Taxing America 0814726615, 9780814726617

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Taxing America

CRITICAL AMERIC A

General Editors: Richard Delgado and Jean Stefancic White by Law: The Legal Construction of Race Ian Haney Lopez Cultivating Intelligence: Power, Law, and the Politics of Teaching Louise Harmon and Deborah W. Post Privilege Revealed: How Invisible Preference Undermines America Stephanie M. Wildman with Margalynne Armstrong, Adrienne D. Davis, and Trina Grillo Does the Law Morally Bind the Poor? or What Good's the Constitution When You Can't Afford a Loaf of Bread R. George Wright Hybrid: Bisexuals, Multiracials, and Other Misfit s under American Law Ruth Colker Critical Race Feminism: A Reader Edited by Adrien Katherine Wing Immigrants Out! The New Nativism and the Anti-Immigrant Impulse in the United State s Edited by Juan F. Perea Taxing America Edited by Karen B. Brown and Mary Louise Fellows

Taxing America Edited by KAREN B . BROW N and MARY LOUIS E FELLOW S

N E W YOR K U N I V E R S I T Y P R E S S

New York & London

NEW YOR K UNIVERSIT Y PRES S

New York & London © 1996 by New York University All rights reserved Library of Congress Cataloging-in-Publication Dat a Taxing America / edited by Karen B. Brown and Mary Louise Fellows, p. cm . Papers presente d a t a conferenc e hel d Nov . 3-5 , 1995 , a t th e University of Minnesota. Includes index. ISBN 0-8147-2661-5 (pbk.)— ISBN 0-8147-2648-8 (clothbound) 1. Taxation—United States—Congresses . 2 . Taxation—Law and legislation—United States—Congresses . 3 . Income tax—United States— Congresses. 4 . United States—Economic policy—1993—Congresses. I. Brown, Karen B., 1954-. II . Fellows, Mary Louise. HJ2381.T396 199 6 336.2*00973—dc20 96-2530 2 CIP New York University Press books are printed on acid-free paper , and their binding materials are chosen for strength and durability. Manufactured i n the United States of America 10 9 8 7 6 5 4 3 2 1

CONTENTS

Preface V

Introduction i

M

PART I . EXPANDIN G TH E TA X DISCOURSE : NE W WAY S T O THIN K ABOUT WEALTH , INCOME , RACE , A N D GENDE R I. LIL Y KAHN G 2

5

Fiction in Tax

2 . DOROTH Y A . BROW N 4

5

3 . JENNIFE R J . S . BROOK S 5

8

A. JOH N A . POWEL L 8

0

The Marriage Bonus/Penalty in Black and White Taxation and Human Capita l How Government Tax and Housing Policies Have Racially Segregated America

PART II . CHALLENGIN G TA X TRADITIONS : TH E BIA S O F TH E I N V E S T M E N T / C O N S U M P T I O N DICHOTOM Y 5 . GWE N THAYE R HANDELMA N 11

9

6 . CHARLOTT E CRAN E 1 4

6

Acknowledging Workers in Definitions of Consumption and Investment Th e Case of Health Care Shifting from a n Income Tax to a Consumption Tax: Effects on Expenditures for Education

7. DENIS E D . J . RO Y I

70

Consumption in Business/Investment at Home: Environmental Cleanup Costs versus Disability Access Costs

PART III . RETHINKIN G DEVELOPMENT : OL D PRACTICES , OLD RULES , NE W WORL D 8 . BEVERL Y I . MORA N 1 9

7

Economic Development: Taxes, Sovereignty, and the Global Economy v

VI C O N T E N T

S

9 . KARE N B . BROW N 2

Transforming the Unilateralist into the Internationalist: New Tax Treaty Policy toward Developing Countries

I O . LABREND A GARRETT-NELSO N 2 3

14

3

The Future of Deferral: Taxing the Income of U.S. Multinationals PART IV . IMPLEMENTIN G SUBSIDIES : TA X RELIEF FO R SAVER S AND FO R WORKER S 11. REGIN A T . J E F F E R S O N 2 5

3

12. JONATHA N BARR Y FORMA N 2 7

7

The American Dream Savings Account: Is It a Dream or a Nightmare? Simplification fo r Low-Income Taxpayers: Some Options

13. GEORG E K . YI N 2 9

7

The Uncertain Fate of the Earned Income Tax Credit Program 1 4 . MAR Y L . HEE N 3 2

Welfare Reform, the Child Care Dilemma, and the Tax Code: Family Values, the Wage Labor Market, and the Race- and Class-Based Double Standard

2

Contributors 34

7

Index 3 5

3

PREFACE

This anthology is a product o f the vibrancy and intellectual excitement found i n a remarkable community of scholars. As a result of some earlier personal interchange s and a long-standing interest i n eac h other' s work, Professor s Richar d Delgad o an d Jea n Stefancic invite d u s to consider participatin g i n the Critical America series by challenging the current political tax discourse and many of the tax reform proposal s generated b y the 199 4 election o f a Republican Congress and the "Contract wit h America." That invitation was most timely because we had spent the previous six months working on a collaborative project rethinking tax theory to consider how it might operate to strip the tax law of its claim to objectivity and hold it accountable for its social and economic impact on traditionally subordinated groups. That reconceptualizatio n itsel f ha d bee n inspire d b y Professo r Beverly Moran. Her earlier formal lectures and patient informal encour agement ove r the last several years had convince d u s that working t o develop an analytical framework woul d both uncover biases in the tax law and revea l antisubordination strategie s to keep the tax law fro m maintaining and perpetuating marketplac e discrimination. That early thinking had been advanced by discussions with other tax academics who attended a series of teaching conferences sponsored by the Society of American Law Teachers (SALT) in which working groups were organized accordin g t o subjec t areas . (Ta x Working Grou p a t th e SALT Teaching Conference (SALT) : Diversity in the Law School Curriculu m (Minneapolis, Minn. Sept. 23-24,1994); Tax, Trusts, and Estates Working Group at the 1993 SALT Teaching Conference: Reimagining Traditional Law School Courses: Workshops Integrating Class, Disability, Gender, Race, and Sexual Preference an d Othe r Issue s of Social Concern int o Teaching and Course Materials (Sant a Clara, Calif., Oct. 29-30, 1993); Tax Working Group a t the SALT Teaching Conference: Reimaginin g Traditional Law School Courses: Workshops Integrating Class, Disability, Gender, Race, and Sexua l Preference int o Ou r Teachin g and Cours e Materials (New York, N.Y., May 22-23,1993)). The tax working groups at the SALT conferences, however, did more: they brought togethe r a VII

VIM P R E F A C

E

group of tax scholars in which each of us who previously had felt isolated by the traditional tax analysis that dominated the legal literature and tax conferences now had found intellectual kinship. The project o f integrating traditional tax theory and antisubordina tion principle s wa s advance d eve n furthe r a t Critica l Ta x Theory : A Workshop organized by Professor Nanc y Staudt at the State University of New York at Buffalo in the fall of 1995. Staudt had attended the SALT conference i n Minnesota and wanted to create another forum t o bring together scholars with a common interest in challenging traditional tax discourse and its claim to objectivity. That successful workshop , which identified ye t more scholars interested i n the project an d new paths of inquiry, encouraged us to organize a conference for the contributors to this anthology to present the drafts o f their essays to each other. Taxing America: A Conference o n th e Socia l an d Economi c Implication s o f Tax Reform, held November 3-5,1995, at the University of Minnesota, was mad e possibl e b y th e generou s suppor t o f Dea n E . Thoma s Sullivan an d th e Cente r fo r Lega l Studies. After thre e day s of creativ e interchange leading to new ideas and researc h projects, each of us lef t feeling that this anthology represents a significant ste p toward rethink ing tax theory. The various gatherings, conversations in hotel lobbies, and long conversations ove r the telephone an d by e-mail suggest that th e grou p of tax critics is several dozen strong. It is our hope that this anthology will be a catalyst for encouraging others, who also feel traditional tax analysis i s inadequat e t o addres s issue s o f discriminatio n an d economi c exploitation, to join in our conversation. For whatever else the anthology accomplishes, it provides evidence that connection an d interchang e within a community of scholars are essential. We especially thank Michael Voran and Rena e Welder, 199 6 graduates of the University of Minnesota, who assisted us in the preparation of the manuscrip t an d a t the Taxing America conference . Further , we are grateful fo r th e research support provided by the reference librari ans o f th e Universit y o f Minnesot a La w Library , especiall y Marc i Hoffman, Georg e Jackson , an d Suzann e Thorpe . W e than k Marth a Heidt, a 1996 graduate of the University of Minnesota, for her willingness t o assis t u s befor e an d durin g th e conference . Patrici a Buenzle , Andrea Sheets , and Li z Steblay helped u s remain organized , complet e the manuscript, an d mak e arrangements fo r th e Taxing America con -

PREFACE I

ference. Finally, we thank Niko Pfund, th e editor i n chief of New York University Press, for his enthusiasm and support throughout the publication process. As always, our friends an d families maintained ou r spirits by asking about our progress and caring about our answers. Although somewha t skeptical that a book on taxation could be interesting, they were willing to listen long enough to believe it might be true. KAREN B . B R O W N MARY LOUIS E FELLOW S

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INTRODUCTION KAREN B . BROW N A N D MARY LOUIS E FELLOW S

We find ourselve s i n a politica l momen t whe n the clamo r fo r ta x refor m has , once again , reache d a high pitch . Yet, although question s abou t ho w the ta x law can contribut e t o a stron g economy abound , what ha s been entirel y lost i n th e discussio n i s the role of tax law as a gatekeeper to the American Dream. Most recently , th e curren t fascinatio n wit h ta x refor m wa s bes t embodied b y the 199 6 presidential candidac y o f Steve n Forbes , publisher o f Forbes magazine , multimillionaire , an d so n o f Malcol m S . Forbes. On th e basis of little more than a flat ta x mantra an d hi s personal fortune , Forbe s briefl y capture d th e imaginatio n o f th e media , policy wonks, and the body politic. Explicit in his political proposal was a repudiatio n o f bi g governmen t an d a ratification an d reificatio n o f private enterprise. Forbes claimed to want to level the tax playing field by eliminating notable loopholes, such as the home-mortgage interes t deduction, but he failed to reconcile his fairness claim with the fact that his proposa l overtaxe d worker s an d undertaxe d owner s o f financial capital. Beyond Forbes' s message , mos t peopl e an d parties , regardles s o f their location o n the political spectrum, seem to agree on a few basics about taxes: (1) the lower they are, the better; and (2 ) if well designed,

