Category Archives: Default

Note to all the Howard Schultz types out there

Sometimes bipartisan legislative ideas can be despicable. A case in point is the provision in the Taxpayer First Act that, as ProPublica explains here, would “make it illegal for the IRS to create its own online system of tax filing. Companies like Intuit, the maker of TurboTax, and H&R Block have lobbied for years to block the IRS from creating such a system. If the tax agency created its own program, which would be similar to programs other developed countries have, it would threaten the industry’s profits.”

It’s true that the IRS is still, to say the least, not very computer-savvy. (But this is largely Congress’s fault for underfunding it, whatever internal institutional issues may have contributed negatively as well.)  But it’s not true that a well-designed program would, e.g., undermine taxpayer confidentiality. The idea would be to create pre-populated tax returns based on information that the IRS already has, and that taxpayers could modify as needed.

And if the companies believe that taxpayers have good reason to pay for an independent service, rather than using a free pre-populated return from the IRS, let them do what businesses that have a worthwhile product usually do: that is, offer to sell it. Suppressing a free alternative that the nation’s taxpayers have already effectively paid for amounts to making them pay for the same thing twice: first as taxpayers, and then again as Intuit customers.

Senator Warren’s “Real Corporate Profits Tax” proposal

Senator Elizabeth Warren has unveiled a proposal for what she calls the Real Corporate Profits Tax, the initial details of which can be found here. Basically, it’s a second tax system – but not an alternative minimum tax – that applies to companies (currently about 1,200 in number) that report more than $100 million in profits for a given year. The Real Corporate Profits Tax would impose tax, at a 7 percent rate, on financial accounting profits – such as those reported under GAAP by public companies – to the extent in excess of $100 million.

As Senator Warren notes, recently “Amazon reported more than $10 billion in profits and paid zero federal corporate income taxes. Occidental Petroleum reported $4.1 billion in profits and paid zero federal corporate income taxes.” Under her plan, “Amazon would pay $698 million in taxes instead of paying zero. And Occidental Petroleum would pay $280 million in taxes instead of paying zero.”

Such disparities between the income and accounting measures are multicausal. Sometimes there are just timing swings between years. Also, the income tax allows net operating losses (whereby loss years can offset the tax due in gain years), as in the case where a company loses $10 billion in Year 1 and makes $10 billion in Year 2. The financial accounting measure is for worldwide income, including that earned abroad through foreign subsidiaries. But also, the managers of publicly traded companies notoriously, at least in some cases, engage in complicated maneuvers to raise financial accounting income while lowering taxable income. The latter is likely to be in the shareholders’ interest but not necessarily the country’s. The former serves managerial goals but is potentially harmful to the aims of financial accounting, which is supposed to provide the capital markets with reliable information.

I gather that the proposal may also attempt to discern and tax inbound, U.S. source profits by foreign corporations, as measured for financial accounting purposes, and subject them to the tax as well.

I have long thought that the interplay between corporate managers’ sub-optimal incentives – i.e., to inflate financial accounting income and unduly reduce taxable income (such as through aggressive tax avoidance transactions) – creates a potentially fruitful opportunity for the U.S. federal income tax system to graze two birds with one stone. If managers have difficulty doing both at the same time – e.g., if raising financial accounting income has adverse tax consequences for them – it’s possible that the overall incentives that they face will be improved. It’s true that this creates pressures on financial accounting choices that, all else equal, would be undesirable. But financial accounting experts who make this point – and they tend, in my experience, to hate proposals of this kind! – need to consider as well the fact that this bias may potentially offset an opposite bias that they know quite well is there.

In sum, while financial accounting is not inherently well-designed as an income tax base, its use in a very secondary fashion, a la the Warren proposal with its 7% rate (I might prefer 5%) and its $100 million exemption amount (which I’d consider increasing), has the virtue of offsetting existing imperfections in both systems. One danger, however, is that having tax consequences depend on financial accounting would cause interest groups, through Congress, to bring their dark arts more to bear than they have already on distorting how financial accounting income is measured.

