ataxingmatter

Bruce Bartlett on the "Fair" Tax Proposals

Bruce Bartlett has a well-written piece on the so-called "Fair Tax" proposal.  Bruce Bartlett, Why the Fair Tax Won't Work, 117 Tax Notes 1241 (Dec. 24, 2007).  The arguments he makes aren't really new, since various people (myself included) have criticized the Fair Tax proponents for trying to have their pie and eat it too.

The Fair Tax proposal calls for elimination of the income and payroll taxes (and the withholding and IRS audit and enforcement machinery that stands behind them) and replacement with a national sales tax.  The sales tax would purportedly apply to every purchase, without exception, including state and local government purchases.  The proponents claim it would be able to generate sufficient revenues at a flat (tax-inclusive) rate of 23%.  They also make various claims that people will be able to keep all their paychecks and that prices won't rise, there will be no compliance failures, and life will be hunky-dory ever after. 

Bartlett effectively debunks these exaggerated and downright misleading (and often contradictory) claims.  Here are a few of the points he makes.

First, the fair tax would be highly regressive, resulting in a huge tax break for those in the top quintile of the income distribution (roughly, those earning $200,000 and up annually) and crushing burdens for those at the bottom.  This is because the poor consume all of their income, and the wealthy do not.  Consumption decreases with wealth. 

In order to make the "fair tax" even somewhat palatable, there'd have to be a mechanism for relief for those at the bottom.  The Fair Tax proposal provides for a monthly government check to every person in the US.  But single parents with children will be discriminated against compared to married couples without children, getting a much smaller rebate.  The rebate isn't based on income or amount of consumption or the cost of living or the cost of raising children; it is not even a rough justice measure of who merits it. It's based at most on an arbitrary back-of-the-envelope calculation from the 1960s determining the poverty level.   Bill Gates will get the same check that the beggar on the corner gets.  This is an immense new governmental entitlement program, that will require reams of disclosure (number of people residing in the household each year, ages, social security numbers).    Nothing "fair" about any of that.  And nothing simple either.  Maybe there's no IRS (more on that later) but there's certainly a lot of big brother mechanism just to figure out the rebate for each household.

Bartlett notes that this is just the kind of situation that brings out the political negotiator in every politician.  One will press for extra help for single parents with multiple children, and another will think of another group needing extra care and attention.  Pretty soon the "fair" and "flat rate" tax will be riddled with different rates because of special exemptions for all those special interest groups.  And it won't stop there.  Some goods just aren't meant to be taxed--many states don't tax groceries, for example.  And services--look at the debacle in Michigan when the legislature tried to initiate a services tax.

The Fair Tax would tend to penalize the young--who need to "over consume" by borrowing to begin to build up assets (homes and cares and all the things required to start a family).   It would also penalize the old-o-who saved for retirement under an income tax and now will be taxed harshly when they spend that savings, instead of being able to spend it freely without further tax.  (Politicians would of course create more exemptions and exceptions to try to deal with this.)

Proponents of the Fair Tax also make all kinds of misleading and simply erroneous claims.  Bartlett calls it a "double free lunch" claim--claiming that prices will fall once the income taxes currently embedded in them are gone, but acting as though wages will not fall as well.  In fact, as Bartlett notes, either prices will stay up or wages must fall.  Neither gives the ordinary guy the windfall that proponents appear to promise.  Of course, if prices really fell, no rebate would be needed so long as everybody is satisfied with a large pay cut while prices steady themselves down lower.  That, Bartlett notes, simply will not happen.  So there will be no windfall gain compared to the income tax.

Oh, about that 23% rate.  It's not really 23%--at least, not if you calculate it the way we ordinarily calculate sales taxes.  We think of the price without taxes ($100) and the  tax that must be added on as a percentage of that price( a 23% tax-exclusive rate yields a $23 tax), giving a total cost of $123.  But that's not what proponents of the Fair Tax are talking about.  They are looking at a $30 add-on tax on a $100 price.  30/130 = 23%.  So we can describe the rate as a 23% "tax inclusive" rate or a 30% "tax exclusive" rate.  We ordinarily talk about sales taxes as tax exclusive rates.  We pay $10 for the item, we pay a 7% sales tax which will be 70 cents on the $10 price.  Most Americans would not be very happy with a sales tax of 30% on every item purchased (and every service purchased), especially when applied to doctors' and hospitals' bills, health and car insurance, and other big ticket items (like large appliances, cars, even houses).  So FairTaxers disguise the negative impact of their proposal by using a tax-inclusive rate.

