ataxingmatter

Budget Conference Stalled; Time to Rethink Investment Income Tax Breaks

The House and Senate have not been able to come to an agreement on the Budget for fiscal year 2007.  The Senate insists on addressing the Alternative Minimum Tax with further temporary legislation increasing the exemption amount, but the House insists on extending tax cuts to the very wealthiest Americans.  The House budget negotiations fell apart on Thursday over turf battles, and (at least for now) the effort to get final approval for a $70 billion package of new tax cuts is also stalled.  See this article in the April 7 New York Times.

It would be helpful if the members of the House would use this break period to re-assess their commitment to further tax cuts for the extraordinarily wealthy.  The New York Times recently ran a front page story by David Cay Johnston on the "Big Gain for Rich Seen in Tax Cuts for Investments."  Based on government statistics and research using Citizen for Tax Justice's modeling of tax legislation and 2003 data, the Times article concluded that "more than 70 percent of the tax savings on investment income went to the top 2 percent, about 2.6 million taxpayers."  Accordingly, the Bush tax cuts on investment income have "significantly lowered the tax burden on the richest Americans, reducing taxes on incomes of more than $10 million by an average of about $500,000."   That's a cool half million tax reduction annually for the creme de la creme of U.S. society.  When the earlier Bush tax cuts on compensation are added in, these taxpayers average slightly more than $1 million in tax savings. The result:  taxpayers with annual incomes averaging $26 million pay no larger a share of their income in taxes than those making between $200,000 and $500,000. 

And those savings will only increase in later years if economic growth continues to rest in stock market gains and not in average wages for ordinary Americans, as expected. "[E]ven the merely rich, making hundreds of thousands of dollars a year, are falling behind the very wealthiest."  Ordinary taxpayers who work for a living get little or no benefit out of the break for investment income--what little stock they own is in retirement accounts, and those funds are not taxed until withdrawn, when they are taxed at much higher compensation income rates. (All statistics and quotes in this and the preceding  paragraph are from the Times article.)

Citizens for Tax Justice also released its own study on Tax Cuts on Capital Gains & Dividends on April 5.  It notes that the change in taxation of investment income in the 2003 tax act resulted in a 95% increase in tax savings for those with annual adjusted gross incomes greater than $10 million.  The comparison to ordinary taxpayers in the CTJ discussion is stark.

[T]he 71 percent of tax filers with AGI less than $50,000 saved an average of only $10 each from the capital gains and dividend tax cuts, adding only 2 percent tot heir $425 average tax reduction in 2003.  Almost 43 percent of the capital gains and dividend tax cuts in 2003 went to the 181,000 filers with AGI greater than $1 million.  These filers represented only 0.1 percent of all tax returns. [emphasis added]

Let's run that by again:  in 2003, 43% of the investment income tax cuts went to just 181 thousand Americans--one tenth of one percent of all federal income tax returns filed that year.

These sobering statistics about the shifting of the tax burden (and services detriment) to ordinary Americans from super-wealthy Americans do not  disturb the think tanks that espouse zero taxes for all investment income, illustrated by Stephen Entin of the Institute for Research on the Economics of Taxation, who was quoted in the Times article.  They also don't appear to disturb the investor-friendly congressional representatives in the House, who continue to assert that huge investment tax breaks aid ordinary Americans.  The Times notes a misstatement by David Camp, the House floor leader for the investment tax cut: he claimed that almost 60% of taxpayers with under $100,000 in income have capital gains and dividend income annually.  But that's just plain wrong, as the Times reports.  Only the top 10% or less of taxpayers make more than $100,000 annually.  For the vast majority of U.S. taxpayers who make less than $100,000, only about one in seven received any benefit from the dividend tax cut in 2003 and only one in twenty received a benefit from the capital gain tax cut. See "Big Gain for Rich Seen in Tax Cuts for Investments."