1

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they can contribute to economic growth in the United States, assuring a share of the American Dream to every hardworking, taxpaying individual. Although one side of the political spectrum may emphasize reducing the burden on the middle class and the other may prefer to focus on lessening the tax burden on businesses, both leave unexamined how the current tax law may be reinforcing market failures that deny some individuals an opportunity to achieve economic security. What i s missin g fro m bot h th e politica l an d th e academi c debat e about taxes is a serious consideration of how the tax system exacerbates marketplace discrimination agains t traditionally subordinated groups . With dramati c an d far-reachin g ta x refor m alway s a possibility , th e purpose o f thi s antholog y i s t o chang e th e ta x discours e t o includ e issues o f disabilit y discrimination , economi c exploitation , heterosex ism, sexism , an d racism . I n a politica l environmen t i n whic h th e Contract with America and the Republican agenda put forth politicall y viable proposals tha t benefi t th e have s a t th e cos t o f th e have-nots , a perspective tha t emphasize s th e exploitiv e an d discriminator y aspect s of the tax code becomes critically important. We have long felt uneasy about the assumption that the tax law only minimally contribute s t o socia l injustic e an d ha s littl e potentia l fo r advancing socia l justice . Tha t uneasines s wa s reinforce d b y Beverl y Moran's pathbreakin g approac h separating issue s o f clas s fro m thos e of gender and race when analyzing a tax rule, so that marketplace discrimination based on gender and race can be uncovered across income levels.1 Most o f th e essay s i n thi s antholog y addres s clas s issue s an d thei r implications in designing a fair tax base and rate structure. Jonathan B. Forman and George K. Yin consider class issues by exploring the politically controversial earned income tax credit (EITC) and its appropriate role in the income ta x system. Both essay s start fro m th e propositio n that the EITC is a welfare transfer to low-income workers and not integral to the income tax structure. In contrast , Jennife r J . S . Brooks , Charlott e Crane , Gwe n Thaye r Handelman, Mary L. Heen, and Denise D. J. Roy investigate how traditional ta x analysi s mask s th e way s th e ta x rule s overestimat e th e productive contribution s o f entrepreneur s an d underestimat e the m for workers, leading to an overtaxation o f workers. Regina T. Jefferson extends th e entrepreneur/worke r discussio n t o conside r th e relation -

INTRODUCTION 3

ship between employers and employees regarding the federal tax policy on retiremen t savings . Sh e focuse s o n th e congressiona l proposa l t o establish America n Drea m Saving s Account s (ADSA ) an d conclude s that they are likely to operate i n a regressive manner agains t low- an d middle-income workers , leavin g man y o f the m withou t sufficien t funds fo r their retirement. Beverly I. Moran als o considers the tax bias toward busines s b y lookin g beyon d th e federa l incom e ta x an d cri tiquing ho w governmenta l unit s compet e fo r businesse s t o locat e i n their regions , usin g ta x incentives . LaBrend a Garrett-Nelson , o n th e other hand , argues that curren t internationa l ta x policy unfairly taxe s U.S. multinational corporations , makin g i t difficul t fo r the m t o com pete effectivel y i n th e world economy . In additio n t o raisin g issue s of class, the essay s b y Doroth y A . Brown, Kare n B . Brown, Lil y Kahng , Mary L . Hee n an d Joh n a . powel l mak e significan t progres s towar d uncovering issues of gender, race and their intersectio n i n the tax law, both domesti c and international . An important contributio n mad e by all the essay s is that the y identif y ho w muc h mor e wor k need s t o b e done bot h wit h regar d t o economi c exploitation , sexism , an d racis m against African Americans , which are addressed in this collection; and with regar d t o disabilit y discrimination , heterosexism , an d racis m against othe r groups , which hav e been lef t largel y unaddressed i n th e anthology and in the tax literature in general.2 Any examination o f whether th e ta x law reinforces th e subordina tion of persons based on their physical and mental abilities, class, gender, race , and sexua l orientatio n follow s fro m tw o propositions . Th e first i s that economic arrangements can contribute significantly to creating socia l hierarchie s an d perpetuatin g discrimination . Th e secon d is tha t th e federa l ta x la w shoul d furthe r th e polic y goa l o f nondis crimination b y includin g rule s designe d t o disrup t discriminator y practices.3 Within ta x polic y discourse , the analysi s tha t w e are advocating — interjecting socia l justice concern s int o ta x law—should b e viewed a s quite unremarkable. It is widely accepted that the federal tax law should be designed to meet the goals of equity, administrability, and economic rationality. These three goal s are embedded i n American politica l values, which includ e respec t fo r individua l autonomy , privacy, and fre e enterprise. Fo r example , a ta x rul e tha t require s a taxpayer t o revea l information generall y viewed as personal, or subjects a taxpayer to gov-

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ernment inspectio n o f such information, i s considered unadministra ble because it would lack public support. Freedom from governmenta l intervention in an individual's private life is a strong American political value that , i f no t consistentl y reflecte d i n existin g ta x laws , carrie s considerable weigh t i n debate s abou t curren t ta x la w an d propose d reforms o f it. Another strongl y held American value reflected i n these goals is a commitment against discrimination on the basis of class, gender, and race. (The same, however, cannot be said with any conviction regarding discrimination based on physical and mental abilities or sexual orientation. ) N o on e would argue , for example , for ta x rules tha t explicitly taxed th e working clas s more tha n capitalists , women mor e than men, or persons of color more than whites. Although some would argue that lega l remedies to reduc e discriminatio n ar e ineffective an d lead to economic inefficiencies, 4 n o one argues that the law should be designed t o exacerbat e marketplac e discrimination. 5 An y proposal t o do so would be vigorously opposed as inconsistent with all three goals of the federal tax system that are based on the American belief in assuring individua l dignit y an d equa l opportunity . Therefore , althoug h much o f current ta x discourse is carried o n without referenc e t o con cerns about physica l and menta l abilities, class, gender, race, or sexua l orientation, th e candi d introductio n o f nondiscriminatio n issue s should be viewed as wholly consistent with the values underlying traditional tax analysis. A social justice critique of tax policy discourse is merely an extension of the current tradition to integrate analysis of tax concepts with social policies regarding redistribution o f income. Although the issue of progressivity remains unsettled, any particular ta x provision o r propose d reform i s evaluate d i n term s o f it s impac t o n th e distributio n o f income. What w e are advocating i s to modif y ta x policy discours e t o embrace othe r issue s o f socia l justice i n additio n t o th e progressivit y principle. The firs t ste p i n pursuin g a social justice inquir y int o tax— a ste p taken i n man y o f th e essay s found i n thi s anthology—i s th e disman tling of the conceptual tools that constrain traditional tax analysis from considering issue s o f discriminatio n an d economi c exploitation . Traditional tax analysis treats as goals of sound tax policy the followin g three principles: economic neutrality, objectivity, and progressivity. As a number o f the essays show, each of these principles is more usefull y

INTRODUCTION 5

understood a s fiction . Th e goa l o f economi c neutralit y i s a goa l o f minimizing th e effec t o f incom e taxe s on economi c decisio n making , which assumes that an ideal marketplace is one that is untainted by tax considerations. Th e goa l o f objectivit y i s accomplishe d throug h th e assumption tha t th e ta x base can , an d should , be define d objectivel y without consideration of other governmental and social goals. An ideal income ta x base is defined a s one that i s deduced fro m logicall y con nected proposition s tha t ar e free fro m an y social and cultura l under pinnings. The final goal , progressivity, assume s that , i f w e accuratel y define th e idea l incom e ta x base, income i s an appropriat e an d suffi cient measure of ability to pay. The exclusive focus o n incom e implie s that acquire d wealth , which make s tha t leve l o f incom e possibl e an d creates opportunities fo r futur e income , should be irrelevant i n deter mining a taxpayer's ability to pay. The rol e o f economi c neutralit y i s explore d her e extensivel y b y K. B. Brown, Crane, Garrett-Nelson, and Handelman. The principle of economic neutralit y establishe s th e marke t a s th e ideal . Economi c activity easily escapes scrutiny within ta x policy discussions because it is understood onl y as something t o be protected fro m interferenc e b y the tax law. Therefore, academic and political commentators comfort ably ignor e marke t failure s i n pursui t o f th e widel y accepte d goa l o f creating a set of tax rules that have a neutral effect o n the economy. In fact, the principle o f economic neutrality is used i n tax discourse as a reason t o rejec t correctio n o f marke t distortion s throug h th e ta x law and a reason t o defend a tax rule that exacerbate s marke t distortions . Disconnected from th e realities of the marketplace, the principle of tax neutrality is converted into a fiction. The one exception to the principle of economic neutrality and nonrecognition o f marketplac e failure s i s the widesprea d agreement tha t the tax law should be used to encourage savings and investment for the purpose of promoting economic prosperity. The savings bias accounts for muc h o f the current attentio n bein g paid to proposals to overhau l the current income tax and replace it with some form o f consumptio n tax. The implication s o f a shift t o a consumption ta x are explored b y Brooks, Crane, Handelman, and Roy, with each raising a range of problems that wil l arise under a consumption tax , including th e problem s created i f th e distinctio n betwee n th e productivit y o f entrepreneur s and that of workers continues to prevail.