As for taxing government to raise government revenues, this is no benefit.  It may mean states have to increase their taxes to pay the taxes to the federal government, which won't provide relief to ordinary taxpayers.  Bartlett estimates that states that pay for their increased costs due to the FairTax by raising sales tax rates would tend to increase the average rate from about 6.5% to 11%.

The FairTax assumes about 80% of the GDP would be taxed.  But no country currently succeeds with that kind of a sales tax.  In small countries where cheating is harder, maybe 48% can be covered by a VAT, but in the EU, only about 38% can be covered by VAT.  The sales tax is less efficient and more prone to abuse than the VAT, so even less than that would be realistic.  That's a lot of slippage compared to the sales pitch from FairTax proponents.   No state taxes anywhere near as broad a base as the proposed FairTax base--services are hardly taxed at all (partly because taxes on them are easier to evade) and of course states don't currently tax imputed rent to homeowners, as the Fair Tax would require (else homeowners would be sitting pretty compared to renters). 

Barlett concludes that "[m]assive evasion is inevitable with the FairTax because all revenue would be collected at just one point in the entire economic system."  And since the states would be doing the collecting for the federal government, the collectors' incentives to engage in the extra administrative hassle would be minimal.  States would have complicated jobs to do, since their sales taxes are not very similar to the proposed FairTax.  With no backup to the collection the retailer on the front line is required to do, no withholding, and  no other points of tax collection, the tax collection process will be "fragile", says Bartlett.  (A wreck might be a more apt description.)  Fake Social Security numbers such as those used by illegal immigrants (I was the one that first informed Barlett about this problem) would magnify noncompliance--invent a Social Security number for your invented dependent, and claim an additional rebate amount.   Tax evasion would probably necessitate a much higher rate--at least 35% or 40% on a tax-exclusive basis, quite possibly as high as 65%, according to one Brookings Institution study.  Id. at 1252 n.55.  (See also this 2005 Urban Institute study by William Gale on the topic.)   In fact, once politicians do their thing to start creating exemptions and special provisions for the most needy (or the loudest special interest groups), it is quite likely that the higher end forecasts would be the more accurate ones.

And remember that problem with the states doing the collecting?  Their sales tax doesn't match the FairTax, so they have two likely options--make it match or get rid of their sales tax and institute a bigger income tax now that the federal income tax is out of the way.  Bartlett is betting on the second choice, and I think that is highly probable.  Most states already have both sales and income taxes, so expanding the income base would be relatively easy.   Most states with income taxes don't exactly copy the federal income tax, so it appears they wouldn't be likely to do so for the sales tax either, especially since their sales taxes have been in place for some time, and they won't be eager to go through the bruising local political battles to make changes that increase the sales tax base.

Complexity will vanish, you say?  Not likely.  As long as states retain an income tax, taxpayers will have to retain their records and face potential audits, etc.   As politicos make changes to make the FairTax more palatable, there are likely to be further recordkeeping requirements.

Are Americans beginning to get more sophisticated on these tax issues, or will they continue to be gullible about these proposals being pushed by groups with ulterior motives about the desired shape of the tax and spending system?  Here's hoping that the 2008 campaign will help focus attention on the issues.  As candidates like Huckabee hawk the FairTax, perhaps the other candidates will start making some of these obvious points about its problems.  I think if ordinary taxpayers get enough information about it, they will soundly reject the idea.

If we want to do something with the tax system, let's have a deliberative consideration of how to improve the income tax system that we are already well familiar with, that an overwhelming majority of Americans complies with, and that satisfies most Americans concept of fairness by providing for a progressive rate structure.

For more on Barlett's criticisms of the FairTax proposal (especially comments from FairTax proponents), see the following:

FairTAx, Flawed Tax, Bruce Bartlett Op-Ed in the Wall St. J. (Aug., 2007)

FairTax.org (organization pushing the FairTax proposal, and responding quickly on any blog that posts Bartlett's criticisms with reiterations of the "double free lunch" claims--see comments on "Freedom Talks" blog, below)

Cato.org (an early 1997 piece praising the FairTax proposal and setting forth various of the flawed arguments highlighted by Bartlett, such as the claim that states can readily administer the system in spite of having different sales tax bases, and the failure to account for the funding needed to provide a payment to the states for so doing).

FreedomTalks (a blog that argues for lower taxes no matter what, but still ran an article on the problems wih the FairTax; the comments are from dyed-in-the-wool FairTaxers who continue to make the same "double free lunch" claims about their pet project that Bartlett debunks--that prices will go down, workers will still keep all their income, and the economy will soar in spite of the need for a high rate of tax on all transactions)

TaxProf Blog's gathering of responses to Bartlett's Wall Street Journal Op-Ed.

