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I love America. More the merrier, I say.

NOTE: I love America. More the merrier, Oops, More (tax) loopholes the merrier.

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…and I am (Tea Party-Hardy-Ha-Ha-Ha) Harth@webworldismyoyster.com

Yale Law School
Yale Law School Legal Scholarship Repository
Faculty Scholarship Series Yale Law School Faculty Scholarship
1-1-1973
Income Tax “Loopholes” and Political Rhetoric
Boris I. Bittker
Yale Law School
This Article is brought to you for free and open access by the Yale Law School Faculty Scholarship at Yale Law School Legal Scholarship Repository. It
has been accepted for inclusion in Faculty Scholarship Series by an authorized administrator of Yale Law School Legal Scholarship Repository. For
more information, please contact julian.aiken@yale.edu.
Recommended Citation
Bittker, Boris I., “Income Tax “Loopholes” and Political Rhetoric” (1973). Faculty Scholarship Series. Paper 2287.

http://digitalcommons.law.yale.edu/fss_papers/2287

INCOME TAX “LOOPHOLES” AND
POLITICAL RHETORIC
Boris L Bittker*
I. INTRODUCrION
D URNG the 1972 presidential campaign, federal income tax reform
came unexpectedly to the foreground as a political issue
in the Democratic primaries and promised for a few weeks to play an
important role in the election itself. It was soon elbowed aside by the
prospect of peace in Viet Nam, charges of political espionage and
corruption, and attacks on the personal attributes of the two candidates,
but for a short time it actually succeeded in crowding school
bussing off the front pages. To the cynic, this might in retrospect
seem to be the principal accomplishment, if not the purpose, of the
vivid charges that the Internal Revenue Code is riddled with loopholes
and that millionaires sometimes pay less in taxes than bluecollar
workers. I am inclined, rather, to believe that these grievances
continued to smoulder below the surface, like the issue of school
bussing, even after President Nixon and Senator McGovern turned
their attention to other questions.
Moreover, just as hostility to school bussing emanated from a
variety of sources, so the assault on tax loopholes brought together
some strange bedfellows. Advocates of a “New Populism” wanted to
close loopholes in order to strengthen the income tax as a tool of income
redistribution. Academic experts, who supplied most of the
intellectual ammunition for the tax reform movement, wanted to
purge the income tax of its imperfections primarily to insure “horizontal
equity”; for most of them, increased progressivity was only a
secondary objective, and some were prepared to accept, or even to
advocate, a less progressive rate structure if that was the legislative
cost of tax reform. Welfare reformers who wanted to replace today’s
welfare system with a guaranteed-income program thought that their
proposals could be financed by closing tax loopholes. For still others,
tax loopholes were only symptoms of a worse disease-a federal
bureaucracy serving the interests of the very rich and the very poor
but financed by those in between. Their remedy was to cut back
* Sterling Professor of Law, Yale University. B.A. 1938, Cornell University; LL.B.
1941, Yale University.–Ed.
Copyright @ by Boris I. Bittker.
This Article is an expanded and revised version of the first of three lectures given
by the author in the Thomas M. Cooley Lecture series, University of Michigan Law
School, on April 4, 5, and 6, 1973.
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federal expenditures, rather than to close the loopholes in order to
support or increase the offensive programs.
“Tax reform” could serve as the rallying cry of forces that had
little else in common because it is irretrievably ambiguous. In academic
circles, to be sure, “income tax reform” almost invariably refers
to proposals to expand the tax’s coverage, but the term can also
be used as a label for proposals to narrow its scope or scuttle it entirely.
The same ambiguity surrounds the term “social change,”
which candidates for admission to law school like to offer as the motive
that animates their interest in practicing law-with no apparent
acknowledgement that Vice-President Agnew may be as dedicated to
social change as they, but in a different direction.
A similar source of ambiguity is the catchy charge that the federal
income tax is so full of loopholes that it constitutes a vast “welfare
program for the rich.”‘ Though intended as a call for heavier taxes
on capital gains, state and municipal bond interest, and the oil industry,
this allegation panders to a popular distaste for the “welfare
mess,” whether its beneficiaries are rich or poor. The same rhetorical
device was employed by President Nixon, but with a better feel for
public reaction, when he alleged that Senator McGovern’s tax reform
proposals would add 82 million people “to the welfare rolls.”2
The instrument that was to accomplish this result was the Senator’s
famous $1,000 tax credit or “demogrant,” a technical device that he
was unable to explain in the headlines, but that, unfortunately, he
could not erase from them either. The very label “demogrant” invited
comparison with a welfare grant, and President Nixon can
hardly be blamed for seizing on the parallelism at a time when tax
scholars have been asserting that tax allowances, including the basic
personal and dependency exemptions, are the equivalent of subsidies
or grants of public funds to the taxpayer.3
Another example of the coalescence of rhetoric can be seen in the
allegation by the authors of A Populist Manifesto that the federal
income tax authorizes “legal larceny,” 4 a phrase that is virtually iden-
1. Stem, Uncle Sam’s Welfare Program-for the Rich, N.Y. Times, April 16, 1972,
§ 6 (Magazine), at 28, col. 2. See also P. STERN, THE RAPr OF THE TAXPAYER (1973).
2. N.Y. Times, Aug. 24, 1972, at 47, cols. 2-3.
3. See Heller, Some Observations on the Role and Reform of the Federal Income
Tax, in 1 HousE COMM. ON WAYS AND MEANS, 86TH CONG., IST SESS., TAX REVISION
COMPENDIUM 181, 190 (Comm. Print 1959); Pfaff & Pfaff, How Equitable Are Implicit
Public Grants?, in REDISTRIBUTION TO THE RicH AND THE POOR 181 (K. Boulding & M.
Pfaff ed. 1972); Surrey, Tax Incentives as a Device for Implementing Government
Policy: A Comparison with Direct Government Expenditures, 83 HARv. L. REV. 705
(1970). See also Bittker, Accounting for Federal “Tax Subsidies” in the National Budget,
22 NATL. TAX J. 244 (1969) and articles cited in id. at 244-45 nn.1-4.
4. J. NEwFIEm & J. GREENFIELD, A POPULIST MANIFEStO 97 (Warner Paperback
Library ed. 1972).
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tical with John Chamberlin's charge, from the right wing, that the
Sixteenth Amendment "legalizes a theft."5 The targets of the latterday
populists are the loopholes for the rich, of course, but they do not
have a copyright on this complaint. A tract calling for repeal of the
Sixteenth Amendment (appealingly entitled The Income Tax: Root
of All Evil), for example, also alleges that "pressure groups" are responsible
for "loopholes," that the rich get around the law with the
aid of "expert accountants," that we now "soak the poor" more than
the rich,8 and that salvation lies with a coalition of workers, housewives,
professional people, and small businessmen, since "the big industrialists,
bankers, and commercial interests . . . have no reason to
favor repeal [of the Sixteenth Amendment].” 9 It has even been suggested,
in language echoing the argument in Pollock v. Farmers’
Loan & Trust Company’° (which held the 1894 federal income tax
unconstitutional and was in turn overruled by the Sixteenth Amendment),
that today’s income tax is “unconstitutionally discriminatory,”
and that a “taxpayers’ liberation movement” should appeal to
the courts, since both Congress and the Treasury have turned a deaf
ear to taxpayers’ grievances.”
Barraged by assertions that the rich have conspired to tax the income
of the poor while exempting themselves, the working man may
conclude that he would prefer a sales tax-a preference that has already
been exhibited by rank-and-file voters in the few states that
still lack a state income tax. In a 1972 public opinion survey commissioned
by the Advisory Commission on Intergovernmental Relations,
for example, almost twice (46 per cent versus 25 per cent) as many respondents
preferred a state sales tax to a state income tax as a source
of substantial additional revenue; when asked to name the nation’s
“fairest” tax, they named the state sales tax about as often as the federal
income tax (33 per cent versus 36 per cent), while the state income
tax was chosen by only 11 per cent of the respondents. 12 At the federal
level, this attitude may well lead to enactment of a federal valueadded
tax, which would be a national sales tax in disguise-a consummation
that the new populists would surely deplore.
5. Chamberlin, Book Review, 21 U. Cm. L. REv. 502, 505 (1954).
6. F. CHODORov, THE INCOME TAx: ROOT OF ALL EvI. 66-67 (1954).
7. Id. at 67.
8. Id. at 51-52.
9. Id. at 108.
10. 157 U.S. 429 (1895).
11. Halby, Is the Income Tax Unconstitutionally Discriminatory?, 58 A.B.A.J. 1291,
1292 (1972).
12. U.S. ADVISORY COMIIN. ON INTERGOVERNMENTAL RELATIONS, PUBLIC OPINION AND
TAXS 7-10 (1972).
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I do not wish by these observations to suggest that critics of the
Internal Revenue Code should suppress their reformist instincts lest
they get bitten by dogs that are now sleeping peacefully. Nor would
I deny the usefulness of political slogans. As Niebuhr has said, “Contending
factions in a social struggle require morale; and morale is
created by the right dogmas, symbols and emotionally potent oversimplifications.”
1 3 The prudent strategist, however, will avoid slogans
and rhetoric that can be captured by the enemy and used in a
successful counterattack. But this is not a manual on political strategy.
My purpose, rather, is to examine the “loopholes” that dominate
the discussion of federal income tax reform.
When used by newspaper reporters and politicians, the term “tax
loophole” is always a pejorative, though the tone of disapproval may
be mingled with a dash of admiration for the astute lawyer or accountant
who discovered the device. Since condemnation is the predominant
tone, it is always assumed that loopholes can be quickly
and reliably distinguished from tax provisions that are reasonable
and fair. Sometimes, to be sure, it is suggested that the only criterion
is self-interest: one man’s loophole is another man’s relief provision.
More frequently, loopholes are said to inure primarily, if not solely,
to the benefit of the rich, either because high-priced experts must be
employed to devise loophole-exploiting transactions or because it
takes capital to consummate the plan after a tax-free route has been
discovered. Finally, it is often thought that tax loopholes entail an
enormous loss of potential governmental revenue, and that their
eradication would either permit everyone else’s taxes to be reduced
or provide the funds for social welfare programs of great magnitude.
Each of these issues deserves scrutiny.
II. STATUTORY AmBIGUITiES AND OMISSIONS
The term “tax loophole” is often used to denote a flaw in the
language of the Internal Revenue Code or in the Treasury Regulations,
discovered by a sharp-eyed lawyer or accountant and exploited
by his clients. In popular mythology, indeed, the major activity of
tax experts is the search for divergencies between the letter of the
law and its spirit, somewhat as W. C. Fields described his purpose in
reading the Bible: “Looking for loopholes, of course, looking for
loopholes.” This usage accords with the Oxford English Dictionary’s
definition of “loophole” as “an ambiguity or omission in a statute,
etc., which affords opportunity for evading its intention.”‘ 4 Result-
13. R. NIEBUHR, MORAL MAN AND IMIORAL SOCIETY XV (1948).
14. 6 THE OxFoRD ENGLISH DICTIONARY 433 (1933). There is, of course, a vast body
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ing by hypothesis from a legislative error, a loophole in this sense is
likely to be corrected by Congress once it comes to public attention;
the phrase "notorious loophole" is thus either a contradiction in
terms or a transitory phenomenon. When discovered by a tax expert,
therefore, a loophole is a wasting asset that he must exploit quickly
but warily. His clientele must be informed of his discovery if he is to
reap a financial benefit from it, but when he exposes it to view, he
reduces its life expectancy by stimulating Congress to enact corrective
legislation. His dilemma resembles that of the archeologist
whose excavation brings an ancient fresco to light but simultaneously
exposes it to the destructive forces of nature.
For its part, the Treasury must also make a difficult decision
when it discovers a loophole. A request for corrective legislation will
call attention to the statutory imperfection and stimulate taxpayers
to exploit it in the interim, but if the Treasury seeks to discourage
such attempts by announcing that the ambiguity or omission is more
apparent than real and hence should not be relied on by taxpayers,
Congress may refuse to take action on the ground that the need for
legislation has not yet been demonstrated. A leading tax publication,
for example, once announced that "for months.., the tax fraternity
has been aware that the Treasury had a list of loopholes in the law
that it considered too hot to release, for fear of encouraging taxpayers