This information is consistent with the concentration of wealth revealed in the IRS's recently released report on Personal Wealth, 2001, based on federal estate tax returns for 2001-2003.  It shows that a very small percentage of taxpayers--about 3.5%--own almost a third of all of U.S. net worth or $13.8 trillion.  For those in the bottom of that group, the main assets are personal residences.  But for those with net worth of $10 million or more, the main assets are publicly traded stock and other financial assets. So even among the well-to-do, stock ownership is heavily concentrated in the very wealthiest hands.

The other chief rationale for the investment tax break is no better grounded than the "America is now an ownership society" rationale.  Supporters claim it will incentivize savings, and hence further investments, by wealthy Americans, and those investments will be a further spur to economic growth.  But the Times article notes that the opposite is at least equally plausible. See "Big Gain for Rich Seen in Tax Cuts for Investments."   With an extra $500,000 from the investment income tax cuts burning holes in their pockets, the wealthy are likely to have a strong incentive to spend, not to invest in new entrepreneurial activities.

Return Preparers' Commercial Use of Taxayer Information

In a prior posting here, I reported on the GAO report about tax return preparer errors, including omission of income from non-W2 sources and other advice that appears to abet client tax evasion.  At the same time, I reminded readers of the IRS decision to facilitate commercial use of tax return information by allowing preparers, with consent, to sell taxpayer information to unaffiliated third parties, discussed in this posting.  The consent requirement may well be insufficiently protective of taxpayers, especially if preparers ask taxpayers to sign the form without explaining it, provide the form routinely with other forms that require signatures, or mislead taxpayers about the uses and protection of their information. 

Representatives Stark, McDermott, Inslee and Bean have introduced legislation to prevent tax return preparers from selling taxpayer tax return information to third parties.  The legislation also restricts outsourcing abroad of tax return preparation work.  See this April 4 release on Representative Stark's website.  The text of the "Taxpayer Privacy Act of 2006" is available on RIA's Checkpoint service, here.  If you'd like to weigh in on the importance of restricting return preparers' ability to commercialize tax return information, you can contact your congressional representatives through the following link: http://www.congress.org/congressorg/dbq/officials/.

Corporate Tax Noncompliance

Michelle Hanlon, Lllian Mills and Joel Slemrod have released a working paper titled "An Empirical Examination of Corporate Tax Noncompliance", available on SSRN here.  The paper was prepared for a 2005 conference at the University of Michigan.

Using IRS audits and appeals data merged with confidential tax return data, the study looks at noncompliance measured by proposed tax deficiencies on audit and upheld after taxpayer appeals.  Here is a statement of their tentative conclusions.

First, [the study] has confirmed that corporate tax noncompliance, at least as measured by deficiencies proposed upon examination, amounts to approximately 13 percent of 'true' tax liablity. ...

Second, noncompliance is generally a progressive phenomenon ...[that] increases with the size of the company.  Combined with other information that the noncompliance rate among very small businesses is significantly higher than 13 percent, this suggests that ...medium-sized businesses hav[e] the lowest rate of noncompliance.

Third, noncomplaince is related to some observable characteristics of companies. ...

Fourth, ...incentivized executive compensation schemes are associated with more tax noncompliance.

Finally, ...there is no consistent simple or partial negative association between [the] measure of tax noncompliance and measures of the effective tax rate calculated from financial statements.  This might mean that the financial statements are uninformative about tax aggressiveness in part because of the tax cushion for future adverse judgments that is included in the tax expense amount on the financial statements.  In addition, it may be that publicly available effective tax rate measures affect the aggressiveness with which the IRS pursues tax noncompliance.

They note that the measure they use for noncompliance is a result of an audit of a "tax return declaration that may itself be the opening bid in what is expected, often correctly, to be an intense negotiation and formal appeals process."  This statement merely confirms what most understand is common practice.  Because a taxpayer is not penalized under the Code for positions taken on a return so long as the taxpayer had "substantial authority" for the position or, in the case of disclosed positions, had a reasonable basis for the position, there is no incentive for aggressive taxpayers to file returns that reflect the position that the taxpayer reasonable believes more likely than not to be the correct position.  Those low, litigation-based standards combine with low audit rates to give large corporate taxpayers--and their managers who are compensated for higher returns--every incentive to engage in aggressive tax strategies.