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The second fiction, tax objectivity, allows the participants in tax discourse to claim a position of innocence and avoid accountability for the role the tax law may play in perpetuating social injustices. Tax objectivity i s achieved b y relyin g o n th e idea l incom e ta x bas e develope d b y Robert Haig and refined by Henry Simons as a starting point for analysis. The ideal tax base is defined to be the algebraic sum of "(1) the market valu e o f right s exercise d i n consumptio n an d (2 ) th e chang e i n value of the store of property rights between the beginning and end of the period in question." 6 To apply this definition require s "distinguishing between consumption an d expense." 7 An expense, meaning investment o r savings, is to be taken int o accoun t i n the secon d par t o f th e algebraic sum when determining the change in value of accumulations. X dollar s expended , fo r instance , fo r inventor y tha t i s late r sol d fo r Y dollars would resul t i n Y-X income being subject t o ta x during th e period. I n contrast , X dollar s spen t durin g th e taxabl e perio d fo r comfort o r pleasure, such a s for heatin g a home o r goin g to a movie, represents an amount t o be taken int o account i n the first part o f th e algebraic sum . The expenditur e fo r hea t o r a movie i s understood a s producing n o increas e i n th e taxpayer' s stor e o f propert y right s an d therefore i s not deductible in part two of the algebraic sum. Instead, it is included in part one as an amount used for consumption for the purpose of determining the total amount of income earned by the taxpayer during the taxable period. Perhaps a more complete description o f the tax treatment of a personal expenditure would recognize that X dollars spent fo r hea t o r a movi e wa s first earne d an d taxe d a s a n increas e in accumulations for the period in accordance with the second part of the algebrai c formula . Onc e expende d fo r consumptio n purposes , the amount of accumulations is reduced by X dollars while the amount of consumptio n i s increase d b y th e sam e amount . Th e ne t effec t o f both explanation s is that the ideal tax base for an y period remain s the same regardles s o f whether th e increas e i n accumulation s i s saved o r consumed. The difficulty, o f course, and the reason why tax objectivity is a mere fiction, is the inheren t proble m wit h Simons' s definition . H e himsel f recognized tha t "[a ] thoroughl y precis e an d objectiv e distinctio n [between persona l an d busines s expense ] i s inconceivable." 8 Simon s conceded that, however "unwelcome [the ] criterio n o f intention," it is "inescapable."9 Without the possibility of an objective basis to make the

INTRODUCTION 7

distinction betwee n persona l an d busines s expenses , relianc e o n th e ideal incom e ta x bas e serve s onl y t o obscur e biase s i n th e ta x law . Brooks, Crane, Handelman, and Ro y extensively explore the personal/ business and the consumption/investment distinction s to uncover with particularity how the Haig-Simons mode l produces the appearance of tax objectivity an d the reality that th e tax system i s thoroughly impli cated in the discriminatory practices of the marketplace. In more recent years the fiction o f objectivity has been perpetuate d in wha t ha s com e t o b e know n a s th e ta x expenditur e budget . Th e essays by Handelman, Heen , and Ro y include excellen t discussion s o f the ta x expenditur e concept , demonstratin g ho w i t canno t withstan d scrutiny a s well as how i t distort s ta x policy analysis. In 196 7 Stanley Surrey in his capacity as assistant secretary of the treasury for tax policy made a speech in which he developed the concepts of tax expenditures and the tax expenditure budget.10 Surrey understood the federal income tax syste m a s consistin g o f tw o type s o f provisions . On e typ e i s th e "structural provisions necessary to implement the income tax on individual and corporate net income," 11 which are determined by reference to Simons' s idea l incom e ta x base. The other typ e i s those provision s that "comprise [] a system of tax expenditures under which the Governmental financia l assistanc e program s ar e carrie d ou t throug h specia l tax provisions rather than through direct Government expenditures." 12 The term tax expenditures was chosen to indicate that these provisions are the equivalen t o f direc t governmen t subsidies , the onl y differenc e being that the y are accomplished throug h th e federa l incom e ta x system. Surrey's purpose for classifyin g ta x provisions as either structura l or tax expenditures was to expose the relationship between tax refor m and government subsidies and to suggest "new pathways to tax reform." For him ta x reform mean t grapplin g wit h question s suc h a s "[I]s ta x assistance the preferred route , or should the assistance be given directly? Which metho d come s closest to the targeted goa l of the assistanc e and does so with fairness and efficiency?" 13 The ta x expenditur e model , o f course , di d no t obviat e th e nee d to addres s th e personal/busines s distinction . O n th e contrary , th e distinction i s incorporated int o th e tax expenditure model . As Surrey acknowledges, ther e are , i n considerin g th e ta x expenditur e budget , "difficulties i n th e applicatio n o f agree d incom e ta x structura l con cepts, such a s the proper lin e between allowabl e expense s incurred i n

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trade o r busines s o r i n th e acquisitio n o f incom e an d nondeductibl e personal consumptio n expenses." 14 Tha t acknowledgment , however , did not lead him or others to account for the difficulties i n developing the ta x expenditur e budget . Instead , th e ta x expenditur e budge t ha s become th e primar y arbite r o f whic h ta x provision s ar e considere d structural an d free fro m scrutin y and which provisions are considered tax subsidies and subject to continuing reexamination for modificatio n or repeal . Th e proble m i s no t onl y tha t th e ta x expenditur e budge t falsely claim s objectivity , bu t als o tha t th e fictio n o f objectivity , achieved throug h referenc e t o th e idea l incom e ta x bas e an d th e ta x expenditure budget , ultimately becomes an excus e for omittin g socia l justice goals from tax analysis. Another wa y that th e ta x la w maintain s it s clai m t o objectivit y i s through th e use of choice, a subject addresse d b y Crane, Handelman , Heen, powell, and Roy . Their wor k demonstrate s i n a variety of con texts how the concept of choice does more to inhibit than to encourage sound tax analysis. The definition o f taxable income, which depends on the personal/business distinction, relies on assumptions about the taxpayer's ability to choose . An expenditur e i s deductible i f it is deemed "necessary" to the production of income.15 Once the taxpayer is identified a s a n entrepreneur , mos t expense s ar e regarde d a s necessar y because the tax law defers t o an d respect s the entrepreneur' s busines s judgment. I t i s not tha t th e ta x la w assumes th e entrepreneu r i s no t making choice s abou t expenditures . It i s that th e ta x law treats thos e choices a s sufficiently constraine d b y the profit-makin g motiv e a s t o make choic e irrelevant . I n contrast , th e ta x la w assume s tha t mos t expenditures incurre d b y nonentrepreneurs (worker s insid e an d out side the marketplace) are the product of unlimited choice, and it is that ability to choos e tha t justifie s th e conclusio n tha t thos e expenditure s are personal in nature and nondeductible. Tax law has appropriated th e ide a o f choic e to perpetuat e th e per ception that the tax law is objective. Once a taxpayer is deemed to have chosen to ente r into a n economi c transaction, the tax law becomes an innocent bystander. Choice serves the dual goal of emphasizing the taxpayer's responsibility for the consequences of the choice and minimizing th e ta x law' s complicit y i n perpetuatin g marketplac e distortions . Choice can only perform thi s function, however, if it remains unexamined. Choic e lose s it s analytica l powe r onc e th e abilit y t o choos e i s

INTRODUCTION 9

understood as operating along a continuum. The more privileged societal positio n a perso n enjoys , th e greate r an d mor e meaningfu l th e choices. Choice an d th e absenc e o f choic e ar e use d i n th e ta x la w to reflect the experiences of those who enjoy power by virtue of the dominant social positions they hold. An exampl e demonstratin g th e choic e continuum , th e fictio n o f objectivity, an d th e obfuscatio n o f socia l injustic e i s found i n th e ta x law's treatment of commuting expenses. This example builds on John a. powell's discussion of the federal government's tax and housing policy. Section 16 2 has been interpreted to deny a taxpayer a deduction for the cost of commuting between home and work.16 The rationale traditionally given for denying commuting expenses is that where one lives relative to where on e works i s a matter o f persona l choice , powell show s that the choice of where one lives and works is structurally and system ically limited depending on one's race and class. Specifically, the denial of commutin g expense s ha s a demonstrate d disparat e impac t o n African American s becaus e thei r choic e o f wher e t o liv e an d wor k i s limited b y the degre e o f housin g an d employmen t discriminatio n i n the region . The absenc e of , o r a t leas t restrictio n on , choic e suggest s that commutin g expense s ar e mor e wor k relate d tha n persona l i n nature. Denial of a deduction, therefore, perpetuates racial discrimination rathe r tha n disruptin g it . Furthermore , providin g n o relie f fo r commuting expense s adds yet more costs to the housing and employ ment discriminatio n alread y experience d b y the taxpaye r i n th e mar ketplace, powell' s essa y reveal s th e inadequac y o f a n analysi s tha t depends o n choic e whe n i t i s unaccompanie d b y a consideratio n o f market failures. With biases in seemingly objective rules uncovered, the challenge remains to establish a framework tha t integrates a social justice critique into the definition o f an ideal income tax base. The thir d fiction , progressivity , depend s o n a serie s o f contestabl e propositions. One propositio n i s that redistributio n o f wealt h ca n b e achieved throug h a progressive incom e ta x rat e structure . Th e redis tributive goal is undermined, however, by the exclusive focus of the tax law on marketplace income. It treats as irrelevant that the greater a person's wealth , th e greate r tha t person' s opportunit y fo r increase d income. No one denies that wealth ownership allows people to generate the kind o f income that ca n avoid taxation, that i s to say, nonmarketplace productivit y tha t i s traditionall y referre d t o i n th e ta x la w a s

