Freeloaders

Two recent opinions illustrate the problems that America's mobility poses states and localities in raising tax revenue.

In Antzis v. Comptroller, the Maryland Tax Court addressed the question of whether a tax, levied on the Maryland income of non-Maryland residents, was constitutional. The facts, as set forth by the Court, are as follows:

Petitioners are three married couples that reside in Pennsylvania and file joint nonresident Maryland income tax returns. The returns are filed because in each case the husband is a partner in a multi-state law firm with Maryland and Pennsylvania operations. The partnership apportions its income among the states in which it does business, and this creates Maryland taxable income for each Petitioner pursuant to §10-210 [of the Maryland Tax-General Article]. There also exists a withholding obligation for the partnership under §10-102.1 [of the Maryland Tax-General Article]. These taxes are not in dispute.

In 2004, the General Assembly of Maryland enacted a special tax applicable to non-residents. The tax requires non-residents to pay income tax equal to the state rate (4.75%) imposed by §10-105 [of the Maryland Tax-General Article], "plus an amount equal to the lowest county income tax rate set by any Maryland county in accordance with §10-106.1 of [of the Maryland Tax-General Article]." . . . Petitioners did not pay the amount required by §10-106.1 and were assessed accordingly. Petitioners' contention is that the tax imposed by §10-106.1 is unconstitutional.

Maryland income taxes on both residents and non-residents can be described as follows. The resident taxpayers’ payment is split between two separate taxes, namely the state income tax portion that goes into the General Fund of Maryland, and a local tax portion that goes to the taxpayer’s county of residence, or to Baltimore City in the case of a city resident. The local tax revenues are used to fund local services. By contrast, the non-resident taxpayers' tax consists of the state income tax portion at the same rate paid by residents, plus the special non-resident tax, both of which go into the General Fund. Non-residents pay no local income tax because they have no local county of residence. As stated earlier, residents do not pay the special non-resident tax prescribed by §10-106.1.

Petitioners contend that imposing the special non-resident tax exclusively on nonresidents, coupled with the differences in how the tax revenue is allocated, equates to discrimination against the non-resident in violation of both the United States Constitution and the Maryland Constitution and Declaration of Rights. To support these contentions, the Petitioners assert that the state income tax and the local income tax are different taxes and cannot be combined to determine whether residents and non-residents are being taxed equally.

The taxpayers principally relied upon Fulton Corp. v. Faulkner, 516 U.S. 325 (1996), contending that the Maryland statute expressly discriminates against nonresidents by levying a tax on nonresident income which has no direct corollary with respect to residents. Among the arguments that they raised was that "the special tax compensates for nothing, and cannot be 'fairly related to the services provided by the State [which benefit interstate commerce].'"

In one paragraph, the Tax Court succinctly put that argument to bed:

To fully explore these contrasting points-of-view, this Court questioned counsel as to whether a nonresident taxpayer gains any direct or indirect benefit from local services being provided by a Maryland county or by Baltimore City. Such local services traditionally include police and fire protection, waste disposal, water and sewer services, and the myriad of other local governmental activities on behalf of people within each local jurisdiction. It was conceded that such local benefits do, in fact, accrue both directly and indirectly to nonresidents while they are present or doing business in a jurisdiction. Obviously, both residents and nonresident receive these local governmental benefits by mere virtue of their physical presence within a jurisdiction, either in person or as part of a business entity doing business within the jurisdiction. It seems perfectly reasonable, therefore, for the State to seek compensation for these services from non-residents through the tax system. Although there is no direct mechanism to allocate the special non-resident tax revenue to a particular county, the General Fund of Maryland exists to provide funding for the benefit of all Maryland counties and Baltimore City, selectively, indirectly, to all persons or entities physically situate or doing business within its local borders.

Emphasis added.

In other words, there's no free lunch when it comes to municipal services.

In District of Columbia v. Bender, the precise legal issue was different, but the overriding tax policy issue was the same. There, owners of valuable commercial real estate in the District of Columbia sought to avoid paying taxes on income generated by those properties. The specific question before the Court was whether the tax statute violated the Home Rule Act, but the same basic principle was at stake: Whether income that is generated as a direct consequence of municipal services can be tax to fund those services. Here too, the Court sustained the taxing authority.

There was a time when most commercial activity could be readily identified to a particular physical situs. To a growing degree, that is no longer the case. Capital, both human and economic, can be put to work in one locale but managed a substantial distance away. The underlying tax policy question is whether the governmental authorities who create and maintain the public infrastructure that supports the economic activities in a specific locale can be funded by taxing income that will, if not immediately taxed, be "exported" out of the locality.

