUM. DECISION PROCESSES 234
(2001); Morwitz et al., supra note 40, at 30-31.
85. See Hayashi et al., supra note 7, at 217.
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larly, if the pennies-a-day strategy has an anchoring component, then
the framing approach may support the notions that the political salience of taxation can be lowered by dividing an aggregate tax liability
into a series of smaller payments collected over time or through the
use of multiple smaller tax instruments in place of a single larger tax
instrument. Withholding may also trigger anchoring responses by
making it so that an aggregate tax liability is paid in small increments over time. Anchoring may thus provide support for the view
that withholding reduces the political salience of taxation even when
taxpayers are forced to later calculate their aggregate tax liabilities
through annual income-tax filing.
Consequently, anchoring can lead to the same behaviors as
bounded rationality and may thus exacerbate the consequences of
bounded rationality. But where anchoring plays a strong role, it may
be far more difficult to restore tax salience. In the context of bounded
rationality, forcing taxpayers to perform tax calculations should usually suffice to counteract salience effects.86 The anchoring phenomenon is potentially more robust. The notion underlying anchoring is
that the judgments taxpayers make using incomplete information are
not always updated even if complete information later becomes
available. Anchoring can be thought of as an even more extreme consequence of limited cognitive resources than in the more standard
bounded-rationality framework. Not only do taxpayers often forgo
fully calculating their tax liabilities, but they also do not always update their prior views and understandings even when they later receive better information than that which was available when the initial views and understandings were forged.
In addition to anchoring, another potentially important framingeffects bias is the “endowment effect,” well known to even casual
readers of the behavioral economics literature. Under the standard
endowment effect, individuals have been shown to assign more disutility to “losses” than utility to equivalent “gains.” 87 Whether a
change in circumstances is coded as a loss or as the absence of a gain
depends on the framing of the individual’s endowment. In regard
to taxation, whether taxpayers perceive taxes as losses from their
pre-tax endowments or as reduced gains from engaging in market
transactions may determine whether the endowment effect comes
into play.88
86. To counteract market salience, taxpayers should be forced to calculate aggregate
tax prices. To counteract political salience, taxpayers should be forced to calculate the tax
components of prices. See Gamage & Shanske, supra note 4, at 54-58.
87. See McCaffery & Baron, supra note 55, at 290; see also Edward J. McCaffery, Cognitive Theory and Tax, 41 UCLA L. REV. 1861, 1875 (1994).
88. See id.
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Compare the political salience of the employer-paid and employeepaid portions of the payroll tax. The employer-paid portion of the
payroll tax is taken out before workers are told their salaries and
thus is likely coded as smaller gains from working. In contrast, the
employee-paid portion of the payroll tax is presented with the employees first seeing pre-tax salary totals and then being shown how
much the government takes out of the pre-tax salary. The employeepaid portion of the payroll tax is thus more likely to be coded as a
loss. Income-tax payments may be even more likely to be coded as
losses, as taxpayers are instructed to calculate their aggregate pretax incomes before being told that the government will take a portion
of this income figure from them. 89 Hence, the endowment effect supports the indirect-taxes political salience hypothesis. 90 If voters view
direct taxes as losses and indirect taxes as forgone gains, then the
use of direct taxes may trigger the endowment effect as compared to
indirect taxes, thereby making indirect taxes less politically salient
than direct taxes. 91
A related form of the endowment effect—often labeled as the status-quo bias—may support the sticky-baselines political salience hypotheses. If voters understand the tax laws on the books to constitute
the status quo and view politicians’ votes to change these laws as departures from the status quo, then any votes to raise taxes may be
coded as losses, whereas the increased tax revenue generated by the
phenomena underlying the sticky-baselines hypotheses may be
viewed as the status quo. 92 The endowment effect may also play a
role in regard to the withholding political salience hypothesis. If
withheld income is not incorporated into taxpayers’ endowments,
89. Related to the endowment effect, the framing of tax design might also affect
whether tax payments are viewed as mandatory extractions or as voluntary payments.
Anecdotal evidence suggests that taxpayers are more averse to property taxes than to real
estate transaction taxes. See Marika Cabral & Caroline Hoxby, The Hated Property Tax:
Salience, Tax Rates, and Tax Revolts (Nat’l Bureau of Econ. Research, Working Paper No.
18514, 2012). The standard endowment effect may explain this result if taxpayers view
property taxes as coming from their pre-tax endowments and real-estate-transaction taxes
as being extra amounts paid to purchase property. Yet in addition to being averse to losses,
individuals may also be more averse to mandatory extractions than to voluntary payments.
If real-estate-transaction taxes are viewed as resulting from the taxpayer’s choice to purchase real estate, while property taxes are viewed as being unrelated to the taxpayer’s
choices, then an aversion to mandatory extractions might come into play in addition to the
endowment effect. Of course, property taxes also result from the choice to purchase property, but taxpayers may view this connection as more tenuous.
90. McCaffery & Baron, supra note 55, at 290.
91. Id. More speculatively, the endowment effect could also lead voters to discount
future tax liabilities—following the deficit-financing political salience hypothesis—if current taxes are viewed as losses and future taxes as forgone gains.
92. For instance, see the discussion of state-level revenue volatility in David Gamage,
Preventing State Budget Crises: Managing the Fiscal Volatility Problem, 98 CALIF. L. REV.
749, 799-801 (2010).
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then taxpayers may be more politically averse to paying additional
taxes at the end of the year than to having amounts withheld regularly from their paychecks.
The existence and importance of framing effects has been well
demonstrated. The framing-effects approach is undoubtedly important for understanding tax salience. Unfortunately, the implications of framing effects are harder to predict than are the implications of bounded rationality or time inconsistency. Most crucially, it
is more difficult to predict when individuals are likely to overcome
the impact of framing effects.
Research suggests that the market salience of at least some framing effects can be overcome through the use of agents. 93 Taxpayers
increasingly use accountants or software to guide them through difficult income-tax decisions. 94 Wealthier taxpayers may rely on lawyers
and financial advisers to assist with decisionmaking, particularly
when large tax liabilities are at stake.95 Books and websites provide
tools to assist even moderate-income taxpayers with weighing the tax
and non-tax factors involved in making large purchases, such as for
housing and automobiles. 96 Similarly, with regard to political salience, voters’ opinions about taxation may depend more on the information they receive from experts and from other trusted sources than
from their direct experience with the tax system. 97 Political experts
93. See, e.g., Jennifer Arlen, Matthew Spitzer & Eric Talley, Endowment Effects Within Corporate Agency Relationships, 31 J. LEGAL STUD. 1 (2002) (finding that subjects situated in agency relationships do not exhibit a significant endowment effect); John A. List,
Does Market Experience Eliminate Market Anomalies?, 118 Q.J. ECON. 41 (2003) (finding
that market experience eliminates the endowment effect).
94. Marsha Blumenthal & Charles Christian, Tax Preparers, in THE CRISIS IN TAX
ADMINISTRATION 201, 201-02 (Henry J. Aaron & Joel Slemrod eds., 2004); Lawrence
Zelenak, Essay, Complex Tax Legislation in the TurboTax Era, 1 COLUM. J. TAX L. 91, 9495 (2010).
95. See Blumenthal & Christian, supra note 94, at 203-04 (describing factors correlated with taxpayers being more likely to hire tax practitioners).
96. See, e.g., Auto Loan Application, DRIVERS LANE, http://www.driverslane.com/
calculators/sales-tax-calc.htm (last visited Jan. 30, 2014); Home Purchase Calculator,
PLANNING TIPS, http://www.planningtips.com/cgi-bin/howmuch.pl (last visited Jan. 30,
2014); Tax, Title, Tags, and Fees Calculator, CARMAX, http://www.carmax.com/enUS/taxtitle-tags-fees-calculator/default.html (last visited Jan. 30, 2014); TurboTax AnswerXchange – For Tax Years 2008-2010 Only: Claiming the First-Time Homebuyer Tax Credit,
TURBOTAX, http://turbotax.intuit.com/support/kb/tax-content/tax-tips/6360.html (last visited Jan. 30, 2014); Used Vehicle Tax Calculator, DMV.ORG, http://search.dmv.org/dmv/usedvehicle-tax-calculator (last visited Jan. 30, 2014).
97. For instance, at the state level, the Tax Foundation’s “state business tax climate
index” and “tax freedom day” rankings have had enormous influence. See State Tax and
http://taxfoundation.org/tax-topics/state-tax-andSpending Policy, TAX FOUNDATION,
spending-policy (last visited Jan. 30, 2014). For criticisms of the methodologies underlying
these rankings, see NICHOLAS JOHNSON, IRIS J. LAV & JOSEPH LLOBRERA, CTR. ON BUDGET
& POLICY PRIORITIES, TAX FOUNDATION ESTIMATES OF STATE AND LOCAL TAX BURDENS ARE
NOT RELIABLE (2006), available at http://www.cbpp.org/cms/?fa=view&id=133.
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and other opinion leaders may function much like agents and software do for market salience—allowing taxpayers to make more accurate voting decisions about taxation even when the taxpayers’ direct
observations about taxation are biased due to framing effects.
Agents and opinion leaders may also assist taxpayers in overcoming the impact of bounded rationality and time inconsistency. Yet
agents and opinion leaders are likely to be even more crucial to framing effects, as it is less clear whether taxpayers can overcome framing effects without the use of agents. If taxpayers become aware that
they are potentially susceptible to framing effects, and if they view
the market or political decision as important enough, taxpayers may
turn to agents or opinion leaders in order to overcome their impact.
IV. LIMITING FACTORS
The existing literature is far from clear about the factors affecting
tax salience or the circumstances in which these factors are likely to
come into play. I have tried to clarify the literature by discussing
three potential operative mechanisms for tax salience in order to provide a foundation for discussing the normative implications of tax
salience and for generating hypotheses to be tested by future empirical work. Yet it is important to emphasize that there are limits to
these operative mechanisms. I will thus discuss three key potentially
limiting factors, beginning with the size of the tax liability in question.
A. Size of the Tax Liability
The first limiting factor for tax salience that I will discuss is the
size of a tax liability. How the size of a tax liability operates is most
straightforward under a bounded-rationality framework, wherein
increasing the size of a tax liability should generally increase taxpayers’ incentives to calculate the tax liability accurately. The boundedrationality framework imagines taxpayers performing implicit costbenefit analyses when deciding whether to expend the required cognitive resources. All else being equal, then, the more money at stake
in calculating a tax liability, the more incentive taxpayers have to do
so accurately. 98
Of course, all else is not always equal. The impact of the size of a
tax liability depends on the opportunity cost of the taxpayer’s cognitive resources. The more a taxpayer has to give up in order to assess
a tax liability accurately, the less likely the taxpayer will be to perform the calculations. Moreover, with regard to political salience,
98. Hence, levying smaller taxes across a wide variety of transactions (as in retail
sales taxes) may create less incentive for taxpayers to calculate their aggregate tax burden
accurately than would levying a larger tax on a fewer number of transactions (as in excise
taxes on luxury goods or real-estate-transaction taxes). See supra Part III.A.
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taxpayers arguably have little at stake in making accurate voting
decisions. 99 Indeed, there is a large literature questioning why it is
that individuals even bother to vote at all.100 Many have argued that
individuals typically vote based on emotions and uninformed intuitions, rather than expending effort to process the information needed
to vote rationally. 101
Yet regardless of whether voters process information based on logic or intuition, there is substantial evidence that voter opinions do
respond to changes in the size of tax burdens. 102 The larger the size of
a tax liability, the more information taxpayers are likely to receive
about the tax instrument in question, whether the information comes
from direct experience, from political-opinion leaders, or from the
media. Even if voter judgments are largely emotional and intuitive,
available evidence still suggests that voters are generally more
averse to large tax liabilities then to small ones. 103
The impact of the size of a tax liability is less straightforward under a time-inconsistency framework. If taxpayers realize in advance
that they are subject to time inconsistency, taxpayers may take steps
(either concrete or cognitive) to limit the discretion of their future
selves. 104 The size of a tax liability might then affect tax salience under a time-inconsistency framework much as it does under a bounded-rationality framework. The larger the size of a tax liability, the
more incentive taxpayers would have to limit the discretion of their
future selves. However, if taxpayers do not realize in advance that
they are subject to time inconsistency, they may be unable to limit
their future selves, and the relative size of a tax liability may have no
effect on tax salience or may even increase the impact of tax salience. 105
It is hardest to predict how the size of a tax liability functions under the framing-effects paradigm. The literature has yet to develop a
sufficiently deep understanding of how framing effects operate for us
99. See, e.g., BRYAN CAPLAN, THE MYTH OF THE RATIONAL VOTER: WHY DEMOCRACIES
CHOOSE BAD POLICIES (2007).
100. See, e.g., GEOFFREY BRENNAN & LOREN LOMASKY, DEMOCRACY AND DECISION: THE
PURE THEORY OF ELECTORAL PREFERENCE (1993).
101. Id.
102. ANDREA CAMPBELL, HOW AMERICANS THINK ABOUT TAXES: PUBLIC OPINION AND
THE AMERICAN FISCAL STATE (forthcoming) (manuscript at 4-5) (on file with author).
103. Id.
104. See supra notes 79-82 and accompanying text.
105. The larger a tax liability, the more a present-self-focused taxpayer can gain by
exporting tax consequences to the taxpayer’s future selves and the more tempting it may
be for a taxpayer to succumb to self-control problems. Also, optimism biases may have
greater impact if taxpayers mispredict that they will be in a better position to deal with tax
liabilities in the future. Hence, when taxpayers cannot limit the discretion of their future
selves, increasing the size of a tax liability can potentially exacerbate time-inconsistency
problems.
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to assess confidently predictions about the relationship between
framing effects and the size of a tax liability. Moreover, since this Essay uses the term “framing effects” as a catch-all category for biases
that do not operate through bounded rationality or time inconsistency, different forms of framing effects may exhibit varied responses to
the size of a tax liability. Nevertheless, I expect that framing effects
respond to the size of a tax liability much as does time inconsistency.
When taxpayers realize in advance that they are subject to framing
effects, they may take steps to counteract them. 106 If a tax liability
becomes large enough, taxpayers may turn to agents or other thirdparty assistance in order to incorporate tax information into their
decisionmaking more accurately.
Ultimately, how the size of a tax liability affects tax salience is
highly interrelated with the extent to which taxpayers learn from
experience with their tax environments. This is particularly true
under the time-inconsistency and framing-effects paradigms, where
taxpayers may be unable to de-bias themselves unless they know
in advance that they are likely to make sub-optimal tax decisions. I
will thus proceed next to discuss the limiting factor of learning
from experience.
B. Learning from Experience
Even when taxpayers cannot accurately assess a tax instrument
directly, taxpayers may still note the connections between taxrelevant decisions and the tax consequences following those decisions.107 Through repeated exposure to the tax consequences of decisions, taxpayers may develop a rough sense of what affects their expected future tax liabilities, even without understanding the tax-law
mechanics of how these liabilities are calculated. In addition to learning from their own experiences, taxpayers may learn from the tax
experiences of their friends, families, and acquaintances, or from stories in the media. 108 In regard to political salience, taxpayers may
learn by noting the consequences of tax-policy choices across different
nations, states, or time periods. 109 Taxpayers can also learn about
106. See supra notes 93-97 and accompanying text.
107. See, e.g., Oren Bar-Gill & Franco Ferrari, Informing Consumers About Themselves, 3 ERASMUS L. REV. 93, 97-98 (2010) (arguing that seller interpretations of consumer
mistakes exacerbates welfare costs associated with such mistakes); Alexander L. Brown,
Zhikang Eric Chua & Colin F. Camerer, Learning and Visceral Temptation in Dynamic
Saving Experiments, 124 Q.J. ECON. 197, 198 (2009) (explaining experimental results
wherein subjects at first saved too little, but then learned to save near optimally after social learning).
108. One need only glance at any major newspaper either in December (before the close
of the tax year) or in early April (before the April 15th income-tax filing date) to be bombarded by tax advice and discussions of the political impact of various tax provisions.
109. For instance, Americans who travel to Europe may note the higher prices Europe-
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taxation from experts or from other political actors. The impact of tax
design on voting behavior may largely occur through a process
whereby tax design influences the views of key opinion leaders who
then preach to the larger population.
Hence, the extent to which a tax environment is conducive to taxpayer learning is a key factor in the operation of both market and
political salience. Liebman and Zeckhauser outline several conditions
relevant for whether individuals are likely to learn from experience,
the most notable of which are: “delayed payoffs,” “bundled consumption,” and “false signals.” 110
Delayed payoffs refer to when the tax consequences of a decision
are not felt until a long time period after the decision is made. 111 It
becomes more difficult to learn from the consequences of a taxrelevant decision when those consequences do not occur for a long
time period, both because more time will have elapsed before any potential learning can take place and because the decision is likely to
become less salient over time, thus weakening the perceived connection between the decision and its consequences. 112 For example, there
is a large literature analyzing how taxpayers respond to tax incentives for retirement savings.113 Because most taxpayers only retire
once, well after their peak earning years, taxpayers have little opportunity to learn from observing the consequences of their earlier retirement-savings decisions. Taxpayers are thus far less likely to learn
about the impact of taxes on their retirement decisions than on their
everyday work and consumption decisions.
Bundled consumption refers to when the consequences of one decision are intermingled with the consequences of other decisions.114 The
ans pay for comparable goods and learn that these price differences are (at least partially)
due to European value added taxes (VATs).
110. Jeffrey B. Liebman & Richard J. Zeckhauser, Schmeduling 5-6 (Oct. 2004)
(unpublished manuscript), available at http://www.hks.harvard.edu/jeffreyliebman/
schmeduling.pdf. In addition to the factors discussed in this Essay, Liebman and Zeckhauser also analyze the additional factors of “heterogeneity in offered schedules,” “obscure
pricing units,” “nonstationary economic environment,” and “frequent revisions of schedules.” Id. at 4-5. There are, of course, many other categorization schemas in the literature
for factors affecting learning from experience. See, e.g., Bar-Gill & Ferrari, supra note 107,
at 97 n.11 (“Learning from one’s mistakes relies on timely, clear and painful feedback . . . .”); Colin F. Camerer, Comment on Noll and Krier, “Some Implications of Cognitive
Psychology for Risk Regulation,” 19 J. LEGAL STUD. 791, 794 (1990) (“Studies show that
learning is difficult unless feedback is clear, frequent, and quick.”).
111. Liebman & Zeckhauser, supra note 110, at 5.
112. This condition is related to how temporal gaps can induce bounded rationality by
making it more difficult to predict the tax consequences of a decision. But as a factor affecting taxpayer learning from experience, delayed payoffs operates ex post rather than ex ante
(affecting after-the-fact learning rather than before-the-fact calculations).
113. See Olivia Mitchell & Stephen Utkus, Lessons from Behavioral Finance for Retirement Plan Design 35 (Pension Research Council, Working Paper No. 2003-6, 2003).
114. Liebman & Zeckhauser, supra note 110, at 5.
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more difficult it becomes to identify which of many tax-related choices caused a particular outcome, the harder it becomes to learn about
the connections between choices and outcomes. For example, the income-tax benefit produced by making a charitable contribution depends on how much the taxpayer claims for other itemized deductions. If a taxpayer claims different amounts in itemized deductions
across different tax years, it may become difficult to learn from
experience how much income-tax benefit is received by making a
charitable contribution.
Finally, the condition of false signals refers to when taxpayers receive potentially misleading information following a tax-relevant decision.115 When economic circumstances change over time, taxpayers
may incorrectly associate tax decisions with outcomes caused by external events. Likewise, taxpayers who have idiosyncratic tax profiles
may learn incorrect lessons from their friends, acquaintances, or the
media. For instance, learning about deficit financing may be obscured
by the tendency for deficits to rise during recessions and shrink during periods of economic growth. When deficit-financed tax cuts (or
spending hikes) are made during economic downturns, voters may
see deficits shrink as the economy recovers and thus conclude that
the tax cuts (or spending hikes) did not negatively affect the governments’ debt levels.
On their own, the conditions of delayed payoffs, bundled consumption, and false signals are neither necessary nor sufficient for taxpayer learning. My discussion of these conditions is aimed at outlining a
few important considerations for whether learning from experience is
likely, but this discussion is by no means exhaustive. Nevertheless,
when conditions are conducive to learning, and when the size of a tax
liability becomes large enough, I expect taxpayer learning to at least
partially counteract the effects of both market and political salience.
Indeed, the ironing hypothesis for market salience is based on the
notion that taxpayers learn from their experience with tax rate
schedules but then develop an imperfect ability to predict future consequences (as non-linear pricing schedules cause marginal rates to
differ from average rates). Any discussion of tax salience that does
not evaluate the possibility of taxpayer learning is unlikely to yield
useful predictions for real-world taxpayer behavior.
Taxpayer learning is particularly important for understanding tax
salience under the time-inconsistency and framing-effects models.
The existing literature has not fully determined the extent to which
taxpayers can de-bias themselves from the consequences of time inconsistency or framing effects. To the extent taxpayers can de-bias
themselves directly, the likelihood of taxpayer learning should work
115. Id. at 5-6.
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together with the size of the tax liability to increase taxpayers’ incentives for de-biasing.116 But even when taxpayers cannot de-bias themselves directly, they may turn to agents, third-party tools, or market
mechanisms to improve their tax decisionmaking. The likelihood of
taxpayer learning and the size of a tax liability should thus work together to increase taxpayers’ motivations for de-biasing, regardless of
whether taxpayers can de-bias themselves directly or only through
the use of third-party assistance.117
Might some instances of framing effects be immune to de-biasing
even through the use of third-party tools and agents? If so, tax-design
techniques drawing on these framing effects could be sufficiently robust so as to be insurmountable even were governments to engage in
massive use of these techniques under conditions where taxpayers
could easily learn from experience. The existing literature does not
rule out this possibility, yet I am skeptical. Framing effects function
through how prices are displayed. I see no reason why agents or
third-party tools could not train taxpayers to perceive tax prices using alternative frames. Reframing techniques may not fully counteract framing effects, but reframing techniques should enable taxpayers to perceive at least a portion of the costs of taxation. 118 And perceiving even a portion of these costs should affect taxpayer behavior
for sufficiently large tax liabilities.
Consequently, my intuition suggests that the potential for governments to employ low-salience tax designs depends largely on
whether conditions are conducive to taxpayer learning. Where conditions are not conducive to learning, governments may have wide discretion to manipulate both forms of tax salience. Deficit financing is
perhaps the most obvious example. Learning about deficit financing
is hindered by delayed payoffs, bundled consumption, and false signals. 119 As such, taxpayers may not learn to incorporate the effects of
deficit financing into their market or political decisions, even if governments engage in massive use of deficit financing. 120
116. The easier it is for taxpayers to learn from experience, the less costly de-biasing is
likely to be.
117. When faced with important decisions with large consequences, taxpayers should
often be more likely to take the time and incur the costs of seeking expert advice or otherwise acting so as to counteract salience effects.
118. For instance, anchoring biases function through taxpayers under-adjusting to new
information. As under-adjustment does not imply non-adjustment, new information still
partially improves taxpayers’ understandings of tax prices.
119. The negative effects of unsustainable deficit financing are not felt until long after
the initial use of deficit financing; the impacts of deficit financing are intermingled with
numerous other economic policy choices and with the effects of the political dynamics that
first led to the deficit financing. Also, deficit financing may produce false signals when the
impact of deficit financing is entangled with the effects of the economic cycle.
120. Whether bond markets can be fooled as easily as voters is another question.
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In contrast, I expect that governments are more limited in their
ability to reduce market salience through the use of retail sales taxes
or to reduce political salience through the use of indirect taxes. If
sales-tax rates were made high enough, I expect that consumers
would take greater note of the additional sales-tax charges added at
store registers. And evidence from comparing voter opinions across
time periods and jurisdictions supports our expectation that increasing the use of indirect taxes heightens voter attention to these taxes. 121
None of this is to suggest that governments cannot reduce tax salience when the environment is conducive to taxpayer learning or
that governments can completely reduce tax salience when the environment is not conducive to learning. The impact of taxpayer learning is a matter of degrees, not absolutes. I have argued that both the
size of a tax liability and the conduciveness of an environment to
taxpayer learning tend to inhibit the effectiveness of tax-design techniques aimed at reducing market or political salience. However, the
magnitudes of these effects remain unanswered empirical questions.
C. Aversion to Being Manipulated
Further underscoring the complexity of how tax salience plays out
in the real world, there is ample evidence from the consumer behavior literature that consumers react negatively if they perceive themselves as being manipulated. For instance, field studies have shown
that the impact of price-presentation techniques can disappear if
consumers become skeptical of vendors’ intentions or come to believe
that vendors are using misleading price-presentation strategies.122
More generally, the empirical evidence suggests that moderate use of
techniques for reducing price salience is often more effective than
high use—as high use can lead to consumer backlash.123
As applied to tax salience, these findings imply that taxpayers’
perceptions of being manipulated place an additional limiting factor
on techniques for reducing both the market and political salience of
taxation. If taxpayers come to believe that the government is actively
trying to reduce the market salience of taxes, the taxpayers may
begin to look through devices for reducing market salience or even to
anticipate non-salient (“hidden”) taxes where none are present. If
121. CAMPBELL, supra note 102.
122. Robert M. Schindler, Maureen Morrin & Nada Nasr Bechwati, Shipping Charges
and Shipping-Charge Skepticism: Implications for Direct Marketers’ Pricing Formats, 19 J.
INTERACTIVE MARKETING 41, 44-45 (2005); Morwitz et al., supra note 40, at 20.
123. Yih Hwai Lee & Cheng Yuen Han, Partitioned Pricing in Advertising: Effects on
Brand and Retailer Attitudes, 13 MARKETING LETTERS 27, 28-29 (2002); Shibin Sheng,
Yeqing Bao & Yue Pan, Partitioning or Bundling? Perceived Fairness of the Surcharge
Makes a Difference, 24 PSYCHOL. & MARKETING 1025, 1039 (2007); Morwitz et al., supra
note 40, at 26-27.
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taxpayers perceive the government as attempting to reduce the political salience of taxation, taxpayers may become more resistant to
supporting taxes (or to supporting politicians who favor taxes) in
their voting decisions. 124 Moreover, taxpayers’ aversion to being manipulated through market-salience techniques can affect the taxpayers’ political decisionmaking, and vice versa. If taxpayers become
hostile toward the governments’ attempts to reduce the market salience of taxation, they may react against all taxes in their voting decisions. Conversely, if taxpayers becomes angry about the government’s
attempts to reduce the political salience of taxation, they may become
more tax-averse (or less tax-accepting) in their market behavior. 125
The empirical literature on aversion to being manipulated is almost entirely focused on how consumers respond to pricepresentation techniques as employed by private-sector firms. Yet
there is reason to suspect that aversion to being manipulated plays
at least as strong a role with respect to tax salience. The media generally covers politics more attentively than it does the behavior of
private-sector firms, and scandalous-seeming political behavior tends
to make for good copy. This is not meant to suggest that governments
are unable to employ techniques for reducing tax salience. Governments clearly do not design taxes to be as salient as possible.126 However, as with private-sector firms, governments may find that moderate attempts to reduce tax salience are more effective than aggressive
attempts, as the aggressive attempts may backfire.
Complicating matters, taxpayers’ aversion to being manipulated
may be more a function of the perceived intent behind government
actions rather than a direct function of the design of the tax system.
Hence, taxpayers’ aversion to being manipulated does not necessarily
play out differently depending on which of the three operative mechanisms is dominant. Whether taxpayers perceive themselves as being
manipulated works somewhat independently of the mechanism by
which taxpayers are (or are not) manipulated. Indeed, taxpayers’
hostility may depend as much on how the media reports on taxdesign techniques as on the nature of the techniques themselves. I
therefore expect that governments have much greater scope for re124. For an example of this phenomenon, see Adam Nagourney & David M. Herszenhorn, Republicans Call Health Legislation a Tax Increase, N.Y. TIMES (Oct. 2, 2009),
www.nytimes.com/2009/10/02/health/policy/02tax.html (describing Republican attacks on
Obama’s health care reform proposal based on allegations that the proposal contains “hidden” tax increases).
125. If hostility toward the use of political salience techniques engenders tax-averse
preferences, taxpayers may be less likely to engage in taxable transactions or more likely
to underreport their income or engage in other forms of tax evasion. For a discussion of the
connection between tax salience and tax-averse preferences, see Gamage & Shanske, supra
note 4, at 50.
126. See Krishna & Slemrod, supra note 38.
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ducing tax salience when the techniques employed for doing so are
primarily directed toward other purposes.
For instance, imagine what might happen were a future U.S. President to explicitly support an expansion of the Alternative Minimum
Tax (AMT) on the grounds that the effective tax-rate hikes caused by
expanding the AMT would be less salient to both voters and market
participants than would raising income-tax rates directly. It is hard
to imagine Congress approving an AMT expansion openly supported
as a means of making the income tax less salient. But even if the expansion could be passed into law, we might expect that taxpayers’
aversion to being manipulated would counteract much (if not all) of
the salience-reducing effects of the AMT expansion. 127
Conversely, imagine a future U.S. President supporting an AMT
expansion with the stated goal of preventing high-income taxpayers
from negating most of their tax liabilities through aggressive exploitation of tax credits and deductions.128 The President’s political opponents might claim that the true goal of the proposed AMT expansion
was to reduce tax salience. But if taxpayers found the President’s position credible—believing that the AMT expansion was actually intended to combat aggressive tax planning—the expansion would be
far less likely to trigger taxpayers’ aversion to being manipulated. All
else being equal, attempts to reduce tax salience are more likely to be
successful when the salience-reducing features of a tax reform are
plausibly viewed as a side effect of a reform aimed at other purposes,
rather than as the primary goal of the reform.
Taxpayers’ aversion to being manipulated should generally work
in concert with the other limiting factors—the size of a tax liability
and learning from experience. After all, taxpayers can only react
against the use of salience-reducing techniques if they know that
these techniques are being employed. The larger the size of a tax liability, the more likely that taxpayers will take note of the tax liability
and become averse to any salience-reducing techniques used to obscure it. Similarly, the easier it is for taxpayers to learn about a salience-reducing technique through experience, the more likely that
taxpayers will perceive themselves as being manipulated. Particularly when tax liabilities are large and conditions are conducive to
127. Taxpayers’ aversion to being manipulated could more than counteract the salience-reducing effects. If taxpayers’ preferences became sufficiently more tax-averse, the
AMT expansion could increase the market distortions caused by taxation. Similarly, if
taxpayers became more distrustful of taxes in their role as voters, the AMT expansion
might increase political resistance to taxation.
128. AMT has generally been supported on these grounds. See COMM. ON FIN., TAX
EQUITY AND FISCAL RESPONSIBILITY ACT OF 1982, S. REP. NO. 97-494, at 108 (1982) (“The
committee has amended the present minimum tax provisions applying to individuals with
one overriding objective: no taxpayer with substantial economic income should be able to
avoid all tax liability by using exclusions, deductions and credits.”).
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learning, governments may thus find that moderate use of techniques for reducing tax salience are more effective than high use.
V. CONCLUSION
I have argued in this Essay (building on my prior article with Darien Shanske) that the existing tax salience literature is not yet sufficiently developed to offer concrete tax policy prescriptions. However,
the literature on tax salience is advancing rapidly. I am thus hopeful
that the tax salience literature will be made policy-ready before too
long. Despite my conclusions about the state of the existing literature, I remain optimistic that the study of tax salience will prove to
be one of the most important paths through which future scholarly
advances can guide the improvement of tax policy.
Importantly, that we currently lack the information needed to
predict with confidence the circumstances in which tax salience effects are likely to manifest does not imply that normative scholars
should simply ignore the possibility of tax salience effects. Normative
prescriptions that hold only in the absence of tax salience effects are
just as likely to prove erroneous as are prescriptions that are based
on the assumption that tax salience effects will strongly manifest despite the possibility of limiting factors.129 The available evidence suggests that tax salience effects are real and that these effects are potentially important in at least some policy contexts.
Instead, humility is the appropriate reaction to the nascent state
of the tax salience literature. There is currently little that scholars
can say with confidence about whether and when tax salience effects
are likely to be important.
Hopefully, this Essay’s analysis of potential operative mechanisms
and limiting factors will aid in the development of a more refined literature on tax salience—a literature that may one day be capable of
offering concrete policy recommendations. Moreover, although this
Essay has focused on evaluating the circumstances under which tax
salience effects are likely to manifest, this Essay’s analysis may also
aid the development of the literature on the normative implications
of tax salience. When taxpayers’ expressed preferences are manipu129. For instance, a number of influential arguments based on optimal tax theory assume that taxpayers will make labor decisions based on fully factoring in the price implications of excise taxes, capital-income taxes, and other tax and regulatory burdens that reduce the purchasing power of the money that taxpayers earn. Yet as Christine Jolls has
speculated, it seems plausible to me that in many contexts these price effects may be significantly less salient for these decisions than are labor-income taxes. For further discussion, see Christine Jolls, Behavioral Economics Analysis of Redistributive Legal Rules, 51
VAND. L. REV. 1653, 1669-73 (1998); David Gamage, On Double-Distortion Arguments,
Distribution Policy, and the Optimal Choice of Tax Instruments II.B.4 (Sept. 25, 2013)
(unpublished manuscript) (on file with the author).