Corporate Lobbying Group has a New Wish List: a Capital Gains Preference for Corporations

Now that businesses have gotten just about every item they had on their tax wish list back in 1999 (and thought they'd never get), they have decided it's time to raise the ante and come up with some new ways that they could get more tax breaks (at the cost, undoubtedly, of higher taxes for ordinary Joes either now, or later to pay off the debt needed to finance the corporate tax breaks).  A new coalition--called "America Gains"--has been formed to push for a change to the tax code that will reduce revenues in the long run (if not in the short term) but that the coalition will try to sell to Congress and the American people as a revenue raiser.  See Alison Bennett, New Coalition to Push Reduced Tax Rate on Business Capital Gains as Revenue Raiser, 57 BNA Daily Tax Reporter March 26, 2007, at G-5.

The claim is that a lower rate on business capital gains will result in freeing assets that have been locked up because corporations keep the assets rather than selling them to avoid the purportedly too high regular corporate rat tax, and thus the sales, even at lower rates, would generate higher revenues.  That hypothesis is doubtful, but--like the claim that the huge 2001 tax cut was first just a way to use a budget surplus (which had long evaporated by the time of the legislation) and then a way to generate economic growth (which tax cuts don't really do)--it's a selling point in a society that looks at spin rather than facts.   Not surprisingly, the coalition appears to have been conceived in the context of a conference at the American Enterprise Institute, which has long stood for zero capital gains rates for everybody.  Their argument is that labor should bear tax, and not capital.   And not surprisingly, the coalition isn't going to tell us who's footing the bill--the members are a secret society.  Leave it to that group to label as "punitive" the US corporate statutory rate that results in the US having tax haven status because it is actually among the developed countries at the very bottom in terms of effective tax rates, when all the loopholes and special provisions are taken into account.

Corporations already divest themselves of subsidiaries in very tax-effective ways, given the expansive reorganization provisions in the Code (and those have been administatively expanded under this tax administration).  Do we want to encourage even more trading of stocks?  I'm not so sure.  Sometimes, as an ordinary person and not a tax lawyer, I think it would be awfully nice to know who owns companies and who really makes their products.  Look at the disaster with Menu Foods in Canada making pet foods for scores of brands--people who thought they were buying one company's product over another's were really buying the same garbage laden with rat poison, as it turns out.  So it may be that encouraging even more rapid turnovers of subsidiary corporate stocks would not be a good thing (if the bill would really have that impact).

Furthermore, given that many of the top 500 corporations have not been paying any tax at all, it is hard to see how the puny effective tax they do pay is "locking them out" from selling assets.  It just doesn't wash.   Congress needs to stop passing revenue reduction bills and start thinking about how best to provide health and elder care for all in a reasonable way.

The Service's New Indopco Ruling--letting a public company deduct securities class action litigation expenses

The Service has released a private letter ruling 200649011 on a question of deductibility of litigation expenses and a settlement amount.  The case involves a merger in which it is later claimed that the target corporation engaged in significant accounting fraud that inflated the value of its stock and that the acquiring corporation actively prevented disclosure of that fraud in the proxy statement in connection with the merger.  The Service applied the origin of the claim analysis to conclude that the litigation expenses, and the settlement amount, are deductible.

The Service analyzed in detail Missouri Pacific Corp v. United States, 5 Cl. Ct. 296 (1984) (holding that claims that led to settlement amounts were in respect of false representations in a prospectus for an acquisition of target shares that overstated the vvalue of taxpayer's shares and understated the value of target's shares and thus originated in the taxpayer's acquisition of target and were not deductible) and Berry Petroleum Corp. v. Comm'r, 104 T.C. 584 (1995), aff'd 142 F.3d 442 (9th Cir. 1998) (unpublished) (holding that the claims of selling classes of shareholders and merging classes of shareholders originated in fraud in the representations made to accomplish the merger at a good price and not merely fraud in the operation of the companies).  Both of those cases found the origin of the claim related to the acquisition and thus denied deduction.  The Service distinguished the current case, concluding that the claims at issue here were rooted in ongoing accounting fraud that occurred in the ordinary operations of the company and hence payment need not be capitalized.