Ain't Necessarily So

Estate-Tax Plans Get Trickier in the weekend WSJ suggests that estate planning has become immeasurably complex because, as currently drafted, the estate tax is scheduled to disappear in 2010 and then bounce back again, at higher rates, in 2011. The article focuses on the problems inherent in measuring how much life insurance estates, particularly modest estates, will need as part of an estate plan.

The article is needlessly alarmist.

No one, least of all me, has a perfect crystal ball when it comes to predicting what Congress will do. But it's virtually a slam-dunk, sure bet that the scheduled reversion of the estate tax to the 55% rates and $1M lifetime credit of 1997 will never take place. It is only a shade less likely that the lifetime credit will, after its increase to $3.5 million, be reduced. Thus, the only real uncertainties are:

1. Can any compromise be enacted early enough to avoid the zero estate tax in 2010? Let me suggest that this issue causes only a limited degree of planning uncertainty, since few clients are focusing their planning efforts around the fact that 2010 will be their year of demise. If no compromise is enacted by 2010 and your client dies in that year, it only means that his or her heirs hit the Estate Tax Lottery Jackpot. If that is the case, it is unlikely that any tax practitioner will have to answer to an unhappy client for failing to correctly predict the state of the law three and a half years in the future.
   


2. Will the estate tax rates be higher than they are currently? At best, this is a minimal factor in the estate tax planning for most clients, since any increase in rates is likely to be more than offset by a hefty increase in the lifetime credit and by other, new, planning devices built into any compromise.


3. How high will the lifetime credit go? Again, this would seem to create only a limited degree of planning uncertainty for most clients. After all, if we assume that the $3.5 million credit is, as a practical matter, a floor for any compromise, then the only families exposed to any estate tax after a compromise is reached are those with family wealth well in excess of $7 million. My suspicion is that relatively few readers of even the WSJ fall into this category.

A more interesting question is why the article was written in the first place. Let's try to guess.

The current estate tax law provides a huge subsidy to the life insurance industry. Virtually any change in the law will dramatically reduce the market for such insurance. Hmmm.

Of the 16 paragraphs in the article, 14 discuss the use of life insurance in estate planning that has, as its principal goal, tax minimization. Could it be that the article was nothing more than the fruit of efforts by insurance industry flacks attempting to sow panic among the wealthy in order to get in a few last licks?

Nahhh.

Hat Tip: TaxProf

Murphy's Law?

Much of what passes for conservative political thought these days is nothing more than rationalizations attempting to justify policies that favor the rich and economically entrenched. It is therefore refreshing to find a judicial opinion that actually applies conservative principles.

Yesterday, in the case of Murphy v. IRS, the U.S. District Court for the District of Columbia (per Ginsburg, C.J.) determined that, as a matter of Constitutional law, "compensation for a non-physical personal injury is not income under the Sixteenth Amendment if . . . it is unrelated to lost wages or earnings."

The taxpayer had "filed a complaint with the Department of Labor alleging that her former employer . . . in violation of various whistle-blower statues, had 'blacklisted' her and provided unfavorable references to potential employers after she had complained to state authorities of environmental hazards . . . ." The Secretary of Labor found in favor of the taxpayer and the case was remanded to an administrative law judge for a determination of the amount of compensatory damages to which she was entitled.

The taxpayer:

submitted evidence that she had suffered both mental and physical injuries as a result of the . . . .blacklisting . . . . A physician testified [that the taxpayer] had sustained "somatic" and "emotional" injuries. One such injury was "bruxism," or teeth grinding often associated with stress, which may cause permanent tooth damage. Upon finding [that the taxpayer] had also suffered from other "physical manifestations of stress" including "anxiety attacks, shortness of breath, and dizziness," the ALJ recommended compensatory damages totaling $70,000, of which $45,000 was for "emotional distress or mental anguish," and $25,000 was for "injury to professional reputation" from having been blacklisted. None of the award was for lost wages or diminished earning capacity.

IRC Section 104(a) provides that "gross income [under IRC Section 61] does not include the amount of any damages (other than punitive damages) received ... on account of personal physical injuries or physical sickness." Since 1996 it has further provided that, for purposes of this exclusion, "emotional distress shall not be treated as a physical injury or physical sickness." The taxpayer had contended that the award was not taxable because she had suffered physical injury (e.g., the bruxism). However, that argument was rejected by the Court which stated that:

[The taxpayer] no doubt suffered from certain physical manifestations of emotional distress, but the record clearly indicates [that she was] awarded . . . compensation only "for mental pain and anguish" and "for injury to professional reputation."

The Court then turned to the argument that makes this case remarkable. Specifically, is IRC Section 104(a)(2), which does not permit the award to be excluded from income, constitutional? The Court held that it was not.