to flock to use these tax-saving devices."' 5
Loopholes of this type-statutory ambiguities and omissions so
clearly in conflict with the intent of the legislature 6 that prompt
correction can be expected as soon as they come to light-are, in my
opinion, not very common. One example (chosen because it is not
excessively technical) is a 1954 provision 7 that permitted the taxpayer
to take a dependency deduction for a member of his household
whose principal place of abode was the taxpayer's home, even if the
dependent was not related to the taxpayer by blood, marriage, or
adoption-relationships that had previously been indispensible to a
dependency exemption. Intended by Congress to permit foster chilof
case law and commentary on legislative "intent," "purpose," and "motive," and the
view that these are fictional concepts is less prevalent than it was two decades ago.
See J. COHEN, MATERIALS AND PROBLEMS ON LEGISLATION 35-186 (2d ed. 1967); A. LENHOFF,
COMMENTS, CASES AND OTHER MATERIALS ON LEGISLATON 577-85, 787-854 (1949).
15. 28 of Treasury's Famous Secret Loopholes and Hardships Revealed by Ways 6
Means Committee, 5 J. TAXATION 322 (1956). See also STAFF OF JOINT CoMMar. ON INTERNAL
REVENUE TAXATION, 84TH CONG., 2D SESs. & STAFF OF TREASURY DEPARTMENT,
LIST OF SUBSANTIVE UNINTENDED BENEFITS AND HARDSHIPS AND ADDITIONAL PROBLEMsS
FOR THE TECHNiCAL AMENDMENTS Acr BiL OF 1957 (1956); Technical Amendments Act
of 1958, Pub. L. No. 85-866, 72 Stat. 1606.
16. See text accompanying note 14 supra.
17. INT. REv. CODE OF 1954, § 152(a)(9).
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dren to qualify as dependents, the language of the new provision
held out the tantalizing possibility that the taxpayer could deduct
$600 a year for the cost of supporting a mistress or kept man. Before
this incentive to what would now be called an alternative life style
got very far, however, the courts shot it down. Invoking “the well
settled rule that statutes should receive a sensible construction, so as
to effectuate the legislative intention and, if possible, avoid an absurd
conclusion,” the Tax Court held:
In our opinion Congress never intended the specific paragraph in
question to be construed so literally as to permit a dependency
exemption for an individual whom the taxpayer is maintaining in
an illicit relationship in conscious violation of the criminal law of
the jurisdiction of his abode.
We are of the opinion that to so construe the statute would in
effect ascribe to the Congress an intent to countenance, if not to aid
and encourage, a condition not only universally regarded as against
good public morals, but also constituting a continuing, willful, open,
and deliberate violation of the laws of the State of Alabama….
This we are unable to do.18
The Tax Court’s surmise about the legislative intent was subsequently
confirmed by Congress, which amended the Code in 1958
to provide explicitly in section 152(b)(5) that a person whose relationship
to the taxpayer violates local law is not to be treated as “a
member of the taxpayer’s household.” Recommending enactment of
this language, the Senate Finance Committee described it as declaratory
of the law (“[I]t is made clear that ….,, )19 rather than as a substantive
change, and provided that it would be retroactively effective
as of 1954, when the ambiguous provision creating the problem entered
the Code.20 Along with this clarification of the law, Congress
closed another loophole in section 152(a)(9) by amending it to provide
that the taxpayer may not claim his spouse as a dependent, since
such a deduction (although arguably sanctioned by the original language
of this provision 21) would ordinarily duplicate a deduction for
the taxpayer’s spouse that was already authorized by another provision
of the Code (section 151). Here again, Congress denied that it
was making a substantive change, asserting instead that the legislation
was intended only “[t]o make it clear that [the loophole] was
18. Turnipseed v. Commissioner, 27 T.C. 758, 760-61 (1957).
19. S. REP. No. 1983, 85th Cong., 2d Sess. 15 (1958).
20. Act of Aug. 16, 1954, ch. 736, § 152(a)(9), 68A Stat. 43 (codified at INT. 1Ev.
CODE oF 1954, § 152(a)(9)).
21. Act of Aug. 16, 1954, ch. 736, § 152(a)(9), 68A Stat. 43.
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not at any time intended" and reinforcing this explanation by providing
that the new language was to be applied retroactively.22
For another example of a loophole arising from inept draftsmanship,
I turn to the Connecticut tax on capital gains, which, after exempting
$2,000 of such gains in specified circumstances, goes on to
provide that the $2,000 exemption is to be multiplied by a fraction,
the numerator and denominator of which are then described in
terms not here relevant.23 The legislative purpose was to reduce the
$2,000 exemption to a lesser amount or even to zero in certain circumstances.
But the draftsman forgot, or perhaps never knew, that a
fraction can be greater than 1/1, as well as smaller. By failing to provide
that the exemption might in no case exceed $2,000, he opened
the door to an exemption of many times that amount-indeed, to an
exemption of unlimited amount-when the statutory fraction exceeds
1/I. Another case of inadvertance-also drawn from the Connecticut
statute books-is the inadvertent omission of the word
"not" from a provision defining the term "resident" for tax purposes.
24
In cases like these, the courts often come to the rescue by holding
that the letter of the law is not controlling, and that the legislative
purpose-gleaned from the statute's history or context, or inferred
by comparing the practical consequences of the competing interpretations-
must prevail over the scrivener's deficiency. A 1940 opinion
of the United States Supreme Court describes this process succinctly:
There is, of course, no more persuasive evidence of the purpose
of a statute than the words by which the legislature undertook to
give expression to its wishes. Often these words are sufficient in and
of themselves to determine the purpose of the legislation. In such
cases we have followed their plain meaning. When that meaning has
led to absurd or futile results, however, this Court has looked beyond
the words to the purpose of the act. Frequently, however, even when
the plain meaning did not produce absurd results but merely an
unreasonable one "plainly at variance with the policy of the legisla-
22. S. REP. No. 1983, supra note 19, at 15. This action in effect endorsed a prior
judicial decision refusing to permit a deduction for the spouse under section 152(a)(9),
despite its language, because the over-all statutory scheme when illuminated by its
legislative history showed "that it was not the intention of the Congress to grant an
additional exemption" for a dependent spouse. Dewsbury v. United States, 146 F. Supp.
467, 469 (Ct. Cl. 1956). See also REv. Rul. 55-325, 1955-1 CuM. BuLL. 18.
23. CONN. GEN. STAT. ANN. § 12-506(c)(1) (1972).
24. No. 5, § l(b)(1), [1971] Conn. Pub. Acts June Spec. Sess. 2173, from which
the bracketed word was omitted: “or who is [not] domiciled in this state but . .” The
error became a matter of only academic interest when the entire act was repealed,
later in the same session, by No. 8, § 1, [1971] Conn. Pub. Acts June Spec. Sess. 2245.
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tion as a whole” this Court has followed that purpose, rather than
the literal words.25
This approach is well illustrated by the Tax Court’s comments in
the dependency exemption case, summarized above, to which numerous
other examples could be added.
The courts are not always this candid in admitting that the words
are being twisted a little to get at the substance lying below the surface.
In Helvering v. Owens,26 for example, the Supreme Court had
to pass on the amount to be deducted as a casualty loss when the taxpayer’s
automobile was slightly damaged in a collision. He had paid
about $1,800 for the car, but it was worth only $225 before and $190
after the accident. Although only $35 of damage was attributable to
the collision, the statutory language seemed clearly to permit the
taxpayer to deduct the difference between the car’s original cost and
its value after the accident, or over $1,600 on these facts. The Court
of Appeals for the Second Circuit so decided, in a per curiam opinion
bearing every indication of Judge Learned Hand’s authorship:
“[T]he letter is too plain; we should have to disregard the words, and
should not be interpreting them, if we refused to take them just as
they read.”2 7 In a substantially identical case, however, the Court of
Appeals for the Fourth Circuit parted company with Judge Hand,
asserting that “it is not reasonable to suppose that Congress intended
to permit [a] deduction in excess of actual loss” and that “the statute
should be construed as containing such exception[s] where necessary
to avoid a consequence which Congress clearly did not intend.”2 8
The Supreme Court, reviewing both cases, 29 endorsed the Fourth
Circuit’s reading of the statute but buried the issue in a cloud of
verbiage rather than admitting that it was stretching the statutory
language. This should not, however, obscure the Court’s implicit
determination to reach an eminently sensible result despite the
draftsman’s ineptitude.
Since loopholes, as I have been using the term, depend for their
existence on a judicial willingness to elevate the letter of the law over
its substance, the kind of judicial activism just described promises
to turn the loophole into an extinct art form. I do not mean to assert
that the courts are never willing to enforce a badly drafted statute as
25. United States v. American Trucking Assns., Inc., 310 U.S. 534, 543 (1940).
26. 305 U.S. 468 (1939).
27. Helvering v. Owens, 95 F.2d 318, 319 (2d Cir. 1938).
28. Helvering v. Obici, 97 F.2d 431, 433 (4th Cir. 1938).
29. Helvering v. Owens, 305 U.S. 468 (1939), affg. 97 F.2d 431 (4th Cir. 1938) and
revg. 95 F.2d 318 (2d Cir. 1938).
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written, or that it is already as difficult for a taxpayer to escape
through a loophole as it is for a camel to squeeze through the eye of
a needle. Judge Learned Hand's refusal in the Owens case to ride
roughshod over the statutory language was reversed by the Supreme
Court, but that does not mean that every statutory deficiency is
corrected. It is an old chestnut that maxims of statutory construction
come in opposing pairs, and occasionally a pair will emanate from
the same author. Thus, the same Holmes who warned his fellow
judges that "if [the legislature] has intimated its will, however indirectly,
that will should be recognized and obeyed ’30 also said, “We
[judges] do not inquire what the legislature meant; we ask only what
the statute means.”31 For loopholes to survive, the latter attitude
must prevail.
Lacking a more systematic study of this question, I offer the
hypothesis that loopholes conforming to the Oxford English Dictionary
definition quoted earlier32 (“an ambiguity or omission in a
statute, etc., which affords opportunity for evading its intention”) are
comparatively rare. The quality of legislative drafting in the federal
tax field is unusually high, the Internal Revenue Code is subject to
frequent revision, and I know of no area of the law in which the
courts are more likely to search for the legislative purpose and prefer
it, whenever it can be discerned, to a literal construction of the
statutory language. Of course, ambiguities in the tax law are sometimes
resolved in the taxpayer’s favor when the legislative intent is
debatable, but by hypothesis these are not cases in which the legislative
intent has been disregarded, however critical one may be of the
substantive outcome.
Even if I overestimate the level of judicial activism, and thus
underestimate the number of loopholes resulting from drafting ineptitudes
that survive judicial scrutiny, it should be noted that
taxpayers will continue to escape through loopholes only if Congress
fails to take corrective action. If Congress fails to overrule a decision
because it is content with the law as judicially interpreted, the loophole
is converted into a legislatively sanctioned tax allowance. If the
decision is allowed to stand only because Congress is too busy with
other matters, the result can be regarded as a loophole-by-inertia.
But the taxpayer who uses such an escape hatch is not so much exploiting
a draftsman’s error that frustrates the intent of the legisla-
30. Johnson v. United States, 163 F. 30, 32 (1st Cir. 1908) (Justice Holmes on circuit).
31. 0. HOLMS, CoLLEcrED LEAL PAPERs 207 (1920).
32. See text accompanying note 14 supra.
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ture as he is benefitting from Congressional inattention or indifference.
A collector of unblemished specimens will not value a loophole-
by-inertia as highly as a statutory mistake that has not yet been
described in the literature and is so clearly at odds with the Congressional
intent that it will almost certainly evoke an amendment when
it comes to public attention.
I do not want to make too much of these paradoxes, or to assert
that there are no “unintended benefits” 33 in the Internal Revenue
Code. No doubt it contains some loopholes in the classic sensestatutory
errors that well-advised taxpayers are exploiting without
the knowledge of Congress or the Treasury. No doubt some of these
unintended benefits will be sustained by the courts, despite the
professed judicial reluctance to allow taxpayers to make a fortress of
