A Taxing Blog

Friday, June 13, 2003
Which came first ....  
A reader from a NY firm offers the following insightful thoughts on which came first, our concept of realization or our concept of income:

Regarding Chorvat's paper on realization, you write, "I wonder if peoples' perceptions of income are in large part created by the tax system, not the other way around." I think you go right to the heart of the problem with his paper. Your comment made me think of the initial reaction to Macomber, as described in Marjorie E. Kornhauser, The Story of Macomber: The Continuing Legacy of Realization, in Paul Caron, Tax Stories. She writes that after Macomber was decided, the N.Y. Times quoted Rep. Hull, the "author" of the income tax, as saying that the decision requiring recognition "opened the way to widespread tax evasion since anyone could now form an 'artificial' entity and avoid his 'fair' share of taxes." The politician chose to make the rhetorical move of appealing to the public's sense of "fairness"--that somehow requiring realization was "unfair." In general, Kornhauser's article suggests that there was no innate sense that realization was required before gain--that, as you suggested, the idea of realization equaling gain is created, at least in part, by the tax code itself.

(This is why Chorvat's discussion of "neuroeconomics" is question-begging--yes, people may react differently to anticipated gain and actual gain, but that doesn't tell us what an individual considers to be anticipated, or actual, gain. And it explains why, as he notes, "certain people" view gain as occurring before realization--it's not just, as he seems to suggest, a happy coincidence that these are the people who are taxed mark-to-market. It seems far more likely that they view gain as occurring without realization precisely because that is how they are taxed.)

Thursday, June 12, 2003
More behavioral econ & tax  
Taxprof Ed McCaffery has updated Framing and Taxation: Evaluation of Tax Policies Involving Household Composition. Here's the abstract:

Three studies of attitudes toward tax policies were conducted on the World Wide Web. The results show several effects. In penalty aversion, subjects preferred bonuses over penalties, when policies differ only in how they are formally described. In the Schelling effect, subjects prefer both higher bonuses (for children) for the poor than for the rich and higher penalties (for being childless) for the rich than for the poor. In the neutrality bias, subjects preferred separate filing for married couples more when it was presented in a format that emphasized the effect of marriage (where it is neutral) than in one that emphasized the effect of the number of earners in a couple (where one-earner couples pay more). In the status-quo effect, subjects preferred the specified starting point to any change. Finally, in the metric effect, subjects favored more progressiveness in tax burdens when taxes were expressed in percent than when they were expressed in dollars.

The research suggests a general framework. Subjects approach a given decision problem with strong independent norms or ideals, such as, here, "do no harm," "avoid penalties," "treat likes alike," "help children," and "expect the rich to pay more." They then evaluate the problem on the basis of the most salient norms. In a complex area such as tax, independently attractive ideals are often in conflict, and the result is shifting, inconsistent preferences.

(Thanks to Larry Solum for the pointer.)

We are seeing the framing problem play itself out in the current battle over the child tax credit. The issue is whether the credit should be refundable so that even those who pay no federal income tax benefit from the increased credit. Dems and Senate Republicans frame the question to appeal to the "helping children" norm. The House GOP and Tom Delay frame the question to appeal to the norm that tax relief should only benefit those who pay taxes. (Some GOP members also characterize the refundable credit as a welfare payment, thus appealing to a "no free lunch" norm. Unlike the EITC, the child tax credit isn't tied to a requirement that one hold a job.)

By the way, Larry Zelenak is working on a fabulous paper on the EITC where he argues that the EITC is best viewed as a family-size adjustment to the minimum wage. Larry is presenting the paper at a conference later this summer, and I'll be sure to link to it once it's publicly available.

Realization versus Recognition  
I will be interested to see the paper on realization although I am not sure I buy the premise. First, I am interested to see how he deals with recognition of income. For example, under the old housing laws, I would say that the taxpayers realized income when they sold their house but did not recognize the income if they invested it in another house. I don't know if he will treat the two concepts the same in the paper.