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lable through salience effects, the question arises as to what are taxpayers’ “true preferences”—which of the multiple possible sets of expressed preferences should be most respected? These questions are
especially important with respect to political salience, under the
thought that democratic institutions should be designed so as to respect voters’ desires. But these questions also arise with respect to
market salience, to the extent that policies are designed based on divergences between taxpayers’ market decisions and taxpayers’ preferences regarding the consequences of their market decisions. For
these sorts of questions, assessing the normative implications of
salience effects requires understanding the operative mechanisms
underlying them.
In any case, it is my hope that by the bicentennial anniversary of
the income tax, 130 scholarly literature building on the currently nascent study of tax salience will have dramatically improved our understanding of how taxpayers respond to taxation. Models based on perfect economic rationality have generated powerful insights. But there
can be little doubt that taxpayer behavior often departs from the assumption of perfect economic rationality. Ultimately, the study of tax
salience must be a key part of our examination of taxpayer behavior.
Even if we do not yet have the tools to answer fully questions related
to tax salience, the importance of these questions demands continued
scholarly attention.
130. Of course, this is assuming that the income tax survives for another hundred
years. But even if the U.S. income tax no longer exists—or even if the U.S. no longer exists—we can reasonably expect that taxation will probably still exist one hundred years
from now and that it will thus remain important to understand taxpayer behavior.
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REFORMING FEDERAL TAX LITIGATION: AN AGENDA
STEVE R. JOHNSON *
I. INTRODUCTION..................................................................................................
II. CRITERIA FOR ASSESSING REFORMS .................................................................
A. Sources of Criteria .....................................................................................
B. Shaping Developments...............................................................................
1. Creation and Expansion of Refund Remedies .....................................
2. The Anti-Injunction Act and Its Exceptions.........................................
3. Creation of Prepayment Remedies .......................................................
4. Flora Full Payment Rule .....................................................................
5. Powell and IRS Information Gathering ..............................................
6. Federal Tax Lien Act ............................................................................
7. Shapiro, Laing, and Jeopardy Assessment Review..............................
8. TEFRA Partnership Audit/Litigation Procedures ..............................
9. Brockamp and Equitable Tolling ........................................................
10. IRS Restructuring and Reform Act......................................................
11. Ballard and Tax Court Process ............................................................
12. Administrative Law in Tax..................................................................
C. Criteria.......................................................................................................
III. REFORMS AS TO AVAILABLE COURTS .................................................................
A. Tax Court Jurisdiction ..............................................................................
1. Historical Growth of Tax Court Jurisdiction ......................................
2. Areas Where the Tax Court Lacks Jurisdiction ...................................
3. Where to Expand Tax Court Jurisdiction and Where Not to
Expand ................................................................................................
B. National Court of Tax Appeals ..................................................................
C. Court of Federal Claims Jurisdiction ........................................................
1. History..................................................................................................
2. Reasons for Change ..............................................................................
IV. REFORMS AS TO AVAILABLE FORMS OF ACTION.................................................
A. TEFRA Rules .............................................................................................
1. Unnecessary .........................................................................................
2. Harmful ...............................................................................................
B. Judicial Review of CDP Determinations ...................................................
V. REFORM AS TO PREREQUISITE TO SUIT .............................................................
A. Flora “Full Payment” Rule.........................................................................
B. Changes Not Proposed ...............................................................................
VI. CONCLUSION .....................................................................................................
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I. INTRODUCTION
King Vertigorn, it is said, wished to build a castle to defend Britain against invaders. Each day, his mason raised and set the stones.
Each night, however, the earth would rumble, bringing the work
* University Professor of Law, Florida State University College of Law. I thank
participants in the Symposium—particularly Professor Leandra Lederman, the primary
commentator on this Article at the Symposium—for their criticisms, observations, and
encouragement. I also thank Mary McCormick of the Florida State University College of
Law Research Center for research assistance.
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crashing to the ground. Vexed, Vertigorn asked Merlin for an explanation. Merlin’s mystical divination revealed that, in a cavern far
below the surface, there resided two foes, a red dragon and a white
dragon. In their perpetual struggle for dominance, first one dragon
then the other would gain temporary ascendancy. Their jostling unsettled the ground, rendering all construction temporary.
In federal tax procedure, the red dragon and the white dragon are
facilitation of revenue collection and fairness to taxpayers. Numerous
times during the first century of the modern federal income tax, the
courts have noted the centrality of the first value: “taxes are the lifeblood of government, and their prompt and certain availability an
imperious need.” 1 But, were that the only value, we could return to
brutal efficiency of the proscription system. We have refrained from
doing so because our limited government traditions demand that citizens’ claims to due process under the law be taken seriously.
Thus, tax administration in the United States—before, during,
and (no doubt) after the income tax’s first one hundred years—has
involved and will involve the balancing of the revenue facilitation
and fairness protection imperatives. 2 Just as the power balance between the red and white dragons fluctuated, so have the relative
weights accorded the two tax imperatives. During times of international or domestic crisis, we have looked to Government to save us
from threats. This demands opening wider the spigot of fiscal flows,
so the first tax value receives greater weight. During more placid
times, menace recedes, causing the virtues of the second value to appear more attractive.
In short, the pendulum swings between emphasis on revenue
maximization and taxpayer protection. This affects legislative, regulatory, and judicial actions; it implicates not just substantive rules of
tax liability and tax rates but also styles of statutory interpretation 3
and the rules and devices of tax procedure.
1. Bull v. United States, 295 U.S. 247, 259 (1935); see also United States v. Dalm,
494 U.S. 596, 604 (1990); United States v. Nat’l Bank of Commerce, 472 U.S. 713, 733
(1985); United States v. Kimbell Foods, Inc., 440 U.S. 715, 734 (1979).
2. The tension between the values has been evident since the founding of the American Republic. Alexander Hamilton, our first Secretary of the Treasury, proposed a general
ad valorem duty on all imports. “Immediate opposition in the Congress was rooted in a fear
of the alleged centralizing tendencies involved in creating a large force of collectors on the
Federal level.” INTERNAL REVENUE SERVICE, U.S. TREASURY DEP’T, PUB. NO. 447, THE
UNITED STATES TAX SYSTEM: A BRIEF HISTORY 4 (1960). One of the opponents described the
proposal as the “horror of all free States,” one that was “hostile to the liberties of the people,” and which would “convulse the government; let loose a swarm of harpies, who, under
the domination of the revenue officers, will range the country prying into every man’s
house and affairs, and, like the Macedonian phalanx, bear down all before them.” Id.
3. This is reflected in the assertion, disappearance, and occasional reappearance in
federal tax jurisprudence of a canon under which tax statutes were construed strictly
against the Government and in favor of taxpayers. See, e.g., Gould v. Gould, 245 U.S. 151,
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This Article is about the procedural rules. Specifically, it considers
the mechanisms by which disputes as to federal tax liabilities are resolved. The Article identifies an agenda for reforming federal tax litigation. 4 Fully developing the justifications for and the particulars of
the proposed changes necessarily is the work of more than one article. Thus, this Article sets the agenda, describing the core elements of
the changes (and, in some cases, the reaffirmations) I propose. Subsequent articles will develop specific proposals in greater detail.
Part II of this Article explores the criteria that should guide choices in this area. A fairly uncontroversial list of candidate criteria
would include such things as decisional accuracy, efficiency, and actual and perceived equity. However, considerable controversy likely
would exist, even among competent commentators, as to the relative
weights that should be accorded the criteria, both generally and in
application to particular situations.
Hence, in Part II, I will not focus on the weightings that best comport with my personal constellation of values. Instead, Part II
sketches key legislative, regulatory, and judicial events that have
shaped our current tax procedure rules. By distilling these events, we
can get a sense of the values that have actually driven the system.
Parts III, IV, and V apply those values to features of the federal
tax litigation system and thereby develop proposals. Specifically,
Part III considers reforms as to the judicial fora that should be available for the resolution of federal tax controversies. It offers three
principal recommendations: (1) the Tax Court should be given quasiplenary jurisdiction in civil tax matters (concurrent, not exclusive,
153 (1917) (“In case of doubt [statutes levying taxes] are construed most strongly against
the Government, and in favor of the citizen.”). Gould cited authorities as far back as Justice Story’s opinion in United States v. Wigglesworth, 28 F. Cas. 595 (C.C.D. Mass. 1842).
This canon was invoked in hundreds of federal cases in the 1800s and the first two
decades of the 1900s, when limited government was the predominant electoral preference.
It was largely replaced by pro-IRS canons (such as that I.R.C. § 61 is construed broadly, see
Commissioner v. Glenshaw Glass Co., 348 U.S. 426, 429 (1955), and that tax deductions
and exemptions are construed narrowly, see Commissioner v. Schleier, 515 U.S. 323, 328
(1995) (exclusions); INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84 (1992) (deductions))
during the 1930s through 1970s, when we looked to Washington to save us from the Great
Depression, then Fascism, then Communism. Under the sway of the Reagan Revolution,
the pro-taxpayer canon returned to the stage briefly in the 1980s and 1990s. See, e.g.,
United Dominion Inds., Inc. v. United States, 532 U.S. 822, 839 (Thomas, J., concurring);
id. at 839 n.l (Stevens, J., dissenting). It has faded again since September 11, 2001. See
Steve R. Johnson, Should Ambiguous Revenue Laws Be Interpreted in Favor of Taxpayers?,
NEV. LAW., Apr. 2002, at 15-16.
The canon retains greater potency in state and local tax litigation. See Steve R.
Johnson, Pro-Taxpayer Interpretation of State-Local Tax Laws, 51 ST. TAX NOTES 441
(2009).
4. The reforms implicate litigation of all federal taxes, not just the income tax. However, the income tax is the most frequently litigated of the types imposed by the federal
government.
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jurisdiction); (2) proposals to create a national court of tax appeals
should continue to be rejected; and (3) the Court of Federal Claims
should be divested of jurisdiction to hear tax cases.
Part IV offers reforms as to the available forms of civil tax actions.
It urges two reforms: (1) repeal of the bulk of the TEFRA unified
partnership audit and litigation procedures, 5 and (2) reduction in the
scope of, but not elimination of, judicial review of Collection Due Process decisions by the IRS Appeals Office. 6
Finally, Part V addresses prerequisites to suits. It proposes that
the Flora full payment rule (that taxpayers must pay the full amount
of liability determined by the IRS as a prerequisite to bringing a tax
refund suit) be abolished. 7
II. CRITERIA FOR ASSESSING REFORMS
Law reform proposals based on idiosyncratic values preferences
are built on a foundation of quicksand. They are unlikely to gain
traction initially and to sustain it over time. I hope to erect this reform agenda on a more solid footing. Thus, I will emphasize not my
values but the values I perceive as embodied in and reflected by leading facets of the federal tax litigation system as it has developed. Below, I describe the sources that generate relevant criteria, identify
key events in the evolution of the current system, and adduce from
those developments the values on which the system is based.
A. Sources of Criteria
There are four principal sets of actors shaping norms governing
the procedural rules of taxation: Congress, the courts, federal tax
regulators (Main Treasury, 8 the IRS, and the Department of Justice), 9 and the communities of taxpayers, their representatives, and
5. See I.R.C. §§ 6221-6234. These provisions were enacted in their original form by
the Tax Equity and Fiscal Responsibility Act of 1982 (“TEFRA”), Pub. L. No. 97-248, 96
Stat. 324 (1982).
6. See I.R.C. §§ 6320, 6330.
7. See Flora v. United States (Flora II), 362 U.S. 145 (1960), reaff’g Flora v. United
States (Flora I), 357 U.S. 63 (1958).
8. The IRS is part of the Treasury Department. Unlike the IRS (which handles dayto-day tax administration and issues lower-level administrative guidance), other parts of
Treasury are involved in taxation at a more general level. So called “Main Treasury” finalizes tax regulations, represents the Administration in tax legislation, negotiates tax treaties, and, through its Treasury Inspector General for Tax Administration, monitors performance by the IRS.
9. For discussion of the roles and responsibilities of these actors, see LEANDRA LEDERMAN & STEPHEN W. MAZZA, TAX CONTROVERSIES: PRACTICE AND PROCEDURE 1-29 (3d
ed. 2009); DAVID M. RICHARDSON, JEROME BORISON & STEVE JOHNSON, CIVIL TAX PROCEDURE 1-17 (2d ed. 2008).
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academic and other commentators. In routine situations, 10 Congress
is the dominant actor, both constitutionally 11 and prudentially. 12 But
it would be a mistake to see the relationships as strictly hierarchical.
Often they are interactive. Courts, through constitutional analysis
and statutory interpretation, and government and private professional communities, through advocacy and an “unwritten code” as to
how things should be done, also have been highly influential in the
development of values shaping the rules of tax procedure.13
The legitimate extent of such interaction is unsettled and is the
subject of considerable debate in many areas of law. For example,
some see statutory interpretation as a collaborative process by which
courts and legislatures formulate law interactively.14 Others have offered similar visions of constitutional law15 and administrative law.16
Tax is about as positivistic as any field of law gets, but courts have
made a great deal of the law even in tax. 17 This tradition was estab10. A non-routine situation would be, for example, when the courts hold that the Constitution forbids some item of tax legislation. The courts are reluctant to do so. Judicial
deference to Congress is considerable in matters of revenue raising. See, e.g., Nordlinger v.
Hahn, 505 U.S. 1, 11-12 (1992); Regan v. Taxation with Representation of Wash., 461 U.S.
540, 547 (1983).
11. See U.S. CONST. art I, § 8, cl. 1.
12. In dealing with the numerous complex considerations that formulating tax rules
entails, Congress has natural advantages over the courts. See United States v. Nunnally
Inv. Co., 316 U.S. 258, 264 (1942) (“The problem of legal remedies appropriate for fiscal
administration rests within easy Congressional control. Congress can deal with the matter
comprehensively, unembarrassed by the limitations of a litigation involving only one phase
of a complex problem.”); see also United States v. Kales, 314 U.S. 186, 200 (1941).
Some might argue that an expert agency could make better tax laws than a democratically selected legislature. Whether or not that is true, Congress surely possesses a
legitimacy in this area that Treasury lacks. See generally Andre L. Smith, The Nondelegation Doctrine and the Federal Income Tax: May Congress Grant the President the Authority
to Set the Income Tax Rates?, 31 VA. TAX REV. 763 (2012).
13. This fact has been recognized for a long time. Over a half century ago, for example, an Assistant Secretary of the Treasury remarked on “one very important factor”: “As
our proposed regulations are published, a cumulative effect is being created. The regulations should give you an over-all indication of attitude on the part of the Treasury Department.” Laurens Williams, The Preparation and Promulgation of Treasury Department Regulations Under the Internal Revenue Code of 1954, 8 TAX EXECUTIVE 3, 7-8 (1956) (emphasis
in original).
14. See, e.g., William D. Popkin, The Collaborative Model of Statutory Interpretation,
61 S. CAL. L. REV. 541 (1988).
15. See, e.g., Blakely v. Washington, 542 U.S. 296, 326 (2004) (Kennedy, J., dissenting) (“Constant, constructive discourse between our courts and our legislatures is an integral and admirable part of the constitutional design.”); Mistretta v. United States, 488 U.S.
361, 408 (1989) (“Our principle of separation of powers anticipates that the coordinate
Branches will converse with each other on matters of vital common interest.”).
16. See, e.g., 1 KENNETH CULP DAVIS, ADMINISTRATIVE LAW TREATISE 138 (2d ed.
1978) (stating that administrative procedure is formulated by “[l]egislators and judges who
are working [as] partners [to] produce better law than legislators alone could possibly
produce”).
17. See, e.g., Dobson v. Commissioner, 320 U.S. 489, 499 n.25 (1943) (“Judge-made
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lished early, and it has proved enduring.18 The benefits of judicial
participation are doubted by some, however, 19 and the legitimacy of
such collaboration was debated in a recent Supreme Court tax case.
In the Home Concrete case,20 the Court invalidated an amended
Treasury regulation dealing with the six-year statute of limitations
on assessment in cases of substantial omissions of income.21 In the
course of its analysis, a four-justice dissent remarked: “Our legal system presumes there will be continuing dialogue among the three
branches of Government on questions of statutory interpretation
and application.” 22
Unsurprisingly, Justice Scalia rose to defend his textualist sensibilities. He addressed and rejected the dissenters’ “romantic, judgeempowering image” and “mirage” of a legislative-executive-judicial
troika.23 He found the dissenters’ vision to be “obliterated” by Vermont Yankee, whose teaching Justice Scalia took to be that “Congress
prescribes and we [the Court] obey, with no discretion to add to the
administrative procedures that Congress has created.” 24
I share Justice Scalia’s belief that in tax (and other statutory areas) a clear congressional command controls, unless unconstitutional
and until Congress amends its direction. But his argument about
constitutional primacy may have missed the point about practical
realities. Congress is not hermetically sealed off from other legal actors. The elected Senators and Representatives are influenced by
values and norms molded and expressed by judges who decide tax
cases, Executive Branch officials who suggest and testify as to tax
legislation, Congress’s staffs of tax professionals, the tax professionals who lobby Congress on behalf of their clients, and, of course, the
law is particularly prolific in connection with federal taxation . . . .” (quoting RANDOLPH
PAUL, SELECTED STUDIES IN FEDERAL TAXATION 2 n.2 (1938))); Charlotte Crane, Pollock,
Macomber, and the Role of the Federal Courts in the Development of the Income Tax in the
United States, 73 LAW & CONTEMP. PROBS. 1, 2 (2010) (“Although the income tax is quintessentially a matter of statute, a significant number of its doctrines are entirely a matter
of judicial definition.”).
18. Initially, decisions of the Board of Tax Appeals (the predecessor of the Tax Court)
were reviewed without any deference. This established a “habit” of free-wheeling review.
During those early years, “[p]recedents had accumulated in which courts had laid down
many rules of taxation not based on statute but upon their ideas of right accounting or tax
practice. It was difficult to shift to a new basis.” Dobson, 320 U.S. at 497-98.
19. See, e.g., Crane, supra note 17; Martin D. Ginsburg, Making Tax Law Through the
Judicial Process, 70 A.B.A. J. 74 (1984).
20. United States v. Home Concrete & Supply, LLC, 132 S. Ct. 1836 (2012).
21. See I.R.C. § 6501(e).
22. Home Concrete, 132 S. Ct. at 1852 (Kennedy, J., dissenting).
23. Id. at 1848 (Scalia, J., concurring).
24. Id. (construing Vermont Yankee Nuclear Power Corp. v. Natural Res. Def. Council, Inc., 435 U.S. 519 (1978)).
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clients themselves who are Senators’ and Representatives’ constituents and contributors.
The values fought for and held by the many actors in the tax
community are the womb from which tax laws issue. 25 We turn now
to the key developments that have formed such values in the area of
tax procedure.
B. Shaping Developments
Ruskin, the British author, critic, and social theorist, asserted
that “[g]reat nations write their autobiographies in three manuscripts—the book of their deeds, the book of their words, and the book
of their art.” 26 For Ruskin’s purposes, the book of art was the most
trustworthy. For the purposes of this Article, the book of deeds and
the book of words—that is, what mechanisms we have created in tax
procedure and why we have said they needed to be created—are particularly illuminating. The norms governing the current federal tax
procedure system—and the criteria that should govern reform efforts—crystallized as a result of a long skein of legislative, regulatory, and judicial events.
In rough chronological order, the key events—the Defining Dozen—have included the following: (1) adapting the common law in the
1800s to fashion a refund remedy for taxpayers and the progressive
expansion of that remedy over more than a century; 2) enactment of
the Anti-Injunction Act in 186727 and creation of increasing numbers
of statutory and judicial exceptions to it; (3) establishment, beginning
in the 1920s, of prepayment administrative (and later judicial) remedies for taxpayers as to income and some other taxes;28 (4) the 1960
decision of the United States Supreme Court in Flora II,29 requiring
full payment of liabilities determined by the IRS as prerequisite to a
taxpayer’s bringing a refund suit; (5) the Supreme Court’s 1964
decision in Powell, 30 establishing standards to govern judicial
challenges to IRS summonses and subsequent statutory elaboration
of additional rules;31 (6) enactment of the Federal Tax Lien Act of
25. See generally LOUIS EISENSTEIN, THE IDEOLOGIES OF TAXATION (1961); see also
William L. Cary, Pressure Groups and the Revenue Code: A Requiem in Honor of the Departing Uniformity of the Tax Laws, 68 HARV. L. REV. 745, 746, 773-80 (1955); Stanley S.
Surrey, The Congress and the Tax Lobbyist—How Special Tax Provisions Get Enacted, 70
HARV. L. REV. 1145, 1146, 1181-82 (1957).
26. JOHN RUSKIN, ST. MARK’S REST: THE HISTORY OF VENICE (New York, John Wiley
& Sons 1877) (author’s preface).
27. Currently codified at I.R.C. § 7421.
28. HAROLD DUBROFF, THE UNITED STATES TAX COURT: AN HISTORICAL ANALYSIS pt. 1
(1979).
29. Flora II, 362 U.S. 145 (1960).
30. United States v. Powell, 379 U.S. 48 (1964).
31. Id. at 57-58; see, e.g., I.R.C. § 7609.
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1966 32 with subsequent statutory amendments and promulgation of
extensive regulations; (7) the Supreme Court’s 1976 Shapiro and
Laing decisions, 33 followed by enactment of administrative and judicial mechanisms for prompt review of jeopardy and termination assessments;34 (8) enactment of the unified partnership audit and litigation procedures in the Tax Equity and Fiscal Responsibility Act of
1982 (“TEFRA”); 35 (9) the Supreme Court’s 1997 Brockamp decision 36
and its partial reversal by legislation allowing limited equitable tolling of the statute of limitations on filing refund claims; 37 (10) enactment of numerous tax procedure changes in the Internal Revenue
Service Restructuring and Reform Act of 1998; 38 (11) the Supreme
Court’s 2005 Ballard decision 39 dealing with Tax Court opinion practice; and (12) the irreversible entry of principles of general administrative law into tax litigation, reflected in part in the Supreme
Court’s 2011 Mayo decision. 40
Others might constitute the list differently. Clearly, there have
been other important developments in federal tax procedure in the
past century. I selected the Defining Dozen developments because
they deal with rights and obligations as between the IRS and taxpayers. It is from these matters that criteria useful to reforming federal
tax litigation are most likely to emerge.
1. Creation and Expansion of Refund Remedies
“In present times, federal income taxes are of such a pervasive
and significant influence that it is easy to forget their relatively recent origin.”41 For most of this country’s history, the federal government assumed limited responsibilities, and so could do with limited
revenue, mostly supplied by tariffs, sale of public lands, and various
excise taxes.42
32. Federal Tax Lien Act of 1966, Pub. L. No. 89-719, 80 Stat. 1125 (codified at I.R.C.
§§ 6323-6325).
33. Commissioner v. Shapiro, 424 U.S. 614 (1976); Laing v. United States, 423 U.S.
161 (1976).
34. See I.R.C. § 7429.
35. Pub. L. No. 97-248, 96 Stat. 324.
36. United States v. Brockamp, 519 U.S. 347 (1997).
37. I.R.C. § 6511(h).
38. Internal Revenue Service Restructuring and Reform Act of 1998, Pub. L. No. 105206, 112 Stat. 685 (codified in various sections of the I.R.C.).
39. Ballard v. Commissioner, 544 U.S. 40 (2005).
40. See Mayo Found. for Med. Educ. & Research v. United States, 131 S. Ct. 704
(2011).
41. DUBROFF, supra note 28, at 1 (1979).
42. The idea of an income tax was not unknown, however. As early as 1643, the New
Plymouth colony had a rudimentary income tax, and some other colonies and states also
imposed income taxes in the seventeenth and eighteenth centuries. Id. at 1-2.
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Nonetheless, it is surprising, perhaps shocking, to contemporary
sensibilities that until 1855 no suit as to tax overpayments was permitted against the federal government. 43 That caused lawyers and
judges to do what they usually do when confronted by an inadequate
statutory framework—use their creativity to fashion an alternative
remedy. The constraint, of course, was the doctrine of sovereign
immunity. The answer fashioned by the courts—upheld by the Supreme Court in 1936—was allowing federal tax collectors 44 to be sued
personally for taxes allegedly collected illegally. 45 “Such a suit
was based on the common-law [action] of assumpsit for money had
and received . . . .” 46
This device was built on a fiction. 47 The real party in interest was
the government, not the collector. 48 Much of the law involves fiction,
of course, but a regime based on dubious premises often leads to convolution erected on convolution as doctrine is expounded. So it was
with this fiction.
There were at least three problems with the solution fashioned by
the courts. First, suits against collectors initially depended on diversity jurisdiction. 49 Suit could be barred, therefore, because of acci43. If the taxpayer had not yet paid the tax at issue, she might be able to secure judicial review of the merits by posting bond for the tax, then, when the government brought
suit on the bond, asserting the absence of substantive liability as a defense. In addition,
Congress sometimes determined the merits of tax claims itself via special legislation. See
William T. Plumb, Jr., Tax Refund Suits Against Collectors of Internal Revenue, 60 HARV.
L. REV. 685, 687 (1947).
44. For discussion of the role of collectors in federal taxation during the nineteenth
century, see Bryan T. Camp, Theory and Practice in Tax Administration, 29 VA. TAX REV.
227, 229-43 (2009).
45. Elliott v. Swartwout, 35 U.S. (10 Pet.) 137, 159 (1836). Elliott was a customs case.
The “sue the collector” remedy was held to apply as well in tax cases. City of Philadelphia
v. Collector, 75 U.S. (5 Wall.) 720, 730-33 (1866).
46. Flora II, 362 U.S. 145, 153 (1960). This common law action should be distinguished from a taxpayer suit on account stated, which is available when the IRS fails to
make a stipulated refund. See, e.g., Bonwit Teller & Co. v. United States, 283 U.S. 258, 259
(1931); MARVIN J. GARBIS, RONALD B. RUBIN & PATRICIA T. MORGAN, TAX PROCEDURE AND
TAX FRAUD: CASES AND MATERIALS 420-21 (3d ed. 1992).
47. “A suit against a Collector who has collected a tax in the fulfillment of a ministerial duty is today an anomalous relic of bygone modes of thought. . . . [Although t]here may
have been utility in such procedural devices in days when the Government was not suable
as freely as now. . . [t]hey have little utility today.” George Moore Ice Cream Co. v. Rose,
289 U.S. 373, 382-83 (1933).
48. The office of “Collector” has since been abolished. When the office existed, there
was a collector for each district. “When the Commissioner [of Internal Revenue] certifie[d]
an assessment to the collector, that official ha[d] a purely ministerial duty to effect its collection.” Plumb, supra note 43, at 687; see also Erskine v. Hohnbach, 81 U.S. (14 Wall.)
613, 616 (1871) (holding that “[t]he collector could not revise nor refuse to enforce the assessment regularly made”).
49. Collector v. Hubbard, 79 U.S. (12 Wall.) 1, 8 (1870). Subsequently, Congress established jurisdiction for “all causes arising under any law providing internal revenue.” Rev.
Stat. § 629(4) (1874) (current version codified at 28 U.S.C. § 1340).
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dents of residency. Second, notice of the alleged illegality was held to
be an essential element of an action against a collector, requiring
that the taxpayer have paid the amount in question under protest. 50
This created a trap for the unwary.51 The taxpayer who neglected this
formality would be nonsuited. 52 Third, underlining the fiction, collectors were initially indemnified by the government for amounts for
which they were held personally liable. 53 This led to the practice of
collectors withholding amounts from collected taxes to provide cushion against the possibility of being held liable. In turn, this led to
theft by collectors 54 and caused Congress in 1839 to prohibit the practice without creating an alternative indemnification mechanism. 55
This had an unintended consequence. The Supreme Court viewed
a reliable indemnification procedure as fundamental to the common
law remedy. The Court held that the remedy could not survive the
removal of this foundation. 56 Justices Story and McLean filed separate dissents, arguing in part that taxpayers could not constitutionally be deprived of all judicial remedies for recovery of illegal or excessive taxes. There being no other remedy, they maintained, suits
against collectors could not be abolished. 57
Congress reacted quickly. Within a few weeks, it passed a sostyled “explanatory Act” declaring that the 1839 legislation should
not be understood as impairing the rights of persons to sue collectors. 58 The Court was satisfied; suits against collectors were rehabilitated as a remedy. 59 But, given the legislation, the Supreme Court
“no longer regarded the suit as a common-law action, but rather as
a statutory remedy which ‘in its nature [was] a remedy against
the Government.’ ” 60
50. Elliott, 35 U.S. (10 Pet.) at 153-54.
51. This ran contrary to “[t]he ideal of the Federal Rules of Civil Procedure and of all
modern code pleading . . . that a party who has timely brought a suit in a court having
jurisdiction shall not be defeated by mere procedural technicalities.” Plumb, supra note 43,
at 685.
52. The federal government abolished the “paid under protest” requirement in 1924.
Revenue Act of 1924, ch. 234, § 1014, 43 Stat. 253, 343.
53. Rev. Stat. § 989 (1875); see, e.g., George Moore Ice Cream Co. v. Rose, 289 U.S.
373, 380-81 (1933).
54. See Cary v. Curtis, 44 U.S. (3 How.) 236, 243 (1845) (noting that the practice “led
to great abuses, and to much loss to the public”).
55. Act of Mar. 3, 1839, ch. 82, § 2, 5 Stat. 339, 348-49 (1839).
56. Cary, 44. U.S. (3 How.) at 243-44.
57. Id. at 252-56 (Story, J., dissenting), 263-66 (McLean, J., dissenting).
58. Act of Feb. 26, 1845, ch. 22, 5 Stat. 727 (1845).
59. See, e.g., City of Philadelphia v. Collector, 72 U.S. (5 Wall.) 720, 731 (1866).
60. Flora II, 362 U.S. 145, 153 (1960) (quoting Curtis’s Adm’x v. Fiedler, 67 U.S. (2
Black) 461, 479 (1862)).
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Congress created a second refund remedy when it established the
Court of Claims in 1855.61 That body originated as an administrative
or advisory body but was elevated to judicial status, with jurisdiction
to hear claims against the federal government, including tax claims. 62
Next, in 1887, Congress created another refund action in the
Tucker Act. It conferred on federal district courts jurisdiction to hear
claims against the United States not exceeding $1000.63 Taxpayers
with larger refund claims could sue either the United States in the
Court of Claims or the collector in district court. The utility of that
second alternative was impaired, however, when the Supreme Court
held that an action against a collector was personal in character and
could not, in the event of the particular collector’s death or other vacation of office, be maintained against her successor.64 Congress responded to that holding by amending the statute to remove the ceiling amount in the event that the collector to whom the tax was paid
was not in office when the suit was commenced.65
These historical artifacts have now been tidied up. Refund suits
against collectors have been abolished.66 Instead, tax refund claims
may be brought against the federal government in either the Court of
Federal Claims (the current iteration of the Court of Claims) or federal district court, without any ceiling on the amount sought. 67
This history was driven by the desire to provide taxpayers effective remedies. Congress’ failure to so provide in early years impelled
the courts to create a common law remedy, however unwieldy. Limitations on that judicial remedy spurred Congress to improve statutory remedies progressively.
2. The Anti-Injunction Act and Its Exceptions
As we have just seen, taxpayers had the ability through refund
suits to attempt to secure the return of taxes allegedly improperly
collected by the federal government. But were taxpayers remitted to
only this “back end” remedy? Lawyers are fond of seeking injunctions. Instead of paying the tax then trying for a refund, could tax61. Act of Feb. 24, 1855, ch. 122, 10 Stat. 612.
62. See Williams v. United States, 289 U.S. 553, 562-65 (1933); United States v. Klein,
80 U.S. (13 Wall.) 128, 144-45 (1871).
63. Act of Mar. 3, 1887, ch. 359, § 2, 24 Stat. 505. This was held to include jurisdiction
over tax refund claims. United States v. Emery, Bird, Thayer Realty Co., 237 U.S. 28, 32
(1915).
64. Smietanka v. Ind. Steel Co., 257 U.S. 1, 6 (1921).
65. Revenue Act of 1921, ch. 136, § 1310, 42 Stat. 227, 310. The amount-incontroversy ceiling was abolished entirely in 1954. Act of July 30, 1954, ch. 648, § 1, 68
Stat. 589, 589.
66. See Act of Nov. 2, 1966, Pub. L. No. 89-713, § 3, 80 Stat. 1107, 1108.
67. 28 U.S.C. § 1346(a)(1) (2006).
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payers obtain earlier judicial determination of the merits of a particular case by bringing an injunction action against impending tax assessment or collection?