the dictionary. No doubt some of these judicial victories will enable
still other taxpayers to exploit the same mistakes because of congressional
inertia.
When all is said and done, however, these are not the “loopholes”
under attack. The major targets of income tax reformers are such
statutory provisions as the exclusion of state and municipal bond
interest from taxable income, percentage depletion, the reduced tax
rate on long-term capital gains, and the deductions for local taxes,
mortgage interest, and charitable contributions. These allowances
have not been brought to light by the diligent burrowing of astute
and highly paid tax experts seeking to frustrate the objectives of
Congress. Sometimes, to be sure, tax scholars seek to enliven their
prose with suggestions to the contrary. Thus, a recent study of
“those hidden subsidies termed implicit public grants3″s promises to
lead us through “the jungle of provisions that convey special advantages
only to the legal wizard or to the individual wealthy enough to
obtain the services of a legal expert or to the person adept at manipulating
potential sources of income in order to conform to some
obscure section in the tax law.”35 But a conducted tour through this
vividly portrayed “jungle” will disappoint the venturesome reader.
Nothing more exotic will be encountered on his safari than an expensive
but familiar flock of domesticated animals, of which the most
prominent are the joint return for married couples, the personal and
dependency exemptions, and the deductibility of charitable contributions,
interest, and taxes. Far from being reserved for “legal
wizards,” these provisions satisfy Gibbon’s description of a late
33. See note 15 supra.
34. Pfaff & Pfaff, supra note 3, at 181.
55. Id. at 183.
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Roman emperor's collection of manuscripts and concubines: "The
one, as the other, was intended rather for use than ostentation." If
the man in the street does not already know about these tax benefits,
he can fill this gap in his knowledge by reading the Treasury's free
publications or paying $5 to a store-front tax "consultant."
III. TAx AvoiDANcE TACTICS
In popular usage, the term "loophole" often also reflects the
widely held view that tax experts have a magical power to reduce
taxes, primarily for the rich, by paperwork that has no other visible
consequences. If Smith makes a series of lifetime gifts to his children
in order to save death taxes by removing the property from his taxable
estate, for example, the transfers may seem devoid of practical
consequences because the Smiths are bound together by ties of
affection that transcend their legal rights. Yet King Lear learned that
family loyalties may dissolve, and even the layman who thinks that
the gifts just described are nothing more than tax gimmicks might
well balk if the Internal Revenue Code required him to include his
teenage children's earnings when computing his taxable income.
While something can be said for disregarding legal rights within the
family, there is also much to be said for treating individuals as discrete
units; debatable judgments are unavoidable in such an area.
The concept of "family" implies a definition that includes some of
the taxpayer's relatives and excludes others; no one would propose
taxing the "family of man" as a single unit. Conversely, however,
few are so committed to individualism as to propose that family ties
be wholly disregarded in computing the individual's tax liability.
The tax advantages that are inevitably conferred on taxpayers who
find themselves on the tax-free side of the fence, or who get there by
arranging their affairs to satisfy the law, may be called "loopholes"
by the layman. So used, however, the term simply expresses disapproval
of the rules; any implication that the legislative intent is
being frustrated is unwarranted.
But the expert sometimes engages in another type of paperwork,
similarly criticized but simultaneously admired by the layman as a
species of black magic, where the implication of a conflict with the
legislative intent may be better founded. I refer to transactions that
are designed to fit within one statutory compartment rather than
another but whose practical consequences are otherwise transitory.
A taxpayer, for example, is about to sell some appreciated property
with the intention of making a gift of the proceeds to his children;
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on consulting his attorney or accountant, he is advised to give the
property itself to the children and let them make the sale, in order
to take advantage of the fact that a donor of appreciated property is
not taxed on his unrealized gain when he transfers it by gift. His hope,
therefore, is that the gain will be taxed to the children, who may be
subject to a lower tax rate. In such a case, and in many others that
could be added to the list, the anticipated tax advantage derives from
the fact that the Internal Revenue Code, despite its awesome detail,
contains many provisions of such disarming simplicity as to invite
manipulation. There is nothing in the Code determining whether
the transaction should be taxed as a sale of property by the taxpayer
followed by a gift of the proceeds by him to the children, or as a gift
of the property to the children followed by a sale of the property by
them. As a result, the courts must decide how the transaction is to be
treated for tax purposes.
Manoeuvres as transparent as these are rarely successful, but
when a bit more time elapses between one step in the transaction
and another, they may get by. If so, is the taxpayer exploiting a
loophole of the type discussed above, viz., a statutory ambiguity or
omission that serves to frustrate the legislative intent? There are,
undoubtedly, taxpayer successes that one can confidently say would
have been disapproved if the issue had been exposed when the legislation
was before the Congress. More frequently, however, a remedy
would have been so complex that no dear legislative intent can be
reconstructed from the materials at hand.
In my gift-sale case, for example, a legislative body that wished to
establish a statutory rule might draw the line by establishing an
arbitrary time limit (e.g., 30 days) and providing that any sale within
that time by the donee should be imputed to the donor. A more restricted
statutory remedy might tax the donor only if the donee is a
minor child. Or the donor might be taxed only if the donee sells the
property to a buyer with whom the donor had negotiated, only if
the terms of the sale had been prearranged, or only if the value of
the property or the tax differential between donor and donee exceeds
a specified amount. Another approach would be a statutory presumption
that the donee acted under the donor’s influence, with an opportunity
to prove instead that the donee made an independent decision
to sell the property rather than keep it. When the choice of statutory
remedies is as wide as this, it is impossible to say with any assurance
that the disputed issue would have been resolved in one way rather
than another by the legislature.
In point of fact, the courts are quite unsympathetic to avoidance
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tactics of this type. This is not the place to describe in detail the
judicial doctrines that are regularly invoked to deflate ingenious and
initially promising schemes, but the labels-"business purpose,"
"sham or camouflage," "step transactions," "form vs. substance," and
the like-convey their flavor.36 Suffice it to say that the courts are
quite ready in tax cases to probe beneath the surface before accepting
a transaction at face value. An acerbic comment by Chief Judge
John R. Brown of the fifth circuit court of appeals can stand as a
summary of this attitude. Refusing to allow the taxpayers in a complex
transaction to hide behind a facade entailing the use of an
attorney named W. R. Deal as an intermediary, he said: "The Deal
deal was not the real deal. That ends it."7
In point of fact, the layman is far more inclined than the expert
to trust paperwork as a shield against tax liability. One is bombarded
at cocktail parties with tax schemes that would not convince the most
inexperienced revenue agent or that teeter on the brink of fraud,
but which are offered as proof positive of the speaker's astute sophistication.
Randolph Paul's comments on this subject twenty years ago
cannot be improved:
Above all things, a tax attorney must be an indefatigable skeptic;
he must discount everything he hears and reads. The market place
abounds with unsound avoidance schemes which will not stand the
test of objective analysis and litigation. The escaped tax, a favorite
topic of conversation at the best clubs and the most sumptuous
pleasure resorts, expands with repetition into fantastic legends.
But clients want opinions with happy endings, and he smiles best
who smiles last. It is wiser to state misgivings at the beginning than
to have to acknowledge them ungracefully at the end. The tax
adviser has, therefore, to spend a large part of his time advising
against schemes of this character. I sometimes think that the most
important word in his vocabulary is "No" ......
But not all tax experts are "indefatigable skeptics," and even
those who are can sometimes be persuaded by their clients to try a
tax avoidance scheme, especially if the only penalty for failure is the
tax that would have been due and payable if the transaction had
taken its normal course. (The deficiency in case of failure must be
paid with interest, but the 6 per cent interest may be less than the
value of the money to the taxpayer in the interim, and it is in any
event deductible.) And these plans sometimes succeed.
36. See generally B. BrrrrER & J. Eusrxic, FEDERAL INCOMr TAXATION OF CORPORATIONS
AND SHAREHOLDERS 1-19 to -20 (3d ed. 1971) and articles cited therein.
37. Blueberry Land Co. v. Commissioner, 361 F.2d 93, 102 (5th Cir. 1966).
38. Paul, The Lawyer as a Tax Adviser, 25 ROCKY MT. L. Rl'V. 412, 416 (1953).
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The layman, then, is right in thinking that business transactions
are frequently cast in a particular form for no reason other than tax
avoidance, that the paperwork may create a distinction without a
difference, and that these formalities often succeed. Indeed, the
paperwork may take the taxpayer through a tax-free route that was
explicitly endorsed by Congress as an alternative to another route
that is taxable. Many other tax avoidance transactions are feasible
only because Congress has failed to enact a safeguard against them.
Congressional inaction may reflect a judgment that the area is unimportant,
that administrative and judicial scrutiny is preferable to a
legislative solution, or that a satisfactory legislative remedy would be
too complex; or it may stem from an unresolved difference of opinion
within Congress or between Congress and the Treasury about
the best remedy to be adopted or even about whether there is a
defect to be remedied. Still other tax avoidance transactions are in
fact vulnerable, but nevertheless escape the attention of the revenue
agent if and when the return is audited. The army may have a
“smart” missile that can find an airplane despite its evasive tactics,
but the Internal Revenue Service has no mechanical device to unveil
“the real deal” (to borrow Judge Brown’s phrase), and its enforcement
budget is scandalously low.
There is no harm in applying the term “loophole” to tax avoidance
opportunities of the type just described, provided one does not
infer from this label that they are caused by flaws in the statutory
language that will be corrected as soon as they come to the attention
of Congress. Moreover, however fertile this area may be as a breeding
ground for “loopholes” in the layman’s sense, it is not a major target
of income tax reform, except to the extent that changes in the basic
tax rules (e.g., in the treatment of capital gains) may reduce the
opportunity for tax “planning” and “manipulation.”
IV. “EROSION,” “PREFERENCES,” AND OTHER EUPHEMISMS
Academic proponents of income tax reform have long been
aware of the confusion generated by applying the term “loophole”
to the major targets of their endeavors. To imply, even by a label,
that they are merely exposing a series of unintended tax benefits
attributable to sloppy draftsmanship belittles their crusade. It also
invites a countercharge of nalvet6, since the provisions in question
were enacted deliberately rather than by inadvertence, and, though
the results may differ from the legislative expectation, a congressional
failure to amend or repeal the provisions is more likely to reflect
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legislative approval or a political stalemate than ignorance. Tax
reformers, therefore, have searched for a more accurate term than
"loophole" to characterize the objects of their criticism.
A veritable thesaurus of alternative labels has come into vogue
in the last two decades; the most common are "exceptions," "preferences,"
"special privileges," "tax expenditure," and "erosion.' ' 9 By
implying that the tax benefits to which they are applied were purposefully
enacted by Congress, these terms reject the aura of inadvertence
and secrecy that emanates from the term "loophole." This,
in turn, implicitly acknowledges that repeal of these provisions will
not automatically follow their exposure to the light, the fate that