I discuss these sorts of issues in this article, the final version of which appeared (here, but possibly behind a paywall for some readers?) in the Georgetown Law Journal.

One issue to think about in relation to the Real Corporate Profits Tax is the equivalent of income averaging. E.g., what should be the result if a company has, say, $80 million of reported profits in Year 1, $200 million in Year 2, and $80 million in Year 3. Should the company just pay $7 million (i.e., 7% of the excess over $100 million) in Year 2? Should there be an adjustment in Year 2 for Year 1? In Year 3 for Year 2?

People in the Warren campaign asked me what I thought about the proposal, and I replied as follows:

“This is a serious proposal that has a lot of merit, and that deserves further debate. It addresses several problems at once – in particular: (1) the excessive size of the unfunded corporate tax cut that Congress enacted in 2017, (2) possible under-taxation of both outbound investment by U.S. firms and inbound investment by foreign firms, and (3) the socially undesirable incentive that public companies’ managers have to overstate their companies’ book earnings.

“It also has the potential to raise revenue from the upper tier of the corporate sector without putting Congress even further into the business of picking winners and losers as between industries, and without magnifying the importance of existing distortions in the corporate tax base.”

Tax policy colloquium, week 11: Steve Bank’s “Manufacturing Tax Populism: Revisiting the 1962 Campaign Against Dividend and Interest Withholding”


