One of the timeless problems in administering tax laws is that norms are often established by accident, with certain areas of the law unenforced and some loopholes left open long enough that the beneficiaries of the unintended largesse start to take for granted that they deserve to continue in their favored status. For example, a staple of the basic income taxation class in law schools across the country is the problem of employee fringe benefits. Not taxing such benefits raises horizontal equity problems and creates perverse incentives, with employers and employees being willing to exploit non-enforcement of taxes on, say, free meals at work by substituting untaxed benefits for taxed cash income. Tax professors thus are left to explain the messy responses over the years from Congress, which has attempted to adjust the tax rules to take reality into account while trying not to allow the tax base to be completely eroded. The joys of sections 119, 125, and 132 of the I.R.C. are among the results that students (and taxpayers) must navigate.
Yesterday, the Obama administration announced a series of relatively small-bore changes in the tax laws and enforcement efforts that apply to the taxation of corporate income earned from overseas operations, part of which includes a proposal to end a longstanding loophole in the law. That loophole arises from the unintended interplay of two utterly sensible and absolutely fundamental tax doctrines.
The first doctrine is simply that an income tax should tax income, which implies that business taxpayers should be allowed to subtract their business-related expenses from their revenues before determining their tax liabilities. If we did not allow this, the income tax would become a revenue tax, and companies with low expenses would be significantly favored relative to companies with high expenses, even if the companies have the same amount of before-tax profit. Even if you do not like the income tax, you would want an income tax to tax income that has been properly measured.
The second doctrine, known as deferral, allows companies operating abroad to delay paying taxes on money earned abroad, waiting until the money is "repatriated" to the United States. Why is that an arguably good policy? One way to look at this is simply as a sub-category of the concept of "realization," another fundamental tax doctrine. Under the realization doctrine (ignoring some gruesome details), taxpayers do not pay taxes on income until they have turned the income into cash (for example, selling shares of stock that were purchased for $100 at $110, paying tax on $10 of income per share). The basic idea is that our tax system is deeply committed to the idea that taxpayers can delay paying taxes on gains until they actually have the cash on hand to pay any taxes due. Deferral of taxes on foreign-earned income essentially says that a company that has earned money abroad but has not yet brought that money home is the same as someone who has earned money on a piece of land but has not yet sold the land.
The argument for measuring income correctly is stronger than the arguments for having a realization requirement, and the arguments for a realization requirement are stronger than the arguments for allowing deferral of foreign-source income; but if you buy into these building blocks, you are on solid ground in terms of being able to justify the two steps of the current process.
The unintended consequence of these two rules is one of the things that the Obama proposals are supposed to address. As it stands, if a company is operating abroad, it can deduct the costs of those operations abroad in the year in which they are incurred but need not declare the revenue from those foreign operations in the same year. The tax game is often less about reducing taxes than simply putting them off as long as possible, and in this case companies have shown a willingness to hold money abroad seemingly forever in an effort to avoid U.S. taxes. Closing this loophole will, the administration estimates, increase tax revenues by about $60 billion between 2011 and 2019. Not enormous sums of money compared to the entire budget, but enough to fund an expansion of the Research and Experimentation Tax Credit, which reduces taxes for companies that engage in (what we hope are) job- and growth-enhancing investments in technology.
While it is easy to describe this proposal as a plain-vanilla effort to fix an unintended loophole, of course, the proposal is fiercely opposed by the companies that would be affected. One possible response to their opposition is simply to roll one's eyes and say that this is fully to be expected. Do they, however, have an actual argument that this seemingly innocuous idea is bad tax policy? Maybe.
To be clear, this part of Obama's proposal really is a "tax increase" in the sense that some taxpayers will pay more tax if it is passed than if it fails (which is a completely reasonable definition of what it means to increase taxes). It is not even a matter of collecting taxes that are currently unpaid due to lax enforcement, which is the focus of other aspects of Obama's announced tax proposals. This really is a change in the law itself, so that a fully honest taxpayer could pay more in taxes due to the change; and even though one can make a pretty good argument that we would merely be forcing companies to align their deductions with revenues in the appropriate years, doing so would definitely increase some companies' tax bills. That is, of course, where the $60 billion figure comes from.
Moreover, any change in tax laws or enforcement will affect behavior, even if the current starting point is not at all the "right" baseline. As today's lead editorial in the New York Times points out, some companies might respond to the proposed change by moving still more jobs offshore, because they would find that they cannot deduct the domestic costs of generating foreign income under the Obama proposal. In other words, there is at least some reason to worry that this change in the tax laws -- even if motivated by a desire to correct an unintended consequence of the interplay between two other tax doctrines -- will be bad for the economy.
Which brings us back to the problem of taxpayers who take for granted that their current situation is right and justified and that any attempt to take away their benefits is an unfair attempt to take what belongs to them. Every change in the tax law -- indeed, every change in the law -- will change people's outcomes and can make a taxpayer/citizen feel that they have been treated unfairly. Whether they then change their behavior in ways that harms other citizens is important, but the more basic point is that any legal change can be cast as a violation of someone's established interests.
If even something as relatively minor as the tax law change described above is beyond the pale, however, maybe we should admit that we no longer have any room within which to govern. Sometimes, changes must be made that do not make everyone happy. That is what government is about and what is supposed to make constitutional democracies superior to all others -- not that they never make people unhappy but that they do so only after going through the appropriate processes. To hear the opponents of the Obama proposals, one would think that there simply are no appropriate means to shift tax burdens. Obama is often cast by his opponents as a radical, but the truly radical notion is that no government should ever make difficult decisions, that is, decisions that involve both gains and losses. If we have really reached that point, then the country is in much worse trouble than we thought.
-- Posted by Neil H. Buchanan