From an early date—essentially contemporaneous with the abolition of the income tax imposed by the Union during the Civil War 68—
Congress answered that question in the negative. In 1867, it enacted
the earliest version of the Anti-Injunction Act (“AIA”). 69 The current
version of the Act, embodied in I.R.C. § 7421(a), 70 provides, in the
main, that “no suit for the purpose of restraining the assessment or
collection of any tax shall be maintained in any court by any person,
whether or not such person is the person against whom such tax
was assessed.” 71
The AIA was adopted by voice vote as a floor amendment and so
was not accompanied by committee reports. Nonetheless, the text of
the statute makes the provision’s purpose plain enough. 72 “This statute protects the Government’s ability to collect a consistent stream of
revenue . . . . Because of the [AIA], taxes can ordinarily be challenged
only after they are paid, by suing for a refund.” 73 This understanding
has existed essentially from the original enactment of the statute. 74
This strong “protect the revenue” measure has been modified by
both Congress and the Supreme Court, however. Congress has
amended § 7421 from time to time to allow injunction actions when
the IRS proceeds with assessment or collection in disregard of statutorily prescribed taxpayer remedies and protections. 75
68. For description of the Civil War income tax, see INTERNAL REVENUE SERVICE,
supra note 2, at 10-15.
69. Act of Mar. 2, 1867, Pub. L. No. 39-169, § 10, 14 Stat. 471, 475.
70. A parallel prohibition exists in I.R.C. § 7421(b) as to suits to restrain assessment
or collection of transferee or fiduciary liabilities.
71. I.R.C. § 7421(a). Taxpayers or third parties seeking injunctions sometimes also
desire judicial declaration of the illegality of the tax rule or its application in the particular
case. Just as the AIA can be a barrier to an injunction, the Declaratory Judgment Act
(“DJA”) can be a barrier to a declaration. The DJA withdraws authority from federal courts
to grant declaratory relief in tax cases. 28 U.S.C. § 2201(a) (2006). The courts typically hold
that the AIA and the DJA are coextensive. See, e.g., Sigmon Coal Co. v. Apfel, 226 F.3d
291, 299 (4th Cir. 2000) (citing In re Leckie Smokeless Coal Co., 99 F.3d 573, 583 (4th Cir.
1996)).
72. Even textualist judges use statutory purpose, as long as such purpose can be derived from the statute itself and its context, rather than from suspect committee reports.
See ANTONIN SCALIA & BRYAN A. GARNER, READING LAW: THE INTERPRETATION OF LEGAL
TEXTS 56-58 (2012).
73. Nat’l Fed. of Indep. Bus. v. Sebelius (NFIB), 132 S. Ct. 2566, 2582 (2012).
74. See Snyder v. Marks, 109 U.S. 189, 192 (1883); Taylor v. Secor, 92 U.S. 575, 61215 (1875).
75. Specifically, I.R.C. § 7421(a) allows injunction suits as provided in § 6015(e) (Tax
Court review of spousal relief cases), §§ 6212(a), (c), 6213(a) (Tax Court review of deficiency
actions), §§ 6225(b), 6246(b) (TEFRA proceedings), § 6330(e)(1) (collection due process
cases), § 6331(i) (levies as to divisible taxes), § 6672(c) (trust fund recovery penalty
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In addition, the Supreme Court created judicial exceptions to the
AIA. Initially, the Court held that an injunction action will lie if all
three of these conditions are satisfied: (1) under the most pro-IRS
view of the facts and the law, there is no possibility that the IRS
could prevail on the merits in the controversy; (2) the taxpayer is
threatened with irreparable harm; and (3) no adequate legal remedy
is available to the taxpayer. 76
Later, taking a purposive tack, the Court created a second exception. Under it, the AIA will bar injunction actions “only in situations
in which Congress ha[s] provided the aggrieved party with an alternative legal avenue by which to contest the legality of a particular tax.” 77
A recent prominent appearance of the AIA was in NFIB, which
tested the constitutionality of the individual mandate provision of the
Patient Protection and Affordable Care Act. Holding that the shared
responsibility payment (which enforces the mandate) constitutes a
penalty, not a tax, for statutory purposes, the Court held that the AIA
did not prevent on-the-merits review of the constitutional issues.78
This chapter in our story reflects a dominant revenue protection
purpose, of course. Dominant, but not unmixed. The AIA does not
prevent all challenges to tax assessment and collection, just injunctions. The presence of an alternative taxpayer remedy—refund
suits—is what makes prohibiting injunctions politically and constitutionally palatable. 79 Moreover, Congress has withdrawn even the
prohibition on injunctions when necessary to maintain the integrity
of a variety of protections for taxpayers and third parties. The judicial exceptions—although limited 80—further evince the system’s desire to protect the revenue only in cases of genuine necessity.
3. Creation of Prepayment Remedies
National crises, especially wars, transform societies. Among other
effects, America’s participation in World War I caused the federal
income and profits taxes to emerge as the federal government’s pribonds), § 6694(c) (preparer penalty), § 7426(a), (b)(1) (wrongful levy and other suits),
§ 7429(b) (jeopardy and termination assessment review), and § 7436 (employment status
determinations).
76. See Miller v. Standard Nut Margarine Co., 284 U.S. 498, 510-11 (1932), overruled
by Enochs v. Williams Packing & Navigation Co., 370 U.S. 1, 6 (1962).
77. South Carolina v. Regan, 465 U.S. 367, 373 (1984).
78. NFIB, 132 S. Ct. at 2583-84; id. at 2656 (Scalia, Kennedy, Thomas & Alito, JJ.,
dissenting); see Steve R. Johnson, It’s Not a Tax (Statutorily), but It Is a Tax (Constitutionally), 32 A.B.A. SEC. TAX’N NEWS Q. 13 (2012).
79. See infra Part II.B.7.
80. See, e.g., United States v. Clintwood Elkhorn Mining Co., 553 U.S. 1, 14 (2008)
(holding that the Williams Packing exception applies only when the taxpayer’s claim is “so
obvious that the Government [would have] no chance of prevailing [on the merits]”).
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mary means of finance. 81 This emergence created great stress on the
then Bureau of Internal Revenue because, first, the taxes were highly
conceptually complex and, second, numerous taxpayers were swept
into the net when the income tax graduated from a class tax to a
mass tax.
Taxpayers who disagreed with the Bureau’s determination of their
tax liability had the judicial remedies described in Part II.B.1, of
course. But the absence of a pre-assessment remedy soon became a
sore point. The first such remedy was administrative. In 1918, Congress confirmed and extended 1917 authority by creating an Advisory
Tax Board, whose members were appointed by the Commissioner of
Internal Revenue with approval of the Secretary of the Treasury.82
The Commissioner could on his own authority, and was required to
on request by the taxpayer, submit to the Board any question as to
interpretation or administration of income, war profits, or excess
profits tax.83 In 1921, Congress required the Bureau to give the taxpayer notice of its intention to assess income tax and an opportunity
to file an appeal with the Bureau’s Committee on Appeals and Review within thirty days of the notice. 84
Not surprisingly, some believed that taxpayers could not get a
“square deal” while the appellate unit remained within the Bureau
itself. 85 Accordingly, in 1924 Congress created the Board of Tax Appeals as an independent agency within the Executive Branch to hear
appeals from deficiency determinations by the Bureau. Decisions by
the Board were appealable to federal district court. 86
In 1942, Congress renamed the Board the “Tax Court of the United States,” although it continued to be an independent agency in the
Executive Branch, with its jurisdiction, powers, and duties unaltered.87 Finally, in 1969, Congress ended the tribunal’s status as an
agency. It “established, under article I of the Constitution of the
United States, a court of record to be known as the United States Tax
Court.” 88 As it is currently constituted, “[t]he Tax Court’s function
81. For discussion of this emergence, see DUBROFF, supra note 28, at 1-12, and David
Laro, The Evolution of the Tax Court as an Independent Tribunal, 1995 U. ILL. L. REV. 17,
19-22.
82. Revenue Act of 1918, ch. 18, § 1301(d)(1), 40 Stat. 1057, 1141.
83. Id. § 1301(d)(2), 40 Stat. at 1141; see Williamsport Wire Rope Co. v. United States,
277 U.S. 551, 562 n.7 (1928).
84. Revenue Act of 1921, ch. 136, § 250(d), 42 Stat. 227, 255-56.
85. 62 CONG. REC. 8913-14 (1922) (statement of Sen. Pomerene); see also DUBROFF,
supra note 28, at 58 (noting “the widespread belief that the Committee maintained a policy
of resolving all doubts against the taxpayer”).
86. Revenue Act of 1924, Pub. L. No. 68-176, § 900, 43 Stat. 253, 336-38, amended by
Revenue Act of 1926, Pub. L. No. 69-20, § 1000-05, 44 Stat. 9, 105-11.
87. Revenue Act of 1942, Pub. L. No. 77-753, § 504, 56 Stat. 798, 957.
88. I.R.C. § 7441.
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and role in the federal judicial scheme closely resemble those of the
federal district courts . . . .” 89 Its decisions are appealable to the circuit courts “in the same manner and to the same extent as decisions
of the district courts in civil actions tried without a jury.” 90
This chapter in the saga of federal tax procedure is clear. The reasons for the creation of the prepayment remedy initially and for its
evolution into greater independence and institutional dignity are evident. Congress was animated by notions of confidence, competence,
and consistency. The confidence of the public in the fairness of the
process was bolstered by the formalization of the Tax Court as a
court, a tribunal separate from the IRS. 91 The competence of the tribunal to decide tax controversies fairly and correctly would be promoted by the tax experience of the members selected for it and their
specialized tax dockets. 92 Consistency—nationwide uniformity in interpretation and application of the tax laws—also was hoped to result
from the Tax Court’s nationwide jurisdiction. 93
4. Flora Full Payment Rule
Part II.B.1 above traced the development of federal refund litigation remedies. An important question remained, however: was full
payment of the assessed amount necessary before a refund case could
be brought? For instance, assume the IRS has assessed $50,000 of
additional income tax liability against Abigail. Can she pay only
$20,000 (or even $100) of that amount and sue for refund of it? Or is
Abigail precluded from bringing suit until she pays the full $50,000?
The lower courts were divided.94 The Supreme Court granted certiorari to resolve the conflict. In Flora I, with only one justice dissent89. Freytag v. Commissioner, 501 U.S. 868, 891 (1991).
90. I.R.C. § 7482(a)(1).
91. John Nance Garner, then ranking Democrat on the House Ways and Means
Committee, expressed the common concern that, as long as members of the reviewing body
were subject to the Treasury Department, “if they did not decide cases to suit [the Treasury
Secretary] he could kick them out and get somebody who would.” 65 CONG. REC. 3282
(1924).
92. For a while, Tax Court decisions were given greater influential weight than other
decisions of lower courts because of this expertise. See, e.g., Dobson v. Commissioner, 320
U.S. 489, 498-502 (1943) (contrasting the “long legislative or administrative [tax] experience” of Tax Court judges to “the lack of a roundly tax-informed viewpoint of [generalist]
judges”), abrogated in part by I.R.C. § 7482.
93. For this reason, the Tax Court originally took the position that when its sense of
the law differed from that of the circuit court to which the case would be appealable, it
would continue to adhere to its view despite the relevant circuit’s contrary view. Lawrence
v. Commissioner, 27 T.C. 713, 716-20 (1957). The Tax Court later abandoned that position,
deferring to the controlling circuit even when that meant that substantively identical cases
would be decided inconsistently because they were within different circuits. Golsen v.
Commissioner, 54 T.C. 742, 756-58 (1970), aff’d, 445 F.2d 985 (10th Cir. 1971).
94. Compare Flora v. United States, 246 F.2d 929 (10th Cir. 1957), aff’g 142 F. Supp.
602 (D. Wyo. 1956), and Suhr v. United States, 18 F.2d 81 (3d Cir. 1927) (holding that full
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ing (in a dissent of only one paragraph), the Court held in favor of the
full payment view. 95 The majority’s opinion turned mainly on statutory interpretation and precedent, not policy. It affirmed what it called
“carefully considered dictum” in one of its 1876 decisions. 96
The majority saw the contrary lower court cases as interlopers. In
its view, the full payment “understanding of the statutory scheme
appears to have prevailed for the succeeding fifty or sixty years” after
1876.97 Thus, “there does not appear to be a single case before 1940 in
which a taxpayer attempted a suit for refund of income taxes without
paying the full amount the Government alleged to be due.” 98 This assertion was important because a long settled tradition of consistent
interpretation is a powerful consideration of statutory construction.99
The Court’s historical assertions were inaccurate. As the Government later conceded, there were in fact pre-1940 cases in which taxpayers sued for refunds without having fully paid the assessment
and without the Government or the court objecting to this omission. 100 Accordingly, the Court granted rehearing.
Flora II, decided in 1960, was a much more searching exploration.
Again the Court held in favor of the full payment approach, but only
by five-to-four, with a much longer majority opinion, one long dissent,
and one short dissent. 101
As befits the closeness of the vote, the majority acknowledged the
closeness of the merits.102 As supporting a partial payment approach,
the majority noted that suits against collectors 103 could be maintained without full payment and that there was an “absence of any
conclusive evidence that Congress ha[d] ever intended to inaugurate
a new rule.” 104
payment is necessary), with Bushmiaer v. United States, 230 F.2d 146 (8th Cir. 1956),
Sirian Lamp Co. v. Manning, 123 F.2d 776 (3d Cir. 1941), and Coates v. United States, 111
F.2d 609 (2d Cir. 1940) (holding that partial payment suffices).
95. Flora I, 357 U.S. 63 (1958).
96. Id. at 68 (discussing Cheatham v. United States, 92 U.S. 85 (1876)).
97. Id.
98. Id. at 69.
99. See, e.g., United States v. Cleveland Indians Baseball Co., 532 U.S. 200, 219-20
(2001); Flora II, 362 U.S. 145, 177-78 (1960) (Frankfurter, J., dissenting) (“[I]n construing
a tax law it has been my rule to follow almost blindly accepted understanding of the meaning of tax legislation, when that is manifested by long-continued, uniform practice, unless a
statute leaves no admissible opening for administrative construction.”).
100. Although there was some wrangling over precisely how many such cases there
were, there were at least two in the Supreme Court and a number in the lower courts. See
Flora II, 362 U.S. at 181-85 (citing Bowers v. Kerbaugh-Empire Co., 271 U.S. 170 (1926);
Cook v. Tait, 265 U.S. 47 (1924), and various lower court decisions).
101. Flora II, 362 U.S. 145.
102. Id. at 152.
103. See supra Part II.B.1.
104. Flora II, 362 U.S. at 157.
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In favor of the full payment predicate, the majority enlisted its
view of the 1876 decision, a 1921 statutory amendment, and—
decisively—the “carefully articulated and quite complicated structure
of tax laws.” 105 The majority perceived “that Congress ha[d] several
times acted upon the assumption that [the Code] requires full payment before suit,” 106 these times being the establishment of the Board
of Tax Appeals and the enactment of the Declaratory Judgment Act
and § 7422(e) of the Code. 107 Although giving primary attention to
statutory construction, the majority also invoked several policy arguments, including concerns about claim splitting, 108 allocation of
caseloads between the Tax Court and refund fora, 109 and erosion of
revenue collection. 110
In contrast, the dissenters expressed their “deep and abiding conviction that the Court today departs from the plain direction of Congress . . . , defeats its beneficent purpose, and repudiates many
soundly reasoned opinions of the federal courts . . . .” 111 The dissenters read the statutes and precedents differently from the majority,
and they disagreed at the level of policy as well. Specifically, the dissent maintained that a partial payment rule would not hamper tax
collection, 112 but it would avoid “great hardships” by allowing suits by
those lacking the resources to pay fully before litigating.113
The full payment rule has been settled since Flora II, but there
are exceptions and ambiguities. For example, the taxpayer’s liability
may include as many as three components: the deficiency, interest on
the deficiency, and one or more penalties. To satisfy Flora II, the taxpayer must fully pay the deficiency, of course, but must she also pay
all the interest and/or all the penalties? The Supreme Court has not
addressed the issue, and lower court decisions have been divided.114
105. Id.
106. Id. (construing 28 U.S.C. § 1346(a)(1)).
107. Id. at 158-67.
108. Id. at 165-66.
109. Id. at 176.
110. Id. at 169 n.36, 176 n.41.
111. Id. at 178 (Whittaker, J., dissenting).
112. Id. at 194-95.
113. Id. at 195, 198.
114. Compare Horkey v. United States, 715 F. Supp. 259, 260-61 (D. Minn. 1989)
(payment of penalty required), with Kell-Strom Tool Co. v. United States, 205 F. Supp. 190,
194 (D. Conn. 1962) (payment of interest and penalties not required). See also Martin M.
Lore & L. Paige Marvel, Claims Court Does About Face on Flora Full-Payment Rule, 78 J.
TAX’N 81, 81 (1993); Erika L. Robinson, Note, Refund Suits in Claims Court: Jurisdiction
and the Flora Full-Payment Rule After Shore v. United States, 46 TAX LAW. 827, 831-34
(1993) (describing four different views of the issue announced within a two-year period by
the Claims Court).
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An important exception applies to so-called divisible taxes, that is,
taxes based on separate transactions the assessments of which occur
separately. Prominent examples include withholding taxes and the
related trust fund recovery penalty under § 6672. 115 One facing the
penalty can secure judicial review by paying the amount attributable
to one employee for each calendar quarter at issue and posting a
bond. The government will then counterclaim for the amounts attributable to the remaining employees.116
What values does this episode reflect? Since the Flora cases are
primarily about statutory interpretation and precedent, the values of
congressional primacy and stability in taxation are much in evidence.
Process efficiency also is implicated. So are revenue protection and
provision of effective taxpayer remedies—with no clear winner between the two. Revenue protection was a policy invoked by the majority, but that should not be overemphasized. The justices were closely
divided. Moreover, the majority thought that the availability of prepayment Tax Court review ameliorated the concern about erosion of
the refund remedy by enshrining a full payment predicate. 117 Thus,
the majority did not see a sharp conflict between revenue protection
and provision of effective taxpayer remedies.
5. Powell and IRS Information Gathering
As Bacon observed, “knowledge itself is power.” 118 The IRS cannot
test the accuracy of taxpayers’ returns without the ability to gather
information on taxpayers’ transactions. Thus, Congress has granted
the IRS authority “[t]o examine any books, papers, records, or other
data which may be relevant or material to such inquiry,” and to
summon taxpayers and third parties to give testimony under oath or
produce “such books, papers, records, or other data . . . as may be relevant or material to such inquiry.”119
But the IRS’s need for information must be balanced with taxpayers’ interest in avoiding unnecessarily burdensome examinations.120
Thus, the Code contains a number of provisions to prevent undue in115. See also Susan V. Sample & Samira A. Salman, Tax Shelter Penalties: Are They
Divisible? Or Does the Taxpayer Have to Pay the Balance Before Litigating?, 4 HOUS. BUS.
& TAX L.J. 447, 455-58 (2004).
116. I.R.C. § 6672(c).
117. Flora II, 362 U.S. at 175.
118. FRANCIS BACON, RELIGIOUS MEDITATIONS (1597), reprinted in 7 THE WORKS OF
FRANCIS BACON 243, 253 (James Spedding et. al. eds., Garrett Press 1968).
119. I.R.C. § 7602(a)(1)-(2).
120. For an excellent description of the history and premises of IRS information gathering in general, and of the summons power in particular, see Bryan T. Camp, Tax Administration as Inquisitorial Process and the Partial Paradigm Shift in the IRS Restructuring
and Reform Act of 1998, 56 FLA. L. REV. 1 (2004).
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trusion. These provisions: (1) require that the times and places of examination be “reasonable under the circumstances;” 121 (2) control audio recording of interviews; 122 (3) require the IRS to explain the audit
process and the taxpayer’s rights in it; 123 (4) limit IRS summonses
when the Department of Justice has entered the case;124 (5) prohibit
the IRS from using especially detailed financial status inquiry programs absent reasonable indication that there is a likelihood the taxpayer has unreported income; 125 (6) impose special restrictions on tax
investigations of churches; 126 (7) establish rules as to IRS contacts
with third parties; 127 (8) heighten requirements when the IRS seeks
sensitive computer information; 128 (9) give taxpayers intervention
rights when the IRS summonses information from third parties;129
and (10) create requirements for the enforcement of “John Doe”
summonses.130 The IRS has established additional protections as a
matter of administrative policy. 131
One of the early protective provisions is § 7605(b), enacted originally in 1921. 132 In current form, the section provides that taxpayers
shall not “be subjected to unnecessary examination or investigations”
and that taxpayers’ “books of account” shall be subject to only
one inspection for each tax year unless the IRS “after investigation,
notifies the taxpayer in writing that an additional inspection is
necessary.” 133 The floor manager of the 1921 bill justified the
measure thusly:
Since these income taxes and direct taxes have been in force very
general complaint has been made . . . at the repeated visits of tax
examiners, who perhaps are overzealous. . . . [F]rom many of the
cities of the country very bitter complaints have reached me . . . of
unnecessary visits and inquisitions. . . . This section is purely in
the interest of quieting all this trouble and in the interest of the
peace of mind of the honest taxpayer. 134
121. I.R.C. § 7605(a).
122. Id. § 7521(a).
123. Id. § 7521(b)(1).
124. Id. § 7602(d)(1).
125. Id. § 7602(e).
126. Id. § 7611(b).
127. Id. § 7602(c).
128. Id. § 7609(a).
129. Id. § 7609(b)(1).
130. Id. § 7609(f).
131. See, e.g., IRS Establishes Five-Year Duration on Continuous Audits of Taxpayers,
25 TAX MGMT. WKLY. REP. 1811, 1811 (2006).
132. Revenue Act of 1921, ch. 136, § 1309, 42 Stat. 227, 310.
133. I.R.C. § 7605(b).
134. 61 CONG. REC. 5855 (1921) (statement of Sen. Penrose).
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The interplay of § 7605(b) and the IRS’s summons was at the
heart of Powell, 135 the most important case in our history as to the
scope of the IRS’s investigatory power. Although the IRS issues
summonses during relatively few examinations, the summons power
lies behind all IRS information gathering. Taxpayers understand
that, if they do not respond to informal IRS requests for information,
the IRS has the ability to proceed to a summons.
In Powell, the IRS was examining two income tax returns of a
company of which Powell was the president. 136 The IRS summoned
Powell to give testimony and produce records.137 Powell declined because the IRS had already examined the returns once before and because the normal statute of limitations on assessing deficiencies as to
those returns had already expired (although the limitations period
remained open if the returns were fraudulent). 138 Powell maintained
that, before he could be forced to respond, it was incumbent on the
IRS to state grounds for believing that the returns reflected fraud.139
The IRS refused to do so. 140 The Government brought an action in
district court to enforce the summons,141 and the district court held
for the Government. 142
The Third Circuit reversed.143 It reasoned that, because the returns could be adjusted only if fraudulent, § 7605(b)’s prohibition of
“unnecessary examination” barred reexamination of the records unless the IRS had information “which might cause a reasonable man to
suspect that there has been fraud in the return for the otherwise
closed year.” 144
The Supreme Court granted certiorari because of conflict among
the circuits as to the standards the IRS must meet in order to obtain
judicial enforcement of its summonses.145 Although it acknowledged
that a standard resembling the stringency of the circuit court’s test
135. United States v. Powell, 379 U.S. 48 (1964).
136. Id. at 49.
137. Id.
138. Id.; see also I.R.C. § 6501(a) (three-year “general” limitations period), (c)(1) (infinite limitations period in case of fraud).
139. Powell, 379 U.S. at 49.
140. Id.
141. Id. IRS summonses are not self-enforcing. In general, when a taxpayer does not
comply with a summons, the Government must seek an order of enforcement. If that order
is granted and not complied with, contempt of court sanctions follow. See, e.g., Reisman v.
Caplin, 375 U.S. 440, 446 (1964).
142. Powell, 379 U.S. at 50.
143. Id.
144. United States v. Powell, 325 F.2d. 914, 915-16 (3d Cir. 1963), rev’d, 379 U.S. 48
(1964).
145. The conflicting circuit court cases are identified at Powell, 379 U.S. at 50, 51 & n.8.
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was “possible,” 146 a 6-to-3 majority of the Court held that the IRS
“need make no showing of probable cause to suspect fraud unless
the taxpayer raises a substantial question that judicial enforcement
of the administrative summons would be an abusive use of the
court’s process.” 147
The majority supported its holding by reference to cases rejecting
probable cause requirements as to summonses and subpoenas issued
by other federal agencies. 148 Clearly, however, the fulcrum was the
majority’s fear that a rigorous standard “might seriously hamper the
[IRS] in carrying out investigations [it] thinks warranted.”149
In place of probable cause, the Powell Court erected the standard
that has controlled summons enforcement cases ever since. It consists of an initial burden on the IRS, satisfaction of which causes the
burden going forward to shift to the taxpayer. 150
The Government’s prima facie case consists of its establishing
(typically by affidavit of the IRS examining agent) four matters: “that
the investigation will be conducted pursuant to a legitimate purpose,
that the inquiry may be relevant to the purpose, that the information
sought is not already within the [IRS’s] possession, and that the administrative steps required by the Code have been followed.” 151 These
elements are minimal, as subsequent cases have underscored. 152
Even if the IRS establishes these elements, the taxpayer or other
summoned party may still “ ‘challenge the summons on any appropriate ground.’ ” 153 Illustratively, the Court noted that enforcement
would be an abuse of process “if the summons had been issued for an
improper purpose, such as to harass the taxpayer or to put pressure
on him to settle a collateral dispute, or for any other purpose reflecting on the good faith of the particular investigation.” 154
The dominant impulse behind Powell was protection of the revenue, based on the centrality of information to IRS examination and
enforcement. However, this impulse is tempered by the second stage
146. Id. at 53.
147. Id. at 51.
148. Id. at 57 (citing United States v. Morton Salt Co., 338 U.S. 632, 642-43 (1950);
Okla. Press Pub. Co. v. Walling, 327 U.S. 186, 216 (1946)). For discussion of these and related cases, see Steve R. Johnson, Reasonable Relation Reassessed: The Examination of
Private Documents by Federal Regulatory Agencies, 56 N.Y.U. L. REV. 742 (1981).
149. Powell, 379 U.S. at 54; see also id. at 56 (“For us to import a probable cause standard to be enforced by the courts would substantially overshoot the goal which [Congress]
sought to attain.”).
150. Id. at 57-58.
151. Id.
152. See, e.g., United States v. Tex. Heart Inst., 755 F.2d 469, 474 (5th Cir. 1985).
153. Powell, 379 U.S. at 58 (quoting Reisman v. Caplin, 375 U.S. 440, 449 (1964)).
154. Id.
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of the Powell test, as explained above. Moreover, the context must be
considered. Summons enforcement is not a determination of the merits. 155 A pro-IRS doctrine at the investigation stage is tolerable as
long as fair procedures are employed in the ensuing determination on
the merits. Indeed, Powell merely reduces informational asymmetry
between the parties, so that administrative and judicial determinations on the merits can be made on something approaching a level
playing field.
6. Federal Tax Lien Act
Assessment is a crucial act in federal taxation. Assessment is a
mere mechanical act, essentially “a bookkeeping notation” by which
the IRS fixes a dollar amount of liability for a particular period of a
particular tax for a particular taxpayer. 156 But this mechanical act
has great legal significance: the IRS has no legal authority to engage
in enforced collection actions until there has been a valid assessment. 157 For the assessment to be valid, all preliminary steps prescribed by the Code must have been accomplished.
Once the assessment has been made, the IRS bills the taxpayer
for any amount not yet paid. If the taxpayer does not “voluntarily”
pay in response to the bill, the IRS may engage in enforced collection.
The IRS’s collection powers far exceed those of private creditors.158
Among the IRS’s collection tools are tax liens,159 filing notices of tax
liens,160 levies on and administrative sale of property, 161 instigation of
judicial sale of property, 162 and offsetting tax debts against otherwise
due tax refunds. 163
Pre-assessment issues get much more attention from tax practitioners and scholars than do post-assessment issues. Nonetheless,
the latter have great practical significance, not only for the taxpayers
155. See id. at 54 (noting the dubious wisdom of “forcing [the IRS] to litigate and prosecute appeals on the very subject which [it] desires to investigate”).
156. Laing v. United States, 423 U.S. 161, 170 n.13 (1976); see I.R.C. § 6203.
157. See, e.g., I.R.C. §§ 6322, 6331(a).
158. See, e.g., Steve R. Johnson, The IRS as Super Creditor, 92 TAX NOTES 655, 655
(2001).
159. The general federal tax lien attaches to “all property and rights to property” of the
tax delinquent. I.R.C. § 6321. A variety of special tax liens also exist. See, e.g., id.
§§ 6324(a) (estate taxes), 6324(b) (gift taxes), 6324A (estate taxes deferred under § 6166),
6324B (additional estate taxes attributable to property qualifying for special valuation
under § 2032A).
160. See id. § 6323(f). Even before filing, the so-called “secret lien” is effective against
the taxpayer. See, e.g., Don King Prods., Inc. v. Thomas, 945 F.2d 529, 533 (2d Cir. 1991).
161. I.R.C. §§ 6331 (levy, also sometimes called seizure or distraint), 6335 (administrative sale of property levied upon).
162. Id. § 7403.
163. See, e.g., id. § 6402(d).
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themselves but also for third parties. 164 Those who owe money to the
IRS often owe money to others as well, and tax delinquents often coown property with persons who do not have tax debts. Accordingly,
whether and how the IRS proceeds against the property of taxpayers
can have powerful effects on the interests and behavior of third
parties as well.
The steady direction of federal tax collection law has been towards
greater solicitude for the rights and interests of third parties, even to
the point, in some instances, of according third party claims priority
over IRS claims. The Federal Tax Lien Act is the most important
landmark along this road, although neither the first nor the last.
Early on, the law was highly protective of governmental revenues.
Before the modern federal income tax, the Union imposed an income
tax during the Civil War. That earlier income tax, too, was enforced
in part by a tax lien.165 That lien was superior to the interests of third
parties—even if the tax lien had not been filed and even if the third
party was a subsequent bona fide purchaser. 166
However, in ensuing generations, Congress displayed “an increasing awareness of the public importance of security of titles, and of the
need of certain creditors to be able to rely upon the taxpayer’s apparent unencumbered ownership of his property.”167 Part of this awareness was enlightened self-interest. Congress realized that protecting
the interests of third parties in appropriate circumstances can induce
them to engage in economic transactions with the tax delinquent, enhancing the ability of the delinquent to pay the IRS.
Here are some of the steps in the unfolding awareness. In 1913,
Congress accorded priority to purchasers, mortgagees, and judgment
creditors over the IRS when notice of the federal tax lien was not
properly filed in the designated office.168 In 1939, this was extended
to pledgees. 169
In some instances, third parties should be protected even when
the IRS has previously filed notice of its lien, either because searching the records is impracticable under the circumstances or because
certain kinds of transactions should be encouraged. Thus, in 1939,
Congress created superpriorities for some purchasers and for those
164. For example, federal tax liens attach to the tax debtor’s property even if notice of
it is not filed. Filing affects priorities between the IRS and other creditors when the taxpayer has insufficient assets to satisfy all claims against him. See id. § 6323.
165. Act of July 13, 1866, ch. 184, § 9, 14 Stat. 98, 107; see also Act of Mar. 3, 1865, ch.
78, 13 Stat. 469, 470.
166. See United States v. Snyder, 149 U.S. 210 (1893).
167. William T. Plumb, Jr., Federal Liens and Priorities—Agenda for the Next Decade,
77 YALE L.J. 228, 229 (1967).
168. Act of March 4, 1913, ch. 166, 37 Stat. 1016 (reversing Snyder, 149 U.S. 210).
169. Revenue Act of 1939, ch. 247, § 401, 53 Stat. 862, 882-83.
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lending on the security of “securities.” 170 A superpriority for purchasers of motor vehicles was established in 1964. 171
The 1966 Federal Tax Lien Act dwarfed in scope previous expansions of collection protections for third parties. Its origins lay in a
decade-long study project by the American Bar Association. The 1966
Act contained important provisions related to the validity and priority of tax liens as against purchasers, security interest holders, mechanic’s lienors, and judgment creditors; release of tax liens and discharge of property from the reach of the liens; property seizures; release of tax levies and return of property levied upon; and judicial
actions by the government, taxpayers, and third parties as to tax
collection issues.172
A leading figure of the time described the Act thusly:
Congress granted specific relief in a number of meritorious
situations and, on the whole, achieved equity in a field that
had been notorious for its absence. . . . Truly it could be said, to
borrow a phrase used by Justice Cardozo in another connection,
that a “high-minded Government renounced an advantage that
was felt to be ignoble, and set up a new standard of equity
and conscience.” 173
The 1966 legislation dramatically advanced the cause of fairness
and economic rationality in federal tax collection, but it did not resolve all problems. 174 Incremental changes continued, and continue,
to be made to the governing Code provisions. A brief survey of the
safeguards as they currently stand follows. 175
Relief from tax liens: Upon request by the taxpayer or another affected person, the IRS may release the tax lien, subordinate it to other interests in or claims upon the property, discharge particular
property from the lien, or certify that the lien does not attach to
particular property.176 The IRS also may withdraw a filed notice of
tax lien. 177
170. Id.
171. Revenue Act of 1964, Pub. L. No. 88-272, § 236, 78 Stat. 19, 127.
172. Federal Tax Lien Act of 1966, Pub. L. No. 89-719, §§ 101, 103, 104, 107-202, 80
Stat. 1125, 1125-49, reprinted at 1966-2 C.B. 623, 623-43.