Yesterday at the colloquium, Steve Bank of UCLA Law School (a former Chicago student of mine, way back in the day) presented a tax history paper concerning an interesting episode in modern U.S. tax law: the failed effort by the Kennedy Administration, as part of what became the 1962 tax act, to enact withholding for people’s dividend and interest income, in response to substantial under-reporting. The effort failed due to unexpectedly intense opposition from members of the general public whom the banks successfully riled up and organized into what was apparently a genuine, not merely Astroturf, grass roots opposition movement. Faced with this level of unusual public upset, Congress settled for expanding information reporting, although it would be some time before the IRS would have the ability to make much use of this resource (which nonetheless over time led to increased compliance).
The article isn’t posted because it’s an early draft. It will be a chapter in a larger book concerning a U.S. change in social norms towards greater respectability and acceptance for aggressive tax avoidance behavior. One might view this as a likely consequence of the income tax’s becoming a “mass tax” rather than just a “class tax” on the rich, during World War II. But the change in norms was lagged and perhaps related to broader cultural trends, such as the Vietnam / Watergate / inflation decade-plus of gloom that looks sunny now by our standards, along with the Republican-led shift in political norms starting with Reagan.
Case studies like this don’t need policy payoffs to be interesting – I find them so for their own sake. But three topics in particular struck me as of particular interest here, from the standpoint of conducting a tax policy seminar.
1.         TAX POLITICS
The 1962 “rebellion” against dividend and interest withholding mainly took the form of a flood of letters, postcards, phone calls, et al to Congress, complaining about the dividend and interest withholding proposal. The banks (along with dividend-paying public companies) hated the proposal, at least in part because they would need to incur the costs of administering it, and perhaps also because it helped them attract customers if non-reporting meant that they were in effect offering people tax-free income. Their efforts to get customers, depositors, shareholders, etc. to protest bore fruit to an extent that possibly startled them, and that showed the proposal was touching a nerve (albeit augmented by deliberate misinformation that the banks were happy to spread).
The 1962 act was mainly tax cut legislation, with the investment tax credit as a centerpiece. Its main “populist” feature – a term the paper uses, and that I’ll further discuss below – was a proposed sharp cutback on deductibility for business meals and entertainment. That effort, by the way, in my view largely failed. Congress enacted a new Code provision, section 274, shot through with provisions limiting business meal and entertainment deductibility, but JFK had proposed outright repeal for a lot of the stuff, and instead Congress just put in a bunch of toothless rules about its not being “lavish and extravagant,” and being “directly related” or some such thing to the pursuit of a particular business deal. (Probably the most efficacious new provision was one requiring greater substantiation of these sorts of expenses, rather than allowing them to be estimated.)
Well yes, it's true that JFK said “the three martini lunch must pass from the scene,” or some such thing, and that indeed it has, but I think we can agree that the causation was otherwise.
Anyway, back to dividend and interest withholding. It was a partial pay-for, meant to reduce the overall cost of the act by increasing compliance (rather than enacting a new tax of any sort). It would have had a flat 20% withholding rate, meaning that rich people would still owe more and some at the low end would need to file income tax returns so they could claim refunds. But the resistance to it was “populist,” in the sense that it took the form of: Why is the Administration going after us, mere pikers when it comes to tax avoidance or evasion, when so many rich people and big corporations are getting away with murder? Go after them first, if you’re going after anyone!
Since Congress backed off – albeit, expanding information reporting rather than doing nothing – this is a rare case in which members of the general public affected political outcomes. But it involved the main such vein in which the public does at times influence legislative outcomes. (Let’s note, of course, the point, that the people who protested here weren’t “the public” in the sense of everyone – they were a particular group, albeit one outside the usual corridors of influence.)
To put this outcome in perspective, it’s useful to consider recent political science research about the question of whose preferences affect U.S. political outcomes. A 2014 paper by Martin Gilens and Benjamin Page has a neat chart showing the effects on the probability of a policy’s being adopted changes as support for it rises among (a) average citizens, (b) economic elites, and (c) organized interest groups.
For (a), the general public, the line is flat – rising public support for a proposal from 0 towards 100% has almost no effect whatsoever on the likelihood of adoption. Well-known recent examples would include, e.g., the preference even among Republican voters for increasing taxation of the rich, and the public’s support for addressing climate change.
By contrast, rising support for a proposal by either economic elites or interest groups has a very sharp upward-sloping effect on the likelihood of policy adoption.
Of course, we knew this already. So why was something like interest and dividend withholding in the 1962 act different?
This is by no means a unique episode. Consider, for example, public opposition to Treasury proposals some decades later to (a) require contemporaneous “auto logs,” documenting people’s claims to have used their cars for business, and (b) crack down on people’s making personal use of frequent flyer miles that had been earned through deductible or reimbursed travel. There are plenty of other examples as well from recent decades.
In each of the above three cases, the outrage was generated by policymakers’ efforts to change the status quo on the ground by collecting taxes that were legally due but not being paid. And in each case the proposal would have imposed compliance burdens, in addition to requiring people to pay more than they had become used to paying. Each time this stimulated defensive pushback, focusing both on the compliance burden and on the “unfairness” of targeting decent and hardworking regular folks, etc.
The lesson that I’d derive from this for policymakers, if I were advising them on how to get what they want without arousing general public opposition, could be called “Don’t wake the sleeping baby.” You can do whatever you like in the next room while the baby is sleeping, as long as you don’t start banging gongs (or whatever) in a manner that will rouse it from its slumbers. Changing settled practice and imposing confusing and anxiety-creating compliance burdens is a good example of unduly banging gongs.
But most of the time the baby sleeps quite soundly. Consider the DC legislative process since Trump took office. The public has had very little influence on any of it, with one exception – the attempted repeal of the ACA. That indeed roused public pushback that, by the barest of margins, led to the effort’s failure. (Several Republican Senators were uneasy about voting to take away health insurance from millions of their own voters, but even so the thing nearly happened.)
The public had next to no discernible impact on the passage or content of the 2017 tax act. That was an inside-the-Beltway process on both sides. Probably the most widely noted provision was reducing state and local tax deductions, which may have helped lose a few blue state Republicans their seats the next year. But that was a narrow yet salient adverse change (its effect perhaps overestimated by voters who were previously subject to the alternative minimum tax), and of course recently we’ve seen news about how people can’t tell apart the 2017 act’s actual impact on their liabilities from its apparent impact, the latter being based on what refunds they get, net of changes to withholding.