In its analysis, the Court extensively reviewed the history of the Sixteenth Amendment. Ultimately, it agreed with the taxpayer's contention that:

a damage award for personal injuries-- including nonphysical injuries -- is not income but simply a return of capital -- "human capital," as it were. See Gary S. Becker, Human Capital (1st ed. 1964); Gary S. Becker, "The Economic Way of Looking at Life," 43-45 (Nobel Lecture, Dec. 9, 1992).

In a footnote, the Court remarked:

[The taxpayer's point] is that as with compensation for a harm to one's financial or physical capital, the payment of compensation for the diminution of a personal attribute, such as reputation, is but a restoration of the status quo ante, analogous to a "restoration of capital," [Commissioner v.] Glenshaw Glass, 348 U.S. [426 (1955)] at 432 n.8; in neither context does the payment result in a "gain" or "accession[] to wealth," id. at 430-31.

In Commissioner v. Banks, the Supreme Court determined that when a litigant's recovery constitutes income, the litigant's income includes the portion of the recovery paid to the attorney as a contingent fee. As a practical matter, any legal fee paid in the course of a lawsuit except one for personal injury will, under IRC Section 104, generally get added back into income when computing the claimant's liability for alternative minimum tax. Since such fees are not deductible for alternative minimum tax purposes, they are, in essence, not deductible at all. See my comments here made before Banks was handed down.

The decision in Murphy re-establishes balance to the equation, at least in those situations where the award sought is for "personal injury." (This would not include, however, awards for economic injuries such as lost wages, etc. In my previous comments on Banks, I pointed out some of the practical problems that employees face in attempting to use attorneys or other paid agents in negotiating contracts or other compensation awards.)

Murphy is a conservative opinion in the traditional sense of the word "conservative." It is doubtful whether a "conservative court" in the post-20th Century meaning of the term (the Fourth Circuit, for instance) would have reached the same conclusion as did the D.C. Circuit.

Income and Wealth Inequality

Brad DeLong has a good summary of the various positions in the debate over whether the growing inequality of income and wealth is determined by governmental policies, including tax policies, or whether it is primarily an outgrowth of other factors such as technology and the globalization of labor markets. It's fairly lengthy as blog postings go, but well worth reading since DeLong is relatively even-handed in describing the various opposing points of view.

And This Is Bad Because . . . ?

In his NYT column today, Wages, Wealth and Politics, (both the column and the follow-up on his related weblog are behind the Times Select subscription wall), Paul Krugman discussed the rapidly growing gap in income and wealth between the really wealthy and the rest of us, drawing a causal connection between our politics and our economy:

[S]ince 1980 the U.S. political scene has been dominated by a conservative movement firmly committed to the view that what’s good for the rich is good for America. Sure enough, the rich have seen their incomes soar, while working Americans have seen few if any gains.

In the blog that he maintains in conjunction with his column, Krugman expanded on that theme:

There are real questions about just how closely supply and demand determine wages; the labor market isn't just like the market for wheat. Also, there's a lot of evidence that unions have a large effect on the wages of non-union workers, too. When you're in an economy in which about a third of private-sector workers are unionized, as was true of the United States when I was growing up, even non-union employers tread carefully, for fear of giving their workers a strong incentive to organize. When you're in an economy where unions have been largely banished from the private sector, as is the case now, things are very different.

Of course, there are bright spots. Government workers, who, by dint of being voters, have some drag with their paymasters, have seen their incomes rise over time. Rather than embracing this as good news, in an op-ed piece in WaPo last Sunday, Chris Edwards, tax director at the Cato Institute, was critical of the growth in federal wages:

The Bureau of Economic Analysis released data this month showing that the average compensation for the 1.8 million federal civilian workers in 2005 was $106,579 -- exactly twice the average compensation paid in the U.S. private sector: $53,289. If you consider wages without benefits, the average federal civilian worker earned $71,114, 62 percent more than the average private-sector worker, who made $43,917.

* * * * *

To get spending under control, Congress should consider trimming overly generous benefit packages and freezing federal wages for a few years.

His comments were echoed by the Tax Foundation's Andrew Chamberlain.

I suspect that there's a good deal wrong with employee management in the federal government. But to say that the principal problem is that federal employees are making too much money relative to employees in the private sector is crazy. After all, one of the major social problems we face is that private sector employees are taking it on the chops. Which is to say that the principal problem we face is that private sector employees are not making enough. The solution to that problem is not to institute policies with respect to federal employees similar to those that have undermined the economic well-being of private sector employees.

Full Disclosure: The woman with whom I sleep with is a federal employee.

Where Does Grover Norquist Stand On This One?