173. Plumb, supra note 167, at 232-33 (quoting George Moore Ice Cream Co. v. Rose,
289 U.S. 373, 379 (1933)).
174. See id. at 297-98; William T. Plumb, Jr., Federal Liens and Priorities—Agenda for
the Next Decade II, 77 YALE L.J. 605, 605 (1968); William T. Plumb, Jr., Federal Liens and
Priorities—Agenda for the Next Decade III, 77 YALE L.J. 1104, 1188-89 (1968); William T.
Plumb, Jr., The Tax Recommendations of the Commission on the Bankruptcy Laws—Tax
Procedures, 88 HARV. L. REV. 1360, 1379-80 (1975).
175. For a more complete description, see RICHARDSON, BORISON & JOHNSON, supra
note 9, at 364-75.
176. I.R.C. § 6325.
177. Id. § 6323(j).
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Relief from levies: Under a variety of conditions—some mandatory
and some within the discretion of the IRS—the IRS may release
a levy and notice of levy and may return property that has been
levied on. 178
Other administrative relief: Taxpayers may secure review of collection controversies by the IRS Appeals Office through the Collection Due Process procedures 179 (with the possibility of subsequent judicial review) and through the Collection Appeals Program 180 (without the possibility of subsequent judicial review). In addition,
the Office of the Taxpayer Advocate is empowered to issue Taxpayer Assistance Orders when the IRS fails to follow established
collection procedures.181
Judicial remedies: Under § 7426, third parties and, in some cases,
taxpayers may sue in federal district court for four kinds of relief: (1)
determination that a levy is wrongful; (2) return of amounts received
from sale of property in excess of tax liability; (3) obtaining funds
held as substituted proceeds; and (4) determination of the IRS’s interest as to substituted proceeds. 182 Taxpayers and third parties may
bring damages actions for improper collection actions by the IRS.183
In addition, a variety of ancillary judicial remedies are provided under statutes outside the Code. 184
7. Shapiro, Laing, and Jeopardy Assessment Review
As seen in Part II.B.3 above, our system is committed to providing
a prepayment mechanism for resolving disputes involving liability for
income tax and some other kinds of taxes. But there is an obvious
peril. In the years that can pass during audit, administrative appeal,
and Tax Court litigation, the ability of the IRS to collect on the eventual judgment can be put at hazard. Taxpayers may secret themselves or their assets, may transfer their assets, or may become insolvent. The government’s legitimate revenue interests must be protected against such eventualities.
178. Id. § 6343.
179. Id. §§ 6320, 6330. These procedures are discussed further in Part IV infra.
180. See I.R.C. § 7123(a).
181. Id. § 7811.
182. Id. § 7426(a).
183. Id. §§ 7426(h), 7432-7433. For discussion of whether existing damages remedies
should be expanded, see Steve Johnson, A Residual Damages Right Against the IRS: A
Cure Worse than the Disease, 88 TAX NOTES 395 (2000); Leandra Lederman, Of Taxpayer
Rights, Wrongs, and a Proposed Remedy, 87 TAX NOTES 1133 (2000); Leandra Lederman,
Taxpayer Rights in the Lurch: A Response to Professor Johnson, 88 TAX NOTES 1041 (2000).
184. See, e.g., 28 U.S.C. § 2410(a) (2006) (authorizing quiet title, foreclosure, partition,
condemnation, and interpleader actions).
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Thus, the IRS has the power to make jeopardy and termination
assessments and levies, shortcutting normal assessment and collection procedures in conditions of peril to the revenue.185 But the very
power of those devices inspires concern about possible abuse. The
right to adequate notice and opportunity to be heard as to governmental deprivation of property “is central to the Constitution’s command of due process.” 186 Normally, this is prior notice and opportunity to be heard. “The purpose of this requirement is not only to ensure
abstract fair play to the individual. Its purpose, more particularly, is
to protect his use and possession of property from arbitrary encroachment—to minimize substantively unfair or mistaken deprivations of property . . . .” 187
Post-deprivation notice and hearing are permissible only in “extraordinary situations where some valid governmental interest is at
stake that justifies postponing the hearing until after the event.” 188
Due process would be traduced were the government to offer no notice and hearing at all, neither pre- nor post-deprivation. 189
In the mid-1970s, the Supreme Court decided two cases involving
the then extant procedures for challenging IRS jeopardy and termination assessments. In Laing190 and Shapiro, 191 the Court expressed
reservations about the constitutional adequacy of those procedures.
Within a few months, Congress enacted § 7429, providing rapid and
reasonably rigorous post-assessment review.192 The section: (1) requires that the IRS inform the taxpayer within five days of the reasons for the expedited assessment or levy; 193 (2) allows the taxpayer
to seek review by the IRS Appeals Office of the expedited action;194 (3)
permits the taxpayer, within ninety days thereafter, to seek district
court or Tax Court review; 195 and (4) requires decision by the court
within twenty days.196 This proceeding does not finally resolve the
185. I.R.C. §§ 6851-6852, 6861-6862.
186. United States v. James Daniel Good Real Prop., 510 U.S. 43, 53 (1993).
187. Fuentes v. Shevin, 407 U.S. 67, 80-81 (1972).
188. Id. at 82 (quoting Boddie v. Connecticut, 401 U.S. 371, 378-79 (1971)).
189. “[I]t is very doubtful that the need to collect the revenues is a sufficient reason to
justify seizure causing irreparable injury without a prompt post-seizure inquiry of any kind
into the [IRS’s] basis for [its] claim.” Commissioner v. Shapiro, 424 U.S. 614, 630 n.12
(1976); see also Bowles v. Willingham, 321 U.S. 503, 520 (1944).
190. Laing v. United States, 423 U.S. 161 (1976).
191. Shapiro, 424 U.S. at 629.
192. Tax Reform Act of 1976, Pub. L. No. 94-455, § 1204(a), 90 Stat. 1520, 1695 (codified at I.R.C. § 7429).
193. I.R.C. § 7429(a)(1)(B).
194. Id. § 7429(a)(2)-(3).
195. Id. § 7429(b)(1)-(2). Review may be sought in the Tax Court only if the IRS made
the jeopardy assessment after a Tax Court deficiency action had already been commenced.
Id. § 7429(b)(2)(B).
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merits.197 It addresses only whether the making of the expedited assessment and the amount of that assessment were reasonable under
the circumstances. 198 Despite occasional murmurs, § 7429 is generally accepted as constitutionally adequate.
This skein of our tax procedure history shows the delicate interplay of the “fair procedures for taxpayers” value and the “protect the
revenue” value. The former value called into existence prepayment
judicial determinations in the Tax Court as to income taxes and some
other taxes. The latter value required modification, through the jeopardy and termination assessment mechanisms, of the prepayment
procedures to obviate the possibility of abuse. But the former value
again reared its head through § 7429, to modify the modification.
8. TEFRA Partnership Audit/Litigation Procedures
Crises often provoke responses that, although dire in their nature
and consequences, were necessary at the time or at least seemed so to
sober persons lashed by the goad of circumstance. 199 In the 1960s
through 1980s, the proliferation of tax shelters provoked a crisis in
tax administration in the United States. Numerous legislative, regulatory, and judicial responses—of varying degrees of effectiveness
and desirability—were called forth. One of them was the enactment
of the so-called unified partnership audit and litigation procedures by
the Tax Equity and Fiscal Responsibility Act of 1982 (“TEFRA”). 200
Tax shelters were designed, in the main, to generate “paper” losses that could offset real income, thus reducing the participants’ income subject to tax. Because they are “pass-through” entities, part196. Id. § 7429(b)(3).
197. The making of a termination or jeopardy assessment does not obviate the IRS’s
obligation to issue a notice of deficiency triggering the opportunity for Tax Court review of
the merits of the adjustments set out in the notice. In the case of a termination assessment,
the notice for the full terminated tax year must be issued within sixty days after the due
date of the return for the year or the date on which the return was filed. Id. § 6851(b). In
the case of a jeopardy assessment, the notice must be issued within sixty days after the
making of the assessment. Id. § 6861(b).
198. Id. § 7429(g). The reasonableness standard “means something more than ‘not arbitrary and capricious,’ and something less than ‘supported by substantial evidence.’ ” Harvey v. United States, 730 F. Supp. 1097, 1106 (S.D. Fla. 1990) (quoting Loretto v. United
States, 440 F. Supp. 1168, 1172 (E.D. Pa. 1977)).
199. One thinks, for example, of Lincoln’s suspension of some civil liberties during the
Civil War, and of, during World War II, Franklin Roosevelt’s internment of Japanese
Americans, Churchill’s fire-bombing of Dresden, and Truman’s use of the atomic bomb on
Hiroshima and Nagasaki.
200. Tax Equity and Fiscal Responsibility Act of 1982, Pub. L. No. 97-248, §§ 401-407,
96 Stat. 324, 648-71 (adding I.R.C. §§ 6221-6232). In ensuing years, some of the original
provisions have been modified and complementary sections have been enacted. The most
significant revisions came in the Taxpayer Relief Act of 1997, Pub. L. No. 105-34, §§ 12311243, 111 Stat. 788, 1020-30. The current TEFRA and related rules are in I.R.C. §§ 62216255.
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nerships (including, later, limited liability companies taxable as
partnerships) and, to a much lesser extent, S corporations were the
vehicles through which tax shelters were structured and sold.
Before TEFRA, if the IRS doubted the validity of tax benefits
claimed through a partnership, the IRS was compelled to audit the
returns of each partner, making common adjustments to each. However, the sheer volume of tax shelters and “investors” in them produced three serious effects. First, the audit resources of the IRS were
overwhelmed. Untold tens of thousands of returns containing bogus
shelter deductions were allowed to stand because the IRS was unable
to audit the returns within the statute of limitations period for assessment of additional liability.201 Second, the returns the IRS was
able to audit led to a volume of notices of deficiency, and petitions
contesting those notices, that inundated the Tax Court.202 Third, the
frenzy of activity sometimes led to a breach of horizontal equity. The
same substantive items on different returns sometimes were treated
differently by the IRS. 203
A new approach was needed. The IRS wanted to be able to audit
at the entity (partnership) level, rather than having to audit all partners’ returns.204 The IRS sought such authority at least as early as
1978.205 When Congress acted four years later in TEFRA, it did not
create a pure entity system. Instead, Congress created a mixed approach. The IRS audits the partnership return at the partnership
level; the IRS issues any determination of adjustments to a person
designated to represent the partnership; and that person may seek
administrative and judicial review of the adjustments on behalf of
the partnership. However, at each stage, all the substantial partners
have notice and participation rights, preserving the potential for
considerable participation by the individual partners in the audit
and litigation.206
201. Normally three years from the dates on which the returns were filed. I.R.C.
§ 6501(a).
202. For example, between fiscal years 1978 and 1986, largely because of tax shelters,
the number of petitions pending in the Tax Court rose from 23,140 to 83,686. The total rose
each year and often dramatically. The 1979 increase was 16.9%, followed by a 28.9% increase in 1980 and a 31.7% increase in 1981. Harold Dubroff & Charles M. Greene, Recent
Developments in the Business and Procedures of the United States Tax Court, 52 ALB. L.
REV. 33, 35 (1987). Tax shelter petitions were the main drivers of these increases.
203. See, e.g., John B. Palmer III, TEFRA Treats Partnerships as Separate Entities
Under Its New Procedural Rules, 58 J. TAX’N 34, 34 (1983).
204. See Jerome Kurtz, Auditing Partnerships, 134 TAX NOTES 977 (2012).
205. See, e.g., The President’s 1978 Tax Reduction and Reform Proposals: Hearing Before the H. Comm. on Ways & Means, 95th Cong., pt. 1, at 280-90 (1978).
206. See I.R.C. §§ 6223-6226. For detailed discussion of the procedures and participation rights, see RICHARDSON, BORISON & JOHNSON, supra note 9, at 161-74.
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Manifold purposes were at work in the creation of the TEFRA
partnership regime. The main inspiration, of course, was protecting
the revenue by providing a more workable method for auditing tax
shelters. 207 This was reinforced by process values, such as enhancement of accurate and consistent decisionmaking. 208
But it would be a mistake to limit the angle of vision to these values. Had they been the whole of Congress’s contemplation, they could
have been achieved—and achieved better—by an unadulterated entity-based approach. Congress chose instead to impose a hybrid system
including substantial notice and participation rights for partners as
an essential part of the bargain.209 Thus, even in this context, Congress cared a lot about providing procedural options that were fair to
taxpayers and perceived by them to be fair.
9. Brockamp and Equitable Tolling
Statutes of limitations serve important functions of promoting finality and minimizing errors caused by stale evidence. But they also
can erode fairness. Reflecting this tension, courts have noted that
“statutes of limitations have numerous statutory and common law
exceptions,” and those exceptions can “profoundly impact[] . . . strict
and literal application[s] of the statute[s].” 210
One of these exceptions is equitable tolling, “a judge-made doctrine ‘which operates independently of the literal wording of the
[statute]’ to suspend or extend a statute of limitations as necessary to
ensure fundamental practicality and fairness.”211 At the federal level,
it is rebuttably presumed that equitable tolling applies,212 and nearly
all U.S. states recognize the doctrine in one form or another.213
Can equitable tolling apply when a taxpayer files a refund claim
after the limitations period has passed? 214 Other than the Ninth Cir207. See, e.g., STAFF OF JOINT COMM. ON TAX’N, 97TH CONG., GENERAL EXPLANATION OF
REVENUE PROVISIONS OF THE TAX EQUITY AND FISCAL RESPONSIBILITY ACT OF 1982, at
268 (Comm. Print 1982).
208. See, e.g., A.B.A. Section of Taxation, Proposal as to Audit of Partnerships, 32 TAX
LAW. 551, 551 (1979).
209. For an argument that partner participation should be increased beyond even the
levels provided by TEFRA, see Don R. Spellmann, Taxation Without Notice: Due Process
and Other Notice Shortcomings with the Partnership Audit Rules, 52 TAX LAW. 133 (1998).
210. Province v. Province, 473 S.E.2d 894, 903 (W. Va. 1996).
211. Lantzy v. Centex Homes, 31 Cal. 4th 363, 370 (Cal. 2003) (quoting Addison v.
California, 578 P.2d 941, 943 (1978)).
212. Irwin v. Dep’t of Veterans Affairs, 498 U.S. 89, 95-96 (1990).
213. See Steve R. Johnson, Equitable Tolling in State and Local Tax Cases, 52 ST. TAX
NOTES 917, 917 (2009).
214. In general, taxpayers who believe they have overpaid must file refund claims with
the IRS “within 3 years from the time the return [for the year] was filed or 2 years from the
time the tax was paid, whichever of such periods expires the later.” I.R.C. § 6511(a).
THE
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cuit, all federal circuit courts that had considered the matter said
“no.” 215 In Brockamp, the Supreme Court granted certiorari to resolve
this conflict.
Brockamp involved two Ninth Circuit cases. In both, the taxpayers
filed their refund claims well after expiration of the limitations period. In both, the taxpayers explained their failure to file timely
as caused by disabilities (senility or alcoholism). In both, the circuit
court accepted that the facts sufficed to trigger application of
equitable tolling.
The Supreme Court unanimously reversed both cases, holding
that equitable tolling is not available as to tax refund claims. As a
matter of statutory construction, the Court noted that “[s]ection 6511
sets forth its time limitations in unusually emphatic form . . . in a
highly detailed technical manner [and] reiterates its limitations several times in several different ways.” 216
The Court also expressed concern about the impact of equitable
tolling on orderly tax administration. Noting that the IRS processes
over 200 million returns each year and issues over 90 million refunds, the Court remarked:
To read an “equitable tolling” exception into § 6511 could
create serious administrative problems by forcing the IRS to respond to, and perhaps litigate, large numbers of late claims. . . .
The nature and potential magnitude of the administrative problem
suggest that Congress decided to pay the price of occasional
unfairness in individual cases (penalizing a taxpayer whose claim
is unavoidably delayed) in order to maintain a more workable tax
enforcement system. 217
Soon thereafter, Congress displayed a more liberal spirit. It partly
overthrew Brockamp by enacting a limited tolling provision. The
statute currently provides that the running of the normal § 6511 limitations period “shall be suspended during any period of such individual’s life that such individual is financially disabled.” 218 In general, one is financially disabled if he “is unable to manage his financial affairs by reason of a medically determinable physical or mental
impairment . . . which can be expected to result in death or which has
lasted or can be expected to last for a continuous period of not less
than 12 months.” 219
215. The conflicting cases are cited in United States v. Brockamp, 519 U.S. 347, 348-49
(1997).
216. Id. at 350-51.
217. Id. at 352-53; see also id. at 352 (“Tax law, after all, is not normally characterized
by case-specific exceptions reflecting individualized equities.”).
218. I.R.C. § 6511(h)(1).
219. Id. § 6511(h)(2)(A).
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This is a narrow statutory exception and has been read narrowly
by the courts. 220 Cases which fall outside the narrow statutory exception are controlled by Brockamp’s “no equitable tolling” rule.221
10. IRS Restructuring and Reform Act
The Internal Revenue Service Reform and Restructuring Act of
1998 (“RRA”) 222 is a particularly unlovely experience in the sausage
factory. It is a story about an opportunistic Republican Senator, a
spineless Democratic President, and a complicit media. Senator William Roth was in a tough reelection campaign. He decided to use his
chairmanship of the Senate Finance Committee to generate favorable
publicity and manufacture a campaign issue. The result was multiday hearings at which disaffected taxpayers, seemingly corroborated
by disgruntled IRS employees (testifying, for dramatic effect, from
behind screens to shield them from their employer’s possible retribution), testified as to IRS behavior appearing to range from callous
indifference to jack-booted thuggery. President Clinton, employing
his well-honed triangulation strategy, preferred to jump on the antiIRS bandwagon than to probe the worth of the assertions seriously. The
media, staring at ratings gold, covered the circus enthusiastically.223
The result was a mood inside the Beltway (and even sometimes in
more sober minds outside the Beltway 224) of “IRS bad; must punish
bad IRS.” The result was the RRA, omnibus legislation containing
numerous measures to rein in (actually or symbolically) IRS abuses. 225 The RRA “introduced seventy-one new taxpayer rights and re220. For a proposal to reform the tolling provisions, see T. Keith Fogg & Rachel E.
Zuraw, Financial Disability for All (Villanova Law Sch. Pub. Law & Legal Theory Working
Paper Series, Paper No. 2013-3009, 2012), available at http://ssrn.com/abstract=2182772.
221. See, e.g., Haas v. United States, 107 Fed. Cl. 1, 7-8 (2012).
222. Internal Revenue Service Restructuring and Reform Act of 1998, Pub. L. No. 105206, 112 Stat. 685 (codified in various sections of the I.R.C.).
223. The story is told in greater detail in Steve R. Johnson, The Dangers of Symbolic
Legislation: Perceptions and Realities of the New Burden-of-Proof Rules, 84 IOWA L. REV.
413, 446-57 (1999). See also Bryan T. Camp, Theory and Practice in Tax Administration, 29
VA. TAX REV. 227, 270 (2009) (“Congress became very concerned—one might say hysterical— . . . [and] worked itself into a lather, and mostly over the wrong problem.”).
224. A striking illustration occurred in our criminal tax jurisprudence. I.R.C. § 7212
criminalizes forcible or corrupt interference with tax administration. In a 1998 decision
clearly influenced by the Senate Finance Committee hearings, the Sixth Circuit gave
§ 7212 a cramped reading. United States v. Kassouf, 144 F.3d 952, 958 (6th Cir. 1998) (“In
this day, when Congress is attempting to curb the reach of the IRS into the homes of taxpayers, we cannot construe a penal law such as § 7212(a) to permit such an invasion into
the activities of lawabiding citizens.”). A year later, the Sixth Circuit realized that the outrage of the moment had led it astray, and it limited Kassouf to its facts. United States v.
Bowman, 173 F.3d 595, 600 (6th Cir. 1999).
225. For a description of the changes wrought by the RRA, see Robert Manning & David F. Windish, The IRS Restructuring and Reform Act: An Explanation, 80 TAX NOTES 83
(1998).
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quired, [as of 2003], 1,900 implementation actions by the IRS.”226
Some of these measures were in fact constructive. 227 Others were
partly good and partly bad. 228 Some were largely meaningless.229
Some were inimical to effective tax administration. 230
Subsequent investigations (which received far less publicity than
the original allegations) were unable to confirm the veracity of the
sensational testimony.231 But, in politics, perception often matters
more than facts. 232 Thus, the point that matters for purposes of this
agenda for reform is the value set that the RRA exercise revealed.
Central to the thinking of Congress was “increas[ing] perceptions
of procedural fairness by allowing taxpayers additional procedural
rights and opportunities to tell their side of the story.” 233 This orientation was evident in the hearings described above and was confirmed by the legislative history. The Senate report, explaining reasons for change, was studded with remarks such as the following:
“[A] key reason for taxpayer frustration with the IRS is the lack of
appropriate attention to taxpayer needs.” 234 “The Committee is con226. Nina E. Olson, Taxpayer Rights, Customer Service, and Compliance: A ThreeLegged Stool, 51 U. KAN. L. REV. 1239, 1243 (2003). For description of the principal changes, see Manning & Windish, supra note 225.
227. For example, imposing an initial burden-of-production on the IRS when it asserts
penalties, see Internal Revenue Service Restructuring and Reform Act of 1998, Pub. Law.
No. 105-206, § 3001, 112 Stat. 685, 726 (codified at I.R.C. § 7491(c)), and strengthening the
office of the National Taxpayer Advocate, see § 1102, 112 Stat. at 697 (codified at I.R.C.
§ 7803(c)).
228. Such as the Collection Due Process rules discussed infra Part IV.B. See § 3401,
112 Stat. at 746 (codified at I.R.C. §§ 6320, 6330).
229. Examples are the creation of the IRS Oversight Board, see § 1101, 112 Stat. at 691
(codified at I.R.C. § 7802), which has been generally insignificant in operation, and directing the IRS to revise its Mission Statement to put greater emphasis on serving the public
and meeting taxpayers’ needs, see § 1002, 112 Stat. at 690. Priorities in the IRS swing between taxpayer service and enforcement (with the pendulum now more on the enforcement
side), without close correlation to the current wording of the Mission Statement.
230. One example is the deceptive burden-of-proof shift provision, see § 3001, 112 Stat.
at 726 (codified at I.R.C. § 7491(a)). The provision has induced taxpayers to argue the point
in numerous cases, expending resources for all parties and the courts, but has almost never
made a difference in how cases actually are decided. See, e.g., Johnson, supra note 223, at
427-46; see also Leandra Lederman, Does the Burden of Proof Matter?, 23 A.B.A. SEC. TAX’N
NEWS Q. 10 (2004); Leandra Lederman, Unforeseen Consequences of the Burden of Proof
Shift, 80 TAX NOTES 379 (1998).
Similarly, the mandatory termination provisions, §§ 1201-1205, 112 Stat. at 71123 (not codified in the Code), had immediate and substantial negative effect on the morale
and productivity of IRS employees.
231. See, e.g., Susan Meador Tobias, Letter to the Editor, IRS Abuse Debate Should Be
a Two-Way Street, 79 TAX NOTES 1071 (1998); Stephen Barr, Report Labels IRS Testimony
“Unfounded,” WASH. POST, Apr. 26, 1998, at A2.
232. Karma also matters. Despite the publicity generated by his hearings, Senator
Roth lost his reelection bid.
233. Leandra Lederman & Stephen W. Mazza, Addressing Imperfections in the Tax
System: Procedural or Substantive Reform?, 103 MICH. L. REV. 1423, 1441 (2005).
234. S. REP. NO. 105-174, at 8 (2d Sess. 1998).
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cerned that individual and small business taxpayers frequently are at
a disadvantage when forced to litigate with the [IRS].” 235 Furthermore,
[T]axpayers are entitled to protections in dealing with the IRS that
are similar to those they would have in dealing with any other
creditor. Accordingly, the Committee believes that the IRS should
afford taxpayers adequate notice of collection activity and a meaningful hearing before the IRS deprives them of their property. 236
11. Ballard and Tax Court Process
Ballard started out as a prosaic case 237 but ended as anything but.
The IRS alleged that the taxpayers engaged in a scheme involving
kickbacks that they failed to report on their federal income tax returns. 238 The taxpayers filed Tax Court petitions challenging the
IRS’s determinations. The chief judge of the Tax Court assigned the
cases for hearing to a special trial judge. 239 The trial lasted almost
five weeks, producing a transcript exceeding 5400 pages and thousands of exhibits with hundreds of thousands of pages. The briefs
reached nearly 4700 pages.
The special trial judge eventually submitted a report on the consolidated cases to the chief judge as required by former Tax Court
Rule 183(b).240 The chief judge assigned the cases, under the same
rule, to a regular judge, who issued a decision on behalf of the court.
The decision stated: “The Court agrees with and adopts the opinion of
the Special Trial Judge, which is set forth below.” 241 The decision
substantially upheld the IRS’s determinations.
The taxpayers came to believe that the document entitled the
“Opinion of the Special Trial Judge” was not, in fact, that judge’s
work but that the original special trial judge’s report had been substantially modified by the regular judge or by a process of consultation between the special trial judge and the regular judge. The taxpayers filed motions with the Tax Court seeking access to the original
235. Id. at 44.
236. Id. at 67.
237. If a marathon case involving multiple fairly high-profile taxpayers, large deficiencies, and fraud penalties can so be described. The principal taxpayers were Burton Kanter,
a prominent tax attorney, and Claude Ballard and Robert Lisle, both vice presidents of
Prudential Life Insurance Company.
238. Ballard v. Commissioner, 321 F.3d 1037, 1038 (11th Cir. 2003).
239. The Tax Court’s nineteen regular judges are appointed by the President with the
advice and consent of the Senate. I.R.C. § 7443. The chief judge of the Tax Court appoints
special trial judges and may designate cases assigned to them. Id. § 7443A.
240. Ballard, 321 F.3d at 1038.
241. Investment Research Assocs., Ltd. v. Commissioner, 78 T.C.M. (CCH) 951, 963
(1999).
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report or, at least, permission to place that report under seal in the
record on appeal. The Tax Court denied the motions.
The taxpayers appealed to the circuit courts within whose jurisdictions they resided. 242 All three appellate courts accepted the IRS’s
argument that the appearance of the special trial judge’s signature
on the Tax Court’s decision meant that the decision was the special
trial judge’s report, and so rejected the taxpayers’ objection to the absence from the record of the original report.243
On the merits, the Seventh Circuit (over a dissent) and the Eleventh Circuit largely affirmed. The Fifth Circuit largely upheld the
asserted deficiencies but reversed as to the fraud penalty.
The Fifth Circuit taxpayer did not seek Supreme Court review.
The Court granted certiorari as to the Seventh and Eleventh Circuit
cases. The Court reversed as to the exclusion of the original report
from the record.244 Justice Ginsburg wrote for the majority.245 Justice
Kennedy, joined by Justice Scalia, concurred. 246 Chief Justice
Rehnquist, joined by Justice Thomas, dissented.247
The majority held that the Tax Court had failed to follow its own
rule. That rule, the Court held, contemplated an initial report by the
special trial judge, the fact-finding of which the assigned regular
judge owed deference. 248 Over time, however, the Tax Court’s practice
under the rule had morphed into the regular judge treating “the
special trial judge’s report essentially as an in-house draft to
be worked over collaboratively by the regular judge and the special
trial judge.” 249
Resolving the case on this ground, the majority found it unnecessary to address the taxpayers’ arguments that the Due Process
Clause 250 and the applicable appellate review statute 251 compelled
inclusion of the original report in the record on appeal. The majority’s
choice of rationale may have reflected Justice Ginsburg’s well-known
242. See I.R.C. § 7482(b)(1)(A).
243. Estate of Lisle v. Commissioner, 341 F.3d 364, 384 (5th Cir. 2003); Estate of Kanter v. Commissioner, 337 F.3d 833, 840-41 (7th Cir. 2003); Ballard, 321 F.3d at 1042.
244. Ballard v. Commissioner, 544 U.S. 40 (2005).
245. Id. at 44.
246. Id. at 65.
247. Id. at 68.
248. Id. at 54.
249. Id. at 57.
250. U.S. CONST. amend. V.
251. I.R.C. § 7482(a)(1); see Brief of Amica Curiae Professor Leandra Lederman in
Support of Petitioners at 2-3, Ballard v. Commissioner, 554 U.S. 40 (2005) (Nos. 03-184 &
03-1034).
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preference to resolve cases on the narrowest available ground, or it
may have seemed the best way of letting the Tax Court down easily.252
Despite the majority’s stated rationale, other commentators 253 and
I see Ballard as driven by the desire to provide fairness in judicial
remedies, rather than by a technical construction of the language and
history of a rule. Three facts point in this direction. First, it is striking that the Court granted certiorari in this case in the first place.
There was no circuit conflict; the Fifth, Seventh, and Eleventh Circuits were in agreement as to the procedural issue. “It is likely that
the Supreme Court granted certiorari out of a concern that the lack
of transparency denied meaningful appellate review.” 254
Second, the majority picked its rationale in disregard of its accustomed practice. The rule construction argument was not made in the
taxpayers’ circuit court briefs, in their certiorari petitions, or in their
questions presented. The Court typically does not consider such arguments. 255 Something was going on beneath the surface.
Third, although seemingly an exercise in rule construction, the
majority opinion is peppered with words and phrases like “transparent,” 256 “undisclosed,” 257 “impedes fully informed appellate review,”258
and “concealment.” 259 Here the subtext is more revealing than the text.
The Court remanded the cases, unfortunately without clear instructions. 260 The course on remand was not smooth. The three in252. Telling a court that it is violating due process is a serious move. On the other
hand, it may be an even greater affront to tell a court that it doesn’t understand what its
own rule says. One of the arguments made by the dissent was that the Tax Court’s interpretation of its own rule was due substantial deference by analogy to Bowles v. Seminole
Rock & Sand Co., 325 U.S. 410, 414 (1945). See Ballard, 544 U.S. at 70 (Rehnquist, C.J.,
dissenting). The majority grudgingly conceded that “the Tax Court is not without leeway in
interpreting its own Rules,” id. at 59, but found deference inappropriate because the Tax
Court’s construction of the rule at issue was “arbitrary,” id. at 61. For discussion of this
principle, see Steve R. Johnson, Auer/Seminole Rock Deference in the Tax Court, 11 PITT.
TAX REV. (forthcoming 2013).
253. See, e.g., Katherine Kmiec Turner, No More Secrets: Under Ballard v. Commissioner, Special Trial Judge Reports Must Be Revealed, 26 J. NAT’L ASS’N ADMIN. L. JUDGES
247, 294 (2006) (“From the public’s perspective, Ballard ensures less secrecy and a fair
trial.”).
254. Robin L. Greenhouse & Joshua D. Odintz, The Status of Tax Court Special Trial
Judge Reports After Ballard: Where Do We Go From Here?, 102 J. TAX’N 352, 355 (2005).
255. See, e.g., DeShaney v. Winnebago Cnty. Dep’t of Soc. Servs., 489 U.S. 189, 195 n.2
(1989). This prompted Chief Justice Rehnquist to remark in his Ballard dissent: “Only by
failing to abide by our own Rules can the Court hold that the Tax Court failed to follow its
Rules.” 544 U.S. at 68 n.1 (Rehnquist, C.J., dissenting).
256. Ballard, 544 U.S. at 55 (majority opinion).
257. Id. at 57.
258. Id. at 59-60.
259. Id. at 62 n.15.
260. Justice Kennedy’s concurrence attempted to make good the deficiency of the majority’s opinion. Id. at 65-68 (Kennedy, J., concurring).