might be hypothesized for a loophole of the classical variety. Thus, a
label like "preference" or "special privilege" has the virtue of political
realism, suggesting that the allowance was enacted to serve an
economic interest, that it is backed by political muscle, and that it
will not be relinquished without a legislative battle.
Tax commentators sometimes substitute these terms for "tax
loopholes" to avoid its pejorative connotation, so that the tax benefit
in question can be examined on its individual merits, without prejudgment.
But this objective is rarely achieved. However impartial
the writer's intent, the new label usually starts with or quickly
acquires an aura of disapproval. "Erosion" can be a good thing, of
course-it brought fertility to the Nile Valley and beauty to the
Grand Canyon-but ordinarily it is no more welcome than an invasion
of termites. As for "special privileges," they are occasionally
praised-lifetime tenure for federal judges is an example-but most
"privileges," particularly "special" ones, evoke enthusiastic denunciation.
The term "tax expenditures" purports to be value-free, but
it grows out of a theory that the direct appropriations process is
presumptively a better way to confer the benefits that are embedded
in the Internal Revenue Code, and it cannot escape the pejorative
flavor that is unmistakably intended by its twin, "back-door spending.'
40 An "exception" to a rule sometimes implies tolerance or
benevolence, but more often it suggests an impropriety, unless justification
is affirmatively proved; we like to think that laws should be
enforced without fear or favor.
What is perhaps most notable is that none of these substitutes
for the term "loophole" implies a favorable attitude. The tax pro-
39. See Bittker, A "Comprehensive Tax Base" as a Goal of Income Tax Reform,
80 HARV. L. REv. 925 (1967).
40. Heller, supra note 5, at 190 ("The back door to government subsidies marked
'tax relief' .... ). See also Surrey, supra note 3.
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visions in question are not described as “refinements of the tax base,”
as attempts to “fine-tune” the Internal Revenue Code, or as examples
of tempering justice with mercy. The alternative labels are, in short,
euphemisms for their predecessor.
It is not surprising, therefore, that studies by experts of tax
“erosion,” “preferences,” and the like are regularly reported in the
press under the generic title “loopholes.” By itself, this stretching of
labels would not matter. Headline writers are not expected to be
lexicographers. But when the popular conception of “tax loopholes”
-gimmicks that are invented by crafty lawyers for the very rich-is
carried over to the provisions that the expert describes as “tax expenditures”
or “preferences,” a monumentally false impression is
created.
A good example of this pervasive practice is a summary subtitle
in a recent article in the New York Times Magazine which portrays
“the average American taxpayer” as suffering the pains of flood and
shipwreck, while the federal government dispenses “a bountiful $77-
billion in ‘tax welfare’ each year” to “a happy few.” 41 Michael
Harrington has used almost identical language to denounce the
Internal Revenue Code: “The unconscionable fact is that the Internal
Revenue Code is a perverse welfare system that hands out $77
billion a year, primarily to the rich.”42 These allegations and others
like them are based on a statistical study of a wide range of tax
allowances, published by the Joint Economic Committee in 1972.
The authors are Joseph Pechman and Benjamin Okner, of the
Brookings Institution, whose eminence as tax economists is exploited
by the new populists to support their claim that the federal income
tax dispenses $77 billion of “tax welfare” to the rich. The carefully
detailed Pechman-Okner study, however, tells a more complex and
less lurid story. It shows that more than half of the $77 billion in tax
allowances goes to taxpayers with income from $5,000 to $25,000, and
that if these provisions were repealed, almost 5 million families with
income of less than $5,000 and about the same number with income
of $5,000 to $10,000 who now pay no income taxes would be added
to the tax rolls. 48 The “happy few” who profit from “erosion” of the
41. Stern, supra note 1, at 28. Although the author refers at several points to
“loopholes for the many,” the central message of the article was satisfactorily summarized
by the editorial captions.
42. Harrington, Ideally We Should Abolish Every Subsidy in the Internal Revenue
Code, SAT. Rav., Oct. 21, 1972, at 49.
43. Pechman & Okner, Individual Income Tax Erosion by Income Classes, in JOINT
ECONOMIC Coerrm-ra, 92D CONG., 2D SEss., THE ECONOMICS OF FEDERAL SUBSIDY PROGRAMS,
pt. 1, at 27 (table 8) (Comm. Print 1972), reprinted in Pechman & Okner, Individual
Income Tax Erosion by Income Classes (Brookings Institution Reprint No. 230,
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tax base, it turns out, are 70.5 million families-not just Middle and
Upper America but most of Lower America as well.44
Pechman himself, unlike some who purport to build on his work,
has made this crystal clear, pointing out "that there are loopholes
for persons at all income levels" and describing the income tax as
"the best tax we have."4 5 Testifying before the House Committee on
Ways and Means in January of 1973, Pechman said that "a great
deal can be done-short of comprehensive reform-to improve the
progressivity of the income tax" and offered a choice of three reform
programs, which would produce revenue increases of $3.1 billion to
$10.2 billion.4 If the Pechman-Okner study demonstrated that the
federal income tax is a $77 billion welfare program for the rich, it
is hardly to be supposed that Pechman would have associated himself
-even as a last resort in a poor year for tax reform-with a program
that would leave $74 of the $77 billion unscathed.
A similar disparity between expert and popular conceptions of
tax loopholes may be found in A Populist Manifesto, which speaks of
$50 billion of tax "subsidies to the wealthy," describing them as
"outrages legislated into the tax code" that "not a senator or congressman
would have the chutzpah to vote for" if they were treated as
subsidies. 47 The authors then call for reforms to "close all of the
loopholes in our tax law," because otherwise "the tax-dodgers and
their advisers will simply move capital from one shelter to another." 48
But they refrain from listing the $50 billion of "subsidies to the
wealthy" that they nominate for wholesale extinction, and the unpublished
study on which they rely discloses that the statutory "outrages"
include substantially the same items that the Pechman-Okner
study detailed, except for the tax benefits conferred on married
couples by the joint return.49 (The fact that the major "tax welfare"
1972). Because this study uses a broader concept of income ("expanded adjusted gross
income') than existing law, many families move up the income ladder when classified
by income dass in the study.
44. Id.
45. Pechman, The Rich, the Poor, and the Taxes They Pay, THE PUBLIC INTERESt,
Fall 1969, at 21, reprinted in 115 CONG. REc. 32361 (1969).
46. Hearings on General Tax Reform Before the House Comm. on Ways & Means,
93d Cong., Ist Sess., pt. 1, at 149 (1973).
47. J. NEwrisn & J. G murIFi, supra note 4, at 100.
48. Id. at 105 (emphasis original).
49. Id. at 100. The "tax expenditure" list on which they rely is substantially identical
with the one published in Surrey, supra note 3, at 709-11. A later version may
be found in House CoMMr=rau ON WAYS & MEANS, 92D CONG., 2D SESS., ESTIMATEs OF
Fm)mtAL TAx EXPENDITURES 4-5 (Comm. Print 1972). For criticism of the tax expenditure
budget, see Bittker, supra note 3; Surrey & Helimuth, The Tax Expenditure
Budget-Response to Professor Bittker, 22 NATL. TAX J. 528 (1969); Bittker, The Tax
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lists can be separated by about $25 billion, attributable to disagreement
over the classification of one item, should suggest to the reader
that both may reflect a variety of other debatable judgments, especially
since a third list, with overlapping populist sponsorship, reduces
the amount of “welfare to the rich” by another $25 billion.)50
An even more heated-but no less misleading-denunciation of tax
loopholes may be found in a discussion of white-collar crime by a
professor of sociology, who accepts an earlier author’s assertion that
“honest payment by everybody liable to income tax would enable the
government to decrease the general tax burden by 40 per cent,” and
then goes on to tell us that this figure “suggests rather graphically
the largely unrecognized or passed over, yet very real, cost to the
individual citizen of tax crimes.”51
This extraordinary confusion results from the fact that the tax
expert’s conception of “preferences,” “tax expenditures,” and the
like embraces many provisions that are so familiar and widespread
that taxpayers often think of them as normal, if not essential, features
of an income tax law. Thus, the largest single component of the $77
billion of “tax welfare” that goes to the “happy few” is the rate
advantage granted to married couples who file joint returns and the
similar concessions to heads of households, to widows and widowers
with minor children, and (since 1969) to unmarried persons.52 The
only taxpayers who do not benefit from these provisions (which
account for $21.6 billion of the $77 billion of “tax welfare”) 53 are
Expenditure Budget-A Reply to Professors Surrey and Hellmuth, 22 NATL. TAX J.
538 (1969).
50. N.Y. Times, April 15, 1973, § 4 at 18, col. 1 (advertisement for Tax Action
Campaign, described as “a project of New Populist Action’). Since the estimated $25
billion evidently embraces the corporate income tax as well as the individual income
tax, the latter’s contribution to the rich must be substantially less than $25 billion.
51. F. Sci un, OuR CamIN.L SocI=Y 165 (1969), referring to a statistical study
described in F. GmNEY, THE OPERATORS (1960). Professor Schur seems to think that the
“tax crimes” which prevent the tax burden from being reduced by 40 per cent are
committed primarily by business executives and large corporations, although the calculations
(which Mr. Gibney advises me were given to him “by people connected with
the I.R.S., who were, however, unwilling to be quoted as their source”) must have
been based on a tax reform program affecting tens of millions of taxpayers. (This
emerges from Mr. Gibney’s own statement that the amount of tax successfully evaded
is about $5 billion, a figure that would not permit the “general tax burden” to be
reduced by anything like 40 per cent. Id. at 200.) In point of fact, both Gibney and
Schur have evidently confused a reduction in tax rates with a reduction in the tax
burden. A rate reducton made possible by expanding the tax base, which is the only
plausible basis for Gibney’s figure of 40 per cent, would of course leave the aggregate
burden unchanged, so that some taxpayers would pay more and others less-the same
result that would be produced by the Pechman-Okner proposal, see text accompanying
notes 65-69 infra, to expand the base and lower the rates.
52. Pechman & Okner, supra note 43, at 33-34 (tables A-1, A-2).
53. Id. at 33 (table A-l).
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married persons filing separate returns, who constitute less than 4
per cent of the taxpaying population.54 The next largest component
in the Pechman-Okner computation, making up $14.2 billion 5 of
the $77 billion total, reflects revenue to be raised by restricting the
itemized deductions for such items as state and local taxes, medical
expenses, and charitable contributions, substituting a flat $1,300 low
income allowance56 for the existing standard deduction, and repealing
the extra $750 personal exemption for persons who are over 65
or blind. The third major item ($13 billion of $77 billion)57 would
result from the taxation of transfer payments-social security, welfare,
workmen's compensation, unemployment benefits, and veterans'
disability payments. Other important provisions that would be repealed
or restricted by the Pechman-Okner proposals are the deductions
for real property taxes and mortgage interest on personal
residences and the exclusion of interest on life insurance policies.
Although all of these tax advantages are enjoyed to some extent
by high income taxpayers, they accrue primarily to taxpayers in the
low and middle income brackets, and these are the taxpayers whose
aggregate tax liability would be most severely increased by their
repeal.5" The only tax provisions of comparable fiscal importance
that are monopolized by high income taxpayers (i.e., those with incomes
of $50,000 or more) are the capital gains rules (including the
failure to tax appreciation on gifts and bequests), accounting for
$13.7 billion of the $77 billion.5 9 High income taxpayers are also the
principal beneficiaries of tax-exempt interest, accelerated depreciation,
and percentage depletion, but the aggregate dollar value of
these allowances ($1.7 billion) is minor when compared with the
items described above.6 0
Thus, tax erosion and tax preferences are as democratic as environmental
pollution: you don't have to be rich to throw a plastic
beer can under a bridge, or to exclude social security benefits from
your federal income tax return. Middle America may be fed up with
54. 1969 IRS, STAnsTIcs OF INCOME, INDIVIDUAL INCOME TAX RETURNs 4 (table 1C)