The argument in the letter ruling appears to suggest that settlement of any claims relating to accounting fraud will not be treated as nondeductible capital expenditures unless the fraud was undertaken solely in order to increase the value of the stock for acquisition purposes.  The Service emphasizes that the accounting improprieties themselves did not stem from conduct in the course of a particular acquisition taxationor the merger of target with taxpayer.  The Service also treats the Section 14(a) securities claim (related to falsification of a proxy statement by instructing an accounting firm not to consider certain target accounting errors that had already been discovered) is treated as not arising in the context of the merger.  Instead, the Service states that "the actual origin of this claim was ...the ongoing fraud allegedly perpetrated by [the target corporation] during the years prior to the merger." 

The basis for this statement is that (i) there were statements about the financial condition of the companies that "did not originate in the merger transaction" [emphasis added] but rather reported financial statements previously published, (ii) the additional misrepresentation by causing the firm giving the merger opinion letter to fail to consider the accounting errors was only of "incidental value" to the claim; and (iii) the allegations of these misrepresentations and omissions were not "made solely in the context of, and for the purpose of, an acquisition"  [emphasis added].

Especially with this last statement, the Service appears to be narrowing the Indopco test even further than the regulations (considered by some as inconsistent with the Code in permitting deduction of otherwise capitalizable expenditures).  The language in the private letter ruling suggests that litigation costs related to accounting fraud will not be viewed as sufficiently related to an acquisition to require capitalization unless the underlying misrepresentations and omissions are "solely for the purposes of an acquisition."  Id. [emphasis added].  Costs of litigating claims related to accounting fraud, which so nicely serves an assortment of purposes all to the advantage of the managers committing the fraud (e.g., inflating executive pay, inflating value of stock for acquisitions, inflating value of stock for monetization, etc.), would under this test only in the rarest of cases be sufficiently connected to a particular acquisition to be required to be capitalized.

Looks like the wrong answer to me as a general approach, given the well-understood value of inflated stock as acquisition currency.  Looks like the wrong answer in particular in the case of the Section 14 claims here, where the taxpayer is accused of instructing the accounting firm preparing a letter to be used in the merger from considering certain accounting improprieties.

Glaxo Transfer Pricing Settlement

The IRS has won a significant settlement in a transfer pricing issue that was preparing to go to litigation, see this Bloomberg article and this CBS News item.   [Addendum: The 1993 Transfer Pricing Agreement between the company and the IRS is available in BNA Tax Core at this link.]  The company, Glaxo SmithKline Holdings, will pay more than $3 billion in taxes and penalties, and forgo a related refund claim for almost $2 billion.  The company says the settlement will have no impact on its earnings statement, since it had reserved $4.3 billion for potential tax costs.  (Query whether that means the IRS should have pushed for more than a 60% settlement?)

Transfer pricing is an area fraught with potential for taxpayer manipulation of reported earnings in non-arm's length deals with affiliates.  IRS Commissioner Everson calls it "one of the most significant challenges...in the area of corporate taxation."  See this IRS news release.  Recognizing the difficulty of litigating these types of cases and the huge potential for tax evasion through manipulation of profits and expenses, it is encouraging to see that the IRS has been able to achieve a significant settlement here.

The IRS News Release includes an interesting statement by IRS Chief Counsel Donald Korb.

"I am often asked the question," Mr. Korb said, "whether the Chief Counsel lawyers are being constantly outgunned by the large law firms they face in the big dollar cases in the Tax Court. During my tenure as Chief Counsel it has become quite evident to me that our lawyers can go up against the best firms the private tax bar has to offer in the Tax Court and achieve quite successful results."

The sheer size of this settlement should help the IRS in its continued effort to stymie corporations' abuse of the tax system.   It will certainly be noted by tax advisers.  Perhaps it will also lead companies' boards of directors to ask more questions about those $4.3 billion tax provisions.

Total Tax Contribution: PricewaterhouseCoopers' New PR Push

Robert McIntyre, of Citizen's for Tax Justice, has an interesting op-ed titled "Transparently Dishonest", American Prospect Online (Aug. 30, 2006), highlighted in today's Tax Digest.  He notes that PricewaterhouseCoopers has a new project, called the "Total Tax Contribution framework" that is claimed to "enhance transparency in corporate tax reporting" but actually is an effort to obfuscate by puffing claims of corporate taxpaying with the "taxes they don't pay, such as those paid by their customers, workers, suppliers, and so forth."  Id. (emphasis in original).  McIntyre provides an example of this TTCf project at work:  ExxonMobil's claim, in a Washington Post ad, that its "total U.S. tax bill was $57 billion, exceeding our total U.S. earnings [over the past five years] by $22 billion."  Similarly, McIntyre notes, the ad claimd that "ExxonMobil earned about $36 billion, but incurred $99 billion in taxes worldwide."  Id.