2.         TAX POPULISM
The paper views the 1962 outcome as to dividend and interest withholding an example of “tax populism,” because discontent so focused on the issue: Why go after us, when the rich and big corporations are getting away with so much more than we are?
BTW, the rich certainly were “getting away” with a lot in those days, in the sense that there was a 91% statutory rate that almost no one was actually paying. There has been a shift since then towards lowering the statutory rate but also requiring that rate to be closer than it was in 1962 to the actual effective rate. In effect, the regime then was: We’ll have very high rates as a kind of public statement, but we’ll tolerate all sorts of devices, a great many of them unambiguously legal, to avoid actually imposing those rates.
But is this “tax populism”? Two particular thoughts on this topic:
(a) If this is populism, it’s very limited and pretextual – People aren’t saying: “Go after tax avoidance by the rich!” They’re saying: “Don’t go after us UNTIL you’ve done that first!” But this is unaccompanied by any strong appetite for actually doing the latter.
Strange as it may seem today, that era’s closest Democratic Party equivalent to, say, Elizabeth Warren or Bernie Sanders today was the Minnesota senator Hubert Humphrey. Among the era’s most progressive mainstream politicians on racial justice issues, Humphrey had long been waiving the era’s more truly “populist” banner for what was then called tax reform. He wanted to attack the era’s income tax preferences that, say, favored the oil industry, or kept effective rate for high-income individuals so far below the top statutory rates.
(As an aside, “tax reform” then meant base-broadening so that the rich and corporations would pay more. In the 1980s, it came to mean instead revenue-neutral and distribution-neutral base-broadening plus rate cuts. In the 2010s, it came to mean absolutely nothing at all.)
Anyway, my sense is that Humphrey never got much mileage out of this tax and other left-populism, either personally or politically. Tax reform in its first manifestation never got too far, in part because the sleeping baby really didn’t care much after all. The scaling back of the 1962 effort to address three martini lunches et al then taught the same lesson.
As for Humphrey himself, JFK famously crushed him in the 1960 West Virginia Democratic primary, being handsomer and far better funded. After that Humphrey, in what sadly became his slavering desperation for the presidency, first became Lyndon Johnson’s abused and widely mocked pro-Vietnam War toady, and then tried a nails-scratching-the-blackboard lurch to the right in 1972 that still got him nowhere. It was a sad ending to a career that had featured earlier moral high points.
Anyway, the point so far as 1962 dividend and interest withholding is concerned is that the public, or such of it as could be roused to harry Congress, might have in principle favored taxing the rich more, but was more than willing to settle for just being left alone itself. Or at least, left alone so far as ways that it would notice were concerned. The expansion of interest and dividend withholding arguably means that, at least over time, riled opponents of the withholding proposal fell well short of getting to preserve the status quo (for many) of significantly under-reporting interest and dividend income.
(b) What is “populism”? – This is a larger and richer subject than I can hope to address here. And there is no single answer, across times and places or even perhaps in a single given time and place. Trump and Elizabeth Warren, for example, have both been called populists, and they do not have a whole lot in common.
But at a very general level, I’d call populism a tool used by one elite against another elite in the effort to call in outside support as they struggle against each other for desired outcomes. Note that elites need not be economic – they can also be social, political, administrative, technological, etc. If you aren’t a member of some elite or other, then you aren’t in the political game to begin with.
Recall the 2012 presidential election. Romney was attacked by the Democrats as epitomizing the out-of-touch business elite (car elevators, firing acquired businesses’ employees when at Bain, etc). Obama was attacked by the Republicans as epitomizing some sort of global / intellectual / professional elite (didn't bowl, liked Grey Poupon mustard, etc.). The business elite on the one hand, and the professional / intellectual / academic elite on the other, have frequently been at odds for more than a century, at a minimum in both the US and the UK, as I show in my forthcoming book DANGEROUS GRANDIOSITY: LITERARY PERSPECTIVES ON HIGH-END INEQUALITY THROUGH THE FIRST GILDED AGE. [Still awaiting a contract to publish, though I’ve had nibbles.] Now, I would say that the super-rich / business elite is the true elite, the one with real power that might reasonably lead to resentment, but then again I’m biased by my own affiliations on the other side of this divide.
3.         THE 1962 CONTROVERSY OVER DIVIDEND AND INTEREST WITHHOLDING
Okay, but what about the 1962 political fight that Bank’s chapter documents and discusses? It was reprised, by the way, in 1982, when Congress actually enacted dividend and interest withholding (as part of that year’s revenue-raising TEFRA legislation), only to repeal it, in the face of similar public outcry, six months later and before it took effect.
Here I’d say, despite any seeming disparagement above of the outcry, that the public may have had a very good point. Dividend and interest withholding truly did impose burdens, and not just on the banks but on people who would have had to file for refunds. And, for behavioral economics reasons, it would likely have reduced saving by people who target-save specified amounts in distinct vehicles, and simply spend the rest of their after-tax income, for the same reason that people apparently save more through Roth IRAs than traditional IRAs, without realizing that they’re doing so, when they fail to equate taxes within the savings vehicle to those imposed outside it.
Yes, compliance was a problem, and it was perfectly reasonable for the technocrats to aim at increasing it, but they may have under-appreciated the burdens being imposed relative to working harder to make information reporting work.
Do we need interest and dividend withholding today? Probably not – compliance with respect to interest and dividends is pretty high due to information reporting.
But what about wage withholding? Well, the thing is that everyone wants that – apart from Grover Norquist types today, and Milton Friedman when he lamented having worked on its WW II era implementation.
The objections of a Friedman or a Norquist rest on the fact that people perceive their income tax burdens as smaller when they pay in small bits, and perhaps even get a refund on April 15, than if the whole thing came due then. But the taxpayers themselves want it to feel smaller. And they don’t want to have to plan for and then implement a large-scale cash withdrawal from their savings on Tax Day.
Against this background – scarcely at all applicable to dividend and interest withholding, especially given the rules for filing estimated taxes – someone who took to the campaign trail pushing the Friedman-Norquist viewpoint would likely see it fall quite flat.
Thus, consider Barry Goldwater’s 1964 presidential campaign. Should he have taken the hint from what happened in 1962 that withholding was generally unpopular, and therefore concluded that he should campaign for the repeal of wage withholding? I doubt this would have worked well for him, and his advisors surely knew that rather than overlooking an opportunity.
Bottom line (or one among others): perhaps the story told in Bank’s Manufacturing Tax Populism should be viewed as having a happy ending, in the sense that it yielded a very reasonable outcome: more information reporting, but no dividend and interest withholding. And the fact that its "success" of populism was accompanied by a more significant failure with regard to the treatment of high-end business meal and entertainment expenses, is instructive as well. (When that stuff was more efficaciously scaled back later, that was a revenue-driven, inside-the-Beltway story.)