(2.1 million taxable returns out of 63.7 million). By classifying the 1969 rate reduction
for unmarried taxpayers as erosion, along with the joint rate applicable to married
couples, the Pechman-Okner study, Pechman & Okner, supra note 43, at 21 n.24, implies
that there was less erosion before 1969, when the tax distance between married and
unmarried taxpayers was greater.
55. Pechman & Okner, supra note 43, at 34 (table A-2).
56. Id. at 17.
57. Id. at 34 (table A-2).
58. Id. at 33 (table A-l).
59. Id. at 34 (table A-2).
60. Id. at 23 (table 3).
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tax loopholes, as we are often told by social commentators who
perceive a taxpayer revolt in their crystal balls, but only a small
fraction of the $77 billion “tax welfare” program is the target of
popular outcry. Moreover, if these provisions were repealed, only
14.7 per cent of the $77 billion yield would come from families with
income over $100,000 and 9.6 per cent from those with income from
$50,000 to $100,000.61 Another 22.5 per cent would come from taxpayers
with $25,000 to $50,000 of income-a group that, however
well off, can hardly be classed with the Mellons and Rockefellers but
whose present tax liability would have to be nearly doubled to raise
their share of the target.62 This leaves more than half of the $77
billion to be collected from taxpayers with income below $25,000.
Thus, analysis of the Pechman-Okner tax erosion study is a sobering
experience. The exhilarating soak-the-rich recommendations that
have been attached to it reflect the emotive power of the term
“erosion,” not the facts in the computer printouts.
To rebut this gloomy suggestion, it may be argued that aggregate
figures are misleading. Even though half of the $77 billion of new
revenue that could be raised by applying current rates to an expanded
reformed tax base would come from taxpayers with $5,000
to $25,000 of income and only about 15 per cent from those with
incomes over $100,000, the per capita effect of tax reform would be
very different. The average tax increase for a family with $100,000
to $500,000 of income would be about $40,000, while the average
taxpayer at the bottom of the heap would pay only a few dollars
more than he does now.63 The fact that comprehensive expansion of
the tax base will cost individual rich men far more than individual
poor men (so that the big loopholes are at the top),64 however, will
not guarantee its popularity among the citizenry at large. HoWever
small, an increased per capita burden on low and middle income
taxpayers can be painful; the last dollar may have a marginal utility
to them that equals or is greater than the marginal utility of the rich
man’s last thousand dollars. In any event, if the issue is whether
comprehensive tax reform could finance massive new federal programs,
the answer is “Yes, but most of the money will come from low
and middle income taxpayers.”
In point of fact, though the Pechman-Okner study of erosion concluded
that $77 billion of additional revenue could be raised by
61. Id. at 26 (table 6).
62. Id.
63. Id. at 86 (table A-5).
64. Benjamin Okner, Letter to the Editor, N.Y. Times, May 8, 1972, at 32, col. 4.
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applying today's tax rates to an "uneroded" tax base (aggregate taxable
income of $644 billion, as against $478 billion under current
law),"5 this was not its principal function. The study focussed, rather,
on the fact that a comprehensive tax base would permit tax rates to
be lowered while holding aggregate revenue constant. The statutory
changes proposed by Pechman and Okner would, of course, distribute
the tax burden differently than existing law even if the total
amount to be collected is unchanged. Their program would, in
general, increase the tax burden of homeowners relative to tenants,
the burden of capital gain recipients relative to recipients of other
types of income, the burden of persons itemizing their personal
deductions relative to those using the standard deduction, and the
burden of married persons relative to unmarried persons. Other
proposals for a comprehensive tax base would have similar effects,
except that some reformers are more tolerant than Pechman and
Okner of the reduced rate granted by existing law to married couples.
These changes in horizontal equity (i.e., among persons on the
same income level) would be accompanied by equally important
changes in vertical equity (i.e., in the burdens borne by taxpayers at
one income level compared with those at other levels). Because alterations
in vertical equity depend upon the rate schedule to be applied
to the expanded tax base, the possibilities are infinite, ranging from
an extremely progressive schedule to an extremely regressive one.
The Pechman-Okner study offers five alternative schedules,6r all of
which might be described as middle-of-the-road rather than extreme
proposals. One is a flat rate of 16 per cent of taxable income (as
newly defined), a proposal that would commend itself to one school
of tax reform-those who reject progression on ethical grounds or
because it complicates the tax law and who would substitute a proportional
tax on all income above a specified subsistence or modest
level. This rate schedule would increase the effective tax rate on
persons with income below $25,000 and greatly reduce the effective
rate on taxpayers with more than $50,000 of expanded adjusted
gross income.67 By contrast, the most progressive of the five Pechman-
Okner schedules (which includes a higher initial exemption or lowincome
allowance than the others) would reduce the effective rate
on taxpayers with less than $25,000 of expanded adjusted gross in-
65. Pechman & Okner, supra note 43, at 24 (table 4).
66. Id. at 30-33.
67. Id. at 31 (table 11). "Expanded adjusted gross income" is adjusted gross income
as defined in section 62 of the Internal Revenue Code modified to include the income
items listed in Pechman & Okner, supra note 43, at 23 (table 3).
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come and increase it for those above the $25,000 level.08 But these
changes would be marginal rather than revolutionary when judged
from a macroeconomic perspective. Taxpayers with expanded adjusted
gross income of $50,000 or more, for example, would pay
only $2.6 billion (2.5 per cent) more of the $103 billion of income
tax than under existing law.69
V. SELECTIVE TAX REFORM
Comprehensive tax reform thus turns out to be only mildly redistributive
if revenue is held constant, while if it is used to raise
the promised $77 billion of additional revenue by applying the existing
rate schedule to the expanded tax base, only about 25 per cent
of the new money would come from families with income above
$50,000.70 Can social reformers who have been led to believe that the
systematic elimination of tax “loopholes” is a promising way to redistribute
income or a bountiful source of financing for major new
public programs salvage their objectives by abandoning the cause of
comprehensive reform and concentrating instead on a limited list of
targets? The most obvious strategy is to eliminate allowances that
favor high income taxpayers, while allowing taxpayers in more
modest circumstances to retain their tax shelters. The prime targets
would be capital gains and such items of “preference income” as
tax-exempt interest and percentage depletion. Once again, we find
that the per-family impact of tax reform may be quite substantial,
but that the aggregate result is not overwhelming. If reform is limited
to the tax shelters patronized primarily by the rich, the aggregate
amount of new revenue would be only about $13.4 billion, of which
$3.4 billion would come from taxpayers with income below $50,000.71
68. Pechman & Okner,supra note 43, at 31 (table 11).
69. Id. at 26 (table 6), 38 (table A-7).
70. Id. at 26 (table 6).
71. The computation is as follows (all dollar amounts, except expanded adjusted
gross income, in millions):
Expanded Adjusted Gross Income Class
Under $50,000 $50,000 & over Totals
Maximum tax on earned
income – $ 112 $ 112
Realized capital gains $1,686 6,355 8,041
Constructive realization of
capital gains 1,401 2,324 3,725
Tax-exempt interest 112 974 1,086
Accelerated depreciation
& depletion 156 268 424
Totals $3,355 $10,033 $13,388
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Income Tax "Loopholes"
Who are the upper-income taxpayers who would be the principal
targets of selective tax reform (confined to capital gains, tax-exempt
interest, and percentage depletion)? The new populists imply that
the principal beneficiaries of these allowances are "tax millionaires"
with such familiar names as Ford, Rockefeller, and Mellon-the
"relative handful of Americans [who] are extravagantly endowed,
like princes in the Arabian Nights Tales, ‘ 2 described in Ferdinand
Lundberg’s 1937 book, America’s Sixty Families, and its 1968 sequel,
The Rich and the Super-Rich.
But just as analysis of the $77 billion of “tax welfare for the rich”
distributed by the Internal Revenue Code disclosed that most of this
amount is received by taxpayers in the middle and lower income
brackets, so an examination of selective tax reform discloses that you
don’t have to be a Rockefeller to feel its impact. The reform program
just described would affect about 825 thousand families, composed
of 2 or 3 million individuals. The inhabitants of these top income
brackets make up only 1 or 1.5 per cent of the population, and hence
can be called a “relative handful,” and they surely have more material
goods than anyone at Haroun-El-Raschid’s court. From a political
perspective, however, it is misleading to imply that a tax reform
program affecting more than 2 million people is aimed at “America’s
Sixty Families.” I am in complete agreement with the objective of
increasing taxes on this segment of our population, but the attempt
to portray them as akin to Rockefellers and Fords is bound to be
counter-productive.
VI. TiE SECOND-ORDER EFFECTS OF TAx REFORM
This analysis of the “$77 billion welfare program for the rich”
becomes even more sobering when a fact of life that I have hitherto
disregarded is taken into account. All of the estimates that I have laid
before you are derived by simple arithmetic. The Pechman-Okner
study is based on a representative sample of tax returns, ingeniously
augmented by estimates of items that are not now reported, to which
the 1972 rate schedule was applied to estimate the changes in tax
liability that would result from enlarging the tax base. But when
items that are not now taxed are multiplied by today’s rates, the
Figures are derived from computation done at Yale University based on the
Peckman-Okner study; a copy of the computer printout is on file with the Michigan
Law Review.
72. F. LUNDBERG, Tim RICH AND THE SUPER-RICH 1 (1969).
hMay 1973] 1121
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Michigan Law Review
product is a hypothetical amount that may vary substantially from
the amount that will actually be due after the taxpayers have adjusted
their financial affairs to the new law.
This is not the place, and I am not the person, to undertake an
analysis of the second-order consequences of comprehensive tax reform.
I will simply list some of the factors that would help to create
a disparity between the estimate of $77 billion of added revenue and
the amount that might actually be produced by so sweeping a
program.
First, if changes in the tax law have effects that are perceived to
be adverse to activities that are now encouraged by tax incentives,
Congress may respond by granting subsidies or other non-tax allowances
as a substitute for the repealed tax incentives. Thus, some of
the “new” revenue will simply be diverted to a partial restoration of
the status quo ante. For example, repeal of the tax immunity of state
and municipal bond interest is simply not in the cards without a
substantial federal subsidy to the issuers to reimburse them for the
higher cost of borrowing. Such a subsidy would absorb a substantial
part of the new revenue, and, if it were generous enough, could cost
the Treasury more than taxing the interest would produce.7 8 Similarly,
one can hardly contemplate taxing social security benefits,
public assistance, unemployment compensation, and some other transfer
payments-as proposed by the Pechman-Okner study-without
using a large part of the “new” revenue to increase these benefits.
In other cases, the reform could hardly be enacted without offsetting
tax concessions (e.g., the repeal of income-splitting for married
couples would unquestionably require an increase in the personal
and dependency exemptions), which would absorb the “new” revenue
to a significant degree. While subsidies in some instances may
be more equitable and efficient than the tax allowance they displace,
74 the $77 billion for new programs may be as evanescent as the
“fiscal dividend” that was to be declared when we withdrew from
Viet Nam.
73. See Fortune, The Impact of Taxable Municipal Bonds: Policy Simulations with
a Large Econometric Model, 26 NATL. TAx J. 29 (1973). The Treasury estimated that
the cost to it of tax exemption in 1968 was $1.8 billion, of which $500 million inured
to the benefit of high-income individual investors, commercial banks, and casualty
insurance companies. A private estimate for fiscal 1971 put these amounts at $3.3
billion and $800 million, respectively. See Hearings on S. 1015 Before the Senate Comm.
on Banking, Housing & Urban Affairs, 92d Cong., 2d Sess. 193, 277 (1972).
74. See Surrey, supra note 3.