Cracking down on this behavior with increased enforcement, as the IRS has recently done, is a good first step.  But Congress should change the statutory penalty standards to require taxpayers to file returns that they think are correct, not just good "opening bids" in a personalized negotiation with the IRS that makes a mockery of fairness requirements.

Tax Return Preparers--the Good, the Bad and the Ugly

The Government Accountability Office (GAO) has conducted a limited empirical study, here, of paid tax return preparers.  Paid preparers were used by about 56% of taxpayers in 2002 and 64% of taxpayers with incomes over $100,000. 

Like the pairs of testers who visit realtors to see if they are shown houses based on race, the GAO sent out testers prepared with information that showed two scenarios--a married plumber with a child in college who had some side income and a small mutual fund investment and a single mother (with one child at home, another living with a grandparent), who was employed in retail sales and had side income from babysitting.  The testers made site visits to 19 commercial tax preparation outlets in a single metropolitan area.  The testers acted as "fairly unsophisticated" taxpayers, testing in part whether preparers would ask the right questions when partial information was provided.

The results of the study are disheartening. The GAO report indicates that most of the prepared returns were "incorrect to some degree" with some returns representing "very bad tax advice."  Id.  Only 2 had the correct refund amount, and even those had errors that did not affect the bottom line.  The returns would have claimed excess refunds up to almost $2000 in 5 cases and would have cost taxpayers more than $1500 in 2 cases.  Seven returns reported too many exemptions.  Six out of 9 returns made some error in determining the education credit. Five of 10 returns inappropriately claimed the child that did not reside with the parent for the earned income credit. Eight returns reported state tax refunds incorrectly.  Ten returns omitted non-W-2 business income.  Eight returns omitted a foreign tax credit that should have been claimed.  5 of the returns did not fully comply with the return preparer identification requirements.

Perhaps most disturbing was the frequent misreporting of non-W2 business income.

"Both of our taxpayer scenarios included self-employment income. ...Despite being told of the side income in every case, 2 out of 9 plumber return preparers and 8 out of 10 sales worker return preparers did not report the income as required.  ... Several advised us that reporting such income was our decision because IRS would not know of it unless we reported it.  One preparer told our investigator posing as a sales worker that she did not have to report the income unless it was over $3,200."

Interestingly, most preparers offered the testers services in addition to the federal tax return preparation work requested.  Some gave additional services without checking with the testers, such as preparation of state tax returns or electronic filing.  Preparers generally offered various options for getting expedited refunds through short term loans or direct deposit alternatives.  The study reports that "[o]ne preparer gave [the testers] a [loan] application to sign at the start of the visit without explaining what it was [they] were being asked to sign."  In another case, a loan was suggested without much information about the advantage of the loan, and the fee amounted to an annual percentage rate of around 400%.  This behavior is especially worrisome in light of the IRS's proposal to make it easier for return preparers to use tax return information for commercial purposes if they obtain consent of the taxpayer.   See this earlier posting on this topic.

Penalties for preparer errors are too low.  Unrealistic positions that understate taxpayers' liabilities only incur penalties of $250 per return.  Even when the understatement is due to willful or reckless conduct, the penalty is only $1000 per return.  Various failures to comply with requirements--such as failure to provide copies of returns, failure to sign returns, or failure to furnish an identifying number--are penalized at only $50 per failure.  The civil penalty for aiding and abetting understatements of tax liability is only $1,000.  The criminal penalties are more onerous: a tax return preparer may be fined up to $100,000 and imprisoned up to 3 years for willful preparation of a false or fraudulent return. 