Neal’s request for Trump’s tax returns

Here is what I told a reporter about this issue:

This is not an issue on which there is any possibility of reasonable disagreement. Any well-informed person who disagrees either that the Ways and Means Committee has an obligation to demand Trump’s tax returns as part of fulfilling its oversight duties, or that he is legally obliged to turn them over, is self-exposed as a partisan hack who has contempt for the rule of law.

Trump has credibly been accused of engaging in criminal activity for decades. It’s undisputed that he is still profiting from his businesses. There is substantial information in the public record suggesting that he is for sale (or subject to blackmail) and that many of his public policy decisions have been made for corrupt reasons. The tax returns may help to provide information that sheds light on his motives and incentives. It’s an indispensable part of Congressional oversight, and Republicans as well as Democrats in the Congress ought to recognize this (and in private probably do, whether or not they care).

All this is even leaving aside the law that would be quite clear in favor of the request even if all of the above evidence of criminality, corruption, and improper motives were not so powerful.

It’s perfectly obvious that business tax returns as well as individual ones are a necessary part of the oversight here. I don’t know why the particular ones were selected, and I would think that casting the net far more broadly (e.g., all Trump businesses, and all tax returns for the last 20 years) would have been well within reasonable oversight.

Any judge who votes or rules against this request does not belong on the federal courts. Such a judge would conclusively show that he or she cares more about partisan advantage than about transparency, honest government, and the rule of law.