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imputed income and nonmarketplace accretion s to wealth that are traditionally referred to in the tax law as unrealized income. The search for a workabl e incom e ta x base , however , generall y proceed s o n th e assumption tha t impute d an d unrealized incom e are beyond practica l reach. Without a seriou s commitmen t t o reevaluatin g th e regressiv e aspects of the tax base by considering the effect o f acquired wealth o n income, a progressive rate structure will remain an inadequate tool for redistribution. Th e importanc e o f wealt h i s considere d b y Brooks , Jefferson, an d powell as they evaluate questions involving the tax base and ability to pay. A second contestable proposition regardin g progressivity is that th e tax law is socially just because it strives to tax according to ability to pay. The progressivit y principl e consider s issue s o f clas s b y adjustin g ta x rates to ameliorat e th e effects o f incom e disparities ; that i s to say , the tax system injects progressivity predominantly through th e rate structure rather than through th e tax base. What remain s unexamined an d outside traditiona l ta x discours e i s ho w th e marketplac e produce s income disparit y an d ho w the tax law contributes t o tha t disparity . If the ta x syste m i s goin g t o b e use d t o furthe r socia l justice , i t mus t address the questio n o f how the tax base can be defined i n a manne r that prevents, or at least discourages, economic exploitation leading to income disparity. Brooks, Crane, Handelman, Heen, Jefferson, powell , and Ro y mak e ta x bas e issue s th e centra l focu s o f thei r essays . Handelman, in particular, identifies th e relationship o f the tax base to marketplace distortions , how the tax base definition ha s been use d t o further economi c exploitation, and how it could be used to ameliorate marketplace distortions. The essays in this anthology establish the parameters of a theory of tax socia l justice an d it s operatio n withi n ta x polic y discourse . The y also can be read as emphatic statements about the need for the theory to be further elaborated , explored, and tested . The contributors' commitment to this multifaceted projec t is reflected in the anthology's fou r parts, which identify th e variety of ways traditional tax analysis can be challenged an d socia l justice critique s ca n b e injecte d int o ta x polic y discussions. In part 1 , "Expanding the Tax Discourse: New Ways to Think abou t Wealth, Income, Race, and Gender, " Kahng and D . A. Brown focus o n tax rate s an d th e effec t o f marita l status , whereas Brook s an d powel l

INTRODUCTION I

treat specifi c ta x bas e issue s o f huma n capita l an d hom e ownership . These seemingly disparate topics are joined t o introduce the reader t o different approache s tha t ca n be use d t o integrat e traditiona l ta x an d social justice theories . All the essay s challeng e basi c tenet s o f th e ta x system generall y though t t o b e unassailabl e an d demonstrat e ho w seemingly objective rules and principles play significant role s in the tax law of obscuring and thereby perpetuating social injustices. Because so much has been written about the income and transfer tax treatment of married couples over the last fifty years, common wisdom holds that all of the issues relating to the subject have been, if not full y resolved, at least articulated. Kahng and D. A. Brown not only demonstrate the inadequacies i n conventional discussion s of tax and marita l status bu t als o provid e tw o distinc t approache s fo r reconsiderin g a wide range of tax issues. Kahng, in exploring the tax fiction of marita l unity, shows how fictions in tax (both the income and the transfer tax ) mask biases and cause harm when those relying upon them fail to recognize their fictional nature. She acknowledges that marital unity—the fiction that a married coupl e is an indivisibl e unit—serve d importan t administrative goals , but sh e question s wh y thos e benefit s wer e no t weighed agains t th e substantia l cost s o f embracin g th e fiction. Sh e shows how the fiction itself was used to trivialize the costs of ignorin g the differing economi c rights allocated to husbands and to wives under differing stat e property law regimes (community- versus common-law property states) an d reducin g the incentive for common-la w propert y states t o provid e marrie d wome n wit h greate r right s t o th e marita l estate. As she says, the proclaimed benefits o f treating all married cou ples, wherever resident , the same for ta x purposes "would b e an independent benefi t . . . only i f husband s an d wive s had th e sam e rights , wherever resident." By exposing the principle of equal taxes for equal income or equally wealthy married couple s as a "fiction tha t masquer ades as a first principle," Kahng not only changes the nature of tax policy discussion s regardin g ta x an d marita l statu s bu t als o chart s ne w paths of inquiry to determine how other fictions in the tax law may be masking bias and causing harm. D. A. Brown further explore s the fiction of marital unity by looking at it s racia l a s well a s its gende r implications . I t i s commonly know n that tw o married spouse s who ear n roughl y equa l income s suffe r th e highest marriag e penalty , meanin g tha t th e coupl e woul d pa y lowe r

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taxes if each earner were single and filed individual returns. Conversely, it is commonly known that a couple in which only one spouse has taxable income enjoys a marriage bonus, meaning that the couple would pay highe r taxe s i f the y ha d no t marrie d an d ha d file d individua l returns. By looking at working patterns of black and white women, D. A. Brown show s that, when gende r an d rac e wage discrimination ar e considered, black couples are more likely to pay a marriage penalty tax, whereas white couples are more likely to enjoy a marriage bonus. She does this by providing data showing that marriage tends to reduce the labor force participation rat e of white women but to increase the participation rat e amon g blac k wome n an d tha t blac k wive s contribut e significantly more toward household income than white wives. By challenging the convention of referring to all married women as "secondary earners" and by showing how current income tax rate schedules exacerbate gende r an d rac e wag e discrimination , D . A . Brow n no t onl y changes th e natur e o f discussion s regardin g incom e taxatio n o f mar ried couple s b y injecting th e interlockin g issue s o f gende r an d racia l justice, but sh e also provides a model fo r ho w to stud y race and clas s issues across income levels. In Brooks' s investigatio n o f th e prope r taxatio n o f huma n capital , she ultimately challenges the Haig-Simons ideal income tax definition . She shows how it has been use d and misuse d t o provide a theoretical justification fo r a consumption tax . The key to Brooks's analysis is her refusal, unlik e other tax theorists, to ignore the "disproportionate dis tribution throughout society of material wealth, cash income, opportunity, an d choice. " Her commitmen t t o th e issu e o f redistributio n o f wealth allowe d he r t o se e th e improbabilit y o f th e clai m tha t labo r income was undertaxed, which in turn led her to make an incisive critique demonstratin g tha t leisure , choice , an d opportunit y generall y associated wit h huma n capita l are , in fact , relate d t o materia l capital . Having injected a social context int o th e consideratio n o f taxatio n o f human an d material capital, Brooks has set the stage for a quite differ ent theoretical debate about the "ideal" tax base. powell's essay on tax and home ownership also emphasizes the relationship between wealth and income. The essay is based on two propositions: (1 ) "hom e ownershi p an d equit y ar e th e mos t importan t sources of wealth t o th e individua l American" and (2 ) housing , especially th e placemen t an d locatio n o f housing , i s racialized . powel l

INTRODUCTION I

demonstrates ho w the federa l government , throug h a variety o f pro grams an d policies , including formall y neutra l ta x policies, "has con tributed to racial separation and perpetuated this separation.'' Just as D. A. Brown shows that the marriage bonus is most likely to inure to the benefit o f white couples, powell shows how tax rules "benefiting hom e owners hav e operate d t o th e disproportionat e benefi t o f whites. " Equally important, he goes on to reveal how the tax law's role in facilitating the ownershi p o f home s fo r white s indirectl y facilitate s whites ' access to employment, good schools, safety, public services, recreational opportunities, and support for child development, all of which operate to improve their quality of life. The nexus between wealth and incom e that i s explore d i n Brooks' s essa y i s examine d wit h particularit y b y powell when h e links black families' inabilit y to tap int o home equit y wealth wit h housin g discrimination . H e show s ho w perpetuatio n o f that discriminatio n throug h th e ta x la w contribute s t o th e vas t eco nomic inequalities between blacks and whites in the United States. In part 2 , "Challenging Tax Traditions: The Bias of the Investment / Consumption Dichotomy, " Handelman, Crane, and Roy scrutinize the tax la w distinctio n betwee n investmen t (business ) an d consumptio n (personal) expense s and demonstrate it s inadequacies and its business bias. Specifically , the y sho w ho w th e distinctio n underestimate s th e productive contribution s o f workers, leading to a misapprehension o f how to analyze worker health car e costs, an undervaluatio n o f invest ment in education, and an inappropriate characterization o f business's environmental cleanup costs as productive and accessibility expenses of workers who hav e or whose spous e o r dependent s hav e disabilities as nonproductive. Handelman make s a forcefu l cas e fo r "acknowledgin g i n ou r ta x policy th e individua l live s an d collectiv e rol e o f workin g peopl e i n American society. " She demonstrates tha t ta x policy on th e on e han d adopts the perspective of property owners, who, as a result, are undertaxed o n incom e o r benefits derive d fro m property , and o n th e othe r hand ignores the perspective of workers, who are not provided equivalent opportunities for income exclusion and tax deferral. Thus, nontaxation o f pensio n o r healt h benefit s traditionall y i s viewed a s a majo r subsidy o f workers , wherea s nontaxatio n o f th e valu e o f th e us e o f property, gifts, and unrealize d appreciatio n enjoye d b y property own ers traditionally is not seen as a subsidy but, instead, as consistent with