Clearly, measures need to be taken to ensure better quality work by return preparers, if this sample provides an accurate portrayal of their work.  One possibility might be institution of a rigorous licensing requirement based on a national test.  The penalty standards and confidence levels required for preparers should be raised.  The level of confidence a tax return preparer is expected to have in advised positions should be increased, to ensure that tax return preparers may only advise a taxpayer to take a position on a return that the preparer reasonably believes to be more likely than not the correct position.  It might also be appropriate to increase the penalty for failing to satisfy that standard to $2000 per return.  A similar increase in the penalty for understatements of a taxpayer's liability due to recklessness might be appropriate. 

Response to Everson

In an earlier posting, here, I noted Commissioner Everson's March 27 suggestion that public disclosure of certain corporate tax return information would further tax law compliance.  Everson has connected the need for greater transparency in part to the discrepancy between financial statement reporting and tax reporting that creates an inherent tension between increasing book profits and decreasing taxable income.  See this March 14 speech before the National Press Club.

Senator Grassley, chair of the Senate Finance Committee, is apparently interested in developing legislation to provide greater transparency.  See this April 3 story in the Daily Tax Report.   Similarly, practitioners Peter Canellos of Wachtell, Lipton and Ed Kleinbard of Cleary, Gottlieb have suggested that the Schedule M-3 reconciliation of book-tax numbers, and specific information relating to cash taxes paid, should be made available to the public (perhaps as part of the regular SEC filing of public companies).  Id.

Many tax practitioners, however, have responded negatively to Everson's suggestion, asserting that disclosure might actually increase noncompliance while negatively impacting U.S. corporations' competitiveness.  Id.  They suggest that disclosure of respected companies' aggressive tax strategies will result in a race to the bottom in which other companies adopt strategies already employed by their competitors, or companies might disguise strategies in order to avoid bad publicity.  Id.

The arguments about harm to competitiveness seem to be overstated.  Public corporations already are required to share considerable tax information through the SEC filing requirements.  And while the race-to-the-bottom concern is real, transparency should, on balance, encourage better compliance rather than fostering greater compliance failures.  If corporate return information is released, along with a clear report on cash taxes paid and a reconciliation of taxes paid to financial statement tax provisions, the public will be able to see whether corporations that make huge profits are carrying a fair share of the tax burden.  Corporate social responsibility has received considerable attention in recent years, and the shaming effect of public scrutiny of actual tax payments can be significant.  See my article "Putting SEC Heat on Corporate Tax Shelters, available here on SSRN.

TRAC Suit

I reported earlier, here, Syracuse Professor Long's suit against the IRS for failure to provide statistical information as required in a prior judgment.  The Western District of Washington has now upheld the original 1976 decision and ordered the IRS to provide extensive statistical information to Professor Long within 14 days. See  the district court's order.  The order, along with TRAC's motion and a TRAC release on Judge Pechman's decision,  are available at the TRAC website, here. 

The TRAC release summarizes and quotes the Judge's order as follows:

The court rejected the IRS's argument that the production of statistical data would violate a statute prohibiting public release of tax return information about individual taxpayers, because there was no evidence that the statistics could be used to identify any taxpayer. The ruling stated that, "[b]ecause Ms. Long seeks to disseminate the information sought in this proceeding to the public, there would be a public benefit from disclosure of the records sought." It also found that, "Ms. Long's interest in this matter stretches back 30 years and has both public interest and scholarly components."   Id.

It is interesting that the IRS pursued this secretive approach on release of statistical information about its own audit and enforcement efforts while at the same time proposing regulations that further facilitate tax return preparers' ability to profit from commercial use of private tax return information.  See the proposed regulations, Notice 2005-93 (with the proposed consent and warning requirements), this article and this prior posting on A Taxing Matter.  New York Senator Schumer has called on the IRS to rescind its plan for permitting tax return preparers more flexibility in commercialization of taxpayer data with taxpayer consent.  See this story.  In response to various critical analyses of the proposed regulations, the IRS website, here, defends the regulations as adequately safeguarding taxpayer information.