A Taxing Blog

Saturday, May 17, 2003
 
State taxation of nonresidents' income
Professor Walter Hellerstein, probably the most distinguished and influential academic in the field of state and local taxation, has an article in this week's State Tax Notes in which he argues that several state schemes for "sourcing" nonresidents' income is unconstitutional. To oversimplify a bit, states can tax individuals on two alternative and distinct bases: residence and source. With respect to residents, states have the authority to tax all of an individual's income, wherever earned worldwide. With respect to nonresidents, jurisdiction only extends to that income that is earned in that state. This leads to the sometimes-knotty question of determining where exactly income is earned. Suppose you are a law professor who lives in Connecticut and commutes into New York three days a week to teach, hold office hours, and attend faculty meetings. Suppose (unlike me) you are productive on those two to four days at home each week, prepping class notes and doing research. How much of your salary have you earned in New York and Connecticut, respectively? New York, among others, has adopted the "convenience of the employer" test (Benaglia, anyone?). This means that you are deemed to have earned all of your salary in New York unless your working from home in Connecticut was for the convenience of the law school (i.e., there was some valid reason that the law school wanted you to work from home). This, of course, prompts the question: when New York taxes the income of a nonresident (over whom the state only has source jurisdiction) earned from services actually performed in another state, has New York exceeded its constitutionally permissible jurisdiction to tax?

Professor Hellerstein says yes--and that the New York source rule is therefore unconstitutional. And without having thought about it a great deal, I think he is right. In our federal system, states are generally limited to regulating and taxing that activity that occurs within their borders. The jurisdiction that states have to tax the entire income of residents might seem to be an exception to this proposition, but it really is not. Residence-based jurisdiction is grounded in the notion that the taxpayer's domicile is where she is entitled to enjoy her entire income. Regardless, with respect to nonresidents, states are limited to taxing that income actually earned within their borders. To tax income from services performed in other states, just on the basis that the individual's principal office is in New York, seems to constitute extraterritorial taxation. And this is generally (although not quite always) unconstitutional.

The hypothetical posed above is a real case involving Cardozo law professor Edward Zelinsky. He lost in the intermediate state court of appeals, Zelinsky v. Tax Appeals Tribunal, 301 A.D.2d 42, 753 N.Y.S.2d 144 (3d Dep't 2002), but the New York Court of Appeals granted review last month. Perhaps the "convenience of the employer" test is in its waning days in New York.

Friday, May 16, 2003
Fraud Insurance  
The Washington Post reports that the Senate bill passed last night would restrict the ability of companies that restate earnings from getting tax refunds after the accounting is corrected. This probably makes sense, as we don't want a tax refund to act as partial insurance for overly aggressive accounting treatment.

But I haven't seen the details yet, and the concept is still a bit confusing to me, as the accounting treatment and tax treatment of transactions frequently differ. Taking away the tax refund thus does not deter transactions in which companies inflate only accounting earnings (but not taxable income). The bill also increases the incentive not to restate earnings by implementing an implicit penalty for doing so. Since companies that restate earnings already take a big hit in the debt and equity markets when they restate earnings, it's possible we might actually be better off by cushioning the blow with a tax refund. (I doubt it, but it's possible.) I'll have to think about this some more.

On a lighter note ...  
Reuters reports on a German "Pleasure Tax" on brothels. Smaller establishments are exempt:
Tax officials are checking out sex venues and prostitutes working from home to see if they are eligible for the tax, which amounts to 5.60 euros ($6.40) per 10 square meters (107 sq ft) of business space per day. Any smaller establishment is exempt.

"Our tax inspectors are combing through sex adverts in local newspapers and then paying visits, but equipped with measuring tapes," said Martin Schulmann, spokesman for Gelsenkirchen.

Prostitutes' lobby group Hydra said in a statement the tax was "pretty absurd."

"Are we going to measure tax payments by the size of the brothel? If so Berlin's clients will have to satisfy their needs in cramped cubbyholes or standing up. Does this city need this?"