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the overall tax structure. Handelman goes on to show that the tax law's failure t o acknowledg e worke r productivit y woul d b e exacerbate d b y current tax reform proposal s that would replace the income tax with a consumption tax . The reason is that the consumption ta x ignores "the production o f wage labor" by characterizing all worker expenditures as consumption. Her essay focuses particularl y on health care and main tains tha t ta x law , whether throug h a consumption - o r a n income based tax, should account for the productivity of workers by reasoning that "[i]f maintenance expenses on a manufacturer's capita l equipment or the utility bills of a shopkeeper can offset thes e entrepreneurs' business income, it seems logical that the cost of medical care to maintain a worker's fitness ought to offset that worker's earnings from labor. " Crane als o addresse s th e consumptio n ta x proposal s an d demon strates wh y th e ta x treatmen t o f expenditure s fo r educatio n wil l b e more problemati c unde r a consumptio n ta x tha n unde r th e incom e tax. Crane begins by providing a critical analysis of the income tax in which she explains the attraction o f its tax logic and it s aspiration fo r economic neutrality. She shows how and why the income tax depends on variou s presumption s tha t produc e tolerabl e errors , ultimatel y making the salient point that, although the errors under the income tax are unavoidable, that does not mean that errors are not made. Turning to th e consumptio n tax , Crane provide s a critical analysi s of why the errors produce d fro m presumption s regardin g investmen t i n huma n potential—errors tha t were tolerable under the income tax—are exacerbated unde r th e consumption tax . She ultimately shows how, under the consumption tax , "investment i n our own , or our family's, human potential woul d becom e th e onl y investmen t tha t w e mus t mak e i n after-tax values " an d wh y tha t migh t hav e a substantia l impac t o n human behavio r regardin g investmen t i n huma n potential . Crane' s thesis is not to show how and when to identify a particular expenditur e as investment (business ) o r consumption (personal ) bu t t o sho w that "[t]ax logi c tell s u s nothin g abou t whethe r th e ta x la w shoul d favo r investment i n human potentia l or investment i n financial capital . The desirability of additional investment in human potentia l and the for m that investmen t take s ar e policy decisions tha t w e should mak e inde pendent of tax logic." Roy also make s a n importan t contributio n t o th e debat e ove r th e inadequacy of the tax law's personal/business dichotomy in her analysis

INTRODUCTION I

of th e ta x treatmen t o f environmenta l cleanu p cost s an d disabilit y access costs. Current la w allows a n immediat e deductio n fo r cleanu p costs bu t require s a portio n o f acces s cost s t o b e capitalize d t o th e extent tha t i t cause s a n increas e i n th e valu e o f property . Th e exces s portion i s deductible, if at all, only as a personal medical expense. Roy examines the differential treatmen t and finds it unjustified becaus e the cleanup costs reflect consumptio n activit y by businesses and the access costs reflect income production by the individual taxpayer. She goes on to explain that the personal/business dichotom y produces unsupport able ta x result s becaus e i t create s a hierarch y betwee n persona l an d business categories through it s "unquestioning associatio n o f personal with consumptio n expenditure s an d business with investmen t expen ditures." Noting that her critique of the personal/business dichotomy is pertinent t o th e variou s consumptio n ta x proposal s tha t Congres s i s currently considering , she concludes by advocating a tax analysis tha t "begin[s] with the question whether the expenditure at issue is for consumption o r for the production o f income, without regar d to whether the expenditur e i s personal o r business. " Only by startin g there , Roy argues, can th e ta x la w "acknowledge an d valu e bot h th e productiv e functions o f the personal realm and the consumption function s o f the business realm." Part 3 , "Rethinking Development : Ol d Practices , Ol d Rules , Ne w World," include s essay s b y Moran , wh o investigate s th e us e b y loca l governments o f ta x incentive s t o encourag e economi c development , and b y K. B. Brown an d Garrett-Nelson , wh o eac h conside r differen t aspects o f U.S . internationa l ta x polic y an d it s effec t o n economi c development. Although al l the contributor s writ e i n th e contex t o f a global econom y an d favo r economi c growt h withi n tha t globa l per spective, their attentio n t o and sympathie s with the various economi c players vary widely. Moran focuses on the relationships between local U.S. governmental units an d th e businesses the y attemp t t o attrac t o r d o attrac t t o thei r regions as well as the relationships among governmental units who are competing against one another for economic development opportuni ties. After lookin g at the past and current histor y of localities attempt ing to attract businesse s through ta x incentives, the essa y underscores the iron y tha t th e ver y qualitie s o f th e communit y tha t attracte d th e business i n th e first plac e (transportatio n arteries , skille d labor , an d

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other infrastructure items , such as sewers) are the "things . .. that companies avoi d payin g fo r b y negotiatin g specia l ta x deals. " I t the n explores th e parado x o f th e governmenta l unit s competin g fo r busi nesses to locate in their area s with ta x incentives even though histori cally the cost of attracting an d supportin g those businesses frequentl y outweighs th e economi c benefit s ultimatel y enjoye d b y th e region . Moran's primary interest is to investigate possible solutions for governmental units to disrupt their "race to the bottom" to provide tax incentives when businesses use their economically powerful positio n to fue l unhealthy competition among governmental units. K. B. Brown investigates a similar dynamic that occur s when developing nations compete for business investment. Her primary attention is o n U.S . tax treat y polic y an d ho w i t ha s serve d t o undermin e th e interests of developing nations a s well as its own interests when thos e interests are, contrary to conventional international tax policy, broadly defined. K. B. Brown identifies the United States as a major player in the global econom y who has failed t o us e its leadership t o be an interna tionalist in tax matters rather than a unilateralist. Notwithstanding th e dramatic changes in the post-World War II global economy, the United States has continued its unilateralist policy of entering into tax treaties with individua l countrie s to advance its own interest s by taking hegemonic stances , including maintainin g tha t th e treaty may be change d unilaterally by subsequent legislation, by revocation of the treaty, or by promulgation o f administrativ e regulations . After demonstratin g th e "enormous promise " that developin g nations consistin g o f significan t populations o f colo r hol d "fo r substantia l contributio n t o world eco nomic growth, " K . B . Brow n challenge s th e Unite d State s t o sto p neglecting these countries and to act as an internationalist by formin g alliances and acting in partnership with them. Current tax policy leaves these developing nations with littl e ability to attract busines s throug h tax incentives; instead it forces them to compete by allowing businesses to exploit their labor force and their other natural resources. Wise multilateral tax treaty making, according to K. B. Brown, can become a crucial ingredient i n creatin g goo d workin g condition s fo r workers , preserving the environment, and assuring healthy economic growth. In contras t t o Mora n an d K . B. Brown, Garrett-Nelson focuse s o n how current internationa l ta x policy unfairly taxe s U.S. multinational corporations, creatin g th e ris k tha t the y wil l no t b e abl e t o compet e

INTRODUCTION I

effectively i n the world economy. Her probusiness stance, viewed as the key to world economi c growth, provides an important contras t t o the views found i n the Moran an d th e K. B. Brown essays. Garrett-Nelson believes tha t th e 199 4 electio n o f a Republican-controlle d Congress , along with the growing interest in a consumption-based tax , will result in a serious reexamination o f the current U.S . international tax policy. Most especially , she focuses o n th e antideferra l policie s of curren t ta x law and how the question o f deferral i s currently being contested i n a variety o f ta x refor m proposals . Deferral i n thi s contex t refer s t o th e general polic y o f th e Unite d State s no t t o ta x a U.S. shareholder o f a controlled foreig n corporatio n (CFC ) until the foreign-source incom e is repatriated t o the shareholder a s a dividend o r the shareholder dis poses of the CFC for a gain. This policy is accomplished throug h for eign tax credits (FTC) . Garrett-Nelson recognize s that the general rule allowing deferra l ha s the potentia l t o "impair th e domesti c ta x base," but sh e i s critica l o f th e "plethor a o f exception s t o deferra l an d th e awful complexit y o f th e curren t rule s limitin g th e us e o f FTCs. " Garrett-Nelson conclude s that curren t proposal s attempting to curtai l the historical antideferral bia s are welcomed and are as good as can be expected unde r curren t budgetar y constraints . Sh e als o believe s tha t fundamental ta x reform leadin g to a consumption ta x is possible an d that this change creates a significant opportunit y for reconsidering the CFC tax regime. Finally, in part 4, "Implementing Subsidies: Tax Relief for Savers and for Workers," the contributors examine the law's progressivity principle and th e ability-to-pa y concept . Jefferso n an d Hee n dea l wit h thes e questions b y looking a t ta x base issues ; Forman an d Yi n concentrat e more on what can be achieved through the tax system's rate structure. Jefferson demonstrate s tha t th e propose d ADSA , widely touted a s an incentive fo r saving s an d a benefit fo r al l Americans, in fact , i s detrimental to low- and middle-income taxpayers. Heen details the ways in which curren t ta x allowance s fo r chil d car e cost s advantag e middle and upper-incom e wome n an d disadvantag e low-incom e women . Forman an d Yi n argu e fo r reform s i n federa l incom e ta x provision s relating t o low-incom e workers . Forma n urge s simplificatio n o f th e income tax system, and Yin contends that reform in the way the EITC is delivered to workers is needed. Jefferson challenge s the current tax reform proposa l establishing the

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ADSA, which is a retirement savings account that, unlike the traditional individual retiremen t accoun t (IRA) , allows no tax deduction whe n funded bu t permit s tax-fre e withdrawal s fo r expenditure s othe r tha n for retirement. Her central criticism of the ADSA is that it is inconsistent wit h thi s country' s polic y of encouragin g saving s fo r retirement . She believe s tha t th e expansio n o f th e us e o f retiremen t saving s through ADSAs for purchas e o f a first-time hom e an d educationa l o r medical expenses may operate to the disadvantage of middle- and lowincome taxpayers and subsidize current consumption for high-incom e taxpayers. Moreover , th e ADS A woul d encourag e middle - an d low income taxpayers to shift fro m traditiona l retiremen t saving s arrangements to nonretirement uses, a dangerous shift that may result in inadequate savings for retirement. Low- or middle-income taxpayers might prefer a n ADS A ove r a traditional retiremen t pla n suc h a s a sectio n 401(k) plan, in order to have earlier access to the funds fre e of penalty. The resulting abandonment of traditional plans by lower-paid employees coul d caus e employer s t o forg o establishmen t o f plan s tha t ma y provide "greate r retiremen t security " tha n th e ADSA . Rejectin g th e contrary claims of the ADSA's promoters, Jefferson demonstrate s tha t the rate of savings is not likely to increase and that the greatest benefit s would inur e t o high-incom e taxpayers . The disproportionat e benefit s to high-income taxpayers result from the progressive rate structure that enhances the advantages of tax deferral for those taxpayers at the higher marginal rate s and fro m th e subsidy for home-buyin g tha t i s available only to those who can afford t o own homes. Moreover, self-funde d mechanisms like the ADSA to provide for medical and health expenses are likely to benefit onl y the wealthy because only they will have suffi cient disposable income to take advantage of the tax benefits offered b y ADSAs. In a n alternativ e approac h t o th e issu e o f progressivity , Forma n argues fo r simplificatio n o f th e federa l incom e ta x syste m fo r low income individuals, and Yin critiques curren t proposal s for refor m o f the EITC, a twenty-year-old tax provision aimed at workers who live in poverty. Both view the EITC as a mechanism for the delivery of benefits to low-incom e individuals , akin t o a welfare program , because i t no t only offset s th e socia l securit y an d federa l incom e ta x liabilitie s o f many workers earnin g wage s a t th e povert y leve l but als o provide s a modest refund i n excess of those tax obligations. They depart from th e