More on homes and realization events  
A couple of readers have pointed out that I was mistaken when I stated a couple of days ago that if you sell your house and buy a new one, you can "rollover" the gain into the new house. (Rollover means that you carry over your basis from the old house into the new house, thus making sure that you eventually pay the gain.) In fact, Congress changed the rules back in 1997 to allow for an exclusion of $250,000 of gains, subject to two year residency requirements. Under the former rollover provisions, one could rationalize the provision as a combination of (1) people's intuition that moving isn't a true realization event, and (2) a subsidy for home ownership. Because gains were rolled over, the subsidy was one of timing. Under the current exclusion rules, however, the excluded gain disappears entirely --- suggesting that the current rules have little to do with anyone's sense of realization, and are just a subsidy for home ownership.

Wednesday, June 11, 2003
Academics vs. practice  
Orin Kerr poses an interesting question at the Conspiracy:
Legal academia: Here's a question for any law professors out there: Do you consider yourself an academic who happens to teach in a law school, or are you a lawyer who happens to be teaching? To put the same question in a slightly different way: If you were told that you couldn't teach law any more, would you look for a non-law teaching job, or a non-academic legal job? I haven't asked lots of law professors this question, but I would guess that most law professors fall into one camp or the other.

If I couldn't teach, I'd probably still be practicing law. When I was at a firm I did stints in both tax and litigation, and if I were practicing long term tax would definitely be the choice. But perhaps that is because tax law is the most academic of specialties in terms of its focus on research and its complex intellectual puzzles.

Either that or I'd be working on a screenplay.

My hunch is that most taxprofs would be practicing if they weren't in teaching; most other lawprofs would be in other academic jobs.

Any other taxprofs want to weigh in?

Shrinking the government  
Thomas Friedman, my favorite Middle East opinion columnist, weighs in on Bush's tax cuts in this op-ed.

Tuesday, June 10, 2003
House Version of Child Tax Credit  
According to the Washington Post, the House Republicans are willing to extend the child tax credit as part of a larger tax package.As noted by Victor, the story suggests that Bush would prefer a quick passage to expand the credit to low income families (probably to get the issue behind him).

Another Supreme Court decision from yesterday affecting state and local tax
In addition to Fitzgerald, the Court yesterday also handed down its opinion in Hillside Dairy, Inc. v. Lyons. The case involved a challenge by out-of-state dairy farmers to California's regulation of milk pricing. The underlying facts are somewhat complicated, but the case presented two pretty simple questions: (1) whether Congress had exempted California's price regulation from dormant Commerce Clause scrutiny, and (2) whether the regulation was exempt from review under the Privileges and Immunities Clause of Article IV, section 2. The Court answered in the negative on both questions (8-1 and 9-0, respectively), reversing the Ninth Circuit (surprise!). What is interesting for state tax purposes is that the Ninth Circuit had held that a state law can never violate the Privileges and Immunities Clause if it does not explicitly discriminate on the basis of citizenship or residency on the face of the statute. The Supreme Court held, in my opinion quite correctly, that express discrimination on the basis of citizenship or residency is not necessary. That is, a law that discriminates on the basis of where milk is produced could potentially violate Article IV, section 2 by effectively discriminating against milk farmers who base their businesses in other states. (Only natural persons are protected by the Privileges and Immunities Clause.) Thus, state taxes that have the effect of discriminating against out-of-state residents, even without doing so explicitly, are now clearly subject to review under Article IV, section 2.