Gives new meaning to the title of David Schizer's influential article, "Frictions as a Constraint on Tax Planning."


Senate Bill  
The Senate Bill which passed with VP Cheney's tiebreaking vote provides for a 50% dividend exclusion for 2003 and total dividend exclusion for 2004-2006, with full taxation of dividends springing back to life in 2007. Other than the obvious phase-in, phase-out despicable budgeting gimmick, the other notable thing about the bill is that it would apply to all dividends (as that term is defined under current Section 301) paid during those years, thereby straying from the "all corporate earnings should be taxed once" mantra used to support the original Bush proposal. In other words, the bill departs from the excludable dividend account (which included only corporate income which had been previously taxed at the corporate level) and basis bump concepts which together were designed to (i) reduce the incentive to shelter corporate income (because that would reduce the amount of dividends you could distribute tax-free), and (ii) to make the decision to retain or distribute earnings tax-neutral (because the basis bump would allow the shareholders to recover the bump tax-free upon a sale or redemption). The current bill creates no disincentive to shelter and creates an incentive to distribute earnings (and to do so quickly in case the phase out sticks). I can't imagine that corporate executives, who hold non-dividend adjusted options, will appreciate the latter incentive. Senator Nickles justified the bill's treatment by saying that the EDA and basis bump concepts were too complex and would take too long to implement.

Thursday, May 15, 2003
 
The Internet Tax Freedom Act and the "physical presence" of out-of-state vendors
Despite its name, the Internet Tax Freedom Act actually does incredibly little to immunize companies that engage in electronic commerce from state and local taxation. Its most significant provision prevents state and local governments from imposing "new" taxes on the provision of internet services. (Thus, state and local taxes that were in place before the Act was first enacted are grandfathered in.) The ITFA really does nothing to address the situation that the California SB 103 attempts to address, or the use tax collection duty for out-of-state vendors more generally.

Jeff asserts that more "physical nexus" should be necessary than agents such as Dell's independent contractors? I think it is important to start this conversation with the understanding that business entities never can have a physical presence of their own, as they have no physical existence. Any business entity's presence in a given jurisdiction will always be through attribution--an employee, an independent contractor, property to which the business holds title, etc. The business itself is never physically anywhere. Thus, the relevant question (contrary to the Court's decision in Quill) needs to be what level of contact with a jurisdiction is sufficient to impose a duty to collect a use tax. The physical/non-physical distinction, at least as applied to business entities, is nonsensical.

Perhaps Jeff is correct that Dell's contacts with California are insufficient to impose this duty. I would probably disagree, and the Supreme Court's decisions in Tyler Pipe and Scripto (I think) tend to support my position. But there are clearly reasonable arguments on both sides. Regardless, it should have nothing to do with the "physicality" of Dell's presence in the state.

Speaking of Internet Taxation ....  

The Washington Post reports the following about a speech by Treasury Secretary Snow, who apparently got a lukewarm reception when pitching the dividend cut to Virginia technology workers:

The audience's loudest applause, however, followed Snow's disclosure that he, along with Secretary of Commerce Donald L. Evans, plans to send a letter to Congress calling for a continuation of the moratorium on Internet taxation.


Makes sense, as Snow was somewhere in the AOL / Reston hi tech corridor at the time.
Although Snow didn't mention it, of course, the dividend cut does little for most tech companies, as many have neither the cash to pay dividends nor the taxable income to get a basis bump for their shareholders.


California Internet Tax  
I find the internet tax stuff quite interesting. I agree that the state should be able to force the company to collect state tax when you have something similar to Brad's example of Walmart and Walmart.com (especially when, as with Barnes and Noble, customers can return bn.com items to the regular stores). However, the bill is also going after Dell, which, I believe, only refers customers to independent repair facilities. Personally, I don't believe that should be enough of a physical nexus to require Dell to collect.

What is also interesting is that the state Board of Equalization estimates this new bill will only bring in an additional $14 million.