INTRODUCTION I

view of some observers that the EITC ameliorates the market exploita tion o f workers resulting from discriminatio n o n th e basis of physical and menta l abilities , class, gender, race , and sexua l orientation . The y also do not embrace the view that the EITC is not a subsidy to workers but a structural correctio n o f a tax syste m tha t undertaxe s entrepre neurs (b y overvaluin g thei r productio n an d ignorin g th e incom e opportunities provide d b y wealth ) an d overtaxe s worker s b y under valuing their production. Notwithstanding their common view that the EITC is a subsidy, both Forma n an d Yin support th e credit an d argu e that i t shoul d b e strengthened . The y ma y disagree , however , o n th e appropriate delivery mechanism. Forman primaril y critique s th e undu e complexit y o f th e federa l income tax system, including the EITC, for low-income individuals. He offers a range of proposals to achieve simplification. In addition to proposals t o streamlin e th e curren t return-filin g process , Forman advo cates alternatively either simplification o f rules qualifying an individual for the EITC, in order to reach a larger group and to minimize administrative costs; or replacement o f the EITC with a simpler social security tax exemptio n o r wit h a worker credi t t o employer s tha t woul d pas s through to wage earners in the form o f higher wages. Forman's proposals culminate in a call for revampin g the current syste m either by integrating the income and socia l security taxes or by moving to a flat ta x on income or consumption. If a major overhau l of the system is rejected, Forman would urge a move to a return-free syste m in which the IRS would comput e liabilitie s fo r low-incom e taxpayers , o r a fina l with holding system, in which mos t taxe s would be collected by employers through wage withholding. Yin conclude s tha t th e mos t beneficia l refor m o f th e EIT C woul d involve a move to a transfer system . He details the problems resultin g from deliver y of the EITC through the tax system. These include complexity leadin g t o less-than-ful l participatio n b y eligibl e individual s and inadvertent erro r and fraud. Yin questions whether the EITC provides a work incentive , because th e refun d typicall y i s recovered onl y once a year, an d ther e i s littl e evidenc e tha t a taxpaye r connect s th e refund wit h work effort. These observations and a fear that a move to a consumption tax would reduce administrability of the EITC lead Yin to propose that th e primary portion o f earned incom e benefits b e delivered through a welfare-type system . He urges use of money otherwis e

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provided throug h a credi t t o worker s t o financ e government-super vised work programs. Heen's essay, like Forman's and Yin's, also examines the tax system's treatment o f low-incom e workers . She , however , focuse s o n th e ta x base issues concerning child care. Heen critiques the tax law's treatment of chil d car e expense s a s i t impact s low- , middle- , an d high-incom e women differently . Sh e notes that th e historical failur e o f welfare an d labor policies to support affordabl e chil d care, coupled with tax provisions tha t d o no t ta x impute d incom e fro m service s provide d t o th e family, have encouraged women to provide services in the home. Those incentives hav e operate d t o th e advantag e o f middle - an d upper income women who can afford t o remain at home. This has established a race- and class-base d doubl e standard; the result is that low-incom e mothers hav e insufficien t acces s to adequat e chil d car e fo r thei r ow n children becaus e they have insufficient resources . Moreover, althoug h the tax law has recognized the work-related nature of child care and has allowed a credi t fo r expense s o r a n exclusio n fo r employer-provide d coverage, these provisions typically do not benefit low-income women. Heen reject s curren t ta x analysis that view s child car e allowances a s a subsidy an d argue s tha t chil d car e cost s ar e a legitimate incom e pro duction expense . Even i f allowance s fo r chil d car e cost s ar e properl y viewed as a subsidy, she favors them as necessary to offset th e tax law's preferred treatmen t o f househol d labo r ove r wage d work. Heen con cludes by supporting tax allowances for chil d care costs for al l taxpayers, includin g upper-incom e taxpayers , withou t th e limit s currentl y imposed, bu t sh e woul d expan d allowance s fo r low-incom e wome n either by increasing the maximum credi t and makin g it refundable s o that i t woul d b e o f benefi t t o low-incom e worker s o r b y mandatin g employer-provided programs for all workers. The wide range of approaches taken and the various topics treated in the essays suggest both the breadth o f a social justice theory in tax law and th e nee d t o explor e th e parameter s o f tha t theor y b y looking a t particular provisions and rules. The essays are as important i n suggesting ne w path s o f ta x researc h a s the y ar e i n disruptin g ol d way s o f thinking abou t th e ta x law . Taken together , the y represen t a uniqu e contribution bot h t o tax scholarship an d t o the political debate abou t how, what, an d who m w e should tax . For thos e intereste d i n joinin g in thi s project , th e challeng e o f unlearnin g comfortabl e assumption s

INTRODUCTION 2

I

about the tax law will be as great as uncovering bias and discriminatio n in th e ta x law. What make s ou r effort s essentia l i s that ho w America taxes itself today will determine what America will be tomorrow.17

NOTES 1. Beverly I. Moran, Black Critique of the Internal Revenue Code, Presentatio n a t Critical Tax Theory: A Workshop, Stat e Universit y o f Ne w Yor k a t Buffal o La w Schoo l (Sept . 8-9 , 1995) ; Beverly I. Moran, Gender Bias in the Internal Revenue Code, Presentatio n a t th e Symposiu m o n Gender Bia s in the Law, University of Chicago Law School (Dec . 2, 1994); Beverly I Moran, Race Conscious Scholarship: Theory, Method, and Practice, Presentation at the Conference on Minorities and Law Teaching of the Association of American Law Schools (Oct. 1992). 2. But see, in this volume, Dorothy A. Brown, The Marriage Bonus/Penalty in Black and White (indicating tha t th e join t ta x retur n i s availabl e onl y t o legall y marrie d couples) ; Lil y Kahng , Fiction in Tax (exploring th e marita l uni t fiction an d it s application i n the incom e an d transfe r taxes onl y t o legall y marrie d couples) ; Kare n B . Brown, Transforming the Unilateralist into the Internationalist: New Tax Treaty Policy toward Developing Countries (examining the effect o f current international ta x policy on developin g countries with predominantl y populations o f color); Denise D. J. Roy, Consumption in Business/Investment at Home: Environmental Cleanup Costs versus Disability Access Costs (comparing th e tax treatment o f cleanu p cost s incurred b y businesses that pollute with the treatment o f access costs accorded individua l taxpayer s who are themselves disabled or who have a spouse or a dependent who is); see also Patricia A. Cain, Same-Sex Couples and the Federal Tax Laws, 1 Law & Sexuality 97 (1991) (analyzin g the tax treatment o f same-se x couples); Karen B. Brown, How Does Tax Law Reinforce Subordination of Workers on the Basis of Race or Gender? Employment Discrimination Damage Awards (unpublished manuscript) (analyz ing the tax treatment of I.R.C. § 104, having to do with compensation for injuries and sickness). 3. See Mary Louise Fellows, The Antisubordination Principle in Tax Policy: A Case Study on the Tax Treatment of Child Care Expenses (unpublished manuscript) (showin g why the antisubordination principle needs to be integrated into traditional tax analysis and how its consideration make s a difference i n the consideration of tax issues). 4. See Richard A. Epstein, Forbidden Grounds : The Case against Employment Discriminatio n Laws (1992); Daniel R. Fischel & Edward P. Lazear, Comparable Worth and Discrimination in Labor Markets, 5 3 U . Chi . L . Rev . 89 1 (1986) ; Richar d A . Posner , An Economic Analysis of Sex Discrimination Laws, 56 U. Chi. L. Rev. 131 1 (1989) . For example s o f argument s favorin g lega l intervention, see Mary E. Becker, Barriers Facing Women in the Wage-Labor Market and the Need for Additional Remedies: A Reply to Fischel and Lazear, 5 3 U . Chi . L . Rev. 934 (1986) ; Joh n J. Donohue III, Prohibiting Sex Discrimination in the Workplace: An Economic Perspective, 56 U. Chi. L. Rev. 1337(1989). 5. See Edward J . McCaffery , Slouching towards Equality: Gender Discrimination, Market Efficiency, and Social Change, 103 Yale L.J. 595 (1993). 6. The definition o f income in an ideal accretion tax system was first stated by Robert Haig as "the mone y valu e o f th e ne t accretio n t o one' s economi c powe r betwee n tw o point s i n time. " Robert M. Haig, The Concept of Income—Economic and Legal Aspects, in The Federal Income Tax 1, 7 (Robert M. Haig ed., 1921). It was later refined b y Henry Simons. Henry C. Simons, Personal Income Taxation 50 (1938). 7. Id. at 54.

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S.Id. 9. Id. 10. Stanley S. Surrey, Pathways to Tax Reform: The Concept of Tax Expenditures 3 (1973). 11. Mat 6 . 12. Id. 13. Jd. atviii-ix. 14. Mat 19 . 15.1.R.C.§ 162(a). 16. See Commissioner v. Flowers, 32 6 U.S. 465 (1946); McCabe v. Commissioner, 68 8 E2d 10 2 (2dCir. 1982). 17. The essay s i n thi s antholog y wer e complete d i n Apri l 199 6 an d d o no t reflec t ta x la w changes after that date.