Monday, June 09, 2003
Supreme Court decides Fitzgerald v. Racing Ass'n of Central Iowa
The Supreme Court today handed down a state and local tax decision concerning Iowa's taxation of revenue from slot machines (although the implications of the decision were potentially much broader, prompting the Solicitor General to file an amicus brief). Briefly stated, the facts were as follows. Before 1994, slot machines were authorized in Iowa only on riverboat casinos, and the revenue of these casinos was taxed at a rate of 20 percent. In 1994, the state permitted dog racing tracks to operate slot machines, albeit with a higher tax rate of 36 percent. Last year, the Supreme Court of Iowa held that this difference in tax rates--20 percent for riverboats but 36 percent for dog tracks--violated the Equal Protection Clause of the Fourteenth Amendment. In a 9-0 decision, the Supreme Court (opinion by Breyer) reversed. The opinion is straightforward, explaining that (1) the law would only violate the Equal Protection Clause if it had no conceivable rational basis, and (2) this law plainly had several conceivable rational bases, such as helping dog tracks but, at the same time, not cutting too much into the riverboats' market (or protecting the riverboats' reliance interests). My only questions are (1) how could the Iowa Supreme Court ever have decided that this law failed the rational basis test, and (2) why didn't the Court simply summarily reverse in a per curiam opinion (as it has done in seven previous cases this Term). The Iowa court's belief that a law is irrational to the point of warranting judicial intervention when it does not singlemindedly pursue one purpose--e.g., a law purportedly to promote dog tracks is irrational if it leaves dog tracks at a competitive disadvantage relative to riverboats--barely passes the laugh test. That sort of searching judicial review under the Equal Protection Clause would drastically alter the roles of legislatures and courts, and not in a good way. The Court thankfully ended this brief forray into searching, Lochneresque review of humdrum legislative trade-offs among interest groups.

White House supports expansion of child tax credit  
The NYT is reporting that the White House is urging the House to pass the expansion of the child tax credit. This is a pretty big turnaround from a couple of weeks ago, though you wouldn't know it from Ari Fleischer:
"The president, as I said two weeks ago, when the original tax bill was passed, the president would have signed that bill, had the low-income provision been a part of it," Mr. Fleischer told reporters.

Here's what Ari said a couple of weeks ago:
"What you always have to keep in mind in the administration of the child credit is, does the tax relief go to people who pay income taxes ... or does it go above and beyond the forgiving of all income taxes and you actually get a check back from the government for more than you ever owed in income taxes?" [Fleischer] said.

Apparently the White House has gotten over its issue about refundable credits looking too much like welfare payments. Well, in any event I'm glad the White House has changed its mind.

Chorvat paper on realization  
Taxprof Terry Chorvat, one of the taxprof community's rising stars, has posted a very interesting paper on SSRN: Perception and Income: The Behavioral Economics of the Realization Doctrine. Chorvat argues that the realization doctrine can be justified as consistent with how people intuitively view income. Here's the abstract:
The requirement that gains be "realized" before they are subject to income tax is one of the most fundamental doctrines in tax law as well as being one of the most controversial. The common assumption in the academic literature is that this requirement leads to significant inefficiencies and inequities. This article argues that requiring a realization event is generally the best way to measure taxable income because it is consistent with how individuals actually perceive income. This perspective helps us to understand the development of the realization doctrine as well as suggest ways in which the current tax system can be improved, such as exempting some of the amounts reinvested in mutual funds from income taxation.

I agree with Chorvat that thinking about how people intuitively perceive income might be useful. This leads, I think, to a conclusion that sophisticated investors should be subject to a mark-to-market system and unsophisticated investors should be subject to a realization-based system. (Then there is the line-drawing problem of figuring out which people and entities are sophisticated.)

But I'm not sure how far the analysis can take you. I wonder if peoples' perceptions of income are in large part created by the tax system, not the other way around. I own shares in a bond fund that automatically reinvests my interest payments; I pay tax on the "unrealized" interest. This doesn't really bother me because I know the rules beforehand. Likewise, if we had in place a system that forced homeowners to pay capital gains on the appreciation in their houses periodically rather than upon sale, eventually people would learn to live with that system too and think of the rising value of their homes as "income."

UPDATE: A savvy reader notes that many homeowners do not actually pay capital gains on the appreciation of their homes, even upon sale. (There are generous provisions that allow you to rollover the gain into a new home, provided you have lived in the home long enough.) This probably supports Chorvat's view .... the political support for the expansion of the capital gains exemption is probably due to an intuitive view that people have that selling a home to move into another isn't a true realization event or an appropriate moment to recognize income. Nevertheless I do think that if it were somehow politically possible to change the rules to require mark-to-market taxation of homes, within a few years people would adjust to the system and understand the gains as "true" income.

Sunday, June 08, 2003
A NYTimes editorial discusses the possible rule change for foundations. Apparently, Congress is considering changing the distribution requirements for a foundation to stay tax-exempt.

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