I try not to republish without any comment material that's appeared on other weblogs. I'll make an exception for this video that was published in TaxProf, for which further comment is superfluous:

More on Rosie Scenario

Late last month, I commented on the report by the Treasury, A Dynamic Analysis of Permanent Extension of the President's Tax Relief. At the time, I said:

The report, apparently authored by noted government economist Rosie Scenario, states that its projections will only be achieved if there is "an offsetting change in government revenues or spending." In other words, there will be significant budget deficits as a result of the tax cuts unless we cut government services.

A just released memorandum by Jane Gravelle of the CRS commenting on the Treasury report states that:

The fact that revenues must be made up by spending cuts clearly acknowledges that the tax cuts do not pay for themselves. But what is the magnitude? According to CBO projections, individual income taxes would be 8.4% of GDP in FY 2009 and 9.8% in FY2012, suggesting that the tax cuts are about 1.4% of GDP. For the base case reported above, output increases by 0.5% in the short run and 0.7% in the long run. In the tax reform study, Treasury indicated the marginal tax rate on labor income was 24% and the marginal rate on capital income 14%. Using an overall rate of 20%, the offsetting revenue gain from induced economic effects would be 0.1% of output, or 7% of revenue loss in the next five years.

Stated more succinctly, notwithstanding the baloney dished out by the Republicans to the effect that tax cuts will generate more government revenue, the additional revenue will only be equal to 7% of the revenue lost from the tax cuts. In other words, to paraphrase Merle Travis (by way of Tennessee Ernie Ford), Republican tax cuts make most of us just another day older and deeper in debt.

Hat Tip: TaxProf.

Rollin'

IRC Section 1033 allows a taxpayer two years to reinvest the proceeds of a sale of property sold under "condemnation or threat or imminence thereof" without having to recognize any gain on the initial sale. However, there has to be an actual threat of condemnation. As the Tax Court said in Rainer Co., Inc. v. Commissioner, 61 T.C. 68 (1973):

It is a well-known fact that local governments possess the power to condemn property for use in public projects. Accordingly, if mere knowledge that a local government entity possessed the power to condemn an owner's property was sufficient evidence of a threat of condemnation, then few sales of land to the public would fail to qualify under section 1033.

This is a lesson that seems to have been lost on U.S. Rep. Gary Miller (R. CA). As reported today in the LAT (free registration required), Rep. Miller rolled over the profits from real estate sales not once, but twice, even though he faced no actual threat of condemnation of any of the properties involved.

In 2002, he "sold 165 acres to the city of Monrovia [and] made a profit of more than $10 million." But "Monrovia officials say that Miller sold the land willingly and that they didn't threaten to force him to sell." While Miller claims that the sale was made under threat of condemnation, that was simply not possible since "the city could not have used eminent domain to purchase Miller's property, because it was acquiring the undeveloped hillside land for a wilderness preserve using state funding that specifically prohibited forced sales." Indeed, it appears quite clear that Miller was chasing the city to purchase the property, not the other way around:

A videotape of a February 2000 City Council meeting, packed with people pushing the city to protect the hillside, shows Miller pleading with city officials four times to buy his land.

"Why don't you buy my property? I've asked you repeatedly," Miller said.

Apparently, Miller is a bit of a one-trick pony, since:

[T]wo years after the Monrovia sale, [Miller] raced to beat his extended deadline of Dec. 31, 2004, for reinvesting the profits. On Dec. 28, he reinvested some of the profits by purchasing 10 lots for about $5 million near the expanded 210 Freeway in Fontana, a building in Fontana for $1.3 million and five acres in Rancho Cucamonga worth about $2 million. He bought the properties from Lewis Operating Corp., a major Inland Empire developer and one of Miller's largest campaign contributors.

Miller took an exemption again when he sold the 10 lots to the city of Fontana in 2005 and again when he sold the building to Fontana this year, claiming both were compulsory sales.

But records and interviews in Fontana show that those sales were not compulsory.

It appears that Miller worked hard, but unsuccessfully, to "paper" the second set of transactions to make it appear as if he was selling under threat of condemnation:

To bolster his case that the sale was forced, Miller also asked the city for "a letter that talked about eminent domain," said Ray Bragg, the city's redevelopment director.

Ultimately, Miller received a letter signed by City Manager Kenneth R. Hunt, that notes that the "redevelopment plan for this project area does not currently authorize the use of eminent domain."

Clark Alsop, the lead attorney representing the jurisdiction, stated that:

"It's pretty clear to me that the city cannot make a representation to the IRS that this is property being taken under the threat of eminent domain and therefore this person deserves a tax break."

And, of course, the taxpayer involved should not make a representation, under penalties of perjury, that income from the proceeds of a sale is subject to Section 1033 when that's not the case. Congressman Miller apparently did this not once, but twice.

