The Crisis in Tax Administration.

The Crisis in Tax Administration. Edited by HENRY J. AARON and JOEL SLEMROD. Washington: Brookings Institution Press, 2004, pp. 402.

INTRODUCTION

This volume, which might have been subtitled "Complexity and the Cost of Compliance and Administration," contains, besides an introductory essay, ten papers (with two comments on each) that were presented at a conference convened by the Brookings Institution and the Office of Tax Policy at the University of Michigan in November 2002 (a date that the Preface unfortunately fails to mention). It brings together much of what is known about the difficulties of compliance with, and administration of, the U.S. federal income tax and also highlights areas where not enough is known. It does not consider the added problems of compliance and administration related to state and local income taxes. The attention the Advisory Panel on Federal Tax Reform appointed by President Bush devoted to simplification reemphasizes the importance of the topic of this volume.

Chapters 2-7 deal with tax shelters, international tax enforcement, small business, computer-assisted return preparation, issues facing low-income filers, and tax preparers. The other four chapters present a theoretical model of the compliance-evasion choice, attempt to quantify the effects of tax simplification, discuss the objectives of the Internal Revenue Service (IRS), and describe some of the experience of other countries. There is, of course, some overlap between topics. For example, the first two topics--tax shelters and international tax enforcement--concern both individuals and corporations (and other business entities); tax shelters may involve international issues; and two somewhat different types of low-income filers face different problems. Leaving aside pass-through entities, I find it useful to think of six sometimes overlapping classes of taxpayers who face (and pose) somewhat different kinds of problems of compliance and administration: large (mostly C) corporations, small businesses, high-income individuals, middle-income taxpayers, low-income taxpayers, and poverty-level filers.

Both corporations and high-income individuals may participate in tax shelters, the latter through what appear to be small businesses. International issues arise for both corporations and high-income individuals, but they take different forms. Whereas individuals, perhaps operating via small businesses, may use off-shore accounts in tax havens to evade taxes on passive income, corporations are more likely to use such techniques as transfer pricing to shift business income to tax havens.

Problems facing the less affluent are quite different (unless, of course, they also fall into the small business category). Middle-income taxpayers must deal with exemptions, deductions, and credits; limitations on those benefits; and, increasingly, the alternative minimum tax (AMT). Computer programs such as TurboTax help the computer literate deal with this type of complexity, but many in this group use professional preparers. Many of those who file the two simplest types of returns, the 1040A and 1040EZ, as well as many of those who qualify for the earned income tax credit (EITC), also utilize professional preparers, but that may be attributable as much to the availability of refund anticipation loans as to the complexity of their returns.

TAX SHELTERS

In the chapter on tax shelters, Joseph Bankman contrasts an approach that assumes that taxpayers should be able to rely on the clear language of tax law and regulations, even if that seems at odds with legislative intent (the "literalist" approach), with an approach that says that intention must be taken into account in judging the legality of a particular scheme to save taxes, because it is impossible to anticipate all the ways taxpayers and their advisers will find to interpret the law to their advantage. The "intentionist" strategy relies on such tests as whether a transaction has "economic substance," that is, motivation aside from tax benefits. In his comment on Bankman's paper, David Weisbach distinguishes between rules and standards such as economic substance, noting Stanley Surrey's argument that standards are needed, because it is impossible to foresee all circumstances.

Tax shelters generally arise where two or more aspects of tax policy are inconsistent, as when a deduction is allowed for interest paid to finance investments that earn tax-exempt, tax-preferred, or tax-deferred income. (Acceleration of deductions, e.g., for depreciation, and investment tax credits effectively defer realization of income.) It is often possible to identify what makes shelters possible, by comparing existing tax law to a system that would allow no opportunities for shelters, such as an economic definition of income or consumption; in this case it is clear that the exemption, preferential treatment, or deferral of income is the culprit, since there is nothing wrong with a deduction for interest incurred to earn taxable income.

There may be many reasons not all income is fully taxed currently: taxing it may be unconstitutional (ostensibly the original reason for the exemption of interest on state and local securities); taxing it may be impractical (imputing income from owner-occupied housing; taxation of accrued capital gains); taxing it may be politically unpopular (ditto); not taxing it may have politically powerful supporters (the lion's share of exemptions, credits, and deferrals involving business); or tax shelters may be virtually impossible to prevent simply by writing tighter laws (some shelters involving "accommodation parties" in foreign countries). It may be that the choice between the literalist and intentionist approaches should hinge on why a particular shelter exists. Shelters that exist because policy is simply incoherent, rather than for constitutional or practical reasons, could generally be avoided by eliminating the preferential treatment that creates incoherence. By comparison, "backstopping" provisions that limit tax arbitrage, for example, by limiting interest deductions, may be needed where incoherence cannot easily be avoided, as in the case of owner-occupied housing and perhaps interest on municipal bonds. Of course, backstopping runs the risk that taxpayers will figure out how to make an end run around the law.

It is ironic that Bankman chose corporate-owned life insurance (COLI) as his poster child for tax shelters, because this is a case where: a) it has long been obvious that it is the exclusion of inside build-up on cash-value life insurance policies, and not the deduction of interest on policy loans, that creates the opportunities for arbitrage that broad-based COLI exploited to the hilt, b) whatever sound reason there might be for the exclusion of inside build-up on policies owned by individuals (which could and should have been restricted to limit opportunities for arbitrage) did not exist for policies owned by companies, except perhaps in the case of "key-person" policies, and c) Congress has long relied on backstopping legislation (tightening the definition of insurance and restricting deductions for interest incurred to finance the purchase of insurance), rather than eliminating the source of the problem by currently taxing the inside build-up on virtually all corporate-owned life insurance and limiting the deferral of tax on inside build-up on policies owned by individuals. (1) It may be true that broad-based COLI could not have been foreseen, but it is equally true and more relevant that Congress did not need to anticipate the development of broad-based COLI to avoid its abuse. It would have been possible, as well as desirable, to avoid the entire COLI debacle by taking the direct approach.

INTERNATIONAL ISSUES

David Tillinghast essentially deals with two types of international issues: tax evasion by individuals, generally those with high-incomes, and, to a much lesser degree, tax avoidance by corporations. The two types of problems generally have quite different origins: lack of access to information that facilitates evasion in the former case and the inherent complexity of the problem in the latter. Unfortunately, Tillinghast does not draw this distinction explicitly or discuss the two types of issues separately.

Tillinghast aptly notes, "Many of the international issues facing the IRS can be appropriately resolved only with the cooperation of its foreign counterparts" (p. 40). To date--or at least up to the time of the conference where this paper was presented--most such cooperation has been bilateral, based on treaties for the prevention of double taxation and cooperation in tax administration. It has focused on which country (source or residence) has priority in taxation of various kinds of income, means of avoiding double taxation, and how to measure business income attributable to a particular jurisdiction (through the use of arm's length pricing). Despite the existence of bilateral tax treaties, especially between advanced countries, cooperation is, as Tilinghast notes, inadequate in many areas related to taxation of multinational corporations, including advance pricing agreements, mutual agreement procedures, and mutually consistent characterization of various types of entities and income by different countries. Tilinghast concludes that shifting to a territorial system, under which the U.S. taxed only domestic-source business income (as well as income from passive investments, without regard to source), would do little to alleviate complexity. Steven Shay agrees, but argues that ending deferral, a policy that would have significant implications for competitiveness, would do so.