240
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volved circuit courts remanded the cases to the Tax Court with instructions to review the matter in accordance with the Supreme
Court’s opinion and to give due regard to the determinations in the
special trial judge’s original report.261 The Tax Court rendered a decision which adhered in significant part to its prior view, that is, that the
taxpayers were liable for large deficiencies and for fraud penalties.262
Again, the taxpayers appealed. The circuit courts were not pleased
with the Tax Court’s work. Each concluded that the Tax Court again
failed to give due deference to the special trial judge’s determinations. They again remanded, this time with instructions that the Tax
Court adopt as its decision the special trial judge’s original decision
holding for the taxpayers. 263
12. Administrative Law in Tax
Authority in tax is a three-legged stool, consisting of statutes, case
law, and administrative guidance. The last leg includes Treasury
regulations, which have force-of-law status if they reasonably implement the statute,264 and a variety of lesser guidance documents,265
which typically are not binding but may have persuasive influence.266
Given the importance of administrative guidance, administrative
law would seem to be important in tax. It is, but the tax community
has recognized this only slowly and grudgingly. 267 For most of our tax
history, courts reviewing challenges to tax regulations or practices
steered clear of general administrative law, developing instead a taxspecific jurisprudence emphasizing reasonableness in general and a
number of hallmarks of reliability in particular. 268
261. Estate of Lisle v. Commissioner, 431 F.3d 439 (5th Cir. 2005); Ballard v. Commissioner, 429 F.3d 1026 (11th Cir. 2005); Estate of Kanter v. Commissioner, 406 F.3d 933
(7th Cir. 2005).
262. Estate of Kanter v. Commissioner, 93 T.C.M. (CCH) 721 (2007).
263. Kanter v. Commissioner, 590 F.3d 410, 414 (7th Cir. 2009); Estate of Lisle v.
Commissioner, 541 F.3d 595, 597 (5th Cir. 2008); Ballard v. Commissioner, 522 F.3d 1229,
1255 (11th Cir. 2008).
264. See, e.g., Helvering v. R.J. Reynolds Tobacco Co., 306 U.S. 110, 115 (1939); Boulez
v. Commissioner, 810 F.2d 209, 212 (D.C. Cir. 1987), cert. denied, 484 U.S. 896 (1987).
265. For description of many types of such documents, see RICHARDSON, BORISON &
JOHNSON, supra note 9, at 17-25.
266. See, e.g., Kristin E. Hickman, IRB Guidance: The No Man’s Land of Tax Code
Interpretation, 2009 MICH. ST. L. REV. 239.
267. See, e.g., Leandra Lederman, “Civil”izing Tax Procedure: Applying General Federal Learning to Statutory Notices of Deficiency, 30 U.C. DAVIS L. REV. 183, 183 (1996). This
phenomenon has been called—and described as—“tax exceptionalism.” See Kristin E.
Hickman, The Need for Mead: Rejecting Tax Exceptionalism in Judicial Deference, 90
MINN. L. REV. 1537 (2006).
268. See, e.g., Nat’l Muffler Dealers Ass’n v. United States, 440 U.S. 472, 477 (1979)
(identifying six factors); Laurens Williams, The Preparation and Promulgation of Treasury
Department Regulations Under the Internal Revenue Code of 1954, TAX EXEC., Jan. 1956, at
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241
To regularize administrative practice among the numerous federal
agencies, Congress enacted the Administrative Procedure Act
(“APA”) in 1946. Treasury and the IRS are “agencies” as defined by
the APA 269 and so are subject to its requirements. Nonetheless, for
decades, both the APA 270 and general principles of administrative
law 271 appeared only rarely in tax decisions.
The frequency of appearance of administrative law doctrines in
tax has increased markedly in the last fifteen years, in part because
of the RRA. Some of the areas at issue involved rights created or expanded by the RRA, such as the CDP rules 272 and spousal relief.273
The greatest recent prominence of administrative law in tax, however, has been in two areas: the procedural validity of Treasury regulations and deference doctrine. Both are discussed below.
For generations, tax regulations promulgated by the Treasury
have been attacked by taxpayers discomfited by them. The standard
attacks have been substantive in nature: that the regulation in question was inconsistent with the text, structure, or purpose of the relevant statute or with important extrinsic norms. 274
In recent years, however, taxpayers have added procedural arrows
to their quivers.275 The use of these weapons is still in relative infancy. Here are examples of that use. First, subject to certain exceptions,
the APA prescribes that in order for it to promulgate binding rules,
an agency must first publish notice of its proposed rulemaking and
give interested persons opportunity to submit comments. 276 Treasury,
3, 9-11 (1956).
269. 5 U.S.C. § 551(1) (2012).
270. See, e.g., Wing v. Commissioner, 81 T.C. 17, 28-29 (1983); Wendland v. Commissioner, 79 T.C. 355 (1982).
271. One area in which the analogy to general administrative law was made involved
whether the IRS has a judicially enforceable duty to treat similarly situated taxpayers
similarly. See Steve R. Johnson, An IRS Duty of Consistency: The Failure of Common Law
Making and a Proposed Legislative Solution, 77 TENN. L. REV. 563 (2010) (reviewing the
cases and commentary); Lawrence Zelenak, Should Courts Require the Internal Revenue
Service to be Consistent?, 38 TAX L. REV. 411 (1985).
272. See, e.g., Robinette v. Commissioner, 123 T.C. 85 (2004), rev’d, 439 F.3d 455 (8th
Cir. 2006); Kitchen Cabinets, Inc. v. United States, 87 A.F.T.R.2d (RIA) 1393 (N.D. Tex.
2001); Mesa Oil, Inc. v. United States, 86 A.F.T.R.2d (RIA) 7312 (D. Colo. 2000); see also
Danshera Cords, Administrative Law and Judicial Review of Tax Collection Decisions, 52
ST. LOUIS U. L.J. 429, 440 (2008); Diane L. Fahey, Is the United States Tax Court Exempt
from Administrative Law Jurisprudence when Acting as a Reviewing Court?, 58 CLEV. ST.
L. REV. 603, 609 (2010).
273. See, e.g., Wilson v. Commissioner, 99 T.C.M. (CCH) 1552 (2010), aff’d, 705 F.3d
980 (9th Cir. 2013).
274. See Steve R. Johnson, Preserving Fairness in Tax Administration in the Mayo Era,
32 VA. TAX REV. 269 (2012).
275. See, e.g., Steve R. Johnson, Intermountain and the Importance of Administrative
Law in Tax Law, 128 TAX NOTES 837 (2010).
276. 5 U.S.C. § 553(c), (d) (2012).
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however, may not always honor these requirements in promulgating
tax regulations.277 This argument has been presented in a number of
recent high-profile tax cases.278
Second, under the APA, courts are empowered to strike down
agency action that is “arbitrary, capricious, an abuse of discretion, or
otherwise not in accordance with law.” 279 Under current doctrine, an
agency’s rule can be arbitrary for a number of reasons, including that
the agency relied on factors Congress did not want it to consider, the
agency failed to take some important factor into account, or the agency gave an unjustifiable or implausible explanation for its action. 280
Among these, the “inadequate explanation” strand has received
considerable attention recently. Cases 281 and commentary 282 are applying this strand to tax regulations with increasing frequency.
Third, in general, “retroactive [tax] regulations are prohibited, except under limited circumstances.” 283 The meaning of retroactivity
and the permitted exceptions to the prohibition of it potentially are at
issue in a number of tax controversies. Retroactivity questions were
raised, but avoided by the Supreme Court, in the recent Home Concrete decision.284 Inevitably, retroactivity issues will have to be
squarely addressed in future tax cases.
Deference doctrine entails the extent to which courts, as they
interpret statutes, must or should accede to the views of the statutes’
meanings espoused by the agencies charged with implementing
the statutes. Deference issues go back generations, but their promi-
277. See Kristin E. Hickman, A Problem of Remedy: Responding to Treasury’s (Lack of)
Compliance with Administrative Procedure Act Rulemaking Requirements, 76 GEO. WASH.
L. REV. 1153 (2008); Kristin E. Hickman, Coloring Outside the Lines: Examining Treasury’s
(Lack of) Compliance with Administrative Procedure Act Rulemaking Requirements, 82
NOTRE DAME L. REV. 1727 (2007).
278. See, e.g., Cohen v. United States, 650 F.3d 717, 721 (D.C. Cir. 2011); Intermountain Ins. Serv. of Vail, LLC v. Commissioner, 134 T.C. 211, 220-23 (2010), rev’d, 650 F.3d
691 (D.C. Cir. 2011), vacated, 132 S. Ct. 2120 (2012).
279. 5 U.S.C. § 706(2)(A) (2012).
280. Motor Vehicles Mfrs. Ass’n v. State Farm Mut. Auto. Ins. Co., 463 U.S. 29, 43
(1983).
281. See, e.g., Dominion Resources, Inc. v. United States, 681 F.3d 1313, 1319 (Fed. Cir.
2012); Mannella v. Commissioner, 631 F.3d 115, 127 (3d Cir. 2011) (Ambro, J., dissenting);
Fla. Bankers Ass’n v. U.S. Dep’t of Treasury, 2014-1 U.S. Tax Cas. (CCH) ¶ 50,133 (D.D.C.
2014); Carpenter Family Invs., LLC v. Commissioner, 136 T.C. 373, 395-96 (2011).
282. See, e.g., Patrick J. Smith, The APA’s Reasoned-Explanation Rule and IRS Deficiency Notices, 134 TAX NOTES 331 (2012).
283. Marriott Int’l Resorts, L.P. v. United States, 83 Fed. Cl. 291, 303 (2008), aff’d, 586
F.3d 962 (Fed. Cir. 2009); see I.R.C. § 7805(b), (e).
284. United States v. Home Concrete & Supply, LLC, 132 S. Ct. 1836 (2012). Compare
Brief for the United States at 12, 132 S. Ct. 1836 (2012) (No. 11-139), with Brief for Respondents at 45-48, 132 S. Ct. 1836 (2012) (No. 11-139).
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nence has grown exponentially since the Supreme Court’s 1984
Chevron decision. 285
The extent to which Chevron or other doctrines of deference
should operate in tax was controversial for decades, but now is moving towards greater clarity. In its 2011 Mayo decision, the Supreme
Court held that, in general, Chevron provides the applicable standard
when a tax regulation is challenged on substantive grounds, regardless of whether the regulation was promulgated under the general
authority of I.R.C. § 7805(a) or specific authority set out in more particular sections of the Code. 286 Numerous details remain to be filled in
as to both regulations and sub-regulation tax guidance documents,
but Mayo sets the general frame for future discussions. 287
Thus, the profile of administrative law in tax has been raised
dramatically and, I believe, irreversibly. What values does this trend
further? The APA was a balance of “green light” and “red light” features. In some respects, the goal was to facilitate agency actions
while, in other respects, the idea was to prevent agencies from trampling on citizens’ rights. 288
More specifically, the APA’s notice-and-comment rules are designed to improve the accuracy with which regulations implement
congressional intent, to minimize unnecessary regulatory burdens, to
provide interested parties meaningful participation in the rulemaking process, and to raise citizen confidence in government.289
Deference doctrine is designed to improve accuracy through bringing
to bear agency expertise while preserving the role of the courts to
keep agencies within their legitimate domains. 290 The increased
prominence of administrative law in tax honors these objectives.291
285. Chevron U.S.A. Inc. v. Natural Res. Def. Council, Inc., 467 U.S. 837 (1984). Chevron is the most frequently cited case in American law. See STEPHEN G. BREYER, RICHARD B.
STEWART, CASS R. SUNSTEIN & MATTHEW L. SPITZER, ADMINISTRATIVE LAW AND REGULATORY POLICY: PROBLEMS, TEXT, AND CASES 289 (5th ed. 2002).
286. Mayo Found. for Med. Educ. & Research v. United States, 131 S. Ct. 704, 714
(2011); see also Halbig v. Sebelius, 2014-1 U.S. Tax Cas. (CCH) ¶ 50,138 (D.D.C. 2014).
287. For evaluation of the significance of Mayo and appraisal of post-Mayo issues, see
Johnson, supra note 274; Steve R. Johnson, Mayo and the Future of Tax Regulations, 130
TAX NOTES 1547 (2011); Leandra Lederman & Stephen W. Mazza, More Mayo Please?
Temporary Regulations After Mayo Foundation v. United States, 31 A.B.A. SEC. TAX’N
NEWS Q. 15 (2011); David J. Shakow, Who’s Afraid of the APA?, 134 TAX NOTES 825 (2012).
288. See ALFRED C. AMAN, JR., ADMINISTRATIVE LAW AND PROCESS: CASES AND MATERIALS 19-24 (2d ed. 2006).
289. See, e.g., Am. Hosp. Ass’n v. Bowen, 834 F.2d 1037, 1044 (D.C. Cir. 1987).
290. See Chevron, 467 U.S. at 864-65.
291. See, e.g., Leslie Book, A New Paradigm for IRS Guidance: Ensuring Input and
Enhancing Participation, 12 FLA. TAX REV. 517 (2012); Rimma Tsvasman, Note, No More
Excuses: A Case for the IRS’s Full Compliance with the Administrative Procedure Act, 76
BROOK. L. REV. 837 (2011).
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C. Criteria
What do we learn from the above key events? Important affairs
over time rarely reveal the hand of only a single cause or influence.
So it is here. Multiple purposes are evident in the legislative, regulatory, and judicial developments shaping tax procedure.
The history shows four sets of values at work: (1) providing remedies for taxpayers and third parties that are both meaningful and
perceived to be fair; (2) protecting revenue collection from unreasonable interference; (3) achieving decisional accuracy; and (4) promoting process efficiency, reducing costs and delays.
Professor, later Judge, Sneed developed a number of criteria driving federal income tax policy generally. As is the approach in this Article, Sneed developed his topoi from distillation of our national experience rather than from his own values preferences. In his view, “the
legislative, administrative, and judicial history of the federal income
tax, as well as the pertinent literature, reveals the existence of seven
pervasive purposes which have shaped its rates and structure.”292
Sneed identified these seven purposes thusly:
(1) to supply adequate revenue, (2) to achieve a practical and
workable income tax system, (3) to impose equal taxes upon those
who enjoy equal incomes, (4) to assist in achieving economic stability, (5) to reduce economic inequality, (6) to avoid impairment of
the operation of the market-oriented economy and (7) to accomplish
a high degree of harmony between the income tax and the soughtfor political order. 293
Of these, the first, second, and seventh purposes bear with particular
force on federal tax procedure.
Taken as a whole, the value most strongly evident in the key
events is providing remedies: mechanisms by which taxpayers and
affected third parties may challenge IRS liability determinations and
collection actions, mechanisms that are both efficacious and perceived to be fair. Henceforth, this Article will sometimes describe this
as the Primary Value. The remaining desiderata will sometimes be
called Second-Order Values.
The Primary Value, then, will be the first criterion against which
to measure the desirability of current features of the federal tax litigation system and of proposed changes to it. But, in practical affairs,
single values rarely are absolute. At some point, the accumulation
292. Joseph T. Sneed, The Criteria of Federal Income Tax Policy, 17 STAN. L. REV. 567,
568 (1965).
293. Id. (emphasis in original).
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of powerful contrary consequences can overwhelm even highly
cherished values. 294
Thus, there are two circumstances in which our evaluation of features and proposed changes will turn on Second-Order Values. First,
there are some situations in which the Primary Value is not reasonably at stake. Second-Order Values will be decisive when the adequacy
of remedies would not be either meaningfully advanced or meaningfully threatened by the current feature or the proposed change. Furthermore, there may be instances in which a trickle of remedies is
outweighed by a torrent of revenue protection, decisional accuracy, or
efficiency. In cases of stark disproportion, large Second-Order effects
should be permitted to defeat small Primary effects.
The following parts of this Article will apply the above criteria in
several areas. Left to my own devices, I would weigh the criteria
somewhat differently. Specifically, process efficiency shines brighter
in my own constellation of values.295 For example, I am more inclined
than Congress has been to say that taxpayers must live with the consequences of their choices, even if the consequences include losing
opportunities to litigate.296
Efficiency also often has a preferred place for me relative to decisional accuracy. I share Justice Brandeis’ conviction that often it is
more important that a question of “law be settled than that it be settled right.” 297 In addition, Congress has shown the ready ability to
reverse tax decisions—both of the Supreme Court 298 and lower
294. For example, the Roman declaration “fiat justicia ruat coelem” (let justice be done
even if the sky falls) is stirring but not a practical reality. No matter how much we aspire
to do justice, every legal system makes decisions that subordinate the pursuit of justice to
other values in some circumstances.
295. For example, I was among the few defenders of the Tax Court’s practice that the
Supreme Court invalidated in Ballard v. Commissioner, 544 U.S. 40 (2005), discussed in
Part II.B.11 supra. See Steve R. Johnson, Further Thoughts on Kanter and Ballard, 105
TAX NOTES 1235 (2004) (arguing that protection of the Tax Court’s decisional process was
more important than doubtful gains to fairness or decisional accuracy).
296. For example, as discussed in Part II.B supra, in responding to the IRS’s plea for
procedural help in auditing tax shelter partnerships, Congress in 1982 created entity-level
audit combined with partner participation. As argued below, this hybridization has been
the cause of great complication and confusion. To me, it would have been reasonable to
dispense with partner participation, on the ground that the partners’ choice to conduct
business in entity form should remit them to only entity-level procedures.
297. Burnet v. Coronado Oil & Gas Co., 285 U.S. 393, 406 (1932) (Brandeis, J., dissenting). Brandeis seemingly was paraphrasing—but with some difference in emphasis—
Justice Swayne’s observation generations earlier in Gilman v. Philadelphia, 70 U.S. (3
Wall.) 713, 724 (1865) (“It is almost as important that the law should be settled . . . as that
it should be settled correctly.”). I am indebted to my colleague Adam Hirsch for bringing
Gilman to my attention.
298. See, e.g., Gitlitz v. Commissioner, 531 U.S. 206 (2001), superseded by statute,
I.R.C. § 108(d)(7)(A). This Article has identified several Supreme Court decisions later
overturned by Congress. See United States v. Brockamp, 519 U.S. 347 (1997) (see supra
notes 210-17 and accompanying text); Cary v. Curtis, 44 U.S. (3 How.) 236 (1845) (see su-
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courts 299—with which it disagrees. Courts should, of course, strive
assiduously to reach results that correctly apply the provisions of the
Code, but the possibility of legislative correction buffers the consequences in those instances in which such efforts come up short. Thus,
my own criteria would accord efficiency concerns higher priority.
I acknowledge the possibility that my personal values preferences
may compromise the dispassion I hope to apply in reading the historical record. This is an ever present peril.300 Some
scholars suggest that facts about the past are without meaning until they are woven into a story by the historian. Thus, in choosing
which facts to emphasize and how to interpret them, the historian
will often make choices based upon factors extrinsic to pure research. Although history is continuously refined through testing
hypotheses against the facts, the story it tells will be decisively influenced by the “meta-theories,” the overarching views of the
world, held by the historian. 301
However, the exercise in this Article is to apply faithfully to procedural choices the values that emerge from the system as it has developed, not the system as I might wish it had developed. 302
III. REFORMS AS TO AVAILABLE COURTS
Based on the criteria developed in Part II, I advance three suggestions as to the courts that should be available as fora in which to litigate federal tax controversies. First, the Tax Court should be given
pra notes 49-58 and accompanying text); Elliott v. Swartwout, 35 U.S. (10 Pet.) 137 (1836)
(see supra notes 43-48 and accompanying text).
299. See, e.g., Commissioner v. Ewing, 439 F.3d 1009 (9th Cir. 2006), superseded by
statute, I.R.C. § 6015(e)(1)(A); Commissioner v. United States & Int’l Sec. Corp., 130 F.2d
894 (3rd Cir. 1942), superseded by statute, Revenue Act of 1942, Pub. L. No. 77-753, § 116,
56 Stat. 798, 812; Cole v. Commissioner, 81 F.2d 485 (9th Cir. 1935), superseded by statute,
Revenue Act of 1938, Pub. L. No. 75-552, §51(b), 52 Stat. 447, 476; Container Corp. v.
Commissioner, 134 T.C. 122 (2010), aff’d, 2011 WL 1664358 (5th Cir. May 2, 2011), superseded by statute, I.R.C. § 861(a)(9).
300. As it is, for example, when judges apply legislative history. “It sometimes seems
that citing legislative history is still, as my late colleague Harold Leventhal once observed,
akin to ‘looking over a crowd and picking out your friends.’ ” Patricia M. Wald, Some Observations on the Use of Legislative History in the 1981 Supreme Court Term, 68 IOWA L.
REV. 195, 214 (1983).
301. William N. Eskridge, Jr., Dynamic Statutory Interpretation, 135 U. PA. L. REV.
1479, 1510 (1987) (citing William E. Nelson, History and Neutrality in Constitutional Adjudication, 72 VA. L. REV. 1237, 1240-45 (1986); G. Edward White, The Text, Interpretation,
and Critical Standards, 60 TEX. L. REV. 569, 569 (1982)).
302. Fitzerald described Omar Khayyam as “preferring rather to soothe the Soul . . .
into Acquiescence with Things as he saw them, than to perplex it with vain disquietude
after what they might be.” OMAR KHAYYÁM, THE RUBÁIYÁT OF OMAR KHAYYÁM 18 (Edward
Fitzgerald trans., Three Sirens Press 1st ed. n.d.) (emphasis in original). That was an inaccurate description of the great Tent Maker. It is a fair description of the approach of this
Article.
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quasi-plenary, but nonexclusive, civil tax jurisdiction. Second, calls to
create a national court of tax appeals should continue to be rejected.
Third, the Court of Federal Claims should be divested of jurisdiction
to hear tax cases. These suggestions are developed below.
A. Tax Court Jurisdiction
The jurisdiction of the ancestors of the Tax Court initially was
limited to deficiency actions, but the Tax Court’s jurisdiction has expanded—piecemeal, but substantially—in ensuing decades. Nonetheless, holes remain in this patchwork quilt.
Almost all these holes should be filled. I propose that Congress
grant the Tax Court nearly plenary jurisdiction over civil tax controversies. Discussed below are: (1) expansions of the Tax Court’s jurisdiction beyond deficiency actions; (2) areas that remain outside the
Tax Court’s jurisdiction; (3) areas to which that jurisdiction should be
expanded; and (4) limits on such expansion.
1. Historical Growth of Tax Court Jurisdiction
As discussed in Part II.B.3, what is now the United States Tax
Court had its roots as an administrative agency, then morphed into
an Article I court. As an Article I court, it is fundamental that “[t]he
Tax Court is a court of limited jurisdiction and may exercise its
jurisdiction only to the extent authorized by Congress.” 303 The Tax
Court does not have authority to enlarge upon its statutory grants
of jurisdiction.304
Starting from its original deficiency jurisdiction, the Tax Court’s
jurisdiction has grown over the generations. In some instances, the
Tax Court’s new jurisdiction over particular types of actions is exclusive. In other instances, such jurisdiction is concurrent with that of
the district courts or the Court of Federal Claims.
The Tax Court’s expanded jurisdiction includes TEFRA actions,305
Collection Due Process actions, 306 and jeopardy assessment review,307
303. Kasper v. Commissioner, 137 T.C. 37, 40 (2011); see also Cohen v. Commissioner,
139 T.C. 299 (2012); Judge v. Commissioner, 88 T.C. 1175, 1180-81 (1987); Naftel v. Commissioner, 85 T.C. 527, 529 (1985).
304. See, e.g., Phillips Petroleum Co. v. Commissioner, 92 T.C. 885, 888 (1989). This
principle has had play in many areas, including whether the Tax Court has authority to
apply equitable doctrines such as equitable recoupment. See, e.g., Leandra Lederman, Equity and the Article I Court: Is the Tax Court’s Exercise of Equitable Powers Constitutional?,
5 FLA. TAX REV. 357 (2001). It has since been confirmed that the Tax Court has such authority. I.R.C. § 6214(b).
305. I.R.C. §§ 6225(b), 6226(a), 6228(a)(1), 6234(c), 6246(b), 6247(a), 6252(a).
306. Id. § 6330(d); see, e.g., Brian Isaacson & Karen Phu, Jurisdiction in the Tax Court
to Hear Section 6330 Challenges: A Need for Clarification, PRAC. TAX LAW., Spring 2008, at
27; Carlton M. Smith, The Tax Court Keeps Growing Its Collection Due Process Powers, 133
TAX NOTES 859 (2011).
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all of which are discussed in greater detail elsewhere in this Article.
In addition, Congress has granted the Tax Court authority to issue
declaratory judgments in a variety of contexts, including declaratory
judgments as to qualification of certain retirement plans, 308 valuation
of gifts, 309 tax-exempt status of state and local bonds,310 eligibility for
deferred payment of estate tax, 311 and eligibility of organizations for
tax-exempt status. 312
The Tax Court also has received jurisdiction to review a variety of
other actions and determinations by the IRS. These include decisions
as to interest abatement, 313 redetermination of interest assessed on
deficiencies, 314 restraint of premature assessment or collection,315 review of proposed sales of seized property, 316 determination of employment status of workers, 317 determinations of awards for tax whistleblowers,318 review of transferee liability, 319 and IRS decisions not to
grant equitable spousal relief.320
In general, the pace of expansions of the Tax Court’s jurisdiction
has accelerated. After slow growth for generations, such expansions
have been occurring more often since the 1980s, inspired in part by
the Taxpayer Rights movement. 321 The expansions have reflected the
desire of Congress to enhance remedies for taxpayers, further judicial
economy, and enhance procedural flexibility.322
307. I.R.C. § 7429(b)(2); see TAX CT. R. 56.
308. I.R.C. § 7476(a).
309. Id. § 7477(a).
310. Id. § 7478(a).
311. Id. § 7479(a).
312. Id. § 7428(a).
313. Id. § 6404(h)(1).
314. Id. § 7481(c); see TAX CT. R. 261.
315. I.R.C. § 6213(a); see TAX CT. R. 55.
316. I.R.C. § 6863(b); see TAX CT. R. 57.
317. I.R.C. § 7436(a).
318. Id. § 7623(b)(4); see, e.g., Cohen v. Commissioner, 139 T.C. 299, 304 (2012); Kasper
v. Commissioner, 137 T.C. 37, 41 (2011).
319. I.R.C. § 6901(a).
320. Id. § 6015(e)(1)(A).
321. This movement included enactment of several Taxpayer Bills of Rights as well as
pro-taxpayer sections in other measures. See, e.g., Omnibus Taxpayer Bill of Rights, enacted as Tit. VI, Subtit. J of Technical and Miscellaneous Revenue Act of 1988, Pub. L. No.
100-647, 102 Stat. 3342, 3730; Taxpayer Bill of Rights 2, Pub. L. No. 104-168, 110 Stat.
1452 (1996); Taxpayer Bill of Rights 3, enacted as Tit. III of Internal Revenue Service Restructuring and Reform Act of 1998, Pub. L. No. 105-206, 112 Stat. 685, 726.
322. See, e.g., F. Brook Voght, Amended Tax Court Rules Reflect New Jurisdiction and
Goal of Increased Efficiency, 73 J. TAX’N 404, 404 (1990).
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2. Areas Where the Tax Court Lacks Jurisdiction
In the pre-assessment context, perhaps the most significant subject over which the Tax Court lacks jurisdiction is refund suits. When
the Tax Court has acquired jurisdiction in a deficiency action, it
might conclude that, not only is there no deficiency for the tax year(s)
at issue, but also that there had been an overpayment for the year(s).
The Tax Court has jurisdiction to determine such overpayment and
to command that it be refunded. 323 The Tax Court does not, however,
have jurisdiction to hear free-standing refund actions.
In the post-assessment context, the Tax Court’s jurisdiction over
collection matters is limited. In the main, it can hear some collection
matters but only if a Collection Due Process case is properly before it.324
In addition, there are several categories of actions that Congress
has authorized to be brought in district court but not in Tax Court.
These include a wide variety of suits by the government in aid of enforcement, 325 taxpayer suits to contest assessable penalties, 326 suits
by taxpayers and others to quash IRS summons or other information
gathering,327 and miscellaneous other taxpayer actions. 328
3. Where to Expand Tax Court Jurisdiction and Where Not
to Expand
The current jurisdiction of the Tax Court resembles a cloak with
many holes of varying sizes. As seen above, the pattern is the product
of history, not rationality. This hit-and-miss arrangement guarantees
the existence of traps for the unwary. Taxpayers regularly discover
323. I.R.C. §§ 6214(a), 6512(b); see TAX CT. R. 260.
324. I.R.C. § 6330.
325. E.g., I.R.C. §§ 7323(a) (action to enforce forfeiture), 7402(a) (miscellaneous actions), 7403(a) (lien enforcement action), 7404 (estate tax enforcement action), 7405(a) (erroneous refund recovery action), 7407(a) (return preparer enforcement action), 7409(a)(1)
(action to enjoin political expenditures), 7611(c)(2)(A)(ii) (government action as to church
tax investigation).
326. E.g., id. §§ 6679(b) (penalty for failure to file foreign returns), 6693(d) (penalty as
to retirement accounts), 6694(c)(2) (preparer penalty), 6696(b) (review of penalties under
§§ 6694, 6695, 6695A), 6698 (penalty for failure to file partnership return), 6699(d) (penalty
for failure to file S corporation return), 6703(b), (c)(2) (penalties under §§ 6700, 6701,
6702), 6706(c) (original-issue-discount information penalty), 6707A(d)(2) (failure to rescind
§ 6707A penalty), 6713(c) (penalty as to disclosure by return preparer).
327. E.g., id. §§ 982(c)(2)(B) (proceeding to quash formal document request),
6038A(e)(4)(C) (proceeding to quash summons as to foreign-owned corporations),
6038C(d)(4) (proceeding to quash summons as to foreign corporation engaged in a U.S.
trade on business), 7609(h)(1) (action to quash third-party summons), 7611(c)(2)(A)(i) (taxpayer action as to church tax investigation).
328. E.g., id. §§ 6402(g) (review of § 6402 reduction), 7426(a) (taxpayer and third party
actions as to collection).
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that they have no Tax Court remedy, despite the fact that the cause
is a core tax matter and is well within the competence of the court.329
The logic behind creation of the Tax Court supports extending the
court’s jurisdiction. As seen in Part II.B.3 above, the Tax Court was
created to bring special expertise to bear and to develop a nationally
uniform body of tax law. Tax Court judges—by virtue of their preappointment backgrounds and their tax-only dockets—are more
technically expert in tax than are the generalist judges of the district
courts, the bankruptcy courts, and the partly-tax/partly-nontax Court
of Federal Claims.
This expertise differential is not confined to deficiency cases. It
extends, in varying degrees, to all tax matters. For example, there is
no reason why the Tax Court should not be able to hear refund suits.
The same substantive issues arise in both deficiency and refund
suits. Some procedural issues are unique to refund cases.330 However,
many Tax Court judges are likely to have handled refund cases before their elevation to the bench, and most district court judges decide tax refund procedural issues quite rarely. The Tax Court already
has refund jurisdiction incident to its deficiency jurisdiction. 331 It
should have independent refund jurisdiction as well.
In addition, the Tax Court should have widespread jurisdiction as
to tax collection controversies. Such controversies often do entail
application of state property and other laws, for example, in the determination of the property interests possessed by the tax delinquent 332 and in assessing the validity and priority of competing
claims of third parties.333
It is sometimes thought that district courts, which deal with state
law more regularly, have an advantage over the Tax Court in this
regard. However, practicing tax lawyers—which are what most Tax
Court judges once were—are often required to work with state property laws. 334 Moreover, Tax Court judges routinely work with state
329. See, e.g., Roberts v. Commissioner, 103 T.C.M. (CCH) 1787 (2012) (holding that
the Tax Court lacks jurisdiction to review applications of overpayments made pursuant to
§ 6402); Adrianne Hodgkins, Getting a Second Chance: The Need for Tax Court Jurisdiction
Over IRS Denials of Relief Under Section 66, 65 LA. L. REV. 1167, 1167 (2005) (“[I]f the
taxpayer filed a separate return while living in a community property state, the Tax Court
will not review of denial [sic] [joint-and-several liability] relief under section 66 of the Code
because Congress failed to give the Tax Court jurisdiction over such denials.”).
330. See RICHARDSON, BORISON & JOHNSON, supra note 9, ch. 9.
331. I.R.C. § 6214.
332. See, e.g., Steve R. Johnson, After Drye: The Likely Attachment of the Federal Tax
Lien to Tenancy-by-the-Entireties Interests, 75 IND. L.J. 1163, 1174-80 (2000); Steve R.
Johnson, Fog, Fairness, and the Federal Fisc: Tenancy-by-the-Entireties Interests and the
Federal Tax Lien, 60 MO. L. REV. 839, 855-68 (1995).
333. See supra Part II.B.6.
334. See, e.g., Erwin N. Griswold, The Need for a Court of Tax Appeals, 57 HARV. L.
REV. 1153, 1183-84 (1944).
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property law in estate and gift tax cases, and often in income tax cases as well. Moreover, as noted in the preceding subpart, the expansion of the Tax Court’s jurisdiction over the decades has given it experience with collection issues in many contexts. In particular, the
thousands of Collection Due Process cases that the Tax Court has
heard in the last fifteen years has exposed the court to numerous
collection controversies.
Also, Part V.B below notes the phenomenon of “pure” APA tax
suits. The Tax Court’s expanded jurisdiction should include them.
There would be relatively few such suits, and the Tax Court is being
forced to learn and grapple with administrative law principles even
in cases already within its jurisdiction.335
The expanded Tax Court jurisdiction should be concurrent, not
exclusive. Such other courts as Congress has already designated, or
may in the future designate, able to hear the various categories
of cases should still be able to hear them. This proposal is not
a stealth initiative; a stalking horse for eventually exclusive Tax
Court jurisdiction.