Followup

I subsequently did some further research on Rep. Miller. It appears that I was unfair to him when I labeled him a "one-trick pony." According to The Hill, Rep. Miller is currently being investigated for violations of House ethics rules for borrowing $7.5 Million from "a campaign contributor and business partner . . . which he used to purchase real estate from" the business partner's company.

Drugged

There's a good post on the Tax Analysts site, Economic Analysis: Drug Firms Move Profits to Save Billions, by Martin A. Sullivan.

Moving profits from the United States to low-tax jurisdictions is the way prosperous U.S. pharmaceutical companies keep their taxes low. And that domestic-to-foreign shift has clearly accelerated in recent years. By Tax Analysts' calculations, in 1999 foreign profits accounted for 39.2 percent of worldwide profits of large U.S. drug companies. By 2005 that percentage had jumped to 69.9 percent.

* * * * *

When one affiliate of a multinational corporation makes a sale or loan to another affiliate, profits are shifted. When the terms of the transactions are set so that affiliates in low-tax countries get the better deals, the low-tax affiliates get larger shares of the profits and the multinational group reduces its overall income tax burden.

Pharmaceutical companies own a lot of marketing intangibles and patents that are developed in one or just a few locations and then used worldwide. Determining fair terms for interaffiliate transactions involving intangible assets involves a great deal of subjective judgment, so those determinations are a constant source of conflict between drug companies and the IRS.

The data strongly suggest the IRS is losing the battle.

How much is the IRS losing? Determining where profits belong is never a clear-cut call, but profits generally track the location of value-creating economic activity. Sales and long-term assets, segmented by geographic location, are two measures of economic activity that are available from company annual reports. As shown in Figure 3 (on page 474), foreign assets on average accounted for 41 percent of worldwide assets and foreign sales accounted for 44 percent of worldwide assets from 2003 to 2005. If we use those measures as profit indicators, foreign profits should be roughly 43 percent of the worldwide total instead of the actual figure of 66 percent. The difference — 23 percent — is the amount of worldwide profit that arguably should be reassigned to the United States.

The nine largest drug companies had total pretax profits of $42.6 billion in 2005. If 23 percent of that number, or $9.8 billion, were shifted back to the United States and taxed at an average rate of 30 percent, the treasury would take in an additional $2.9 billion — in just one year, from just nine companies.

One of the principal drivers behind escalating health care costs is the rapidly rising cost of prescription drugs that are protected by patents. I happen to believe that patent protection is necessary to encourage investment in new drugs. According to this report in thestreet.com, "The pharmaceutical industry is a far riskier investment than the broad market as a whole, as defined by its distribution of returns since the Dec. 29, 2000, inception of the current S&P Pharmaceutical index." Taking away patent protection would throttle the industry, meaning that the development of new medicines would be dramatically slowed.

Presumably, the use of the tax dodges described by Sullivan have resulted in an increase in the stock price of pharmaceuticals. The economic question, that I cannot answer, is whether this has resulted in greater investment in new drug development.

In a sense, the question raised by Sullivan's report is a specialized version of a question posed in another Tax Analyst report by Joseph J. Thorndike, What's a New Democrat to Do?:

[T]he fundamental issue of tax policy in a global economy [is] the future of progressive taxation in a world of mobile capital. Taxes on capital income have long been regarded as a vital component of tax fairness. But in recent decades, experts have begun to question whether capital income should be taxed at all. Even more striking, some economists have suggested that taxes on capital income can't be made to work, at least not over the long term.

Library Card

There's a great search site, WorldCat, that will locate libraries in which particular books and other publications can be found. Thus, if you type in "Robert Ercole," you will find 36 publications authored by Mr. Ercole or someone with a similar name (such as Robert d Ercole, the author of Les Risques naturels potentiels liés aux lahars d'origine volcano-glaciaire: cas de la région du Cotopaxi (Equateur)).

The "real" Mr. Ercole is one of the co-authors of Maryland Limited Liability Company Forms and Practice Manual. You will discover that this work can be found in 8 fine libraries around the country.

Search "Stuart Levine"? Apparently there are a great number of scholars with that name. They have published such varied works as The American Indian Today, The Short Fiction of Edgar Allan Poe, and The Monday-Wednesday-Friday Girl: and Other Stories. And, of course, you will also find that he I am one of the authors of Maryland Limited Liability Company Forms and Practice Manual.

In addition to searching by the name of author, you can also search by subject or title.

Hat Tip: Kevin Drum

Am I Dead or Am I In Miami?