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Income Tax "Loopholes"
Second, the additional yield will be offset to some extent by
revenue reductions in later years when the new structure has reached
a "steady state." Thus, the denial of accelerated depreciation and of
the deduction for intangible drilling and development expenses in
the year of payment will increase the taxpayer's deductions in later
years (e.g., for "dry holes" and losses when the property becomes
worthless dr is sold for less than its adjusted basis). These offsets are
likely to be of more importance to high income than low income
taxpayers.
Third, some taxpayers will shift to tax avoidance tactics that are
not prohibited even by the comprehensive reform program, such as
the deferral of earned income to later years, intra-family transfers of
property, and investments in growth stocks and real property. The
reader may be inclined to reject this suggestion, believing that Congress
could be induced to define "income" in such sweeping terms
as to outlaw all tax avoidance devices.75 He would do well to
remember the Duke of Wellington's response when an otherwise
forgotten person accosted him in Hyde Park with the salutation,
"Mr. Smith, I believe?" The Duke's reply: "If you believe that, you'll
believe anything."
Fourth, major changes in the tax structure are bound to have
an impact, however obscure and difficult to measure, on the taxpayer's
economic choices-such as between work and leisure, between
investment and consumption, between risky and safe enterprises-
that will affect his pre-tax income, and therefore his tax
liability.
Fifth, these changes in each individual taxpayer's economic behavior
will alter the price of goods and services for other taxpayers
who, in turn, will respond by changing their economic behavior;
these decisions will alter their pre-tax income, and hence their tax
liabilities.
VII. SUMMARY AND CONCLUSIONS
In concluding this analysis, I should like to look once more at the
"$77 billion welfare program for the rich," this time from the perspective
of the tax reform proposals offered to the electorate by Sena-
75. On the extent to which even the most dedicated and enthusiastic advocates of
the broad Haig-Simons definition of "income" disagree about its application in practice,
see Bittker, supra note 39.
May 1973] 1123
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Michigan Law Review
tor McGovern during the 1972 campaign. During the Democratic
primaries, Senator McGovern espoused a plan that, for the first time
in American history, would have brought rich and poor together into
a single comprehensive program to tax persons above a specified
break-even point and pay benefits to those below it. There were
several versions of the plan, but the one that caught the popular
imagination called for a “demogrant” of $1,000 per person as assured
income maintenance, to be paid in cash to those at the bottom of the
ladder, reduced gradually for those at low and modest income levels
by the amount of tax on their outside income, and credited against
the tax liability of those with higher incomes.7 6
This integration of “positive taxes” with public assistance (“negative
taxes”) had many adherents in academic circles, uniting economists
of such diverse political convictions as Milton Friedman and
James Tobin, 7 but the idea was unknown in the outside world.
Lacking an infrastructure of public information and journalistic
support, which could not possibly be supplied in the superheated
haste of a primary campaign, the “demogrant” proposal quickly
collapsed under stress. The reasons need not be recited here, save as
they illuminate the main themes of this Article.
When first advanced by Senator McGovern, the $1,000 tax credit
proposal seemed to offer a way to redistribute income on a significant
scale by taxing only the very rich, and thus to respond to such
slogans as “take the rich off welfare.” But a careful reading of Senator
McGovern’s own statement would have disclosed that “about 20 per
cent of Federal taxpayers would experience a tax increase” 78-an
estimate that was later revised upward to embrace about 90 million
individuals,79 only a few of whom are named J. Paul Getty. Moreover,
under the original McGovern plan a tax increase would be
experienced by a single person with income of $2,000 or more and a
married couple without children if their income was $4,000 or more.
Families with two or more children fared better under the plan,
and its supporters pointed out that a family of four would pay less
than under existing law unless its income exceeded 20,000. It was
impossible to focus solely on this idyllic and authentic American
76. McGovern, Tax Reform and Redistribution of Income, 118 CONG. REc. S5626,
S5628 (daily ed. April 7, 1972), reprinted in N.Y. REV. OF BOOKS, May 4, 1972, at 7, 10.
77. See C. GREEN, NEGATIVE TAXES AND THE POVERTY PROBLEM 57-61 (1967).
78. McGovern, supra note 76, at S5628, reprinted at 10.
79. Calculations made at Yale University.
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Income Tax "Loopholes"
group, however, because in the California Democratic primary Senator
Humphrey quickly made himself the standard-bearer for other
American life styles. He exploited the plan's bias against unmarried
persons and childless couples, asserting that it would produce a 50
per cent increase (from $1,100 to $1,666) in the federal income tax
liability of an $8,000-per-year unmarried secretary living in San FranciscoS°
0-a homely geographical touch that could have been amended
to fit every city and hamlet in the nation. The charge, unconvincingly
denied by Senator McGovern, was devastating; it would have been
even more deadly if Senator Humphrey had had access to the computer
printouts on the plan,8' showing an aggregate reduction of $100
million in taxes for families with income of $1 million or more and
scattered reductions for many other high income taxpayers, attributable
to the fact that the proposed top tax rate was 48 per cent.
Though Senator McGovern won the California primary, his narrow
margin in a state that had been expected to give him a smashing
victory was blamed in large part on the tax plan, which then went
back to the technicians for revision. The intolerable bias against
single persons and childless couples could be mitigated by changing
the "demogrant" from a flat amount of $1,000 per person and by distinguishing
between adults and children (e.g., $1,320 for the first one
or two adults in a family, and $500 for each child), but this change
meant that many welfare families would be left below the poverty
line and would get less in 1975-the target date for a full employment
economy-than their 1972 welfare payments, especially if the
mother was the only adult.8 2 Moreover, this version of the plan was
no more financed by the rich and the super-rich than was its predecessor.
Almost one half of the nation's families, comprising more
than a third of the population, would have paid more taxes than
under existing law.
Once these deficiencies, along with others that need not be
detailed here, were digested by Senator McGovern's advisers, the
"demogrant" proposal was abandoned, and an orthodox tax reform
program was substituted. It was limited to attacking such old favorites
as long-term capital gains, percentage depletion, and accelerated
80. Washington Post, May 29, 1972, § A, at 12, col. 1.
81. Calculations made at Yale University.
82. Retired persons living on social security benefits and homeowners also presented
problems, for which McGovern's advisers sought to provide remedies that were not
included in the original plan.
May 1973.] 1125
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Michigan Law Review
depreciation, and the pill was sugar-coated with a proposed reduction
of the maximum tax rate from 70 to 48 per cent. The target was
$12.6 billion of added revenue from the individual income tax88-
well under 20 per cent of the legendary $77 billion of tax welfare
dispensed by existing law. By the time this plan was disclosed, however,
the election was only two months off and, as we now know,
victory for Senator McGovern was not at hand. In accepting the
Republican nomination just a week before the revised McGovern
tax plan was unveiled, President Nixon said that the original plan
would add 82 million people to the welfare rolls.8 4 He could have
offered no more ironic an obituary to the “demogrant” proposal,
which had been intended to bar the demeaning term “welfare” .by
bringing rich and poor together. The President simultaneously
demonstrated that the term “welfare” as a label for tax allowances
was a two-edged sword, tendered to him by a political opposition that
did not realize which edge was sharper. We are still hearing reverberations
of this tactical reversal. John D. Ehrlichman, former assistant
to the President, has asserted that comprehensive tax reform
means that “you don’t let the average householder deduct the interest
on his mortgage anymore, and you don’t let him deduct charitable
contributions to his church or to the Boy Scouts. ‘ 8 5 It is hard to deflate
rhetoric of this type if one has been proclaiming that the deductions
allowed by current law for local property taxes, interest on
home mortgages, and charitable contributions are integral parts of a
577 billion welfare program for the rich and the super-rich.
Despite this painful history, I am convinced that a comprehensive
income-maintenance program, integrated with the federal income tax
system, should be high on our national agenda. But the technical
foundation for such an integrated program has only begun to be laid,
and public acceptance of its cost is even further in the future. Macroeconomic
estimates, in which a hundred million dollars is the smallest
unit of calculation, are easily made, but the fiasco just described
83. N.Y. Times, Aug. 30, 1972, at 1, col. 8, at 22, cols. 4-5.
84. N.Y. Times, Aug. 24, 1972, at 47, cols. 2-3. The estimated 82 million “on welfare”
were evidently those who would receive some cash, however small the amount. If the
President had accepted the broader theory of “tax expenditures” or “implicit grants”
espoused by some tax theorists (Pfaff, supra note 3, Heller, supra note 3, Surrey, supra
note 3), he could have said that the entire population, not merely 82 million people,
would be on the welfare rolls. See McGovern, supra note 76, at S5628, reprinted at 10.
(“I propose that every man, woman and child receive from the federal government an
annual payment.”)
85. N.Y. Times, March 17, 1973, at 30, col. 2.
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Income Tax "Loopholes"
shows that more is required than impeccable arithmetic. We must
be clear about the effect of the program on the unmarried secretary,
the policeman who moonlights as a taxi driver, the salesman who is
married to a school teacher, the retired pharmacist living on social
security, and so on. The technician may wish to drown these cases
in a sea of averages, dismissing each inconvenient instance as idiosyncratic,
but sooner or later the facts must be disclosed.
Of these facts, the most difficult to face is that the income pyramid
gets narrower as it gets higher. The rich and the super-rich at the top
make a convenient target for rhetoric, but most of the money is to
to be found at lower levels. It is a counter-productive hoax to encourage
the belief that $77 billion can be raised by "taking the rich off
welfare," if the term "rich" is to have the meaning ascribed to it by
the audience to which this slogan is addressed.
In conclusion, the time has come to rescue the federal income tax
from the superheated rhetoric of its populist friends. By denouncing
it as a web of "loopholes," "organized larceny," a vast and uncontrolled
program of "back-door spending," and a pork barrel of
"upside-down subsidies," they threaten to persuade wage earners
and other low and middle income taxpayers that the income tax is
the worst of all possible taxes, while leaving its competitors-state
sales taxes, local property taxes, and value-added taxation-stronger
by comparison. By indiscriminately lumping together percentage
depletion, income-splitting for married couples, the exemption of
state and municipal bond interest, the extra $750 exemption for the
blind, accelerated depreciation, the exemption of social security
payments, and so on, they imply that these features of existing law
are equally objectionable, and that a tax reform proposal is a craven
surrender to vested interests if it does not eradicate all of them
simultaneously.
This implication cannot be- faulted if it is what the populist critics
of the existing law really mean. But for those who believe, as I do
(and as I suspect the new populists, for all their rhetoric, do), that
these "loopholes" can be ranged in a hierarchy-from offensive,
through debatable and trivial, to justified-and that we would do
well to pick and choose among them, the rhetoric I have described
undermines rather than supports the cause of tax reform. If $77
billion of new revenue comes to be the popular measure of serious
tax reform, the revenue impact of any feasible program of selective
reform is bound to be disappointing, even if it concentrates on
May 1973] 1127
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1128 Michigan Law Review
capital gains, tax-exempt interest, accelerated depreciation, percentage
depletion, and similar high-income provisions. In my view,
therefore, the time has come for a drastic revision of the rhetoric of
tax reform.
HeinOnline — 71 Mich. L. Rev. 1128 1972-1973