Even the Political Scientists aren't buying it ...  
Chicago PoliSciProf Jacob Levy at the Conspiracy weighs in on the temporary dividend tax cut plan.

Dynamic Progressive Taxation (The Anti-Flat Tax)  
Yale Econprof Robert Shiller has an op-ed in the NYT arguing for a progressive taxation system in which the marginal rates change depending on the level of social inequality.

I'm not sure I follow the argument either as a matter of efficiency / economic incentive or as a matter of equity / distributive justice. If a flatter society is the goal, then a wealth tax (a tax on x % of total wealth) would be much more effective than an income (i.e. a tax on yearly change in wealth) tax. Shiller's proposal is a tax on the upwardly mobile, not a tax on the rich.

Wednesday, May 14, 2003
 
Taxing sales over the Internet: California and "affiliate nexus"

Those who have followed the Internet tax debate know that the most contentious issue thus far has been the states' inability to require out-of-state vendors to collect a use tax (the complement to the sales tax) when the vendor has no physical presence in the taxing state. For instance, because Amazon has no physical presence in California, California lacks jurisdiction to require Amazon to collect a use tax when I purchase a book from here in Santa Clara. (This is the result of the Supreme Court's 1992 decision in Quill Corp. v. North Dakota.) The California Senate has recently passed a bill that would narrow (but certainly not close) this loophole. The bill, SB 103, would address the so-called "entity isolation" strategy of many bricks and mortar retailers. For instance, Wal-Mart might create a wholly owned affiliate, walmart.com, that engages in the exact same line as business as Wal-mart, using the same trade dress and using Wal-Mart's goodwill. But while Wal-Mart clearly has a physical presence in California, walmart.com might not. Consequently, online retailers like walmart.com have not been required to collect use taxes on sales to California customers despite the presence throughout the state of their parent corporations. SB 103 would essentially treat the bricks and mortar stores as the agents of the online affiliates when (a) there is a common ownership interest in the businesses, and (2) they engage in essentially the same line of business. As has been reported widely, the California Senate passed SB 103 last week. Governor Davis has vetoed a nearly identical measure twice before. But with the state now facing a $35 billion budget shortfall, advisors to the Governor have indicated that he is likely to sign it this time.

 
Proposition 13 turns 25

June 6 will mark 25 years since California voters approved Proposition 13, the ballot initiative that amended the state's constitution and radiacally altered the landscape of taxation and public finance in the state. In short, Prop 13 (1) rolled back property assessments to 1975 levels, (2) limited property tax rates to 1% of assessed valuation, (3) limited annual increases in assessed valuations to 2%, (4) provided that assessed valuations will be "stepped up" to fair market value when properties are sold (with some exceptions), and (5) imposed the requirement of two-thirds majorities for most tax increases at both the state and local level. The effects on California have been profound. The San Jose Mercury News this past Sunday ran this article and this article concerning Prop 13's legacy and the ongoing debate about the wisdom of its adoption. The Merc also ran this editorial urging that Prop 13 be amended to discontinue its application to commercial property and this editorial lamenting how local governments in the state have become financially beholden to Sacramento under the Prop 13 regime.

Brookings paper  
Brookings has a new paper analyzing the various tax cut proposals.

Fiscal (in)sanity?  
Washington Post reports that the White House is now pushing a plan in the Senate that would phase in the dividend tax cut -- 50% relief next year, 75% in 2005, 100% in 2006 and 2007 .... and then back to full taxation of dividends after that. The sunset allows the scoring of the proposal to fit within the Senate's tighter budget resolution.

The obvious flaw, as everyone seems to realize, is that even if one believes that the dividend cut is an economic stimulus, the structure of the phase in gives companies an incentive to hoard cash until 2006.

The White House, however, thinks that the stock market will get a boost anyway. A staffer acknowledged that the temporary aspect of the proposal was just a budget gimmick, but reported that they think the financial markets will assume that full relief will be passed later. The hope would be that the markets would price in future permanent dividend relief today, thus immediately boosting equity prices and providing a wealth effect, even if dividend payouts do not increase.