I LILY K A H N G

Fiction in Tax

Legal fictions have long made us uneasy.1 Jeremy Bentham, perhaps legal fiction's most vociferous critic, described it as a "syphilis, which run s i n ever y vein, and carrie s int o ever y part o f th e system the principle o f rottenness." 2 What i s a legal fiction? Although scholars have disagreed over its precise definition, generally speaking, a legal fiction is a false statement o f fact o r a false factual construc t use d to serve a legal end. For example, in medieval times, English common law court s ha d jurisdictio n onl y ove r cause s o f actio n arisin g withi n England. However , a cour t coul d acquir e jurisdictio n ove r a foreig n cause of action i f the parties t o th e actio n mad e a false assertio n tha t the foreig n plac e givin g ris e t o th e actio n wa s i n England. 3 A mor e modern exampl e o f a legal fiction i s the ta x doctrin e o f constructiv e receipt, unde r whic h a cas h metho d taxpaye r i s deeme d t o hav e received income when in fact she has not. 4 Legal fictions hav e bee n defende d a s providin g a creativ e wa y t o reach equitable results.5 Thus, for example, the doctrine of constructive receipt prevent s a cas h metho d taxpaye r fro m artificiall y deferrin g income fro m on e yea r t o th e nex t b y manipulatin g th e timin g o f it s receipt. However , lega l fictions historicall y hav e bee n criticize d fo r a variety of reasons. Bentham abhorred them because, among other rea25

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sons, h e believe d tha t they , alon g wit h th e res t o f th e commo n law , made the law inaccessible to the people. 6 Henry Maine criticized legal fictions for obscuring the law to lawyers, thereby hindering their func tion.7 Joh n Chipma n Gra y though t lega l fictions wer e "dangerou s tools" when used to change the law rather than merely to classify established rules. 8 Gray also thought i t important tha t th e user o f a fiction be aware of its fictional nature. He said, "One shoul d alway s be read y to recogniz e that th e fictions are fictions, and be able to stat e the rea l doctrine fo r which they stand." 9 Lon Fuller, like Gray, emphasized th e importance of recognizing that fictions are fictions and warned that the danger o f a lega l fiction la y i n it s user' s unawarenes s o f it s fictional nature.10 In tax, fictions abound. A taxpayer can be in "constructive receipt" of income;11 foreign taxes can be "deemed paid" by a foreign corporation' s U.S. shareholder;12 "transitory" corporations ca n be "disregarded" in a corporate reorganization. 13 Eac h o f thes e fictions serve s t o achiev e a desired polic y resul t an d appear s t o avoi d th e danger s describe d b y Bentham, Maine, Gray, and Fuller. However, tax fictions can be dangerous. They can mask underlying motives and biases and they can cause unforeseen harms . This essa y will illustrate th e danger s o f fictions i n tax by tracing the emergence of one such fiction, that of marital unity, the notion that a married coupl e is an indivisible unit rather than two individuals with separate and distinct rights in income and wealth.

T H E G E N E S I S O F T H E F I C T I O N O F MARITA L UNIT Y

As recently as 1942, all taxpayers were taxed as individuals. However, not al l married individual s were taxed in the same way. Married indi viduals residin g i n community-propert y state s receive d certai n ta x advantages ove r marrie d individual s residin g i n common-la w states . Under the Supreme Court's 193 0 decision i n Poe v. Seaborn,14 income earned by a husband i n a community-property stat e was taxed half t o him and half to his wife. (This essay refers to men as earners and wealth holders because men were the dominant earners of income and holders of wealth durin g thi s time period.) 15 In contrast , income earne d b y a husband i n a common-law stat e was taxed completel y t o him . Poe v . Seaborn s income-splitting rule allowed husbands in community-prop-

FICTION I N TA X 2

erty states to pay less tax than husbands in common-law states, because income splitting mitigated the effect o f progressive tax rates. In Lucas v. Earl16 the Supreme Court denie d husbands i n common-law state s the ability to reduce tax liability by shifting personal service income to their wives throug h contractua l assignment . Husband s i n common-la w states could shift incom e to their spouses through othe r devices , however, suc h a s famil y partnership s an d trusts . Th e Interna l Revenu e Service (IRS ) ofte n challenge d thes e devices as sham transaction s an d heavily litigated the issue.17 Husbands i n community-propert y state s als o enjoye d favorabl e estate and gift ta x treatment. (Fo r the sake of simplicity, this essay will discuss only the estate tax and not the gift tax. The gift tax, however, has a parallel history and raises similar issues with respect to married individuals.) Fo r example, if a decedent bequeathed hi s entire estate to his widow, he wa s taxed onl y o n hal f o f th e communit y propert y trans ferred to her because of a presumption that the wife already owned the other half. 18 In contrast, a common-law deceden t who bequeathed hi s entire estate to his widow was taxed on it all.19 The disparate treatment o f community-property an d common-la w married resident s cause d muc h disgruntlement , an d th e firs t federa l attempt to redress the disparity came in 1942 . The Revenue Act of 1942 (1942 Act) increased the estate tax on decedents in community-proper ty states to equaliz e thei r ta x liability with decedent s i n common-la w states. Th e equalizatio n wa s achieve d b y requirin g mos t communit y property to be taxed entirely in the estate of the first spouse to die. The 1942 Act, of course, provided fo r exceptions. Two types of communit y property, that derive d originall y fro m th e survivin g spouse' s separat e property and that derived from persona l service income of the surviving spouse, continued to be taxed one-half in each spouse's estate.20 Obviously, marrie d resident s o f community-propert y state s wer e not pleased by the increase in their estat e taxes. They complained tha t the increase caused hardships and inequities. 21 In the meantime, married resident s o f common-la w state s continue d t o b e unhapp y wit h their heavier income tax burden. Pressure mounted on state legislatures in common-law jurisdictions to adopt community-property systems in order t o obtain favorabl e incom e tax treatment fo r thei r constituents . Several states (Oklahoma , Oregon, Michigan, Nebraska, Pennsylvania , and th e Territor y o f Hawaii ) succumbe d t o th e pressur e b y enactin g

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community-property regimes. 22 (Al l repealed thei r community-prop erty laws after the federal legislation of 1948 discussed below.) In 194 8 Congress resolve d th e turmoil i n both th e income tax and the estate tax. For the income tax, the Revenue Act of 194 8 (1948 Act) created a n income-splittin g scheme , under whic h al l husbands coul d shift hal f o f thei r incom e t o thei r wive s fo r ta x purposes. 23 Fo r th e estate tax, the 194 8 Act repealed the 194 2 provisions that had increased the estat e ta x o n resident s o f community-propert y state s an d i n it s place created a marital deduction. The new marital deduction permit ted common-law decedents to transfer u p to one-half of their property to their surviving spouses tax free, thus lightening the estate tax burden on common-la w resident s an d equalizin g i t with tha t o f community property residents.24 The adoption of income-splitting introduced one element of the fiction of marital unity: all married couples were treated as if "they shared their income whether or not they actually did. Stated another way, married couple s with equa l amounts o f income were deemed t o be equa l for tax purposes despite the fact that husbands and wives had differin g rights to the income depending on whether they resided in communi ty-property or common-law states. For example, a husband living in a common-law state , who ha d complet e contro l ove r hi s earnings , was taxed a t th e sam e rat e a s a husband livin g i n a community-propert y state, who by law had a right to only half of his earnings. Clearly, the immediate political goal in adopting this fiction was to reduce tax liability for husbands residing in common-law states. 25 Less clear i s whethe r th e fiction furthere d som e independen t polic y goa l and, if so, what deliberative process Congress undertook i n determin ing that goal . The deliberativ e proces s shoul d hav e weighed th e cost s of incom e splittin g agains t it s benefits . Incom e splittin g ha d certai n administrative benefits . I t eliminate d th e incentiv e fo r common-la w states to switch to community-property regimes and thereby eliminated the cost of shifting from one system to the other. It also removed the incentive fo r resident s o f common-la w state s t o us e devices , such a s partnerships an d trusts, to shift incom e to their spouses , which eliminated the cost of creating and policing such devices. Both the Report of the House Committee on Ways and Means and the Report of the Senate Committee on Finance cite these two administrative benefits as the reasons fo r adoptin g incom e splitting. 26 Neithe r report , however , men -

FICTION I N TA X 2

tions the costs of income splitting. One cost was that incom e splittin g mismeasured incom e t o th e exten t tha t i t ignore d th e differin g eco nomic right s allocate d t o husband s an d wive s unde r differin g stat e property law regimes. Another cos t was its effect o n married women' s property rights . Income splittin g eliminate d th e politica l pressur e o n common-law states to provide married women with the stronger property rights of a community-property regime. The Specia l Ta x Stud y Committee , whic h recommende d tha t th e Ways and Means Committee adopt income splitting, at least mentioned the differin g right s o f marrie d wome n i n differen t states . It s repor t explicitly state d tha t uniformit y i n th e taxatio n o f marrie d couple s among common-la w an d community-propert y state s was the desire d policy goal and that the differing right s of married women in differen t jurisdictions wer e not significan t fo r ta x purposes: "The fac t tha t th e legal rights of [ a man's] wife under the State law may differ .. . does not seem t o justif y th e significan t difference s i n Federa l incom e taxe s payable. There has come to be rather, general agreemen t tha t spouse s with similar incomes should pay similar Federal taxes, no matter where they live."27 This conclusion o f the Special Tax Study Committee, however, does not reflec t a reasoned polic y analysis. Instead, the committee fel l pre y to the danger of which both Gray and Fuller warned: it failed to recognize the fictional nature of the fiction. Rather than recognizing the fictional natur e o f treatin g al l marrie d couple s a s i f the y share d thei r income, the committee relied upon the fiction to trivialize the differin g allocations o f right s betwee n husban d an d wif e unde r commo n la w and communit y property . Th e committe e define d th e polic y goa l a s "equal treatmen t o f marrie d couple s wit h equa l income, " thereb y assigning uniformit y a valu e independen t o f it s rea l administrativ e benefits. The Special Tax Study Committee demonstrated the error in its logic through it s treatmen t o f othe r alternatives . Th e committe e viewe d nonuniform alternatives—thos e that would have recognized the differ ing rights accorded t o married wome n i n different states—a s inferior , not only because of the administrative costs the alternatives would have entailed bu t als o becaus e o f thei r nonuniformity . Fo r example , th e committee considere d taxin g all earned incom e t o the earner, even in community-property states , an d al l community-propert y incom e t o