Last year, I commented on the case of Maloof v. Commissioner after the Tax Court had rendered its opinion. The case raised the question of whether a shareholder's guarantees of an S corporation's loans could be used by the shareholder to increase his basis for using S corporation losses. The Tax Court held that loan guarantees could not be used to increase basis.

Last week, the 6th Circuit Court of Appeals handed down the decision on Maloof's appeal. As expected, it upheld the Tax Court on all points. The decision underlines the substantive point that I made last year that:

LLCs classified as partnerships or as disregarded entities have benefits over S corporations. Were [Maloof's] company an LLC classified as a partnership or a disregarded entity, [Maloof] would have obtained the benefits he sought.

In addition to discussing the main issue, I also focused on one of the peripheral arguments raised by the taxpayer: That the Tax Court should have applied the decisional law of the 11th Circuit since the taxpayer lived there with his mother, rather than the 6th Circuit, where the taxpayer's wife lived. I thought that the argument was frivolous and I said, "Note to Counsel: Your client's name is 'Maloof' not 'Oedipus.'"

Oddly, Maloof continued to press the question of his residency and thus the proper appellate court to entertain the appeal. The appeals court made short work of the argument:

Maloof, finally, argues that because he lived in Florida at the time he filed his petition in tax court, Eleventh Circuit precedent should control this appeal. See 26 U.S.C. § 7482(b)(1)(A) ("[Decisions of the United States tax court] may be reviewed by the United States court of appeals for the circuit in which is located . . . the legal residence of the petitioner."). That he volitionally filed this challenge to the Tax Court's decision in the Sixth Circuit, not the Eleventh Circuit, makes this something of a bewildering argument. . . . But the argument is of no moment anyway. . . . Maloof cannot show that the application of Eleventh Circuit precedent would make any difference to the outcome of this appeal.

Final Note to Counsel: Florida is hot and has alligators and palm trees. Ohio is not as hot and has no such fauna or flora.

Good Writing

David Brunori writes a column, The Politics of State Taxation, for TaxAnalysts. His most recent column has great commentary on the Maryland Wal-Mart bill, the BAT nexus tax legislation, the proposal in Ohio to cut state capital gains taxes, and various state proposals to tax rental cars.

The column has a "Quote of the Week" feature, but for my money the best quote is Brunori's:

As reported in several major newspapers, a study has found that people will try to avoid taxes on rental cars. Enterprise Rent-A-Car, the nation's second-largest rental-car company, commissioned two well-known scholars to study the effects of taxes on the business. Bill Gale of the Brookings Institution and Kim Rueben of the Urban Institute looked at local car rental taxes across the United States.

Gale and Rueben found that many renters went out of their way to rent cars in jurisdictions with lower or no car rental taxes. I could have told Enterprise that and saved it whatever it paid Gale and Rueben. Eighty local governments in 38 states have car rental taxes. Politicians like the tax because they think it will be exported to nonresident visitors. But half of all car rentals are by people who live in or near the jurisdiction. As Gale and Rueben found, those people will shop around and avoid the tax. Local governments can't effectively or efficiently tax mobile tax bases. This study is just one more piece of evidence.

Some More Clarity

An article in today's NYT illustrates with even greater clarity that Gov. Jon Corzine was not speaking in favor of supply-side economics in his comments to a New Jersey newspaper. The article relates how in many states the growth in the tax burden represented by the property tax has outstripped the growth of individual income. The Times quotes Corzine as follows:

"It is all too clear to everyone: The property tax burden is simply overwhelming our citizens and their economic well-being," Gov. Jon S. Corzine of New Jersey said to the State Legislature on July 28 as it gathered for the special session. "Our citizens pay through the roof for a tax that is imposed without any regard to income or ability to pay."

Of course, the ability of any state, particularly geographically small states such as New Jersey, to shift the tax burden to the more well-off is limited because the well-off can more easily "take a walk" and move to lower tax states.

What Corzine Said

The Tax Foundation's Tax Policy Blog had an interesting headline, Corzine Denies He's a Supply-Sider, But.... The premise of the post was that Governor Jon Corzine of New Jersey had made pro-supply-sider comments while denying that he was a supply-sider. William Ahern, who authored the post, either did not read the newspaper article in which Corzine was quoted or failed to understand his comments.

In the article, Corzine Opposes Any Increase in State Income Tax, in the Courier Post Online, Corzine stated that:

he believed the income tax rates were so high that they were near the point where they could be cut, which in turn might spur economic growth and bring more money into the state's coffers.

"I have a . . . view that you could almost lower taxes on income and generate revenue," Corzine told the Asbury Park Press editorial board.

Ahern interprets this as support for the theory of supply-side economics, the idea that you can raise government revenue by cutting taxes. This theory is allegedly illustrated by the Laugher Laffer Curve.