What I really like about the Post story is the final quote:

"There needs to be fiscal sanity in Washington," Bush told about 7,500 seniors, military personnel and supporters.


Figuring out the economic impact of this proposal is enough to drive one insane. The White House is betting that it knows how the market will react to the dividend cut, which in turn depends on how the market thinks Congress will act in 2004, which in turn depends on how the market in fact reacts to the dividend cut. It all reminds me of the poker game I played in last night -- trying to figure out what the other guy thinks that I think that he has ...

Tuesday, May 13, 2003
Oops  
NYT reports that some staffer put the wrong bill number on the Senate Bill, so they will have to re-vote. Apparently changing the number of the bill requires unanimity, which the Dems refused, so they'll have to send it back to committee. Not clear yet if the Dems will try to reopen issues in committee.

I do hope that the Dems have a better plan for contributing to this tax cut debate beyond throwing sand in the gears, which is about all they've been doing so far.

I also hope the Senate parliamentarian has a good bodyguard. Those Republicans can be mean sometimes, especially to their own.

More on Codifying Economic Substance  
I've received a few emails, all pointing in the direction that the proposal to codify the economic substance doctrine is likely to be enacted. I'm somewhat surprised by this, as it is the sort of esoteric proposal that could be easily defeated by some spirited lobbying by the accounting firms. But I suppose the accounting firms have other things to worry about these days.

The most important impact of codification is a shift in power and discretion from the judiciary to the administrative branch. Under current law, the economic substance doctrine is a common law doctrine, applied by judges when they believe it fits the facts and circumstances of a case before them. One problem is that judges are unpredictable, with some rule-oriented judges eschewing the common law doctrines in all but the most egregious cases. (Joe Bankman has a nice article in the SMU Law Review (2001) discussing the sociology behind this.) Because judges are unpredictable, the deterrent effect of the common law doctrines is greatly watered down.

Codification is thus important because, under administrative law principles (the leading cases are Chevron and Mead) judges must defer to any reasonable interpretation of a statute by an administrative agency, so long as the interpretation is not flatly inconsistent with the plain meaning of the statute and is also consistent with the underlying congressional mandate. The statutory language of the codification proposal expressly delegates power to the Treasury to write regulations that will guide what sort of transactions the doctrine applies to; these so-called "legislative regulations" (as opposed to "interpretive regulations") are almost invincible to attack and will expand administrative discretion even a bit further. The end result is that codifying the economic substance doctrine would allow the Treasury and the IRS, not judges, to determine to a large extent when and how the doctrines apply, rather than leaving it up to judges alone. And this, I submit, is good.

To illustrate the point, consider a doctrine --- let's call it the "Careful and Prudent" doctrine -- which says that even though the speed limit is 65, when driving conditions are hazardous, one is required to drive more slowly. The Careful and Prudent doctrine, like the economic substance doctrine, lacks the bright line of the speed limit, but is necessary to a functioning system of driving rules, so as to deter drivers from going 65 when the roads are covered with freezing rain. After all, one cannot be expected to write an exact speed limit for every possible weather and road condition imaginable (and unimaginable).

Now suppose that the Careful and Prudent doctrine, like the economic substance doctrine in tax, is not codified. Rather, it is applied by judges who ---- in their discretion --- sometimes do, and sometimes don't, decide to call an offense "reckless driving." So a state trooper sees a driver going 60 in freezing rain, pulls him over, writes a ticket. The driver then goes to the judge and argues that because the speed limit is 65, the speeding ticket cannot be valid. If the driver gets lucky and pulls a literalist and rule-oriented, or, say, a pro-sports car judge, the driver might well get away with it. Other drivers who see this driver get away with it are then somewhat less deterred by the Careful and Prudent doctrine.

If the Careful and Prudent doctrine is codified, however, and state troopers are given explicit authority to write tickets based on the violation of the Careful and Prudent principle, the trooper is much less likely to be second guessed by the judge, even a rule-oriented judge.