I propose that the Tax Court have nearly plenary, not plenary, tax
jurisdiction. I would reserve three areas. First, criminal tax cases
should remain the exclusive province of the district courts, just as all
criminal cases are. The Tax Court is and should remain a civil tribunal.
Second, I would keep Tax Court cases as taxpayer, not IRS, initiated events. As seen in Part III.A above, there is concern in some
quarters that the Tax Court has a pro-IRS bias. That concern is misplaced, but it does exist. If the IRS were able to go into Tax Court to
secure compulsive orders, 336 the concern would rise. The Primary
Value of providing taxpayer remedies that are both fair and perceived
to be fair could be compromised. To prevent this, the reform would
give the Tax Court jurisdiction over taxpayer-initiated actions only.
Third, judicial review of jeopardy and termination assessments
under § 7429 337 should continue to take place only in the district
courts, not the Tax Court (except to the limited degree currently
permitted). 338 A paramount need—a Primary Value need—in such
review is expedition.339 The district courts sit in ninety-five districts
with divisions in multiple cities within the districts. The Tax Court
sits only in Washington, D.C., except when it periodically sends out
335. See supra Part II.B.12.
336. Such as summons enforcement orders, writs of entry, search warrants, promoter
and preparer injunctions, and other types of writs and orders.
337. See supra Part II.B.7.
338. See I.R.C. § 7429(b)(2)(B).
339. Hence the short time frames for requesting review and for decision by the reviewing court. See id. § 7429(a)(1)(B), (b)(3).
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judges to “ride circuit.” District court can best provide the speedy
resolution required by § 7429 at reasonable cost and convenience
to taxpayers.
B. National Court of Tax Appeals
Discussion of the jurisdiction of the Tax Court—a tax specialist
trial court—invites inquiry as to appellate level tax specialization.
This involves a long-playing controversy.
Proposals often have been made to create a national court of tax
appeals. Not surprisingly, the details of the proposals vary. 340 At the
core, however, the idea is to centralize federal tax appeals—now
heard by thirteen circuit courts—in a single, new tax appellate court.
The decisions of the new court would be final absent Supreme Court
certiorari review, legislative reversal, or regulatory reversal as sanctioned by the Brand X decision.341
This idea is most frequently associated with Dean Griswold,342 but
many others, including an impressive array of luminaries, have associated themselves with the proposal. 343 The eminence of the proponents, however, did not stifle opposition. The proposal has been decried with at least as much vigor as it has been urged. 344 The debate
comes in and goes out like the tide but never is silent for too long. 345
340. The details of some of the early proposals, and of alternatives to them, are described by H. Todd Miller, Comment, A Court of Tax Appeals Revisited, 85 YALE L.J. 228
(1985). See also Gary W. Carter, The Commissioner’s Nonacquiescence: A Case for a National Court of Tax Appeals, 59 TEMP. L.Q. 879 (1986).
341. Nat’l Cable & Telecomms. Ass’n v. Brand X Internet Servs., 545 U.S. 967, 982
(2005) (holding that Chevron-entitled regulations can reverse prior contrary decisions of
the lower federal courts).
342. Griswold, supra note 334.
343. The idea was advanced at least as early as 1925. Oscar E. Bland, Federal Tax
Appeals, 25 COLUM. L. REV. 1013 (1925). Among other advocates, see Henry J. Friendly,
Averting the Flood by Lessening the Flow, 59 CORNELL L. REV. 634, 644 (1974); Charles L.
B. Lowndes, Taxation and the Supreme Court, 1937 Term: Part II, 87 U. PA. L. REV. 165,
200 (1938); Stanley S. Surrey, Some Suggested Topics in the Field of Tax Administration,
25 WASH. U. L.Q. 399, 414-23 (1940); Roger John Traynor, Administrative and Judicial
Procedure for Federal Income, Estate and Gift Taxes—A Criticism and a Proposal, 38 COLUM. L. REV. 1393 (1938).
344. See, e.g., Montgomery B. Angell, Procedural Reform in the Judicial Review of Controversies Under the Internal Revenue Statutes: An Answer to a Proposal, 34 ILL. L. REV.
151 (1939); E. Barrett Prettyman, A Comment on the Traynor Plan for Revision of Federal
Tax Procedure, 27 GEO. L.J. 1038, 1048-50 (1939); William A. Sutherland, New Roads to
the Settlement of Tax Controversies: A Critical Comment, 7 LAW & CONTEMP. PROBS. 359,
360-61 (1940).
345. For a recent call for creation of the court, see Jasper L. Cummings, Jr., Creation of
National Appellate Tax Court Will Improve Tax Law, in TOWARD TAX REFORM: RECOMMENDATIONS FOR PRESIDENT OBAMA’S TASK FORCE 30, 30-32 (Tax Analysts ed., 2009).
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It is sometimes hoped that a tax-specialized appellate court would
make decisions of higher quality. 346 However, decisional harmony and
doctrinal clarity—there would be fewer inconsistent tax precedents—
always has been the more heavily emphasized justification.347
Opponents of the idea discount the extent to which the tax law
will be made more predictable.348 They also assert that tax specialization would create its own problems, such as that the court would forfeit a valuable perspective by losing contact with the general law and
would tilt in favor of the IRS. 349 The last of these objections—pro-IRS
orientation—is a species of the well-known administrative law theory
of “agency capture,” the idea that when an agency (in this case the
court) deals repeatedly with a party (usually the regulated industry;
here the IRS), it comes to sympathize and identify with that party’s
needs and concerns. 350 These objections have thus far made the proposal politically nonviable. 351
If a tax appellate court could be “captured” by the IRS, one would
expect that the Tax Court already has been so captured. There is
long-running disagreement about whether this has occurred. Some
practitioners and commentators believe that the Tax Court favors the
IRS, 352 and they point to studies suggesting that the IRS wins more
often in Tax Court than in district court.353
I am convinced that this view is incorrect. The studies that may
seem to hint at bias typically do not adequately control for differences
between the types of cases and the types of taxpayers appearing in
346. It is not obvious that a far higher caliber of decisions would ensue. “Tax law is
undeniably complex, but [several justices without much pre-judicial tax experience] have
demonstrated that it is not beyond the capacity of generalist judges and Justices to write
thoughtful and sophisticated opinions in tax cases.” Lawrence Zelenak, The Court and the
Code: A Response to The Warp and Woof of Statutory Interpretation, 58 DUKE L.J. 1783,
1787 (2009).
347. See, e.g., ROSWELL MAGILL, THE IMPACT OF FEDERAL TAXES 209 (1943).
348. Madaline Kinter Remmlein, Tax Controversies—Where Goes the Time?, 13 GEO.
WASH. L. REV. 416 (1945).
349. See Robert N. Miller, Can Tax Appeals Be Centralized?, 23 TAXES 303 (1945).
350. See generally MARVER H. BERNSTEIN, REGULATING BUSINESS BY INDEPENDENT
COMMISSION 87-90, 270 (1955); James M. Landis, S. SUBCOMM. ON ADMIN. PRACTICE &
PROCEDURE, 86TH CONG., REP. ON REGULATORY AGENCIES TO THE PRESIDENT-ELECT 71
(Comm. Print 1960). But see Richard A. Posner, Theories of Economic Regulation, 5 BELL J.
ECON. & MGMT. SCI. 335, 342 (1974) (arguing that “agency capture” lacks theoretical foundation and is unsupported by evidence).
351. See, e.g., Cummings, supra note 345.
352. See Glenn Kroll, Are Tax Court Judges Partial to the Government?, 45 OIL & GAS
TAX Q. 135, 136 (1996).
353. See, e.g., Deborah A. Geier, The Tax Court, Article III, and the Proposal Advanced
by the Federal Courts Study Committee: A Study in Applied Constitutional Theory, 76
CORNELL L. REV. 985, 998 (1991).
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Tax Court versus district court.354 The better studies refute rather
than confirm the Tax Court’s alleged pro-IRS bias. 355
Nonetheless, perceptions sometimes matter as much as (or even
more than) reality. “Legislation concerning judicial organization
throughout our history has been a very empiric response to very definite needs.” 356 Those needs include widespread and stubborn misconceptions as well as accurate perceptions.
By the criteria adduced in this Article, we should continue to reject a national court of tax appeals. Such a court might contribute to
efficiency and uniformity, although the extent of such contribution is
difficult to estimate. But those are Second-Order Values, which yield
to the Primary Value in most cases. The Primary Value includes
remedies that are perceived to be fair, not just are in fact fair. Suspicion of the fairness of specialized tax tribunals is too widespread to be
ignored. Confidence in the system is too important to risk. 357
C. Court of Federal Claims Jurisdiction
As maintained above, the civil tax jurisdiction of the Tax Court
should be expanded substantially. The tax jurisdiction of the Court of
Federal Claims and the Federal Circuit should be abolished, however. Below, I first sketch the relevant history of these courts and then
explain why abolition of their tax jurisdiction would promote the values identified in Part II.C above.
1. History
As noted in Part II.B.1, the United States Court of Claims—the
original ancestor of the current Court of Federal Claims and the Federal Circuit—was created in 1855. Its jurisdiction was significantly
expanded by the Tucker Act in 1887, granting the court nationwide
354. See, e.g., Robert M. Howard, Comparing the Decision Making of Specialized Courts
and General Courts: An Exploration of Tax Decisions, 26 JUS. SYS. J. 135, 138 n.1 (2005).
For example, there are more pro se taxpayers in Tax Court and more wealthy taxpayers in
district court.
355. See, e.g., James Edward Maule, Instant Replay, Weak Teams, and Disputed Calls:
An Empirical Study of Alleged Tax Court Judge Bias, 66 TENN. L. REV. 351, 353 (1999).
356. FELIX FRANKFURTER & JAMES M. LANDIS, THE BUSINESS OF THE SUPREME COURT
13 (photo. reprint 1993) (1927).
357. Tax-specialized courts—whether trial or appellate—are parts of a larger topic.
There is a substantial and growing literature on specialized courts. See, e.g., Lawrence
Baum, Probing the Effects of Judicial Specialization, 58 DUKE L.J. 1667 (2009); Steve R.
Johnson, The Phoenix and the Perils of the Second Best: Why Heightened Appellate Deference to Tax Court Decisions Is Undesirable, 77 OR. L. REV. 235, 235 & n.1, 236 & n.2 (1998)
(citing sources). Thorough evaluation of proposals to create a national court of tax appeals
should address this literature.
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jurisdiction over most suits for monetary claims against the government, including claims for overpaid taxes.358
The jurisdiction of the Court of Claims and its successors was further expanded by subsequent enactments, so that the Court of Federal Claims now hears a wide array of matters, including claims for
just compensation when the federal government takes private property, military and civilian compensation controversies, contract disputes, claims against the government for patent and copyright infringement, suits by Indian tribes, compensation claims for injuries
attributed to specified vaccines, suits by disappointed bidders in federal procurements, and congressional references of legislative proposals for compensation of individual claims.359
Beginning in 1925, the Court of Claims’ trial jurisdiction was
vested in a separate trial function consisting of commissioners, review of which was available from the court’s appellate judges (with
the later possibility of certiorari review by the Supreme Court). In
1973, the commissioners were renamed the trial judges. 360
The courts took their modern form in 1982 when the Court of
Claims was split. The old court’s trial jurisdiction was vested in a
new Article I court: the United States Claims Court (later renamed
the Court of Federal Claims). The old court’s appellate jurisdiction
was combined with that of the United States Court of Customs and
Patent Appeals to comprise an Article III court: the United States
Court of Appeals for the Federal Circuit. 361
During 2006, the Court of Federal Claims had about 8700 cases on
its docket, of which about 3100 involved the court’s general jurisdiction and 5600 were vaccine cases.362 The court had 302 tax cases
pending as of October 2010 and 263 as of October 2011.363 Sixty-one
new tax cases were commenced in the court in 2010 and fifty-four
in 2011. 364
358. 28 U.S.C. §§ 1346(c), 1491(a)(1) (2006).
359. United States Court of Federal Claims: The People’s Court, U.S. CT. FED. CLAIMS,
http://www.uscfc.uscourts.gov/sites/default/files/court_info/Court_History_Brochure.pdf
(last visited Feb. 2, 2014). “In recent years, the Court’s docket has been increasingly characterized by complex, high-dollar demand, and high profile cases in areas such areas as . . .
the savings and loan crisis of the 1980s, the World War II internment of JapaneseAmericans, and the federal repository of civilian spent nuclear fuel.” Id. at 9-10.
360. Id. at 8.
361. Federal Courts Improvement Act of 1982, Pub. L. No. 97-164, 96 Stat. 25.
362. An Overview of the United States Court of Federal Claims, U.S. CT. FED. CLAIMS,
http://www.uscfc.uscourts.gov/sites/default/files/court_info/Court_History_Brochure.pdf
(last visited Feb. 2, 2014).
363. STATISTICS DIV., ADMIN. OFFICE OF THE U.S. COURTS, JUDICIAL BUSINESS OF THE
UNITED STATES COURTS: 2011 ANNUAL REPORT OF THE DIRECTOR 291.
364. See id. at 35.
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In contrast, the number of tax cases commenced in district court
in 2011 was 1194, in 711 of which the government was the plaintiff
and in 481 of which the government was the defendant. 365 Both the
Court of Federal Claims and district court totals are dwarfed by Tax
Court cases: 29,720 Tax Court cases were started in 2011. 366
2. Reasons for Change
The original acquisition of tax jurisdiction by the Court of Claims
was a felicitous development. As shown in Parts II.B.1 and II.B.3
above, prepayment remedies did not yet exist and other refund remedies were underdeveloped. The subsequent development of Tax Court
and district court channels of redress, however, has rendered superfluous the Court of Federal Claims tax jurisdiction. It should be abolished.
Some taxpayers and their representatives would oppose this reform. First, it is human nature—and especially lawyers’ nature—to
want as many options as possible. When the Tax Court and the relevant district court have rejected a particular argument, those who wish
to press that argument take comfort in having a third available forum.
Second, the Court of Federal Claims possesses, or is believed to
possess, certain useful characteristics. It has gained a reputation in
some quarters as being a taxpayer-friendly tribunal. 367 Some consider
it the forum of choice when the taxpayer has a weak case on the
law—one likely to be rejected by the Tax Court. 368 And the court
styles itself as the “keeper of the nation’s conscience” and “the People’s Court,” 369 so taxpayers with good litigating equities may view
the court as an attractive forum. 370
Nonetheless, the Primary Value does not counsel in favor of retaining the tax jurisdiction of the Court of Federal Claims. That value means that taxpayers should have remedies that both are fair and
effective and are perceived to be fair and effective. That requirement
365. Id. at 127. New district court tax cases were 1522 in 2007, 1451 in 2008, 1306 in
2009, and 1190 in 2010. Id. at 130.
366. INTERNAL REVENUE SERVICE, DATA BOOK 61 (2011).
367. See Christopher R. Egan, Checking the Beast: Why the Federal Circuit Court of
Appeals is Good for the Federal System of Tax Litigation, 56 SMU L. REV. 721, 725 (2003).
368. For example, before being reversed, the Court of Federal Claims was the only
court to have held that the judicially crafted economic substance doctrine—the IRS’s principal weapon against recent tax shelters—is illegitimate as a violation of the separation of
powers doctrine. Coltec Indus., Inc. v. United States, 62 Fed. Cl. 716, 755-56 (2004), vacated & remanded, 454 F.3d 1340 (Fed. Cir. 2006).
369. United States Court of Federal Claims: The People’s Court, supra note 359, at 1.
370. For instance, the court, on the basis of sparing taxpayers unnecessary expense,
created a de minimis exception to the capitalization doctrine. Cincinnati, New Orleans &
Tex. Pac. Ry. Co. v. United States, 424 F.2d 563 (Ct. Cl. 1970). The Tax Court rejected Cincinnati Railway. Alacare Home Health Servs., Inc. v. Commissioner, 81 T.C.M. (CCH) 1794
(2001).
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is not synonymous, however, with affording taxpayers redundant options simply to multiply their convenience and advantages.
Under the federal tax litigation structure proposed by this Article,
taxpayers would have prepayment opportunities in the Tax Court
and, when bankruptcy jurisdiction exists, in the bankruptcy court.
Taxpayers would have refund opportunities in the Tax Court, district
court, and, when bankruptcy jurisdiction exists, in the bankruptcy
court. The Primary Value does not require that taxpayers have yet
another refund opportunity, this time in the Court of Federal Claims.
The Primary Value not being engaged, the matter turns on Second-Order Values. Removing one redundant level of refund litigation
will decrease the potential for conflict among the courts, reducing
forum shopping and increasing predictability and efficiency.
One of the reasons for creation of the Court of Federal Claims was
development of a uniform body of law for cases within its jurisdiction.371 That rationale works well as to the numerous areas, sketched
above, in which the court has exclusive jurisdiction. Because of the
multiplicity of alternative tax refund fora, however, the uniformity
rationale would be better served in the tax area by abolishing the
Court of Federal Claims’ tax jurisdiction.372
If one tax forum is to be removed, which should it be? The Tax
Court should be retained because of its expertise and its opportunity
for prepayment review. The bankruptcy court should be retained because the tax issues of debtors are best handled as part of the total
complexion of the debtor’s situation. As between the district court
and the Court of Federal Claims, the district court should be retained. Jury trials are possible in district court but not in the Court
of Federal Claims. 373
More importantly, district courts are Article III courts while the
Court of Federal Claims is an Article I court. Thus, district court
judges have life tenure while Court of Federal Claims judges have
renewable fifteen-year terms (like Tax Court judges). 374 Those suspicious that courts may favor the IRS are more likely to see the district
court as the more vigilant sentinel.
Accordingly, the Primary Value reinforces the Second-Order Values. We should dispense with the tax jurisdiction of the Court of Fed371. An Overview of the United States Court of Federal Claims, supra note 362.
372. See, e.g., Martin D. Ginsburg, Commentary, The Federal Courts Study Committee
on Claims Court Tax Jurisdiction, 40 CATH. U. L. REV. 631, 635-36 (1991).
373. Jury trials are not the norm in tax cases. But they are fairly common in cases
involving the trust fund recovery penalty under § 6672, and they occasionally are used in
refund cases involving other issues, e.g., Scriptomatic, Inc. v. United States, 74-1 U.S. Tax
Cas. (CCH) ¶ 9246, 33 A.F.T.R.2d (RIA) 827 (E.D. Pa. 1973), aff’d, 555 F.2d 364 (3d Cir.
1977) (§ 385 case).
374. 28 U.S.C. § 172 (2006).
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eral Claims. That court would be left with the heavy workload and
the important duties entailed with the other types of cases, described
above, that comprise its jurisdiction.
IV. REFORMS AS TO AVAILABLE FORMS OF ACTION
The prior Part advanced proposals as to the courts that should be
available to hear federal tax disputes. This Part addresses the forms
of actions and the kinds of relief that should be available regardless
of the court.
I propose two such changes. First, the TEFRA partnership audit
and litigation rules enacted in 1982 have proved to be more harmful
than beneficial. In the main, they should be repealed. This would return us to partner-level audit and litigation, with some collateral
rules to promote efficiency.
Second, among the major products of the IRS Restructuring and
Reform Act of 1998 were the Collection Due Process (“CDP”) rules. In
the main, these rules have entailed great expenditure of effort and
resources by taxpayers, the IRS, and the courts without producing
commensurate genuine and lasting benefits for taxpayers. Some
commentators have urged abolition of the CDP regime. This Article
does not go that far. It proposes reducing the scope of, but not eliminating, judicial review of CDP decisions by the IRS Appeals Office.
A. TEFRA Rules
When originally enacted, the rules governing taxation of partnerships and their partners were intended to be, and largely were, simple, in order to facilitate the flexibility partnerships offer for non-tax
purposes. These rules are, in the main, embodied in Subchapter K of
Chapter 1 of the Code. Over time, Subchapter K has become anything
but simple, both because of unresolved tensions in its original design
and because—flexibility being the spawning ground of creative tax
planning 375—Congress has superimposed numerous complex étages
of anti-abuse on the originally simple edifice. 376 In my view, the game
is no longer worth the candle. Some others and I have advocated the
375. “A partnership is a magic circle. Anything that is dropped into it becomes exempt
from taxation. Forever. . . . Adherents to this view of subchapter K understand the word
‘flexible’ to mean that you can do absolutely anything you want without incurring tax.” Lee
A. Sheppard, Partnerships, Consolidated Returns and Cognitive Dissonance, 63 TAX NOTES
936, 936 (1994).
376. See, e.g., Lawrence Lokken, Taxation of Private Business Firms: Imagining a Future Without Subchapter K, 4 FLA. TAX REV. 249, 250 (1999) (“Subchapter K is a mess.”);
Andrea Monroe, What’s in a Name: Can the Partnership Anti-Abuse Rule Really Stop Partnership Tax Abuse?, 60 CASE W. RES. L. REV. 401, 402 (2010) (“Partnership taxation is a
disaster.”).
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abolition of Subchapter K, leaving S corporations as the Code’s principal “pass-through” form. 377
This radical suggestion is unlikely to be adopted any time soon,
however. Thus, we should direct our attention to a lesser reform: the
abolition of the bulk of the TEFRA regime. Others 378 and I 379 have
advocated this reform previously, but additional persuasion will be
required to forge an effective consensus.
There are two reasons for ending the principal aspects of the
TEFRA rules. First, the TEFRA rules are unnecessary. The circumstances causing creation of the regime in 1982 no longer exist. Second, the TEFRA rules have proved to be harmful. From far promoting clarity, consistency, and efficiency in resolving partnership related controversies, the TEFRA rules have undermined these values.
1. Unnecessary
There is some question as to whether the TEFRA rules truly
were needed by the time of their enactment in 1982, 380 but let us
assume they were. That necessity has evaporated as a result of post1982 developments.
In 1986, Congress enacted § 469, the passive activity loss rules,
and strengthened the § 465 at-risk rules. Section 469 especially
struck at the core of tax shelter marketing. It prevented taxpayers
from using losses from passive activities (tax shelters) to offset their
income from other sources. 381 It was no longer necessary to examine
tax shelters individually and to disallow their alleged benefits on
technical or substantive grounds.
377. See Steve R. Johnson, The E.L. Wiegand Lecture: Administrability-Based Tax
Simplification, 4 NEV. L.J. 573, 589-96 (2004); Philip F. Postlewaite, I Come to Bury Subchapter K, Not to Praise It, 54 TAX LAW. 451 (2001).
378. See, e.g., Peter A. Prescott, Jumping the Shark: The Case for Repealing the
TEFRA Partnership Audit Rules, 11 FLA. TAX REV. 503 (2011); Burgess J.W. Raby & William L. Raby, TEFRA Partnership Rules: The Solution Becomes the Problem, 88 TAX NOTES
795 (2000); see also N. Jerold Cohen & William E. Sheumaker, When It’s Broke, Fix It! It’s
Time for TEFRA Reform, 136 TAX NOTES 815 (2012) (expressing concerns about the
TEFRA rules but stopping short of urging their repeal).
379. Johnson, supra note 377, at 596-602; Steve R. Johnson, Letter to the Editor,
TEFRA: No Fix Possible, Just Get Rid of It!, 136 TAX NOTES 964 (2012).
380. In the time before Congress acted in 1982, the IRS and the courts developed improved techniques for identifying, processing, and managing tax shelter cases. See Johnson, supra note 377, at 601. Of course, in the decades since 1982, technological capacities
have improved greatly, further undermining the bureaucratic necessity of the TEFRA
rules. See Prescott, supra note 378, at 562-64.
381. See generally Boris I. Bittker, Martin J. McMahon, Jr. & Lawrence A. Zelenak, A
Whirlwind Tour of the Internal Revenue Code’s At-Risk and Passive Activity Loss Rules, 36
REAL PROP., PROB. & TR. J. 673 (2002); Robert J. Peroni, A Policy Critique of the Section
469 Passive Loss Rules, 62 S. CAL. L. REV. 1 (1988); Lawrence Zelenak, When Good Preferences Go Bad: A Critical Analysis of the Anti-Tax Shelter Provisions of the Tax Reform Act
of 1986, 67 TEX. L. REV. 499 (1989).
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As a result and in short order, the old tax shelter market collapsed. After some years, shelter promoters found new strategies,
and new tax shelter vehicles were marketed in the 1990s and early
2000s. Critically, however, that second wave differed fundamentally
from the first wave, in ways that makes the TEFRA rules obsolete.
Before 1986, shelters were mass marketed to upper middle class as
well as rich taxpayers—thousands of shelters, most of which were
sold to scores or hundreds of “investors” each. Now, shelters are rifle
shots, not shotgun blasts. There are far fewer of them, and typically
each shelter partnership or LLC has only a few “investors,” mainly
large corporations or extremely high-wealth individuals, who are
likely to be audited in any event. The audit and litigation challenges
posed by current shelters are barely a shadow of challenges posed by
pre-1986 shelters.
Moreover, investors in current shelters typically can avoid the
TEFRA regime if they wish. In general, the regime does not apply to
“any partnership having 10 or fewer partners each of whom is an individual . . . , a C corporation, or an estate of a deceased partner.” 382
Since very few current tax shelter partnerships have over 10 investors, the TEFRA regime adds little to the IRS’s ability to combat
current shelters.
This observation leads to a broader point about the demography of
partnerships. At the “small” end of the spectrum, the TEFRA rules
have little applicability as a result of the “10 or fewer partners” exception.383 Depending on the year studied, partnerships have on average only five or six partners, 384 well within the exception. At the
“large” end of the spectrum, “electing large partnerships” with 100 or
more partners and “publicly traded partnerships” (which may have
thousands of partners) also are outside of TEFRA. 385 Thus, TEFRA is
potentially meaningful only in the middle of the partnership spectrum, but that middle is not densely populated. Less than ten percent
382. I.R.C. § 6231(a)(1)(B)(i). This exclusion, if applicable, is automatic unless the
partnership affirmatively elects into TEFRA treatment. Id. § 6231(a)(1)(B)(ii). Many current shelters do elect in. At least sometimes, this decision is motivated by the harms
caused by TEFRA described in the following subpart. In a number of important respects,
the TEFRA rules are unpredictable in their application, so electing into TEFRA treatment
gives the taxpayers additional opportunities to prevail if the IRS “messes up” or guesses
incorrectly how the reviewing court eventually will interpret TEFRA’s requirements.
383. This exception has been in the TEFRA rules from the start, and Congress has
shown little inclination to repeal or modify it. Id. § 6231(a)(1)(B).
384. See Prescott, supra note 378, at 558.
385. Electing large partnerships are outside of TEFRA under I.RC. § 6240(b)(1). With
narrow exceptions, publicly traded partnerships are treated as corporations for federal tax
purposes and so are outside of TEFRA. Id. § 7704.
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of partnerships are in this range, 386 and, as noted above, current tax
shelter partnerships typically are not there.
In the main, therefore, the TEFRA procedures are dispensable.
There are three particular rules that should be retained, though.
First, in general, partners are required on their returns to treat
items derived from partnerships consistently with the way those
items are treated on the partnership’s return. 387 Inconsistency allows
the IRS to automatically assess any resulting deficiency388 and may
expose the partner to a penalty. 389
Second, if the IRS settles some or all partnership items with some
partners, the other partners are generally entitled to settle their
items on similar terms.390 Both of these consistency rules—the consistent reporting rule and the consistent settlement rule—advance
the Second-Order Value of process efficiency and should be retained.
Third, § 6229 sets out limitation periods for IRS assessment of
partnership items. There was initial uncertainty as to the relationship between these periods and the general assessment limitation
periods prescribed by § 6501. It is now settled that the § 6229 rules
may extend the period allowable under § 6501 but may not contract
it. 391 This rule too should be retained to protect audits in case of late
filed partnership returns. 392
2. Harmful
The preceding subpart mentioned unresolved tensions in the original design of Subchapter K. A principal tension involves the “entity
versus aggregate” question: are partnerships entities separate from
their owners or are they mere aggregates of the activities of their
owners? 393 Creating unending confusion on specific substantive
issues, Subchapter K sometimes applies an entity approach, some386. In 2011, slightly over 3,285,000 partnerships filed returns with the IRS. Slightly
over 3,082,000 of them (93.8% of the total) had under ten partners. Rob DeCarlo, Lauren
Lee & Nina Shumofsky, Internal Revenue Service, Partnership Returns, 2011, STAT. OF
INCOME BULL., Fall 2013, at 81, 83 fig. C.
387. I.R.C. § 6222(a). Deviation is permitted, however, when the partner specifically
notifies the IRS. Id. § 6222(b).
388. Id. § 6222(c).
389. Id. § 6222(d).
390. Id. § 6222(c)(2).
391. See Andantech L.L.C. v. Commissioner, 331 F.3d 972 (D.C. Cir. 2003).
392. I have argued that repeal of the main TEFRA rules should not create problems for
the IRS auditing partnership items within I.R.C. § 6501’s statute of limitations. Nonetheless, should Congress harbor concern on this score, it could amend § 6229 to extend the
limitations period. Cf. I.R.C. § 6901(c)(1), (2) (extending the limitations period with respect
to transferee liability).
393. See, e.g., Bradley T. Borden, Aggregate-Plus Theory of Partnership Taxation, 43
GA. L. REV. 717, 719 (2009).
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times an aggregate approach, and sometimes a mixed entityaggregate approach. 394
TEFRA—a mix of the aggregate and entity approaches—extends
that confusion to the procedural realm. This tension is responsible for
many ambiguities and inefficiencies in the TEFRA rules. They
showed up early in numerous cases, many of which the IRS lost. Undoubtedly, the TEFRA rules sometimes resulted in the government
being able to assess and collect amounts it would otherwise have lost.
Equally undoubtedly, however, in other cases the IRS lost money because it construed the TEFRA rules in ways the courts later held to
be erroneous. Neither side of this revenue ratio ever has been (nor,
probably, can it ever be) reliably quantified, so we do not know the
extent to which TEFRA succeeded in its fiscal objectives, or even
whether it succeeded at all.
Even more troubling than the immense confusion the TEFRA
rules spawned early on is the fact that great confusion and dysfunction as to them persist even today. In an en banc opinion, the Tax
Court noted the “distressingly complex and confusing” nature of
TEFRA rules.395 Similarly, the Treasury has acknowledged that the
TEFRA rules sometimes “generate[] complex and burdensome procedural issues that do not contribute to the determination of the [partners’] tax liabilities.” 396
A trifurcation at the core of TEFRA is the source of many of these
problems. For TEFRA purposes, one needs to distinguish among
partnership items, non-partnership items, and affected items. Partnership items are items “more appropriately determined at the partnership level than at the partner level.” 397 Examples include each
partner’s share of the partnership’s income, gain, loss, deductions,
credits, non-deductible expenditures, and liabilities. 398 Penalties also
are partnership items to the extent that they relate to partnership
items.399 Affected items are not partnership items but are influenced
in their availability or extent by partnership items. 400 Examples
include items that vary in accordance with the partner’s income,
394. See ROBERT J. PERONI, STEVEN A. BANK & GLENN E. COVEN,
NESS ENTERPRISES: CASES AND MATERIALS 1002-04 (3d ed. 2006).
TAXATION OF BUSI-
395. Rhone-Poulenc Surfactants & Specialties, L.P. v. Commissioner, 114 T.C. 533, 540
(2000); see also Shamik Trivedi & Jeremiah Coder, TEFRA Raises Complex Jurisdictional
Issues, Judge Says, 135 TAX NOTES 985 (2012) (reporting remarks of Tax Court Judge
Mark V. Holmes).
396. Tax Avoidance Transactions, 74 Fed. Reg. 7205, 7206 (proposed Feb. 13, 2009) (to
be codified at 26 C.F.R. pt. 301) (proposing new regulations under § 6231).
397. I.R.C. § 6231(a)(3).
398. Treas. Reg. § 301.6231(a)(3)-1(a)(1).
399. I.R.C. § 6221.
400. Id. § 6231(a)(5).
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a partner’s basis in her partnership interest, and a partner’s atrisk limitation. 401
Even when the rules are clear, the potential for inefficiency is considerable. Partnership items are determined in TEFRA proceedings.402 Nonpartnership items are determined in separate, traditional
partner-level deficiency proceedings. Affected items are determined
after the partnership adjustments have been resolved, sometimes
through automatic computational adjustments and other times
through deficiency procedures.403 Thus, when a partner’s individual
return for a given year includes both partnership and nonpartnership items, multiple separate proceedings can be required
before the partner’s correct tax liability for the year is established
with finality.
Similarly, assume the partnership engages in a transaction that
the IRS finds abusive. Assume further that both the partnership and
a particular partner obtained legal opinions supporting the transaction’s tax legitimacy. When the reasonable reliance defense is raised
against the penalties asserted by the IRS, 404 it will have to be litigated in two separate cases. Reasonable reliance based on the opinion
obtained by the partnership is a partnership item that must be determined in a TEFRA proceeding. Reasonable reliance based on the
opinion obtained by the partner is an affected item that must be determined outside the TEFRA case.405 Every first-year law student is
told that our legal system abhors claim splitting. TEFRA requires it.