• tikakar

Tax Loopholes Block Efforts to Close Gaping U.S. Deficit

By JONATHAN WEISMAN

Published: July 20, 2012

WASHINGTON — As a member of the “Gang of Six,” Senator Mike Crapo of Idaho has emerged as something of a hero among advocates of bipartisanship, one of three conservative Republicans working with three Democrats to cut the deficit by closing loopholes that allow businesses and households to avoid paying taxes.

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Stephen Crowley/The New York Times

Senator Mike Crapo, Republican of Idaho, fought to save a tax loophole for the timber industry.

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Yet earlier this year, the senator made sure that a $3 billion loophole — protecting “black liquor,” an alcoholic sludge used as fuel in timber mills and factories — remained open in the negotiations over the highway bill that President Obama signed this month. Many budget experts criticize the loophole as a tax dodge because it allows the sludge to qualify for an energy subsidy created to wean the country off imported oil for vehicles, which black liquor does not do.

On Capitol Hill, lawmakers casually point to closing loopholes as the answer to much that ails the country. Negotiations to avoid automatic military spending cuts in January, to enact sweeping deficit reduction and to lower corporate and personal income tax rates all hinge on closing unidentified loopholes.

But the back-room actions on black liquor point to just how difficult it will be to lower the budget deficit through painless changes in the tax code. Even for a self-proclaimed deficit hawk like Mr. Crapo, one man’s loophole can be another’s vital constituent interest.

An Idaho company “feared losing the write-offs could affect employment decisions,” said Lindsay Nothern, a spokesman  for Mr. Crapo.

Mr. Nothern would not identify the company, but Matt Van Vleet, a spokesman for Clearwater Paper, a Spokane company with a large pulp mill in north-central Idaho, confirmed that his company had gone to Mr. Crapo seeking to keep the tax break open.

“We would have felt significant pain,” he said.

Federal tax receipts are reduced by more than $1 trillion a year by various tax deductions and credits, known as tax expenditures, often tied to a policy aim. Ending them would nearly eliminate the federal deficit, which is projected to be $1.2 trillion in the current fiscal year.

But the three largest are as popular as they are expensive: the mortgage interest deduction has cost about $75 billion a year recently, the employer deduction for health care has cost $120 billion a year, and the charitable-giving deduction has cost $38 billion a year, according to the bipartisan Joint Committee on Taxation.

Others are more hotly debated, like the exclusion or deferral of taxes on overseas corporate earnings. Legislation by Senator Debbie Stabenow, Democrat of Michigan, to end a tax deduction for the expense of moving business overseas fell to a Republican filibuster in the Senate this week.

Still other tax breaks verge on the unpopular, criticized by aides of both parties. Offshore tax havens and other tax shelters cost the government about $150 billion a year, said Senator Kent Conrad of North Dakota, chairman of the Senate Budget Committee.

For tax aides in both parties, black liquor falls into the category of the hard to defend.

Mr. Nothern, the spokesman for Mr. Crapo, confirmed the senator’s role in the disappearance of the provision that would have eliminated the loophole, which happened sometime between its approval by the Senate Finance Committee and its arrival on the Senate floor this spring.

But he added that those actions bore no impact on the deficit negotiations that Mr. Crapo helped start. Mr. Nothern said in an e-mail: “Instead of discussing individual loophole closures to save a buck here or there (more than likely so the bucks can be immediately spent elsewhere), the Gang of Six and bipartisan partners remain talking about a much larger agreement — a simultaneous effort to agree on spending caps, tax reforms (including loophole adjustments and lowering of tax rates), plus reforms to Social Security, Medicare and related programs to keep them solvent.”

The company in question did not appear to be a political contributor to Mr. Crapo, but the forestry and forest products industry has given him $216,286 over his career, ranking 13th among industry givers, according to the Center for Responsive Politics.

Since the 1930s, the timber industry has used an alcoholic sludge produced as a byproduct of wood processing to power its mills and plants. In 2009, black liquor became something else — a tax haven. The timber industry labeled black liquor an alternative fuel under the provision Congress created to encourage ethanol production for cars and trucks. Congress never agreed, but the Internal Revenue Service did, backing the timber industry’s interpretation.

That year, black liquor cost the Treasury more than $4 billion.

Congress reversed track later in 2009, saying black liquor would not count as an alternative fuel after 2009, and lawmakers went further in the 2010 health bill, also barring the timber industry from claiming black liquor as a cellulosic biofuel, which receives even bigger tax advantages.

But the I.R.S. gave black liquor one last chance. It ruled that the health care provision did not prevent the timber industry from redefining black liquor produced in 2009 as a cellulosic fuel, worth $1.01 a gallon, even if a company had claimed it as a regular alternative fuel, worth 50 cents a gallon. In other words, companies were permitted to give back one credit already claimed for another worth double, a $2.8 billion bonus for the industry.

Senator Max Baucus of Montana, chairman of the Finance Committee, saw the money as a way to help pay for a transportation bill this year. But Mr. Crapo protested, saying at a hearing that changing the law would “cause very significant damage to a number of people and impact jobs around the country, not the least of which is a major facility in my state.”

Mr. Baucus, a Democrat, tried to assuage his colleague’s concern, whittling down the black liquor provision to save $1.6 billion. It still was not acceptable. Finance aides said a bipartisan vote on the committee was more important than a fight over black liquor. By March, the bill reached the Senate floor with the provision gone, and Mr. Crapo was the first Republican to back the Baucus measure.

In the demise of the provision, members of the Gang of Six, including Mr. Crapo, see a cautionary tale: Go big or don’t go at all. Little provisions can be picked off by members in ways that a comprehensive deficit reduction cannot, they say.

Senator Richard J. Durbin, Democrat of Illinois, who is participating in the deficit talks with Mr. Crapo, said: “We have to invite the American people to be part of a conversation about how to rationalize this tax code, reduce its complexity, try to bring rates down in a reasonable way and still reduce the deficit.”

He added: “I drink red wine. I’m not into black liquor.”

Economic Scene

The Paradox of Corporate Taxes

By DAVID LEONHARDT

Published: February 1, 2011

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The Carnival Corporation wouldn’t have much of a business without help from various branches of the government. The United States Coast Guard keeps the seas safe for Carnival’s cruise ships. Customs officers make it possible for Carnival cruises to travel to other countries. State and local governments have built roads and bridges leading up to the ports where Carnival’s ships dock.