All-star cast makes valuable contribution

The Oxford International Tax Group, chaired by Michael Devereux, has just posted this chapter of a forthcoming book, entitled (i.e., the chapter) “Residual Profit Allocation by Income.”

The cast of authors for the chapter includes Devereux, Alan Auerbach, Michael Keen, Paul Oosterhuis, Wolfgang Schoen, and John Vella. (Michael Graetz is also credited with having contributed to the group’s deliberations about the chapter’s proposal.) Happily, the committee here appears to have indeed designed a horse as intended, not a camel.

The basic idea is to replace current transfer pricing practice in international taxation with something that looks a bit like it but is actually (and by design) quite different. They propose to split a multinational’s profits into the “routine” and “residual” components, allocate the former based on arm’s length comparables, and assign the latter to market countries where sales occurred, proportionally to sales.

As the paper notes, routine versus residual may tend to overlap considerably with normal returns vs. rents, but they’re not identical. “‘Routine’ profit is the profit a third party would expect to earn for performing a particular set of functions and activities on an outsourcing basis.”

The approach resembles sales-based formulary apportionment, except that it only applies that approach to the residual element. The routine piece ends up being allocated to the countries where the underlying activities take place.

It even more closely resembles this proposal by Reuven Avi-Yonah, Kimberly Clausing, and Michael Durst. The big difference is that Devereux et al look to standard transfer pricing comparables for the routine piece, rather than assigning a fixed rate of return. They argue that this makes their proposal less distortive albeit more complex to apply.

While I obviously follow international tax policy stuff pretty closely, you can only get your hands fully immersed (so to speak) in so much of it. I’ve regarded the transfer pricing / formulary apportionment et al debate as an area in which I have leanings but don’t regard myself as having invested fully enough to have the same degree of confidence about my views, as in areas that I have focused on more directly. Also there are empirical tradeoffs to worry about here that I don’t believe the literature has as yet fully resolved.

That said, my inclination has been to strongly favor an approach like that in Avi-Yonah, Clausing, and Durst, even if a given country such as the U.S. at first adopts it unilaterally. But I understand that there are serious people who have looked at this issue and NOT liked it so much (e.g., Altshuler and Grubert). Clearly such a proposal leaves in place enough distortions and tax planning opportunities that it is at best a third-best; the case for it is that transfer pricing is at best a fourth-best. (Which is not to say that I have a particular candidate in mind for second-best.)

I’m also initially inclined to view Devereux et al as an improvement on Avi-Yonah et al. The transfer pricing comparables at issue here are for routine stuff, like say for advertising and manufacture. There will be no pretense or possibility of their applying to, say, Amazon’s mega-profits from succeeding with the iPhone. They could well end up, much of the time, being about as formulary (e.g., using a fixed percentage markup) as Avi-Yonah et al, only this would be particularized to market conditions. Its retaining conventional, recognizable transfer pricing more as a matter of form than of substance (i.e., insofar as the big money is concerned) is arguably a further practical point in its favor.

Video appearance on Vox Media’s Consider It

On Tuesday in between colloquium sessions, I went downtown (even as defined from an NYU perspective) to tape an episode of Vox Media’s Consider It, hosted by Liz Plank and Shermichael Singleton. It went live today, and you can view it here.

The topic was inequality and the tax system; Dylan Matthews was the other guest.

Tax policy colloquium, week 10: Omri Marian on international tax law convergence

Yesterday at the colloquium, we discussed Omri Marian’s The Making of International Tax Law: Empirical Evidence from Natural Langugage Processing (coauthored by Elliott Ash). The paper offers an empirical study of bilateral income tax treaty language, using statistical natural language processing to test for convergence in treaty language over time. The main findings are that (1) there has been convergence in treaty language over recent decades – the treaties now use the very same terms et al to a greater extent than they did in the past – and (2) the OECD Model Tax Treaty appears to have the greatest linguistic influence, outweighing that of the U.N. and U.S. Model Tax Treaties. (Not a surprise when one thinks of how active and well-staffed the OECD is!)