All of this inefficiency is compounded by the fact that the demarcations TEFRA requires are often difficult to make. In many situations, there can be reasonable disagreement as to whether an item is
a partnership, non-partnership, or affected item. If a party makes the
wrong choice and commences a proceeding on the wrong track, the
court will lack jurisdiction. Numerous recent cases have tested such
TEFRA jurisdictional issues, often with surprising results. 406
Under the trifurcation central to TEFRA, “[t]he potential for overlapping effects and hidden boomerangs is mind-numbing.” 407 And, of
401. Treas. Reg. § 301.6231(a)(5)-1.
402. I.R.C. § 6221.
403. See, e.g., N.C.F. Energy Partners v. Commissioner, 89 T.C. 741, 744 (1987); Treas.
Reg. § 301.6231(a)(6)-1(a)(1).
404. See I.R.C. § 6664(c)(1).
405. See Treas. Reg. § 301.6221-1(d).
406. See Petaluma FX Partners, LLC v. Commissioner, 591 F.3d 649, 650-51, 656 (D.C.
Cir. 2010); Tigers Eye Trading, LLC v. Commissioner, 138 T.C. 67 (2012); see also Karen C.
Burke & Grayson M.P. McCouch, Reflections on Penalty Jurisdiction in Tigers Eye, 136
TAX NOTES 1581 (2012).
407. F. Brook Voght, Frederick H. Robinson & Michael E. Baillif, New Rules for
TEFRA Partnerships Provide More Flexibility in Resolving Disputes with the IRS, 88 J.
TAX’N 279, 279-80 (1998).
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course, this is not the only source of the uncertainties and inefficiencies TEFRA has engendered.408
In short, the harms of the TEFRA partnership audit and litigation
rules now exceed the regime’s benefits. In 1982, TEFRA-like procedures also were enacted for S corporations. 409 They were repealed in
1996, however.410 We should learn that lesson in the partnership context as well.
B. Judicial Review of CDP Determinations
The Collection Due Process rules were enacted as part of the RRA
blizzard of reforms, discussed in Part II.B.10 above. They were not
the most ballyhooed aspect of the RRA at the time, but they have
proved to be the most consequential and controversial. 411
Before enactment of the CDP rules, once tax had been properly
assessed and notice and demand for payment had been made, the
IRS was permitted to file notice of the tax lien and to levy on the taxpayer’s property with minimal statutory hurdles to jump. The CDP
rules create speed bumps. Now, within five days after the IRS files
notice of the lien 412 or not less than thirty days before levy is effected, 413 the IRS is required to notify the taxpayer of its action or intended action. Among other things, the notice explains the nature of
the IRS action and the taxpayer’s rights, including the right to administrative hearing. The taxpayer has thirty days from the issuance
of the notice to request review by the IRS Appeals Office.414 The request operates to stay IRS collection action and also to stay the running of the statute of limitations on collection.415
Appeals Office CDP hearings are conducted informally. 416 What
matters may be considered at the Appeals Office hearing? First, the
Appeals Officer is required to verify that the IRS Collection Division
has complied with applicable statutory and regulatory provisions.417
408. See, e.g., Raby & Raby, supra note 378, at 795 (noting the persistence of TEFRA
statute of limitations uncertainties nearly two decades after TEFRA’s enactment).
409. Subchapter S Revision Act of 1982, Pub. L. No. 97-354, § 4(a), 96 Stat. 1669, 169192 (formerly codified at I.R.C. §§ 6221-6245).
410. Small Business Job Protection Act of 1996, Pub. L. No. 104-188, § 1307(c)(1), 110
Stat. 1755, 1781.
411. Tens of thousands of CDP hearing requests are made each year. Danshera Cords,
Collection Due Process: The Scope and Nature of Judicial Review, 73 U. CIN. L. REV. 1021,
1022 n.7 (2005).
412. I.R.C. § 6320(a)(2)(C).
413. Id. § 6330(a)(2)(C).
414. Id. § 6330(a)(3)(B).
415. Id. § 6330(e). Normally, IRS efforts to collect unpaid taxes become time-barred ten
years after assessment. Id. § 6502(a).
416. See Treas. Reg. § 601.106(c).
417. I.R.C. § 6330(c)(1).
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Second, the taxpayer may raise “any relevant issue relating to the
unpaid tax or the proposed levy, including—(i) appropriate spousal
defenses; (ii) challenges to the appropriateness of collection actions;
and (iii) offers of collection alternatives . . . .” 418 Third, the taxpayer
may contest the underlying tax liability if she “did not receive any
statutory notice of deficiency for such tax liability or did not otherwise have an opportunity to dispute such tax liability.”419
The CDP rules expressly recognize the tension between revenue
collection and taxpayer protection. Congress directed Appeals Officers to determine in their resolution of the matter “whether any proposed collection action balances the need for the efficient collection of
taxes with the legitimate concern of the person that any collection
action be no more intrusive than necessary.” 420
If the taxpayer is dissatisfied with the Appeals Office’s determination, she may appeal within thirty days to the Tax Court.421 The
standard of review is de novo when the underlying tax liability is
properly at issue and abuse of discretion when it is not.422
Despite its beguiling name (who could possibly be against due process in collection?), CDP was controversial from the start. A lively
debate has gone on for years, with knowledgeable, passionate, and
eloquent champions on both sides.423 Defenders see the judicial review component of CDP as “a step in the progression of the rule of
law principles that came to permeate twentieth century legal culture.” 424 Detractors find it “an outstanding regulatory failure” that
“likely hurts those who most need its promised protection from arbitrary agency action,” and argue that CDP demonstrates how “adversarial process, used in the wrong place and the wrong time, becomes
a rule of deception rather than a rule of law.” 425
There is little question that CDP has been extremely expensive in
terms of the Second-Order Value of efficiency. The many tens of
thousands of CDP cases claim substantial resources from the IRS
418. Id. § 6330(c)(2)(A).
419. Id. § 6330(c)(2)(B).
420. Id. § 6330(c)(3)(C).
421. Id. § 6330(d)(1).
422. H.R. REP. NO. 105-599, at 266 (1998) (Conf. Rep.).
423. See, e.g., [2004] 1 NAT’L TAXPAYER ADVOCATE ANN. REP. 226-45, 451-70, 498-510
(discussing critiques of CDP and proposals for its reform). The debate between Professor
Leslie Book and Bryan Camp identified key issues. Bryan Camp & Leslie Book, Point &
Counterpoint: Should Collection Due Process Be Repealed?, 24 A.B.A. SEC. TAX’N NEWS Q.
11 (2004).
424. Leslie Book, The Collection Due Process Rights: A Misstep or a Step in the Right
Direction?, 41 HOUS. L. REV. 1145, 1161 (2004).
425. Bryan T. Camp, The Failure of Adversarial Process in the Administrative State, 84
IND. L.J. 57, 57-58 (2009).
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and the Tax Court. They also delay collection and, by extending the
collection limitations period, postpone the day of repose. 426
These costs have not been justified by appreciable gains to the
Primary Value of taxpayer protection. First, the IRS wins the overwhelming majority of CDP cases. 427 Second, most of the relatively few
taxpayer “wins” are victories in name only. They result in recommital
of the case to the administrative process, with the taxpayer’s ultimate position often benefitted little at the end of the day. Third, the
deferential abuse-of-discretion standard of proof may cause losing
taxpayers to feel they did not receive a fair day in court.
Another problem is that CDP litigation mixes and confuses the
executive and judicial roles. The Executive Branch (in this case, the
IRS) applies the law. The courts exist to make sure the IRS follows
the law, not to interfere with the IRS’s exercise of administrative discretion or second-guess the choices the IRS made among options legally available to it. 428 The notoriously loose standards for judicial
review of Appeals Office CDP determinations 429 can tempt the reviewing court to overstep its legitimate role. The Tax Court sometimes displays a regrettable tendency to operate as a self-appointed
superintendent of tax administration.430 That is properly the role of
Congress, the Treasury, and the IRS Oversight Board, not of a court
of law, 431 except when Congress expressly provides to the contrary. 432
426. One sorry aspect of this has been the use (or abuse) of CDP by tax defiers (the now
in-vogue name for those once called “tax protestors”) to delay the system through assertion
of worthless arguments. See Steve Johnson, The 1998 Act and the Resources Link Between
Tax Compliance and Tax Simplification, 51 U. KAN. L. REV. 1013, 1061 (2003) (proposing
changes to reduce this problem).
427. See Camp, supra note 425, at 57 (noting, as of 2009, that “[o]f the over sixteen
million collection decisions made since 2000, courts have reviewed at most 3,000 and have
reversed only sixteen”).
428. For an example of a court overstepping its role—and later having to retract its
excesses—see Fidelity Equip. Leasing Corp. v. United States, 462 F. Supp. 845 (N.D. Ga.
1978), vacated in part, 81-1 U.S. Tax Cas. (CCH) ¶ 9319 (N.D. Ga. 1981) (§ 7429 case).
429. See, e.g., Cords, supra note 411, at 1024 (arguing that judicial review of CDP determinations “is an unsettled and problematic area of law because it lacks clear direction
from Congress”).
430. See, e.g., Rauenhorst v. Commissioner, 119 T.C. 157, 169-73 (2002) (holding the
IRS to a position expressed in previous Revenue Rulings despite the fact that Revenue
Rulings do not have the force of law); Walker v. Commissioner, 101 T.C. 537, 550-51 (1993)
(same).
431. The Tax Court has struggled for generations to be recognized as a court, not an
agency. See, e.g., DUBROFF, supra note 28, at 165-215.
432. For example, the IRS is authorized to relieve spouses of the normal joint and several liability as to joint income tax returns when “taking into account all the facts and circumstances, it is inequitable to hold the individual liable.” I.R.C. § 6015(f)(1). Persons denied such relief by the IRS may bring an action in Tax Court. In such action, the Tax Court
may “determine the appropriate relief.” Id. § 6015(e)(1)(A). Two courts have held that this
provision empowers the Tax Court to go outside the administrative record and proceed de
novo in determining the demands of equity. Wilson v. Commissioner, 705 F.3d 980, 987
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Despite these problems, I do not join those who call for complete
repeal of the CDP rules. These rules have been salutary in at least
one respect. In recent years, “the IRS has implemented procedures
and controls significantly improving [its] compliance with legal and
internal guidelines” applicable to its seizure of property to satisfy tax
debts. 433 This is the wholesome product of spotlights on IRS derelictions cast by Congressional oversight, reports by the National Taxpayer Advocate, 434 investigations by the Treasury Inspector General
for Tax Administration, 435 and—yes—by the CDP process. CDP hearings and litigation act as a tripwire alerting the IRS to, and prodding
it to correct, its breaches of tax collection rules.
Based on the foregoing, I propose two changes to CDP. First, the
current rule—§ 6330(c)(2)(A)(iii)—that authorizes consideration of
collection alternatives offered by the taxpayer should be amended.
Taxpayers should still be able to present such alternatives to the Appeals Office. However, the Appeals Office’s decision with respect to
such alternatives should no longer be judiciary reviewable.
Second, the current rules—§ 6330(c)(1) and § 6330(c)(2)(A)(ii)—
that require verification of and permit challenges to collection procedures should be amended. Only failures to follow procedures required
by a statute or regulation should be judicially reviewable. Failures to
follow lesser requirements—such as those set out in the Internal
Revenue Manual—should be fodder for administrative review (to
serve the tripwire function) but not for judicial review. 436
V. REFORM AS TO PREREQUISITE TO SUIT
A. Flora “Full Payment” Rule
We need not explore whether the majority or the dissenters in
Flora II had the better of the statutory construction argument. Our
inquiry is whether the full payment rule is wise as a matter of policy.
(9th Cir. 2013); Commissioner v. Neal, 557 F.3d 1262, 1263-64 (11th Cir. 2009). The Neal
court expressly distinguished the language of § 6015(e) from that of § 6330(d)(1). Neal, 557
F.3d at 1276. But see id. at 1287 (Tjoflat, J., dissenting) (“Today, the court has given the
Tax Court the authority to second-guess the Commissioner at its whim . . . .”).
433. TREASURY INSPECTOR GEN. FOR TAX ADMIN., FISCAL YEAR 2011 REVIEW OF COMPLIANCE WITH LEGAL GUIDELINES WHEN CONDUCTING SEIZURES OF TAXPAYERS’ PROPERTY
3 (2011).
434. See I.R.C. § 7803(c)(2)(B).
435. See id. § 7803(d)(1)(A), (B).
436. Cf. United States v. Caceres, 440 U.S. 741, 756-57 (1979) (holding that the exclusionary rule does not prevent use of evidence obtained in violation of procedures set out in
the Internal Revenue Manual); see also Sandin v. Conner, 515 U.S. 472, 487 (1995) (holding that an agency regulation—a state prison regulation—did not create a protected liberty
interest entitling the affected prisoner to procedural due process protections).
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I join those who believe that it is not. 437 I.R.C. § 7422 and 28 U.S.C.
§ 1346(a) should be amended to permit refund suits to be brought
even upon partial payment of the assessed liabilities.
The full payment rule traduces the Primary Value: it blunts the
efficacy of taxpayer remedies. A full payment requirement shuts the
courthouse door to some taxpayers who have reasonable claims that
they overpaid their taxes. The Flora II dissenters explained this consequence of a full payment rule:
Where a taxpayer has paid, upon a normal or a “jeopardy” assessment, either voluntarily or under compulsion of distraint, a part
only of an illegal assessment and is unable to pay the balance
within the two-year period of limitations, he would be deprived of
any means of establishing the invalidity of the assessment and of
recovering the amount illegally collected from him, unless it be
held . . . that full payment is not a condition upon the jurisdiction
of District Courts to entertain suits for refund. Likewise, taxpayers
who pay assessments in installments would be without remedy to
recover early installments that were wrongfully collected should
the period of limitations run before the last installment is paid. 438
It is impossible to quantify the extent of this problem, but one fact
is certain and two facts are probable. It is certain that some taxpayers experience the problem. It is probable that some of those taxpayers experience significant economic distress when the problem hits
them. And it is probable that enough taxpayers experience enough
hardship that this concern is worth addressing. The four Flora II dissenters certainly thought so. They referred to “great hardships,”
“harsh injustice,” and a “grossly unfair and . . . shockingly inequitable result.” 439 Commentators have echoed the concern. 440
The Flora I majority conceded that “the requirement of full payment may in some instances work a hardship.” 441 The Flora II major437. See, e.g., Thomas Vance McMahan, Note, Income Tax—Federal Tax Court—
Election of Remedies—Federal District Court Lacks Jurisdiction of Suit for Refund of Income Tax Payments Which Do Not Discharge Taxpayer’s Entire Assessment. Flora v. United
States, 362 U.S. 145 (1960), 39 TEX. L. REV. 353, 355 (1961) (“Viewed from a policy standpoint[,] . . . [the Flora II Court] chose the less desirable of the two [options].”).
438. Flora II, 362 U.S. 145, 195-96 (1960) (Whittaker, J., dissenting) (footnotes omitted). A refund claim must be made within the later of three years after the return was filed
or two years after the tax was paid. I.R.C. § 6511(a). If the three-year period applies, the
amount that can be refunded is generally limited to the amount paid within three years
before the claim is made. Id. § 6511(b)(2)(A). If the two-year period applies, the amount
that can be refunded is limited to the amount paid within two years before the claim is
made. Id. § 6511(b)(2)(B); see also id. § 6532(a)(1).
439. Flora II, 362 U.S. at 195 & n.22, 198 (Whittaker, J., dissenting).
440. See, e.g., McMahan, supra note 437, at 355; J.Q. Riordan, Must You Pay Full Tax
Assessment Before Suing in the District Court?, 8 J. TAX’N 179, 181 (1958); Carlton Smith,
Let the Poor Sue for Refund Without Full Payment (Benjamin N. Cardozo Sch. of Law,
Working Paper No. 256, 2009), available at http://ssrn.com/abstract=1354145.
441. Flora I, 357 U.S. 63, 75 (1958).
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ity sought to alleviate the concern by maintaining that the taxpayer
so harmed should have challenged the IRS adjustments before assessment in the Tax Court. “If he permits his time for filing such an
appeal [to the Tax Court] to expire, he can hardly complain that he
has been unjustly treated, for he is in precisely the same position as
any other person who is barred by a statute of limitations.” 442
This is not a full answer to the problem. First, as proposed in Part
III.A above, this Article would expand the Tax Court’s jurisdiction.
Under current law, however, the Tax Court does not have deficiency
jurisdiction over all types of federal taxes. 443
Second, the taxpayer may not have realized until after expiration
of the Tax Court petition period 444 that the adjustments proposed by
the IRS are legally questionable. For example, the IRS’s adjustment
may have appeared correct initially but was cast into doubt by a decision handed down after the Tax Court petition period lapsed. Or, the
adjustment may have been dubious from the start, but the taxpayer
received bad advice from her lawyer or accountant, the error of which
was discovered only after the petition period ended.
Third, the taxpayer may have been unaware that a notice of deficiency had been issued, and thus unaware that the clock had started
to run on a Tax Court petition. This is especially possible for poor
taxpayers—the very ones least likely to be able to satisfy a full payment prerequisite. One highly regarded director of a low-income taxpayer clinic reported:
In my experience, some common reasons why the poor fail to receive the notice [of deficiency] are: First, the poor tend to move frequently, failing to notify either the IRS or the Post Office of address changes—particularly in cases of eviction. Second, they often
live in group housing situations where their names are not on the
mailbox, so either the Postal Service employees do not deliver the
certified notices or another household member picks up the notice
but fails to give it to the taxpayer. Third, their mail is often stolen
from mailboxes that have their locks perpetually broken. 445
In such situations, the Flora II majority’s “you should have filed a
Tax Court petition” rebuke is too harsh. 446
442. Flora II, 362 U.S. at 175.
443. See I.R.C. § 6211(a) (limiting the Tax Court’s deficiency jurisdiction to income,
estate, and gift taxes).
444. In general, the Tax Court petition must be filed within ninety days after the IRS
issues it. Id. § 6213(a).
445. Smith, supra note 440, at 3 n.7.
446. Congress has already made this value judgment (although only after Flora II was
decided). See I.R.C. § 6330(c)(2)(B) (allowing taxpayers to challenge at a CDP hearing “the
existence or amount of the underlying tax liability . . . if [she] did not receive any statutory
notice of deficiency for such tax liability or did not otherwise have an opportunity to dis-
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Sometimes, taxpayers may have an administrative remedy. For
instance, they might be able to challenge the liability via an offer-incompromise based on doubt as to liability under § 7121 or via a CDP
hearing under § 6320 and § 6330. However, such remedies will not
always be available, often for reasons similar to the reasons why Tax
Court review may be an empty remedy.
Thus, there is a Primary Value objection against the full payment
rule. Are there Second-Order Values of sufficient moment to overcome that objection? I think not.
The Flora II majority expressed three policy concerns about a partial payment rule: (1) it could encourage claims splitting, with taxpayers paying part of the liability and bringing a refund action but
challenging most of the asserted liability in a Tax Court case; (2) it
could shift cases away from the Tax Court and into district court;
and (3) it could threaten revenue collection. 447 None of these concerns
are substantial.
There are psychological and financial barriers to claims splitting.
It is nerve-wracking enough for a taxpayer to litigate against the IRS
in one case; few would have the appetite to “double their fun.” And, of
course, two cases are more expensive to prosecute than one. Were
claims to be split, the courts have tools by which to protect themselves. For example, one court can stay its case pending resolution in
the other court, then apply a doctrine of preclusion or a “show cause
order” to expedite resolution of its case. Finally, if I have underestimated the gravity of the concern, Congress could amend the jurisdictional statutes of the Tax Court or the district courts to prohibit them
from hearing matters when substantially related matters already are
at issue in other courts.
The channeling concern is diminished by this Article. When Flora
II was decided, and still today, the Tax Court was and is without
general refund jurisdiction. Part III.A above proposes giving the Tax
Court such jurisdiction. Were both proposals adopted, a taxpayer in a
partial payment world could obtain a desired refund remedy without
abandoning the Tax Court for district court. There sometimes would
be reasons—perhaps desire for a jury or better precedents—for preferring district court over Tax Court, but one may doubt that this
would occur with unacceptable frequency.
In any event, Flora II’s channeling goal is a bit dated. The Court
endorsed the Tax Court as the preferred tax trial tribunal in Dobson,
and Dobson influenced Flora II.448 Congress partially reversed Dobpute such tax liability.”).
447. Flora II, 362 U.S. at 165-66, 176.
448. See Flora v. United States, 246 F.2d 929, 931 (10th Cir. 1957) (quoting Dobson v.
Commissioner, 320 U.S. 489, 501-02 (1943)).
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son by directing that appellate courts give district court decisions no
less deference than they give Tax Court decisions.449
The threat to revenue concern is the weakest of all. A refund suit
comes after assessment. Following assessment and notice and demand for payment, the IRS is authorized to employ its full panoply of
collection tools, described in Part II.B.6 above. The filing of a refund
suit after partial payment would impose no bar to the IRS proceeding
with enforced collection of the unpaid portion of the assessment. The
IRS might choose to stay such collection in the exercise of its administrative discretion, but one must presume that the IRS would use
this discretion in a fashion consistent with its statutory duties.
Thus, any adverse Second-Order Values effects of a partial payment rule would be manageable. They do not outweigh the Primary
Value benefits of such a rule. Congress should amend the relevant
statutes to overturn Flora II.
B. Changes Not Proposed
Among the core problems of litigation generally are its cost and,
derivatively, the prospect of unequal access to justice. These problems do exist as to federal tax litigation. I make no proposals along
these lines, however, for two reasons. First, these challenges are far
from unique to federal tax litigation. They pervade many kinds of
litigation in the United States and elsewhere. Second, and more significantly, strides have been made in addressing the problems. The
IRS Appeals Office has been effective in resolving tax controversies
informally, inexpensively, and without the need for litigation. The
Tax Court’s small case procedures allow taxpayers, often appearing
pro se, to resolve cases faster and less expensively. 450 The growth of
low-income taxpayer clinics 451 and the existence of the Office of the
Taxpayer Advocate 452 have been boons to many.
A recent phenomenon has been the institution of suits against
Treasury or the IRS based, not on traditional remedies set out in the
Internal Revenue Code or related statutes, 453 but upon the general
judicial review provisions of the APA. 454 The applicability of the AIA
has been and is being tested in such “pure” APA tax suits.
449. I.R.C. § 7482(a).
450. See id. §§ 7436(c), 7463; TAX CT. R. 170-174.
451. Among the useful provisions of the RRA was federal financial support for such
clinics. See I.R.C. § 7526.
452. See id. §§ 7803(c), 7811.
453. Such as the provisions governing deficiency, refund, and CDP actions. See supra
Parts II.B.1, II.B.3, IV.B.
454. 5 U.S.C. § 706(2) (2012).
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In the Cohen line of cases, 455 for example, taxpayers used the APA
to obtain judicial invalidation of an IRS procedure for returning
overpayments of telephone excise taxes. The APA was held not to
foreclose such suit. 456 Similarly, in Oklahoma v. Sebelius, a case currently pending in district court, Oklahoma is using the APA to
challenge regulations under § 36B as to tax credits with respect
to medical insurance coverage purchased through federally established exchanges. The government has moved to dismiss, in part on
AIA grounds.457
Such “pure” APA tax suits raise potentially troubling questions
about their effect on orderly tax administration and their consistency
with the purposes behind the AIA. 458 Nonetheless, this Article refrains from offering a specific proposal in this context. There need to
be more decided cases before the reality and magnitude of the potential problems can be accurately ascertained and the contours of condign correction can be responsibly proposed.
VI. CONCLUSION
Unlike Athena, the current federal tax litigation system did not
spring full-blown from the brow of Zeus. As we have seen, it developed piecemeal over nearly two centuries, with the pace of change
being greatly accelerated by the enactment of the modern federal
income tax.
The federal tax litigation system has been especially shaped by
the Defining Dozen events and trends described above. From them,
we can infer the values that drive the system. The most powerful of
those goals—the Primary Value—is providing remedies for taxpayers
and affected third parties that are fair and effective and are perceived to be fair and effective. In situations in which this imperative
does not operate or operates only weakly, a variety of Second-Order
455. To date, there are four decisions in this line: In re Long-Distance Tel. Serv. Fed.
Excise Tax Refund Litig. (Cohen I), 539 F. Supp. 2d 281 (D.D.C. 2008), rev’d in part sub
nom. Cohen v. United States (Cohen II), 578 F.3d 1 (D.C. Cir. 2009), aff’d in part, Cohen v.
United States (Cohen III), 650 F.3d 717 (D.C. Cir. 2011) (en banc), on remand In re LongDistance Tel. Serv. Fed. Excise Tax Refund Litig. (Cohen IV), 853 F. Supp. 2d 138 (D.D.C.
2012) (holding on remand that refund mechanism established by the IRS violated the
APA’s notice-and-comment procedure requirements).
456. Cohen II, 578 F.3d at 7-11, aff’d in part, 650 F.3d at 724-27 (D.C. Cir. 2011); see
also Swisher v. United States, 2009-2 U.S. Tax Cas. (CCH) ¶ 70,293 (M.D. Pa. 2009).
457. Memorandum in Support of Defendants’ Motion to Dismiss the Amended Complaint at 16-18, Oklahoma v. Sebelius, No. 6:11-cv-00030-RAW (E.D. Okla. Dec. 3, 2012).
458. Not all pure APA tax suits implicate the AIA, at least as the AIA is currently understood. See, e.g., Loving v. IRS, 917 F. Supp. 2d 67 (D.D.C. 2013) (invalidating Treasury
regulations as to tax return preparers); Anonymous v. Commissioner, 134 T.C. 13 (2010)
(holding that the APA did not prevent the IRS from disclosing a private letter ruling adverse to the taxpayer).
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Values govern. These include protecting the revenue, enhancing decisional accuracy, and promoting process efficiency.
Based on these criteria, major portions of the current system are
sound. However, some features should be altered. In some instances,
they were unwise from the start, the result of momentary exuberances that ill serve the system over the longer haul. In other instances,
the features reasonably balanced the relevant values at the time of
their enactment or promulgation, but the constellation of pertinent
considerations has subsequently realigned.
Based on the relevant values, this Article has set out an agenda
for reform of federal tax litigation. The proposals include expanding
the tax jurisdiction of the Tax Court, abolishing the tax jurisdiction of
the Court of Federal Claims, continued rejection of a national court of
tax appeals, substantially repealing the TEFRA partnership audit
and litigation rules, limiting judicial review of CDP determinations,
and abolishing the Flora II “full payment” prerequisite to refund
suits. The agenda having been defined by this Article, it will be the
work of future articles to develop these proposals in greater detail.
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WILL THE FEDERAL INCOME TAX
HAVE A BICENTENNIAL? *
LAWRENCE A. ZELENAK †
I. INTRODUCTION..................................................................................................
II. CONSUMPTION TAXES AS INCOME TAXES, ACCORDING TO THE DISSENTING
EXPERTS ...........................................................................................................
III. THE ELUSIVE ESSENCE OF THE INCOME TAX ....................................................
IV. CONCLUSION .....................................................................................................
275
277
278
288
I. INTRODUCTION
Will there be a Florida State University Law Review symposium
issue in 2113 celebrating (or lamenting) the bicentennial of the federal income tax? In the conventional usage of tax policy wonks, “income” tax has a specific technical meaning. The defining characteristics of an income tax are that it taxes saved income (in addition, of
course, to taxing income devoted to current consumption) and that it
taxes the investment return on savings. 1 The taxation of saved income distinguishes an income tax from a consumption tax, and the
taxation of investment returns distinguishes an income tax from a
wage tax. Despite the income tax label, the federal income tax has
very significant consumption tax features, including most prominently the exclusion from the tax base of unrealized appreciation and the
long-term deferral of tax on most retirement savings. 2
To the extent the income tax really does tax income, it has been
under both academic and political assault for the past few decades.
On the academic side, as noted by Daniel Shaviro, there are signs of
“an emerging new consensus . . . that an ideal consumption tax is unambiguously superior to an ideal income tax, taking into account concerns of both efficiency and distribution.”3
* This Essay is a revised version of a portion of an earlier article. Lawrence A.
Zelenak, Foreword: The Fabulous Invalid Nears 100, 73 LAW & CONTEMP. PROBS. i, vii-xvii
(2010).
† Pamela B. Gann Professor of Law, Duke University School of Law.
1. The inclusion in the income tax base of savings and of investment returns follows
from the standard economist’s definition of a person’s income for a particular period as “the
algebraic sum of (1) the market value of rights exercised in consumption and (2) the change
in the value of the store of property rights between the beginning and end of the period in
question.” HENRY C. SIMONS, PERSONAL INCOME TAXATION 50, 61-62, 206 (1938).
2. I.R.C. §§ 1001 (indicating that gains are taxed only when realized), 219 (providing
for deferral of tax on contributions to individual retirement accounts), and 401-20 (providing rules for employer-provided pensions and individual retirement accounts).
3. Daniel Shaviro, Beyond the Pro-Consumption Tax Consensus, 60 STAN. L. REV.
745, 747 (2007). For examples of representative pro-consumption tax scholarship, see
EDWARD J. MCCAFFERY, FAIR NOT FLAT: HOW TO MAKE THE TAX SYSTEM BETTER AND
SIMPLER (2002) and Joseph Bankman & David A. Weisbach, The Superiority of an Ideal
Consumption Tax Over an Ideal Income Tax, 58 STAN. L. REV. 1413 (2006). The emerging
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On the political side, the federal income tax has been in the crosshairs of House Republicans for the last twenty or so years. In the
mid-1990s, the Chairman of the House Ways and Means Committee
repeatedly expressed his desire to “tear the income tax out by its
roots and throw it overboard.” 4 In 1998, the Republican-controlled
House of Representatives did what it could to grant his wish, voting
in favor of a bill to terminate the income tax at the end of 2002 (with
the tax to be replaced by some unspecified new federal tax). 5 More
recently, one of the two fundamental tax reform proposals offered in
2005 by President George W. Bush’s Advisory Panel on Federal Tax
Reform had so many consumption or wage tax features—including
immediate expensing of all long-lived business assets and a tremendous expansion of the availability of Roth IRA-type 6 wage tax treatment for savings—that the Panel made a point of not labeling the
proposed tax an income tax. 7
The income tax may be in no danger of being replaced by a consumption tax or a wage tax as long as any one of the White House,
the Senate, or the House of Representatives is controlled by Democrats. If, however, the survival of the income tax for a second century
depends on a Republican monopoly over Congress and the White
House never emerging at any point in the next hundred years, the
income tax would seem to be in deep trouble.
This Essay contends that the long-term survival prospects of the
income tax are better than the preceding discussion might suggest—
but not because continued taxation of savings and of investment return is anywhere close to assured. Rather, this Essay offers two
arguments demonstrating how the conventional wisdom has misunderstood what it is that makes the income tax the income tax. According to these arguments, the income tax could meaningfully be
said to have survived even if the current system were replaced by
certain forms of taxation that are not income taxes in the standard
expert usage.
consensus has certainly not gone unchallenged. Significant challenges include Shaviro,
supra, and Chris William Sanchirico, A Critical Look at the Economic Argument for Taxing
Only Labor Income, 63 TAX L. REV. 867 (2010).
4. Barbara Kirchheimer, Archer Addresses Contract Compromises and Reform, 66
TAX NOTES 1083, 1083 (1995) (quoting Rep. Bill Archer).
5. Tax Code Termination Act, H.R. 3097, 105th Cong. (2d Sess. 1998).
6. I.R.C. § 408A.
7. THE PRESIDENT’S ADVISORY PANEL ON FED. TAX REFORM, SIMPLE, FAIR, AND PROGROWTH: PROPOSALS TO FIX AMERICA’S TAX SYSTEM 163-64 (Nov. 2005), available at
http://www.treasury.gov/resource-center/tax-policy/Documents/Simple-Fair-and-Pro-GrowthProposals-to-Fix-Americas-Tax-System-11-2005.pdf [hereinafter PRESIDENT’S ADVISORY
PANEL] (describing the expensing of business assets under the “Growth and Investment
Tax Plan”).
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The first argument points out that there is significant expert dissent from the standard usage, and that according to the dissenters
some types of consumption taxes are also properly described as income taxes. The second argument (in my view the more interesting
and more important of the two) considers public understandings and
intuitions about the essence of the income tax, and concludes that—
despite the income tax label—the taxation of saved income and investment returns is rather far down the list of the defining features
of the income tax. According to this argument, if enough of the other
(and more important) defining features continued to exist after fundamental tax reform had eliminated the taxation of saved income
and investment returns, then the income tax would have survived.