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Andy Newman/Carnival Cruise Lines, via Associated Press

Thanks to an obscure loophole in the tax code, Carnival can legally avoid most taxes.

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The Trouble With Corporate Taxes

 

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But Carnival’s biggest government benefit of all may be the price it pays for many of those services. Over the last five years, the company has paid total corporate taxes — federal, state, local and foreign — equal to only 1.1 percent of its cumulative $11.3 billion in profits. Thanks to an obscure loophole in the tax code, Carnival can legally avoid most taxes.

It is an extreme case, but it’s hardly the only company that pays far less than the much-quoted federal corporate tax rate of 35 percent. Of the 500 big companies in the well-known Standard & Poor’s stock index, 115 paid a total corporate tax rate — both federal and otherwise — of less than 20 percent over the last five years, according to an analysis of company reports done for The New York Times by Capital IQ, a research firm. Thirty-nine of those companies paid a rate less than 10 percent.

Arguably, the United States now has a corporate tax code that’s the worst of all worlds. The official rate is higher than in almost any other country, which forces companies to devote enormous time and effort to finding loopholes. Yet the government raises less money in corporate taxes than it once did, because of all the loopholes that have been added in recent decades.

“A dirty little secret,” Richard Clarida, a Columbia University economist and former official in the Treasury Department under President George W. Bush, has said, “is that the corporate income tax used to raise a fair amount of revenue.”

Over the last five years, on the other hand, Boeing paid a total tax rate of just 4.5 percent, according to Capital IQ. Southwest Airlines paid 6.3 percent. And the list goes on: Yahoo paid 7 percent; Prudential Financial, 7.6 percent; General Electric, 14.3 percent.

Economists have long pleaded for an overhaul of the corporate tax code, and both President Obama and Republicans now say they favor one, too. But it won’t be easy. Companies that use loopholes to avoid taxes don’t mind the current system, of course, and they have more than a few lobbyists at their disposal.

The official position of the Business Roundtable, one of the most important corporate lobbying groups, is telling. The Roundtable says it supports corporate tax reform. But it actually favors only a reduction in the tax rate. The group refuses to say whether it also favors a reduction of loopholes. In effect, the Roundtable wants a tax cut for its members regardless of how much the tax code is simplified — or whether the budget deficit grows.

•

The tax filings of companies, like those of individuals, are confidential. In their public reports to investors, however, companies are required to list something called “cash taxes paid” — the total amount of corporate income tax they paid that year, be it to foreign governments, the United States government or state and local governments.

This number varies significantly from year to year, depending on how many loopholes a company qualifies for. So looking at a single year’s number is often misleading. But in a 2008 academic paper, three accounting professors — Scott Dyreng of Duke, Michelle Hanlon of M.I.T. and Edward Maydew of the University of North Carolina — suggested a new method for analyzing corporate tax avoidance.

It compares cash taxes paid over several years — like five, as in the analysis for The Times — to pretax earnings over that same period. The accounting experts I interviewed called it the best available method for looking at corporate taxes.

Some obvious patterns emerge. Companies that lost large amounts of money in previous years can subtract these subsequent losses from their initial profits and avoid taxes until they’re turning a consistent profit. Yahoo falls into this category. Of all the reasons to have a low tax rate, this one may be the most defensible, economists say.

Other companies are able to avoid taxes by spending large sums on new equipment or buildings. Such spending can often be deducted. Southwest Airlines, for instance, has bought a lot of planes in the last five years. Several energy companies with tax rates below 2 percent, like NextEra, Xcel and Range Resources, have likewise been expanding.

A third group of companies simply seems to have become expert at avoiding taxes. When the three accounting professors analyzed more than 2,000 companies, they found big variations in tax rates within almost every subset of companies. Companies in the same industry often paid very different rates, even when they were similar in size.

G.E. is so good at avoiding taxes that some people consider its tax department to be the best in the world, even better than any law firm’s. One common strategy is maximizing the amount of profit that is officially earned in countries with low tax rates.

Carnival pays so little tax partly because of a provision that lets some shipping companies legally incorporated overseas (Panama, in Carnival’s case) avoid taxes. The fact that Carnival’s executives sit in Miami and or that many passengers board in Baltimore, Los Angeles, Miami, New York and Seattle doesn’t matter. Nor does the fact that Carnival isn’t paying much tax in Panama.

Companies that pay relatively high rates tend to be those that are not expanding rapidly and that are not as ingenious as G.E., at least on taxes. The average total tax rate for the 500 companies over the last five years — again, including federal, state, local and foreign corporate taxes — was 32.8 percent. Among those paying more than the average were Exxon Mobil, FedEx, Goldman Sachs, JPMorgan Chase, Starbucks, Wal-Mart and Walt Disney.

The problem with the current system is that it distorts incentives. Decisions that would otherwise be inefficient for a company — and that are indeed inefficient for the larger economy — can make sense when they bring a big tax break. “Companies should be making investments based on their commercial potential,” as Aswath Damodaran, a finance professor at New York University, says, “not for tax reasons.”

Instead, airlines sometimes buy more planes than they really need. Energy companies drill more holes. Drug companies conduct research with only marginal prospects of success.

Inefficiencies like these slow economic growth, and they are the reason that both conservatives and liberals criticize the corporate tax code so harshly. Mitch McConnell, the Republican Senate leader, says it hurts job creation. Mr. Obama, in his State of the Union address, said that the system “makes no sense, and it has to change.”

A lot of economists agree. Then again, any system that creates as many winners as this one won’t be changed easily.

E-mail: leonhardt@nytimes.com;
twitter.com/DLeonhardt

International Taxation – Tax Research Paper — Document Transcript

• 1. Kesha Haley July 14, 2009 ACCT 8570 International Taxation Tax Research Project In the May 4, 2009 press release by President Obama, the Administration revealed its plan for international tax reform. The need for reform comes out of the fact that, due to the “broken tax system written by well-connected lobbyists on behalf of well-heeled interests and individuals”, it’s perfectly legal for a “number of individuals and companies to abuse overseas tax havens to avoid paying any taxes at all” (Obama). The US tax codes give “competitive advantage to companies that invest and create jobs overseas compared to those that invest and create those same jobs in the U.S.”. The loopholes in the tax system are costing “taxpayers tens of billions of dollars a year” (Obama). Every year, US companies with subsidiaries in foreign tax havens get out of paying their fair share of US taxes. For example, in 2004, “U.S. multinational corporations paid about $16 billion of U.S. tax on approximately $700 billion of foreign active earnings – an effective U.S. tax rate of about 2.3%” when the top US corporate tax rate is 35%. Also, as President Obama has pointed out throughout his campaign, over 18,000 US companies have one Cayman Island addressed registered as their own. Very few of those companies actually have any physical presence in the country. President Obama announced proposals that addressed overseas tax evasion, tax loopholes, and US job creation. He is asking Congress to pass some laws that he anticipates will save Americans over $210 billion over the next ten years, which could be used to reduce the deficit, reduce taxes, and provide relief for individuals. The reform includes plans such as requiring foreign financial institutions to provide 1099s on their American customers, incentivizing companies to create jobs in the US instead of giving advantages to create jobs overseas through the reform of tax deferrals, cracking down on tax haven abuse, and closing foreign tax credit loopholes.
• 2. Currently, the rules for companies operating abroad as a subsidiary allow a company to avoid paying taxes on any profit until it is repatriated into the United States by the subsidiary. These companies only pay tax on the dividends they receive, if they receive any at all. If the subsidiary never pays any dividends, the parent company never pays any tax on that profit. However, that company can still take deductions against their US income for expenses incurred on their foreign operations. This treatment gives advantages to investors who invest and create jobs overseas as opposed to investing and creating jobs in the United States. In order to eliminate this issue, the Administration is proposing that deductions associated with foreign profits be deferred until such a time when the profits are repatriated into the United States. Corporations will only be able to take deductions related to foreign income when they pay US taxes on that income. The only expenses excepted are Research and Development expenses because those expenses are expected to provide benefit to the United States. When dealing with taxes, companies want to defer as much income and accelerate as many deductions as possible. This practice reduces taxable income and ultimately the tax liability. The current law does just this, although maybe unintentionally. The new proposal by the Obama administration will defer deductions for as long as the income is deferred. As a result of this, corporations will either invest more in the United States or be forced to repatriate more income into the United States, therefore paying more US taxes. Depending on the host country, the corporations may be subject to a withholdings tax on dividends on any money leaving the country as well as a tax on profits. Corporations that invest overseas will then be subject to higher rates and will pay more money in taxes. Currently, one corporation that invests in the United States is eligible to receive a deduction for all business expenses but is subject to a 35% tax rate. Meanwhile, a corporation with the same investment in a foreign country is still eligible to receive deductions for all business expenses, but is subject to a different, maybe much lower, tax rate. The company that invests in the United States is at a
• 3. disadvantage because the other company has more after-tax cash flow. More companies want to invest overseas. In 2011, when this proposal takes effect, companies that invest overseas will see an increase in their overall taxes. The company that invests overseas in a country that imposes a 25% income tax and 10% dividend tax has $200,000 US taxable income excluding foreign income and deductions as well as $300,000 foreign taxable income including $100,000 deductions. If they repatriate none of their income, they get no deduction against US income and they pay $70,000 in US taxes. They pay $75,000 in income taxes in the host country for a total tax of $145,000. If they decided to repatriate all of their after-tax income to the US in order to take advantage of the foreign deductions, they pay an additional $22,500 ([300,000-75,000]*.1) in dividend withholding taxes in the host country. In the United States, they will be able to take the deduction for the $100,000 expenses, and they will pay $105,875 ([200,000+300,000-75,000-22,500-100,000]*.35) for a total tax liability of $203,275. Meanwhile, the company that invested in the United States with the same $500,000 taxable income only pays $175,000 in total tax liability. President Obama’s proposal to reform international tax laws are expected to bring more money into the US in the form of taxes. Requiring that corporations defer deductions will help this cause in one or more of three ways: 1) companies that never repatriate their income and therefore never take deductions will pay more US taxes equal to the deduction times the US tax rate, 2) companies that do repatriate money into the US increase will pay more US taxes equal to the income minus the deductions times the US tax rate, and/or finally, 3) companies will take advantage of the overall lower tax liability and create jobs in the US.
• 4. BIBLIOGRAPHY Barack Obama Press Release May 4, 2009 http://www.whitehouse.gov/the_press_office/Remarks-By- The-President-On-International-Tax-Policy-Reform/ Barack Obama Press Release May 4, 2009 http://www.whitehouse.gov/the_press_office/LEVELING-THE- PLAYING-FIELD-CURBING-TAX-HAVENS-AND-REMOVING-TAX-INCENTIVES-FOR-SHIFTING-JOBS- OVERSEAS/

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10. SparkNotes: Policy Debates: Budget Deficit

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   www.webworldismyoyster.com/…/childish-games-played-in-th…

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…and I am Sid Harth@webworldismyoyster.com