As I noted here, the wealthy have a greater ability to minimize their taxes by picking an appropriate state for their domicile. That was the point that Corzine was focusing on, not some subtle support for supply-side nonsense. The article makes this clear:

Reports have said New Jersey has lost residents and jobs in high-paying sectors in recent years. Some experts argue the state's taxes and high cost of living are to blame.

Corzine indicated Thursday that he was looking at that issue. He said New Jersey's income taxes made the state "less attractive" than Connecticut, and put it at a "competitive disadvantage" to Pennsylvania and Delaware.

In other words, Corzine was examining the question of whether Jersey's tax rates were driving businesses and wealthy individuals into near-by states, not whether lower taxes would spur economic growth resulting in higher state revenues.

One can debate the merits of supply-side theory. But one should not cherry-pick partial quotes from elected officials (or anyone else for that matter) that seem to support the theory when it is clear from their full comments that no such support was intended or implied.

Death of a Trojan Horse

In case you haven't heard, the attempt to gut the estate tax has failed. Details of the vote in the Senate are here.

The money quote from the NYT:

"The bottom line is, we bet on the wrong horses," said Senator Charles E. Grassley, Republican of Iowa and chairman of the Finance Committee.

Hot Tip

In what now seems to be the increasingly unlikely event that the Estate Tax Gutting and Minimum Wage Undermine Act of 2006 passes, there is a great way to attempt to assure that service personnel actually benefit from any tip that you might want to bestow for quality service.

The bill would reduce the minimum wage for any person who receives tips in an amount equal to the tips received. How much does an employer know the amount of the tip?

One way is to count the tips, if a tip jar is used, or tally them, if tips are paid via credit card. If, however, the service provider receives the tip directly in cash, the employer basically relies on self-reporting.

While my suggested solution relies on some self-interested dishonesty on the part of the employee and it's not a good thing to encourage dishonesty, I somehow think it's justified here.

If there's a tip jar, hand the tip directly to the server. If you use a credit card, put down a 10% tip on the card. Then give the employee another 10% in cash. (Why not give the entire tip in cash? The employer will always assume that some tip was given and will likely assume at least a 10% tip, if not more.)

The boss will think you're a schnorrer, but the server will think you're a hero.

Tax Sham Update

The statement of Senator Carl Levin at the Permanent Subcommittee on Investigations Hearing: Tax Haven Abuses: The Enablers, The Tools & Secrecy succinctly summarizes the case studies in sham detailed in the report, the Wyly case study and the POINT case study. According to Levin's summary, "[E]ach scheme relied on a key deception made possible by tax haven secrecy."

In the Wyly case:

The key deception . . . is the Wyly claim that the 58 offshore trusts and corporations were independent. Under U.S. law, the tax on the income of a truly independent trust is paid by the trustees. But if a U.S. person controls the trust's assets and investments, then the trust's income is generally taxable to that person.

The claim that the offshore trusts were independent of the Wylys is contradicted by overwhelming evidence. This is not a case where the Wylys handed over their stock options and awaited the annuity payments, while independent trustees operated the trusts. Instead, for thirteen years, the Wylys and their representatives continually told the trusts what to do – when to exercise the stock options, when to sell the shares, and what to do with the money. The Wylys conveyed their directions through so-called "trust protectors," individuals selected by the Wylys, who worked for the Wylys, and who were empowered to fire any offshore trustee. The protectors transmitted the Wyly directions to the offshore trustees who consistently carried them out.

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When the offshore entities opened securities accounts at Bank of America and were asked to name their beneficial owners as required by new U.S. anti-money laundering laws, they refused to do so, claiming again they were independent. Bank of America allowed the accounts to operate without getting the information required by law.

In the POINT case:

[A] phony Isle of Man corporation sold stock it didn't own to another phony Isle of Man corporation for money it didn't have. The fake stock was lent back with fake cash as security for repayment of the loan, and the fake loss on the stock price was transferred out to offset real gains. No real economic activity took place, but one critical thing happened – a $9 billion paper portfolio was created. This paper portfolio originated with Jackstones and Barnville, shell operations with no employees, no offices, and paid-in capital of £2 – that’s about $5 each.

The final step in the POINT scheme was for Barnville to sell the paper losses to wealthy individuals, including Haim Saban and Robert Wood Johnson IV. These clients used the paper losses to offset real capital gains. Mr. Saban used POINT to offset about $1.5 billion in capital gains; Mr. Johnson offset about $143 million. Together, the fees they paid to Quellos, the lawyers, the bankers, and others totaled about $75 million. One more proof that this sordid tale was used to concoct tax losses is the fact that the greater the paper loss generated for a client, the greater the fees charged by Quellos.