II. CONSUMPTION TAXES AS INCOME TAXES, ACCORDING
TO THE DISSENTING EXPERTS
There is less-than-total agreement among experts concerning tax
base terminology; some experts apply the income tax label to tax bases that would be considered consumption tax bases under conventional usage. A little more than a century ago, the prominent economist Irving Fisher argued that income should be defined as consumption.8 Henry Simons strongly objected to Fisher’s terminology, 9 but
some later experts have followed Fisher’s lead. Consider, for example,
the title of William D. Andrew’s seminal 1974 article extolling the
merits of a cash-flow consumption tax, which would be administered
in a manner similar to the income tax, but under which all savings
would be deductible (and all spending out of savings would be taxable): “A Consumption-Type or Cash Flow Personal Income Tax.”10
Other scholars have also referred to a cash flow tax as a “consumed
income tax,” 11 despite the fact that under the standard usage a cash
flow tax is a quintessential consumption tax. In fact, this usage can
be traced back at least as far as John Stuart Mill, who claimed that
“[n]o income tax is really just from which savings are not exempted.” 12 The implication, of course, is that a tax from which savings are
exempted can still qualify as an income tax.
8. IRVING FISHER, THE NATURE OF CAPITAL AND INCOME 101-18 (1906). What is usually called income, Fisher referred to as earnings or as earned income. Id. at 332-33.
9. SIMONS, supra note 1, at 98.
10. William D. Andrews, A Consumption-Type or Cash Flow Personal Income Tax, 87
HARV. L. REV. 1113 (1974) (emphasis added).
11. See, e.g., J. Clifton Fleming, Jr., Scoping Out the Uncertain Simplification (Complication?) Effects of VATs, BATs and Consumed Income Taxes, 2 FLA. TAX REV. 390 (1995);
George K. Yin, Accommodating the “Low-Income” in a Cash-Flow or Consumed Income Tax
World, 2 FLA. TAX. REV. 445 (1995).
12. JOHN STUART MILL, PRINCIPLES OF POLITICAL ECONOMY 814 (Sir William Ashley
ed., Augustus M. Kelley Publishers 1969) (1848).
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The cash flow tax is not the only consumption tax (in standard
expert usage) to be described by some experts as an income tax. The
flat tax, designed by economists Robert E. Hall and Alvin Rabushka, 13 and formerly championed politically by Steve Forbes 14 and Dick
Armey,15 is basically a value-added tax, bifurcated into a business tax
and a wage tax. In the standard usage, it is indisputably a kind of
consumption tax. According to Hall and Rabushka, however, the flat
tax is an income tax. 16 They describe the base of the tax as a “comprehensive definition of income.” 17 Although they also describe the
base of the flat tax as consumption, 18 they avoid contradicting themselves by explaining that, in their view, an income base and a consumption base are the same thing. 19
In sum, there is a significant amount of non-standard expert usage under which at least some forms of consumption taxes—
especially cash flow taxation and the Hall-Rabushka flat tax—are
considered income taxes. Adoption of this non-standard usage would
improve considerably the long-term survival chances of the federal
income tax, as the income tax would be considered to have survived if
the current system were replaced by either a cash flow tax or the flat
tax. To be sure, improving the odds of survival of the income tax by
adopting an unconventional definition of income is not a very profound move and may even be something of a trick. A more interesting
question is whether the basic premise of this approach—the assumption that the survival of the income tax depends on the continued use
of income as the tax base—is mistaken. Perhaps the income tax label
does not capture the essence of the tax. Perhaps what makes the income tax the income tax is something other than the fact that its
base is (in a very imperfect sort of way) income. I consider that possibility in the next part.
III. THE ELUSIVE ESSENCE OF THE INCOME TAX
I suspect the public, if asked, 20 would identify five defining features of the federal income tax: (1) it is a mass tax, imposed on the
13. ROBERT E. HALL & ALVIN RABUSHKA, THE FLAT TAX (2d ed. 1995).
14. Ernest Tollerson, Bowing Out: Forbes Quits and Offers His Support to Dole, N.Y.
TIMES, Mar. 15, 1996, at A26 (summarizing the 1996 Forbes presidential campaign).
15. Freedom and Fairness Restoration Act of 1995, H.R. 2060 and S. 1050, 104th
Cong. (1st Sess. 1995) (sponsored by Rep. Armey and Sens. Shelby, Craig, and Helms).
16. Robert E. Hall & Alvin Rabushka, The Flat Tax: A Simple, Progressive Consumption Tax, in FRONTIERS OF TAX REFORM 27 (Michael J. Boskin ed., 1996).
17. Id.
18. HALL & RABUSHKA, supra note 13, at 40-41.
19. Id. at 40 (“[I]t is a comprehensive income tax (the base is GDP) with a 100 percent
immediate write-off of all business investment at the level of the business enterprise. It is a
consumption tax because it removes all investment spending from the tax base.”).
20. There has been extensive public opinion polling on a wide range of tax issues, but
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bulk of the population; (2) it is imposed directly on individuals as
taxpayers (as contrasted with the indirect effects of a retail sales tax
or a value-added tax); (3) it is imposed on inflows (receipts) rather
than on outflows (expenditures); (4) it features progressive marginal
tax rates; and (5) it uses exclusions, deductions, and credits to adjust
tax liabilities in response to various aspects of taxpayers’ economic
circumstances. Perhaps the public would also include (as the experts
would think it should) a sixth feature: (6) its base is income, as distinguished from either wages or consumption. My guess, however, is
that the sixth feature is considerably less perspicuous to the public
than the first five. Whether or not the tax base includes investment
income is of little or no personal significance to most taxpayers because most taxpayers have little or no investment income.21 Similarly, that the tax base includes some saved income is of little or no personal significance to most taxpayers, both because they currently
consume the bulk of their earnings and because most of what they do
save is excluded from their tax base under either the rules governing
qualified employment-based retirement savings or the rules governing individual retirement accounts. 22
If I am right about the public’s sense of the income tax, is the public wrong to attach greater significance to the features that do not
appear in the experts’ definition of the income tax than to the experts’ defining feature? The imagined question to the public is about
the essence of the income tax—what makes the tax what it is—not
about the source of the name of the tax. If the tax happened to be
named after its rate structure instead of its base—the “unflat tax”
instead of the “income tax”—such a change would have no effect on
the essence of the tax. It is not unusual for things to be named after
their incidental features rather than their essential features. The
fact that the office of the president of the United States is the president’s office is more important than the shape of the office, and yet it
is called the Oval Office (and that office is in the White House, the
most significant attribute of which is decidedly not its color). Similarly, the income base of the income tax might be no more important—
to the best of my knowledge there has never been any polling concerning what features of
the income tax are crucial to its identity. The absence of such polling questions is not surprising because the answers to the questions would not reveal whether the respondents
supported or opposed those features.
21. On 2006 income tax returns, solidly middle income taxpayers—with adjusted
gross incomes in the range of $75,000 to $100,000—reported taxable interest income aggregating only 2.4% of their aggregate salaries and wages, reported ordinary dividends
aggregating only 1.8% of salaries and wages, and reported capital gains (including both
capital gains distributions and net gains on sales of capital assets) aggregating only 3.0% of
salaries and wages. See Justin Bryan, Individual Income Tax Returns, 2006, STAT. OF
INCOME BULL., Fall 2008, at 5, 21-23 (calculations based on Table 1).
22. I.R.C. §§ 219 (individual retirement accounts), 401-20 (qualified employmentbased retirement savings).
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might even be less important—than the other five defining features,
despite being the source of the name.
The survival of the core of the current federal tax called the income tax does not depend uniquely on whether there continues to be
a federal tax with an income base. Some prominent scholars plausibly claim that the difference between an income base and a consumption base is of only limited significance, because (1) taxpayers can
and do avoid income taxation of risky investment returns by making
portfolio adjustments in response to the tax, and (2) the unavoidable
income taxation of the risk-free rate of return is almost trivial, given
how low the risk-free rate of return has been over most of the past
century. 23 If those scholars are right, then the income tax base may
be the least important of the defining features of the so-called income
tax. In short, it would be perfectly reasonable for the public to believe
that the taxation of income (as contrasted with the taxation of
consumption or wages) is not of the essence of the current federal
income tax.
Different proposals for substantially modifying or replacing the
current federal income tax would result in the survival of different
numbers of the six features of the current tax. The table set forth below indicates which features would persist following the adoption of
five leading reform proposals. For purposes of the table, the first two
features of the current income tax, mass taxation and direct taxation
of individuals, are combined into a single feature, mass direct taxation of individuals. This is because any plausible replacement for the
income tax would have to involve mass taxation; the interesting
question is whether that mass taxation would be direct (as with the
current income tax) or indirect (as with a retail sales tax or valueadded tax (VAT)).
The five proposals considered are (1) Michael Graetz’s proposal to
introduce a federal VAT, retaining the income tax only for those taxpayers with six-figure incomes;24 (2) the “Growth and Investment Tax
Plan” (GITP), featuring immediate deductions for the cost of all longlived business assets, proposed in 2005 by the President’s Advisory
Panel on Federal Tax Reform; 25 (3) The “flat tax” proposed by Robert
E. Hall and Alvin Rabushka, which would have two components: (a) a
23. See, e.g., David A. Weisbach, The (Non)Taxation of Risk, 58 TAX L. REV. 1 (2004).
But see Lawrence Zelenak, The Sometimes-Taxation of the Returns to Risk-Bearing Under a
Progressive Income Tax, 59 SMU L. REV. 879, 889-90 (2006) (suggesting that the historically low inflation-adjusted risk-free rates of return may not be a good indication of real riskfree rates of return in the future).
24. Michael J. Graetz, 100 Million Unnecessary Returns: A Fresh Start for the U.S.
Tax System, 112 YALE L.J. 261, 282 (2002).
25. PRESIDENT’S ADVISORY PANEL, supra note 7, at 163-64 (describing the treatment
of the cost of long-lived business assets under the GITP).
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flat-rate business tax imposed on a base identical to the base of a
VAT, except that a deduction for salaries and wages paid would be
allowed, and (b) a tax imposed on individuals, at the same flat rate,
on salaries and wages in excess of a rather high exemption level;26 (4)
a federal retail sales tax (or VAT) introduced as a complete replacement for the federal income tax; 27 and (5) a cash flow consumption
tax with progressive marginal tax rates, resembling the current income tax except that (a) all savings would be deductible and (b) all
consumption spending would be taxable (including spending financed
by savings and spending financed by borrowing). 28
Proposal
Mass
Taxation of
direct
inflows
taxation
rather than
of
outflows?
individuals?
Progressive
marginal
rates?
Significant
use of
exclusions,
deductions,
and credits?
Tax imposed
on saved
income and
investment
returns?
Number of
retained
features of
current
income tax
(1)
VAT-pluselite income
tax
no
no 29
yes 30
no 31
yes 32
2
(2)
GITP
yes
yes
yes
yes
no 33
4
26. See HALL & RABUSHKA, supra note 13, at 55-64.
27. See generally NEAL BOORTZ & JOHN LINDER, THE FAIRTAX BOOK: SAYING
GOODBYE TO THE INCOME TAX AND THE IRS (2005) (arguing that the federal income tax
should be replaced by a federal retail sales tax).
28. See, e.g., MCCAFFERY, supra note 3. Edward McCaffery has been the leading academic advocate of such a system. Id.
29. The elite income tax would continue to tax inflows, but for most people the relevant tax would be the outflow-taxing VAT.
30. Graetz proposes a single rate for the income tax imposed on six-figure incomes.
Graetz, supra note 24, at 284-86. Viewing the VAT and the elite income tax as an integrated system, however, the combined rate of the VAT and the income tax (applicable to highincome persons) would be higher than the stand-alone rate of the VAT (applicable to lowincome and moderate-income persons).
31. The “no” characterization is debatable. The elite income tax would retain deductions for home mortgage interest, charitable contributions, and medical expenses, and a
replacement for the earned income tax credit (EITC) for low-income workers would be introduced into the payroll-tax system. Graetz, supra note 24, at 295-96 (income tax deductions), 290-93 (EITC replacement). However, for the majority of the population neither
eligible for the EITC replacement nor subject to the income tax, the “no” characterization
would clearly be correct.
32. The “yes” characterization is debatable, because tax would not be imposed on the
saved income and investment returns of the majority of the population not subject to the
elite income tax. On the other hand, the bulk of saved income and investment returns
would belong to the minority of taxpayers subject to the income tax, so the “yes” characterization seems appropriate.
33. Actually, the GITP would retain a sort of residual tax on investment returns—a
15% tax rate applicable to dividends, capital gains, and interest. PRESIDENT’S ADVISORY
PANEL, supra note 7, at 152, 159. The panel considered this residual taxation insufficient
to justify describing the GITP as an income tax, id., and that judgment seems reasonable.
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Proposal
(3)
The flat tax
(4)
Sales tax
(or VAT)
Mass
Taxation of
direct
inflows
taxation of rather than
individuals? outflows?
[Vol. 41:275
Progressive
marginal
rates?
Significant
use of
exclusions,
deductions,
and credits?
Tax imposed
on saved
income and
investment
returns?
Number of
retained
features of
current
income tax
yes
yes
no 34
no 35
no
2
no
no
no 36
no
no
0
yes
yes
yes
yes
no 37
4
(5)
Progressive
cash flow
tax
As indicated in the right-hand column of the table, two of the proposals that would be considered non-income tax proposals under the
standard usage of tax experts—the GITP and the progressive cash
flow tax—retain four of the five defining features of the current income tax. A proposal that would be considered an income tax proposal under standard expert usage—the VAT-plus-elite-income-tax—
retains only two of the five defining features.
Of course, a glance at the numbers in the right-hand column is not
sufficient to determine whether the current federal income tax would
persist in essence, even if not in name, if a particular reform proposal
were adopted. It would not necessarily be right to conclude that the
essence of the current tax system survives when the replacement system retains at least three of the five defining features of the current
system and that the essence does not survive when the replacement
34. Although the flat tax as proposed by Hall and Rabushka has only one positive tax
rate, HALL & RABUSHKA, supra note 13, the exemption allowance under the wage tax portion of the flat tax functions as a zero bracket. Thus, the tax can be understood as really
featuring two tax brackets—a zero-rate bracket and a positive-rate bracket. In addition,
the structure of the wage-tax portion is readily adaptable to the introduction of any number of progressive marginal rates, if Congress should so desire. See David F. Bradford,
What are Consumption Taxes and Who Pays Them?, 39 TAX NOTES 383, 384-86 (1988) (describing the “X tax” under which progressive marginal rates would apply to the wage-tax
portion of the flat tax).
35. Although the flat tax as proposed by Hall and Rabushka does not allow any deductions (other than the personal allowances designed to shelter subsistence-level income from
the wage tax), HALL & RABUSHKA, supra note 13, there would be no technical difficulty in
introducing exclusions, deductions, and credits into the wage-tax portion of the flat tax.
36. The Boortz and Linder sales tax proposal features a “prebate”—a universal refund
of the sales tax on subsistence consumption—which mimics the effect of a tax with a zero
rate on subsistence consumption and a single positive rate on above-subsistence consumption. BOORTZ & LINDER, supra note 27, at 81-90.
37. McCaffery explains that a progressive cash flow tax will impose a burden on the
returns to saving of a taxpayer who saves in a low-consumption year to finance a high level
of consumption in a later year. Edward J. McCaffery, A New Understanding of Tax, 103
MICH. L. REV. 807, 814-15 (2005).
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system retains two or fewer of those features. Mere counting is inadequate both because it is not clear that all features are equally significant 38 and because in many cases it is debatable whether a replacement should or should not be characterized as retaining a particular
feature (a problem suggested by the footnotes to nine of the twentyfive yes-or-no answers in the table).
The question of whether the income tax should be considered to
have survived the enactment of these various proposals finds an analogue in Derek Parfit’s analysis of the survival (or not) of personal
identity over time. 39 For Parfit, continued personal identity is a matter of two things.40 The first is direct psychological connectedness of
memory and of other psychological features, such as intention, belief,
and desire. 41 There is a direct memory connection (for example) between Z today and X of twenty years ago if Z can remember having
had some of X’s experiences. Parfit emphasizes that “[c]onnectedness
can hold to any degree.”42 The second element of continued personal
identity is psychological continuity—“the holding of overlapping
chains of strong connectedness.” 43 Even if Z remembered none of X’s
experiences (so that there was no memory connectedness between Z
and X), there would be memory continuity if Y of ten years ago remembered many of X’s experiences, and Z today remembers many of
Y’s experiences. Because direct connectedness diminishes over time,44
personal identity also weakens over time. Parfit argues that in some
cases of significant reduction in direct connectedness identity is not
determinate. In such a case, “it would be an empty question whether
the resulting person would be me.” 45 Similarly, although we can confidently conclude that the income tax survives when Congress tinkers
38. As shown in the table, the flat tax has only two of five income-tax-like features.
Although the presence of only two features suggests the flat tax is not an income tax, that
conclusion is not inevitable if one puts considerable weight on those features, or on some
feature not included in the table. Former Ways and Means Committee Chairman Bill
Archer wanted to replace the income tax with a federal retail sales tax or VAT. Clay Chandler, Archer Calls for End to Income-Based Tax; Lawmaker Wants Levy Tied to Consumption, WASH. POST, June 6, 1995, at D1. Archer’s opposition to income taxation extended to
the Hall-Rabushka flat tax because he viewed it as a type of income tax: “In my common
sense, if your wages are going to be taxed before you get them, that’s an income tax.”
Jacqueline Rieschick, March Madness Spurs Trash Talk on Tax Reform, 78 TAX NOTES
1209, 1210 (1998) (quoting Rep. Bill Archer). Archer’s remark suggests that, for him, withholding at the source was the essence of income taxation.
39. DEREK PARFIT, REASONS AND PERSONS 199-347 (1984). For a more detailed summary of Parfit’s analysis (on which this paragraph is based), see Lawrence Zelenak, Tax
Policy and Personal Identity Over Time, 62 TAX L. REV. 333, 338-43 (2009).
40. PARFIT, supra note 39, at 205-07, 262.
41. Id.
42. Id. at 206.
43. Id.
44. See id. at 276-77, 306.
45. Id. at 239.
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with the tax rate schedules, and that it would not survive if replaced
by a retail sales tax, there may be no real answer to the question of
whether it would survive in some of the intermediate cases.
Subject to all of these qualifications and caveats, however, it
would be at least plausible to conclude both (1) that the essence of
the current federal income tax would survive the adoption of either
the GITP or a progressive cash flow tax (despite the loss of the experts’ income tax label in both cases), and (2) that the essence of the
current federal income tax would not survive the adoption of the
VAT-plus-elite income tax (despite the survival of a tax with an
income base).
If one accepts the multi-feature account of the essence of the current federal income tax system (despite its undeniable lack of precision), how would one evaluate the system’s long-term prospects?
Crystal ball gazing a century into the future may be a hopeless exercise. Who, in 1913, could have predicted the events—from the Great
Depression, to World War II and the Cold War, to the Reagan Revolution—that shaped the development of the income tax in its first
century? And who has any idea today what the United States will be
like in 2113? (How much of it, for example, will be under water?) Less
ambitiously, however, it may be possible to make meaningful prognostications over the next decade or two.
The survival of the income tax over that shorter time frame is
likely under the multi-feature approach to defining survival. By contrast, the survival of the income tax would be very doubtful under an
approach focused exclusively on the propriety (according to the usual
terminology of experts) of the continued use of the income tax label.
Income as a tax base may be in serious trouble over the next few decades. The George W. Bush Administration repeatedly proposed “Retirement Savings Accounts” (RSAs) and “Lifetime Savings Accounts”
(LSAs) that would have greatly expanded the availability of wage tax
treatment for savings. 46 The long-term strategy seemed to be a sort of
slouching away from an income tax base, culminating in a tax system
with too little remaining taxation of investment income to be fairly
described as an income tax. Although the Bush Administration did
not achieve this goal, and the Obama Administration has shown no
interest in pursuing it, it is easy to imagine future administrations
46. See, e.g., Patti Mohr, White House Begins Selling Its Tax Cut to Congress, 98 TAX
NOTES 631, 633-34 (2003); U.S. DEP’T OF THE TREASURY, GENERAL EXPLANATIONS OF THE
ADMINISTRATION’S FISCAL YEAR 2007 REVENUE PROPOSALS 5-10 (2006), available at
http://www.treasury.gov/resource-center/tax-policy/Documents/General-ExplanationsFY2007.pdf. Contributions to RSAs and LSAs would not have been deductible, but the
investment returns would have been permanently tax-exempt. The Bush Administration’s
RSA and LSA proposals were the inspiration for the “Save for Retirement” and “Save for
Family” account proposals of the President’s Tax Reform Panel. PRESIDENT’S ADVISORY
PANEL, supra note 7, at 119-21, 159.
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285
and Congresses—particularly Republican ones—reviving RSA and
LSA proposals and perhaps prevailing. A tax reward for thrifty savers has obvious political appeal, and the incrementalism of the approach is more likely to succeed than any attempt to eliminate all
vestiges of an income tax base in one fell swoop. And although there
may be only an attenuated connection in the tax arena between intellectual movements and political outcomes, it is also noteworthy (as
mentioned earlier) that income as a tax base has lost much of its
support among tax policy experts in the past few decades. 47 All things
considered, then, the long-term survival chances for income as the
tax base are not particularly good.
By contrast, the long-term survival chances for the other defining
features of the current income tax—mass direct taxation of individuals; taxation of inflows rather than outflows; significant use of exclusions, deductions, and credits; and a modestly progressive marginal
tax rate structure—seem quite good. As Michael Graetz has wryly
observed, in recent years
Congress ha[s] used the income tax the way [his] mother employed
chicken soup: as a magic elixir to solve all the nation’s economic
and social difficulties. If the nation has a problem in access to education, child care affordability, health insurance coverage, or the
financing of long-term care, an income tax deduction or credit is
the answer. 48
As Graetz explains, the attraction is bipartisan; Republicans like almost any tax cut, and Democrats realize their favorite spending programs are more politically viable as tax expenditures than as direct
expenditures.49 Moreover, members of the House Ways and Means
and Senate Finance Committees can increase their campaign contributions by sending the message that they are always open to the enactment of new tax subsidies. 50 And the administrative costs of delivering subsidies through the income tax are generally much lower
than the administrative costs of delivering nontax subsidies. 51
In short, Congress seems hopelessly addicted to the extensive use
of exclusions, deductions, and credits in lieu of direct spending pro47. See supra note 3 and accompanying text.
48. Graetz, supra note 24, at 274.
49. Id. at 275.
50. Milton Friedman, Remarks at the Sixth Meeting of the President’s Advisory Panel
on Federal Tax Reform 117-18 (Mar. 31, 2005); Richard L. Doernberg & Fred S.
McChesney, On the Accelerating Rate and Decreasing Durability of Tax Reform, 71 MINN.
L. REV. 913, 914 (1987).
51. See, e.g., Janet Holtzblatt, Choosing Between Refundable Tax Credits and Spending Programs, 93 PROC. ANN. CONF. ON TAX’N 116, 122 (2001) (comparing the substantial
direct administrative costs of the food stamp program with the minimal direct administrative costs of the earned income tax credit).
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[Vol. 41:275
grams—and thus also addicted to the existence of mass direct taxation of individuals’ inflows as the vehicle for the delivery of subsidies.
By now, the addiction seems so strong that even if (in some alternate
universe) there were no need for a revenue-producing direct mass
tax, Congress might opt for a zero-revenue direct mass “tax” solely
for its usefulness as a vehicle for delivering subsidies. There might
never have been a direct mass tax, 52 but once such a tax was enacted
and Congress discovered the joys of tax expenditures, the elimination
of direct mass taxation became very unlikely.
The survival of progressive marginal rates does not seem quite as
assured as the survival of tax expenditures and the direct mass taxation of inflows. The intellectual foundation of progressive marginal
tax rates has been undermined by optimal-tax analysis. The objective
of optimal-tax analysis 53 is to determine what marginal tax rate
structure, in combination with a system of universal cash transfers,
will maximize a chosen social welfare function (SWF) 54 under various
assumed conditions (relating to the distribution of wage-earning abilities in society, the elasticity of the labor supply, and the rate at
which the marginal utility of money declines). Different optimal-tax
simulations, based on different factual assumptions and using different SWFs, can produce very different levels of transfer payments and
very different levels of taxation. However, as a leading optimal-tax
scholar has explained, “One of the main conclusions to be drawn from
the Mirrleesian optimal non-linear income tax model is that it is difficult (if at all possible) to find a convincing argument for a progressive marginal tax rate structure throughout” the societal wage distribution. 55 As in the case of the shift in expert opinion concerning the
52. See Lawrence A. Zelenak, The Federal Retail Sales Tax that Wasn’t: An Actual
History and an Alternate History, 73 LAW & CONTEMP. PROBS. 149 (2010) (describing how
during World War II Congress might have chosen a federal retail sales tax—rather than an
expansion of the income tax—as the tool of mass taxation, but for the Roosevelt Administration’s unwavering opposition to a sales tax).
53. See, e.g., MATTI TUOMALA, OPTIMAL INCOME TAX AND REDISTRIBUTION (1990) (a
comprehensive monograph on optimal income taxation); J.A. Mirrlees, An Exploration in
the Theory of Optimum Income Taxation, 38 REV. ECON. STUD. 175 (1971) (the seminal
work in the field); Lawrence Zelenak & Kemper Moreland, Can the Graduated Income Tax
Survive Optimal Tax Analysis?, 53 TAX L. REV. 51 (1999) (including a nontechnical introduction to optimal income tax analysis).
54. An SWF specifies how the well-being of individuals contributes to the overall wellbeing of society. A simple utilitarian SWF, for example, values equally the well-being of
each member of society. At the other extreme, a maximin social welfare function (commonly associated with the political philosophy of John Rawls) is concerned solely with the wellbeing of the least well-off members of society. JOHN RAWLS, A THEORY OF JUSTICE 75-83,
152-56 (1971).
55. TUOMALA, supra note 53, at 14. For a wide range of factual assumptions and
SWFs, optimal tax rate structures feature rising marginal rates through the bottom decile
of the wage distribution and falling marginal tax rates through the remaining nine deciles.
Id. at 95-99. But see Zelenak & Moreland, supra note 53, at 62-71 (demonstrating that
optimal tax analysis does support progressive marginal tax rates in the absence of univer-
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287
relative merits of income taxation and consumption taxation, it is
difficult to predict how much, if at all, a change in academic views
will influence political outcomes.
Public attitudes toward progressive marginal rates are probably
more important politically than the views of academics. In this regard it is noteworthy that Robert E. Hall and Alvin Rabushka, the
developers of the particular consumption-tax proposal known as the
flat tax, were sufficiently persuaded of the political attractiveness of
a single (“flat”) rate that they named their tax after its rate structure, rather than following the nearly universal approach of naming
taxes after their bases. 56 On the other hand, opinion polling indicates
considerable public support for progressive tax rates, 57 and in the almost three decades since the flat tax was originally proposed 58 neither
the Hall-Rabushka tax nor any other single-rate tax has even come
close to enactment as a replacement for the current federal income
tax. The George W. Bush Administration, for example, demonstrated
no interest in eliminating progressive marginal tax rates, in marked
contrast with its strong interest in moving toward a consumptiontax base.59
Moreover, it is debatable whether the Hall-Rabushka proposal
and other proposals for taxes with a single positive rate are accurately described as flat-rate tax proposals. In fact, the wage-tax portion of
the Hall-Rabushka proposal (like most other so-called single-rate
proposals) actually features two tax rates: a zero rate on subsistencelevel wages produced by “a generous personal allowance” in the wage
tax, and one positive rate imposed on above-subsistence wages. 60 Hall
and Rabushka do not think this prevents their tax from being flat. In
this respect they are intellectual heirs of Walter Blum and Harry
Kalven, who argued that a tax applying a single positive rate above
an exemption level was different in kind, rather than merely in degree, from a tax with multiple positive rates—so much so that they
sal cash transfers and arguing that universal cash transfers are politically unrealistic in
the United States).
56. See HALL & RABUSHKA, supra note 13.
57. See KARLYN BOWMAN & ANDREW RUGG, AM. ENTER. INST., PUBLIC OPINION ON
TAXES: 1937 TO TODAY 34 (2012) (reporting results of a 1981 Harris poll in which a majority of respondents found it was “fair” that “higher-income people not only have to pay more
in taxes but must pay a greater percentage of their income in taxes,” and of a 2005
AP/Ipsos poll in which a majority of respondents thought that those “who earn more money
should pay a higher tax rate on their incomes than people who earn less”).
58. HALL & RABUSHKA, supra note 13 (first edition published in 1985).
59. The Executive Order creating the President’s Advisory Panel on Federal Tax Reform instructed the Panel that its proposals should be “appropriately progressive.” Exec.
Order No. 13,369, 70 Fed. Reg. 2323 (Jan. 7, 2005). By contrast, the order indicated the
Panel could offer one or more non-income tax proposals, as long as it offered “[a]t least one
option . . . us[ing] the Federal income tax as the base for its recommended reforms.” Id.
60. HALL & RABUSHKA, supra note 13, at 53-54.
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gave the single-positive-rate tax its own adjective, “degressive.” 61 Despite the protestations of Hall, Rabushka, Blum, and Kalven, a tax
featuring a single positive rate above an exemption level has both of
the features essential to a progressive marginal tax rate structure:
the existence of more than one tax rate, and the application of the
higher rate(s) to higher levels of income.
A forecast limited to the next few decades might predict that (1)
the survival of progressive marginal tax rates in the narrower sense
of the term—requiring the existence of at least two positive rates of
tax—is probable, and (2) the survival of progressive marginal tax
rates in the broader sense of the term—as including the “degressive”
rate structures of Blum and Kalven—is nearly certain.
IV. CONCLUSION
Summing up the life expectancies of the major features of the existing income tax: Although the income tax base is in considerable
peril, three of the other features—mass direct taxation of individuals,
taxation of inflows rather than outflows, and the continued availability of an array of exclusions, directions, and credits—are almost certain to survive for decades, and the final feature—progressive marginal rates—is more likely than not to survive. If the income tax base
disappears, but three or four of the remaining features persist, would
the resulting tax still be the income tax? Reasonable minds can differ
on the answer to that question. There is much to be said, however, in
favor of a “yes” answer. The survival of an income base, as contrasted
with a consumption base or a wage base, may not be necessary to the
survival of the core of the current federal income tax. There is no objective way of determining something as amorphous as the essence of
a tax system, so there is no reason to expect a consensus as to whether the essence of the income tax would have survived in various possible futures. The argument offered here is negative at its core—not
in favor of any particular view of the essence of the current federal
income tax, but against the assumption that the “income tax” label
captures the essence of the tax.
My focus is on the survival of essential features, not of labels; but
it would not be surprising if the income tax label, as well as the income tax essence, survived the decline and fall of the income tax
base. Suppose that over the next few decades Congress gradually
slouched away from an income tax base, eventually arriving at a
point at which the tax base could no longer be fairly described as income (at least according to standard expert usage), but without disturbing the other key features of the current system. It would be rea61. Walter J. Blum & Harry Kalven, Jr., The Uneasy Case for Progressive Taxation,
19 U. CHI. L. REV. 417, 506-16 (1952).
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sonable to conclude that the core of the current tax system had survived, even if tax experts would say the tax was no longer an income
tax. It also seems likely that the income tax label would survive the
gradual dismantling of the income tax base. A cynic might attribute
the survival of the income tax label to the boiling frog effect—just as
urban legend claims that a frog will allow itself to be boiled to death
as long as the water temperature is raised gradually, 62 perhaps the
income tax label can endure as long as the income tax base is gradually eroded. But the label might also survive for a better reason. The
income tax label may come to be understood nonliterally as a shorthand reference to the several key features of the current tax system,
rather than as a literal description of the base of the tax. There are
instances of things being named after nonessential features, losing
those nonessential features, and retaining their names—think of the
nongreen greenrooms of television fame 63 or (for tax aficionados) the
nonblue bluebooks produced by the Staff of the Joint Committee on
Taxation.64 Perhaps the income tax is destined to become another
example of that phenomenon.
62. See, e.g., Paul Krugman, Boiling the Frog, N.Y. TIMES, July 13, 2009, at A19 (“Real frogs will, in fact, jump out of the pot—but never mind. The hypothetical boiled frog is a
useful metaphor . . . .”).
63. See William Safire, The Greenroom Effect, N.Y. TIMES, Apr. 23, 1989, at SM16
(explaining that the use of the term in the theater predates the advent of television by
several centuries, that the term may or may not have been based on the wall color of early
greenrooms (the origins of the term are lost in the mists of time), and that the term is routinely used today even when nothing in a particular greenroom is actually green).
64. Bluebooks are prepared by the Staff of the Joint Committee on Taxation to describe recently enacted tax legislation. See, e.g., STAFF OF JOINT COMM. ON TAXATION,
111TH CONG., GENERAL EXPLANATION OF TAX LEGISLATION ENACTED IN THE 110TH
CONGRESS (Comm. Print 2009). Their covers are frequently gray, but that does not affect
their status as bluebooks.
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