This is interesting and worth knowing, but a key question is what one learns from and should make of it. For example, it’s not immediately clear to what extent common or even converging treaty language relates to underlying legal content. One can use common terms, especially vague and general ones such as those used, say, to imply a need for transfer pricing, to mean very different things. Nor is it immediately clear how treaty law relates to domestic international tax law or to unwritten customary practice in the field.

The paper’s current draft argues that treaty language convergence is relevant to debate in the international tax policy field regarding Reuven Avi-Yonah’s claim that a sufficiently well-developed and binding regime of transnational tax law has arisen to suggest that nation-states “are not free to adopt any international tax rules they please, but rather [must] operate within the context of the regime.” In particular, Avi-Yonah argues in favor of a “single tax principle” under which all income should be taxed once, not zero times or twice.  Although the Marian paper does not discuss the single tax principle as such – and  the treaties generally focus on parceling out non-overlapping rights to tax, whether or not exercised by someone in each case – it states: “While we stop short of concluding that a binding international tax regime exists, we believe our findings lend support to such an argument.”

I have historically been somewhat skeptical regarding the “binding regime” claim’s centrality with respect to policy debates on which, as it happens, Avi-Yonah and I often find ourselves in significant substantive agreement regarding the bottom line. The binding regime debate raises a rich set of issues all on its own, but the extent to which tax treaty linguistic convergence sheds light on it is probably best evaluated separately from this paper’s very interesting empirical findings.

Tax policy colloquium, week 9: Jeffrey Hoopes on tax planning by private C corporations

Yesterday at the Tax Policy Colloquium, after a one-week hiatus for our spring break, Jeffrey Hoopes of the UNC Kenan-Flager Business School presented his paper “Is Tax Planning Best Done in Private?” The paper can’t as yet be posted publicly, but here is the abstract:

“We investigate the conventional wisdom that privately-held firms engage in more tax planning than do publicly-held firms. Private firms are believed to face lower nontax costs of tax planning relative to public firms, allowing them to engage in more tax planning. However, empirical evidence of U.S. private firm tax planning is limited, primarily because of difficulty in obtaining private firm data. We make use of detailed administrative data from the Internal Revenue Service, which covers virtually all U.S. public and private firms. Using a variety of tax planning measures, and contrary to conventional wisdom, we find no evidence that private firms engage in more tax planning relative to similar-sized public firms in the same industry. Moreover, some evidence suggests that private firms actually engage in less tax planning. These findings persist across different measures of tax planning and are not explained by firm characteristics commonly used to explain tax behavior. These results have important implications for researchers as well as for policymakers and managers.”

Here is some background about the setting for this: Conventional wisdom in the biz (drawing both on field knowledge and empirical research into the tax and accounting behavior of publicly held companies) holds that, at such companies, agency costs at the managerial level, and/or surprising lacunae in capital markets’ grasp and use of information, cause managers to care more about reported profits than true after-tax profitability. Hence, they may do less to reduce taxes than they ought to do, from the perspective of a buy-and-hold shareholder, because they are so focused on the financial accounting measure that they will be reporting in their 10-Ks. (Shareholders have every reason to want higher true profits, but higher reported profits in a given year do nothing for them unless it boosts the stock price when they happen to be selling.)

Anyway, an obvious inference would be that private firms, since they’re not filing 10-Ks or similarly engaged in trying to impress credulous investors, are going to do more tax planning than the public firms. And agency costs in this regard may recede if you have high-percentage owner-managers who are playing with their own money. It has therefore been presumed that “private firms” should be expected to do more extensive and (given low penalties) aggressive tax planning than public firms.

When we think of “private firms” in the U.S. setting, we may mainly think about passthroughs, such as partnerships and S corporations. But these are NOT the focus of the Hoopes paper; hence, we learn nothing about them directly (although it’s open for further thought whether, and to what degree, the findings might affect our assumptions or understandings about them). Instead, the paper uses previously un-studied IRS tax data to look at private C corporations, which have chosen to be subject to the corporate tax (and then potentially the shareholder-level tax upon selling shares or receiving corporate distributions) even though they are not publicly traded.