The POINT tax shelter included transactions to create the appearance of a complex investment with real economic substance. In reality, the transactions were expertly designed to remove all risk, using circular transactions that cancelled out or were unwound. A 5-year warrant, for example, which was included in the transactions to produce the illusion of a profit potential, was always terminated before any profits were realized. In a transaction involving Mr. Saban, an $800 million loan and stock purchase were added to provide a patina of economic substance, but the way the transaction was structured, it could not realize a profit in comparison to the transaction's fees and other costs. For example, the cost of a collar that capped possible profits at 8% of the total investment reduced a $130 million profit to $13 million, which was then dwarfed by fees totaling $53 million.

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The key deception in POINT was the fake offshore portfolio that generated fake stock losses sold to partnerships with a false business purpose. The end result was $2 billion in real and taxable capital gains that were supposedly erased.

Senator Levin was particularly incensed at the lawyers, accountants, and bankers who participated in the frauds:

Each participant essentially told the Subcommittee: "I was only responsible for my little piece of this. I didn't know the other parts. It's not my fault."

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Could it be true that the banks and brokers and lawyers who participated in POINT didn't know what they were involved with? Or is it that they didn't want to know?

Hmmm. Did Senator Levin question this lawyer for the taxpayers?

More Valuable Than Money

"A good reputation is more valuable than money." Publilius Syrus

This week, in a memorandum decision, Lehrer v. Commissioner, the Tax Court dealt with the question of whether taxpayers could be relieved of penalties for substantial understatements of income tax because they had reasonable cause for, and acted in good faith with respect to, the understatements. The taxpayers argued that they reasonably relied on their tax preparer and therefore the accuracy-related penalties under IRC Section 6662 did not apply.

The Tax Court opinion noted that:

Reasonable cause has been found when a taxpayer selects a competent tax adviser, supplies the adviser with all relevant information, and consistent with ordinary business care and prudence, relies on the adviser's professional judgment as to the taxpayer’s tax obligations. . . . To establish reasonable cause, the taxpayer must prove by a preponderance of the evidence that: (1) The adviser was a competent professional who had sufficient expertise to justify the taxpayer's reliance on him or her, (2) the taxpayer provided necessary and accurate information to the adviser, and (3) the taxpayer relied in good faith on the adviser's judgment.

(Citations omitted.)

The Tax Court rejected the taxpayers' reasonable cause argument on two bases.

First, it found that:

[The taxpayers] hired [the return preparer] after a relative's recommendation and a few telephone conversations in which [the preparer] cited some Code provisions. [The taxpayers] introduced no evidence regarding [the preparer's] credentials or his experience in preparing tax returns. [The preparer] was not called as a witness at trial. In short, [the taxpayers] failed to introduce any credible evidence that [the preparer] was a competent tax adviser with sufficient expertise to justify their reliance.

Second, the Court also concluded that the taxpayers failed to demonstrate that they relied in good faith on the tax preparer's advice:

We find that [the taxpayers] failed to perform the due diligence that a reasonably prudent person would perform before hiring an income tax return preparer. [They] did little to investigate [the preparer's] qualifications before hiring him. [They] did not determine whether [the preparer] was a CPA or had relevant education and experience.

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We cannot excuse a taxpayer who makes little or no effort to discern whether the person the taxpayer has chosen to prepare a return is competent to give tax advice.

Of course, there are taxpayers who are more discerning. Today, the United States Senate Permanent Subcommittee on Investigations issued a staff report entitled Tax Haven Abuses: The Enablers, The Tools and Secrecy. The report has gained a fair amount of public attention. See the NYT article, Tax Cheats Called Out of Control, and the WaPo article, Tax Shelters Saved Billionaires A Bundle.

In one case, a major law firm, Byran Cave, received fees of $1.3 Million. Lawyers from that firm:

[P]rovided tax opinions with respect to the strategy for [Haim] Saban [the client] and helped draft the factual representations on which the opinion was based, as well as transactional documents to help implement the strategy. The legal opinions prepared by Bryan Cave were based on extensive factual representation statements signed by various persons, including Mr. Saban. However, according to Mr. Saban, he did not read these statements before signing them. Further, after having now read some of the representations, Mr. Saban told the Subcommittee he could not have attested to the facts if he had read them at the time and that some of the representations were completely inaccurate. . . .[T]he attorney for Bryan Cave was not aware of the nature of [certain critically important] underlying transactions . . . .

All too neat. All too perfect.

The client relies on the reputation of the law firm to avoid the imposition of penalties. For $1.3 Million, he can presumably present a facially better case than the Lehrers.

The law firm, in turn, invokes the Sargent Schultz defense.

Willful blindness all around.