If the ad (and the PwC approach) were truthful, it would be a cause for grave concern for American businesses, especially the extractive industries like ExxonMobil.  It would mean their profits are swallowed in whole by their tax obligations, resulting in losing businesses that portend ill for the American economy.  But this would be very strange in light of the recent coverage of the windfall profits experienced by companies like ExxonMobil with Katrina and other forces causing gas prices to skyrocket across the country.  See, for example, this Oct. 28, 2005 CNN article, Oil Industry Under Fire, about the talk of a windfall profits tax, and this New York Daily News Aug. 31, 2006 report, Pay's a Gusher, about the huge compensation windfalls for oil company CEOs.  Note in particular the report about (former) CEO Raymond of  Exxon Mobil, the U.S.'s most profitable company in 2005.

Indeed, McIntyre reviewed ExxonMobil's annual report for 2005, available here, and found that the figures in the ad were simply misrepresented. Those $36 billion in worldwide "earn[ings"?  Actually, that's only the after-tax profits.  "The company's pretax profit ... was $59 billion."  Transparently Dishonest.  That $99 billion paid in taxes?  Actually, that includes about $75 billion paid by its customers in gasoline taxes and other foreign levies and not paid out of its profits.  Id.  McIntyre notes that ExxonMobil's actual taxes paid in the U.S. were considerably higher than in recent history, because its "recent windfall profits from high oil prices have been so big that the company simply ran out of loopholes to shelter them."  Id.  McIntyre ends with a comment about PwC's increasing lack of credibility in light of these misleading PR strategies, on top of its tax-shelter work over the last decade.

I second McIntyre's concern about the creditiblity of PwC in light of this TTC "framework." I think the framework and the ExxonMobil ad are worth noting for two other issues, as well.

First, big corporations (and their allies) are constantly engaged in lobbying Congress for tax policies that favor their businesses.  An ever-present piece of the campaign is the claim that high U.S. taxes, often emphasizing the statutory rates, make U.S. corporations uncompetitive.  But few U.S. corporations pay effective taxes at the 35% statutory rate.  In fact, during the 1990s many corporations had developed extensive tax shelters so that they paid no income taxes.  See, e.g., this Center for American Progress report on the Corporate Tax Dodge (April 2004) and this Boston Globe article titled  "Most U.S. Firms Paid No Income Taxes in '90s" (April 2004) covering a recent GAO report.  The article states:

The report by the General Accounting Office raises questions about whether the corporate income tax burden is too light and distributed unequally. It could undermine arguments that US companies are overtaxed and provide ammunition to politicians and activists who claim companies are using loopholes to avoid paying their fair share.

The United States is generally at the lower--rather than the higher--taxed end of the tax scale among OECD nations, and corporations in the U.S. generally pay a smaller share of the U.S. tax burden now than they did in the past, even though corporate tax payments did increase in 2005 beyond the exceptionally low rates to which they had declined in recent years.  See, e.g., Citizens for Tax Justice International Tax Comparison 1965-2003 (April 2005) and this New York Times July 9, 2006 article by Edmund Andrews. 

Ads like ExxonMobil's therefore will require extra vigilance by ordinary citizens to ensure that Congress sees these ads' tax statistics for what they are--an attempt to create an unrealistically dire picture of the tax burden on major U.S. corporations. 

Second, Sarbanes-Oxley (S-OX) was passed after a high-profile spate of accounting scandals at major corporations, including WorldCom and Enron.  Among other things, it resulted in a stronger focus on the accountability of audit firms, including restrictions of tax services.  See my article about the accounting scandals and need for restrictions of tax services, and the SEC's approval of new PCAOB rules restricting tax services. 

Some commentators now urge that S-OX should be relaxed.  See, e.g., Larry Ribstein's article evaluating Sarbanes-Oxley after three years (suggesting that S-OX was passed in a fit of "sudden acute regulatory syndrome" and that markets can effectively self-regulate, perhaps even in areas of fraud).  In contrast, I believe that PwC's promotion of the TTC framework suggests a need for continued vigilance of regulatory agencies dealing with audit firms, in particular. When audit firms are actively marketing PR schemes that misleadingly report important information, it suggests that there may also be a lax approach to the various discretionary decisions that they may make as auditors of public reporting companies.  The S-OX rules imposing greater oversight of auditor indepedence continue to be important.

(In the interest of full disclosure, I should state that I am now associated with Wayne State University, where Robert McIntyre's brother Michael McIntyre is a member of the tax faculty.)