To quote Butch and Sundance, but with an opposite implication (one is asking “Are they stupid?” rather than “How can they be so smart?”): Who are these guys? In the aftermath of the 2017 tax act, private C corporations may be drawn by the 21 percent corporate rate, which is much lower than the top rate of 37 percent for individuals. There has been debate in the biz regarding how great a deal this actually is, given the potential second level of tax (plus the chance that the corporate rate might be raised in the future), but at least it’s a big up-front discount that might attract some savvy operators. Pre-2017, however, when the rate difference was only 35 percent corporate versus 39.6 top rate for individuals, the conventional wisdom was that you just shouldn’t be a C corporation unless your aim of being publicly traded effectively forced it on you.

The literature offered some interesting answers to why there might be private C corporations. E.g., one might be planning to go public soon, and in that regard want to be able to offer key employees incentive stock options, or appeal to venture capitalists who were familiar and comfortable with the C corporation form. One might really like access to standard corporate law (if one was actually incorporating, not just checking the box for C corporation tax status despite using some other sort of legal entity). Or, as recent work by Emily Satterthwaite suggests is possible, one might simply be relatively uninformed and ill-advised regarding one’s tax planning choices.
OK, back to the Hoopes paper. It uses tax data to compare public with private C corporations when they otherwise look extremely similar – same size, industry, etcetera. More specifically, it uses a matched pair design, under which each public firm is matched to a private firm that is in the same industry and similar in size. As to these matched pairs, it finds no evidence (using multiple specifications) that the private firms domore tax planning than the public firms. This is potentially contrary to what one might have expected, under the standard view as described above.

How might we explain this result? Perhaps pre-2017 C corporations are an odd group, partly including those who are simply bad at tax planning (or otherwise atypical of private firms generally). Surely the post-2017 group will be quite different, given that it will now attract more players who are interested in the up-front tax rate difference. Perhaps these pre-2017 private corporations had their own agency costs with respect to their tax decision-makers, or did not have as good access to the best tax planning advice. Perhaps agency costs at public C’s can lead to “too much” tax planning from the shareholders’ standpoint, as well as “too little.” For example, complex structures that are rationalized on tax planning grounds may also serve managerial objectives of diverting funds from the shareholders’ pockets to the managers. Or managers may have an unduly short time horizon if they anticipate exiting the firm (or, at least, exercising the options) before any dubious tax planning that they have done catches up with the firm.

But whatever the explanation, and whether or not one considers it illuminating as to private firms generally, and/or likely to persist in the significantly altered post-2017 business tax planning environment, it’s an interesting result that merits attention.

Death of Alan Krueger

I was very sad to hear about Alan Krueger’s untimely and tragic death.

I didn’t know him personally, but was only two degrees of separation away by multitudinous pathways (if we define knowing someone directly as one degree of separation).

On a professional note, I was intrigued and influenced by Krueger’s minimum wage work with David Card, which I first read – fittingly enough – when I was on the verge of leaving the University of Chicago for NYU in the mid-1990s. To economists, part of the interest lay in the use of well-chosen natural experiments to raise questions, the answers to which had unduly been taken for granted (and left unchallenged by reason of publication bias in favor of positive findings). But for me, the main interest lay in its potential theoretical and policy implications.

I found the Card-Krueger work illuminating with respect, not just to minimum wages’ potential employment and broader wage effects in particular, but also the more general need to go beyond “Econ 101-ism” and think hard about how particular markets’ – especially labor markets’ – odd features can lead to non-neoclassical results. (This even before the full rise of behavioral economics, which plays an important, albeit only partial, role in explaining how Card-Krueger outcomes could come to be.)

Throwing in as well my interest in the interrelationships between various formally distinct, but substantively overlapping, types of rules (e.g., minimum wage versus cartelization versus mandate versus EITC versus negative income tax), I wrote here about all of the above, including the Card-Krueger work. I probably still agree with most, though perhaps not all, of what I wrote there more than 20 years ago.

Krueger continued to do important work after his minimum wage research, in addition to being a great public servant in two Administrations.