[In the tax arena, of course it is even harder to write rules than in a driving system. Not only does the weather change frequently, but there are entire industries devoted to actively changing the weather conditions --- derivatives are analogous to snow-making machines here --- so as to make the application of the rules blurry.]


Ultimately codification of the economic substance doctrine is a choice about how we want the rules of the tax system enforced: whether we want the judges or the cops (IRS / Treasury) to have the lion's share of the discretion. In the ordinary criminal / civil liberties context, I can see a strong argument for greatly limiting the discretion of street cops. After all, giving unfettered discretion to street cops in the criminal context can lead to diminished accountability and undermine our democratic ideals of equality and freedom. In a highly specialized arena like tax, however, I think greater administrative discretion makes more sense. I've yet to see any persuasive evidence that the Treasury / IRS has abused its power in this context. Moreover, the realities of the political process make it much less likely that the rights of big corporations like StanleyWorks or Tyco will be trampled on than the rights of (in the con law parlance) discrete and insular minority groups.

Lawprof Ellen Aprill explores these issues in more detail in an excellent article in the SMU Law Review, Tax Shelters, Tax Law, and Morality, 54 SMU L. Rev. 9 (2001).

Monday, May 12, 2003
Transitioning to Consumption Tax  
Taxprof Mitch Engler (Cardozo) and Michael Knoll (Penn) have a paper on how to transition to a consumption tax. Here's the abstract:

"Simplifying the Transition to a (Progressive) Consumption Tax"
Southern Methodist University Law Review, Vol. 56, No. 53,
2003

The article discusses transitioning from an income tax system to
a consumption tax system. The existing personal income tax
system is seriously flawed and the benefits of shifting to a
consumption tax system, which has fewer opportunities for tax
avoidance and evasion, are obvious. As a result, the article
demonstrates how a conventional cash-flow consumption tax
eliminates many of the tax avoidance and evasion problems of the
current income tax system. The article further discuss how
retention of the tax on wages would greatly simplify the
transition to a consumption tax, noting that this would
alleviate the difficult transition issues that arise in any
discussion of moving from an income tax system to a consumption
tax system.


Taxprof Joe Bankman (Stanford) has a comment piece in response. The abstract:

"Comment: The Engler-Knoll Consumption Tax Proposal: What
Transition Rule Does Fairness (or Politics) Require?"
Southern Methodist University Law Review, 2003

This commentary on the Engler-Knoll proposal on transitioning
from an income tax system to a consumption tax system argues
that full transition relief is unfair because it
"overcompensates holders of capital, exacerbates unequal
distribution of wealth, and reduces welfare." While
acknowledging that the Engler-Knoll proposal is ingenious, the
commentary argues that a cash flow tax with limited transition
relief and lower rates is more likely to be enacted than the
Engler-Knoll proposal.


As we creep towards a consumption tax, these transition issues will become ever more important.

Angry Bear  
Angry Bear describes the impact of the administration's dividend tax cut proposal for the President, the VP and the cabinet. It's entertaining, although I don't mean to suggest that the administration is driven by personal greed.

(I think they are driven by a sincere but mistaken belief that eliminating the tax on dividends will instantly and powerfully boost the stock market. And perhaps also by the sincere and accurate belief that the cut will instantly and powerfully boost campaign contributions. But personal greed -- probably not.)

In Praise of Sunsets  
Victor Davis of the Dead Parrot Society argues that sunset provisions aren't all bad.

Davis's key point, which I hadn't thought of, is that a sunset provision is itself evidence of a political compromise, so that scoring a sunsetting tax cut as if it were permanent isn't accurate, either. The best approach, I think we would both agree, would be to score a sunsetting tax cut as somewhere between the temporary cost of the cut (which is how current rules operate) and the permanent cost (which would assume 100% chance of re-enactment). It's complicated, sure, but as long as we are trying dynamic scoring we ought to at least try to get this right, too.



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