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the spous e who exercise d managemen t an d contro l o f th e property . As an alternativ e proposal , th e committe e considere d reversin g Lucas v . Earl s o tha t marrie d couple s i n common-la w state s coul d ente r int o sharing agreement s tha t woul d b e recognize d fo r ta x purposes . Th e committee rejecte d thes e alternative s a s inferio r t o incom e splitting, 28 in par t becaus e the y believe d th e income-splittin g schem e woul d b e easier t o administer . However , th e Specia l Committe e cite d unifor m taxation a s the most importan t benefi t o f income splitting : [Income splitting] eliminate s the legal and administrative problems which now arise from th e many attempts to divide income between spouses.... I t avoids th e seriou s question s whic h woul d aris e i n th e interpretatio n an d construction o f contracts between spouses . Most important, [income splitting] puts the incomes of husbands and wives, wherever resident, on a like basis for Federal tax purposes.29 Uniform treatmen t o f husband s an d wives , wherever resident , woul d be a n independen t benefi t o f incom e splittin g onl y i f husband s an d wives had th e sam e rights , wherever resident . Husbands an d wive s ha d different propert y rights, however, depending o n where they lived. The fiction tha t al l married couple s share their income di d not serv e a valid policy goal. Rather, it served t o obscur e the cost s of taxing mar ried couple s uniforml y an d transforme d uniformit y int o a n indepen dent benefit . Th e fiction di d no t implemen t a polic y determinatio n that too k accoun t o f al l th e cost s an d benefit s o f unifor m taxatio n o f married couples . Rather, th e fiction substitute d itsel f fo r suc h a polic y determination. As a political matter, how could the costs of income splitting , particularly it s effec t o n marrie d women' s propert y rights , hav e bee n over looked? There appears to have been a great deal of support fo r stronge r married women' s property rights . No women testifie d i n the 194 8 con gressional hearing s leadin g t o th e enactmen t o f incom e splitting , bu t the Genera l Federatio n o f Women's Club s submitte d a n articl e statin g their views during the 194 7 congressional hearings : Instead o f penalizin g th e communit y propert y system , . . . the Congres s should encourag e it s spread. By its recognition o f the contribution o f th e wife to the marital partnership earnings, the community property system is

FICTION I N TA X 3

far in advance of any common-law State. Services are recognized to be rendered by the marital community, and income as earned by husband and wife alike. . . . Recognition i s given to the fact tha t the wife is entitled to something more than food, clothing, and a place to sleep, and it ought to be the law everywhere.30 Men from community-property states also expressed support for the stronger rights given to married women under their systems during the 1947 hearings. They expounded o n the superiority of the community property syste m i n recognizin g marrie d women' s contributio n t o th e production of income and suggested that common-law states would do well t o adop t thi s superio r system. 31 The y argue d tha t th e favorabl e treatment accorded to community-property residents did not discriminate unduly against common-law residents but rather reflected real differences i n th e economi c right s o f husband s an d wives. 32 They criti cized the income-splitting proposa l fo r givin g common-law husband s the ta x benefit s o f a propert y syste m intende d t o protec t marrie d women without requiring husbands to bear any of the burdens of such a system.33 These statements of support for stronger married women's property rights, however, masked a hidden motiv e among residents of commu nity-property states . At th e tim e o f th e 194 7 hearings , Congres s wa s considering severa l option s t o equaliz e th e incom e ta x treatmen t of community-propert y an d common-la w residents . Som e o f thes e options would have repealed the income splitting prescribed fo r com munity-property resident s by Poe v. Seaborn and would have increased their income tax burden, for example , by taxing earned incom e exclusively to the earner rather than taxing half to each spouse.34 In championing the community-property regime, community-property residents were at least partly motivated b y the desire to preserve their favorabl e tax treatment. A year later, in 1948 , the only income tax proposal under considera tion wa s incom e splittin g fo r al l marrie d couples , a proposa l tha t decreased the tax burden on common-law residents but left the tax burden o n community-propert y resident s unchanged . At this poin t resi dents o f community-property state s were predictably silen t abou t th e adverse effect o f income splitting on married women's property rights.

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The 194 8 congressiona l hearing s contai n onl y on e statement , b y a Chicago accountant, that refers explicitly to married women's property rights, and it is distinctly unsympathetic: Every time the mandatory joint return issue has been raised, hosts of goldplated suffragette s hav e descende d upo n Congres s t o reenac t thei r epi c drama regarding married women's rights, and claim that all will be lost if ever a wife must file a joint return with her husband and thereby again be "relegated t o economi c slavery. " The real issues being thereby muddled , various moralists and misled church groups joined the battle and a deafening thunder o f cries about marriage, morals, economic serfdom, and the like killed any further relevant determinations or any action.35 Professor Carolyn Jones has argued that sentiments like those voiced by the Chicag o accountan t playe d a central rol e i n th e enactmen t o f income splitting . Sh e argue s tha t incom e splittin g wa s attractiv e no t only becaus e i t reduce d taxe s fo r common-la w resident s bu t als o because it halted the community-property movement, thereby preserving traditiona l gende r role s an d powe r relationships. 36 Whethe r Congress wa s motivate d simpl y by the desir e fo r lowe r taxe s o r b y a more complex set of motives that included preserving traditional gender roles and powe r relationships , the fiction o f marital unit y was the vehicle by which Congress could both justify it s goals and obscure the social costs of achieving these goals. The estate tax story is more tortuous than the income tax story but is equally imbued with the fiction of marital unity. Like the 194 8 income tax amendments, the 194 8 estate tax amendments wer e motivated b y the desire for lower taxes.37 Also like the 1948 income tax amendments, the 194 8 estate tax amendments' stated goa l was to equalize the estat e tax treatment o f married resident s o f community-property an d com mon-law states. 38 This alleged goal, however, was even less plausible in the estate and gift tax context than in the income tax context, given that the 194 2 Act equalized th e estate and gif t ta x burden o n community property residents.39 The 1948 Act permitted all husbands, whether residing in community-property or common-law states, to transfer one-hal f o f their wealth to their wives tax free. The deduction was tailored to mimic community-property treatment for husbands in common-law states making outright transfers to their wives.40 Accordingly, transfers in trust—those in

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which th e wife had a n incom e interes t tha t would terminat e afte r som e period o f time—generally di d no t qualif y fo r th e deduction. 41 A transfer i n trust was deductible onl y if it met th e requirements o f a power o f appointment trust . The most significan t o f these requirements was tha t the wif e b e give n contro l ove r th e ultimat e dispositio n o f th e trus t property. 42 Significantly , dowe r transfers—thos e i n whic h th e wif e received onl y a n incom e interes t fo r life , wherea s th e deceden t desig nated th e ultimat e recipient s o f th e trus t propert y upo n hi s wife' s death—did no t mee t this requirement an d were not deductible . The estat e ta x marita l deductio n wa s premise d o n a n assumptio n that parallel s th e fiction underlyin g incom e splitting . Incom e splittin g was premise d o n th e fiction tha t husband s an d wive s share d thei r incomes. Th e estat e ta x marita l deductio n wa s premise d o n th e assumption tha t husband s an d wive s wanted t o share , and actuall y di d share, their wealth. A husband actually ha d to transfer hal f his wealth t o his wif e i n orde r t o b e treate d fo r ta x purpose s a s i f h e share d tha t wealth. I n contrast , unde r th e incom e ta x join t return , husban d an d wife were treated as if they shared his income, whether o r not they actu ally did shar e it . The assumptio n underlyin g th e marita l deductio n wa s mistake n i n a crucia l respect : husband s di d no t want t o shar e thei r wealt h wit h their wives . They wante d t o retai n contro l ove r thei r wealt h throug h dower transfers , bu t dowe r transfer s di d no t qualif y fo r th e marita l deduction. Estat e planner s an d thei r client s wer e chagrine d t o find that th e 194 8 Act provide d ta x reductio n a t wha t the y considere d a n exorbitant price : women ha d t o b e give n contro l o f th e property . Th e extreme distres s cause d b y thi s prospec t i s evidence d i n th e practica l literature o f the time : The wife mus t b e give n absolut e control , eithe r durin g he r lif e o r b y he r will; in eithe r even t sh e may (foolishl y perhaps ) cu t of f th e object s o f hi s bounty and leave his estate to a gigolo second husband. 43 Even wher e th e [powe r o f appointmen t trust ] (rathe r tha n outrigh t bequest) i s used , th e wife' s unrestricte d powe r o f appointmen t ca n b e a source o f grea t persona l power . The [husband' s designate d beneficiaries ] can be cut off by a stroke of mother's testamentary pen. 44 There are few men in common law states who are willing to grant their wid-

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ows more than a life estate where there are surviving children. The tax law should not offer a premium to a husband who ignores his better judgment and grants his widow a general power of appointment leavin g his children at the mercy of any charlatan who has his widow's ear. 45 In general, property relieved of taxation i n the estate of the first t o die will be taxed in the estate of the survivor—and will be subject to the unfettere d disposition of the survivor in the meantime. For many people this power of disposition will be too high a price to pay.46 How coul d a provision a s disruptiv e a s th e 194 8 marita l deductio n have bee n enacted ? Two factor s offe r a n explanation . First , th e 194 8 marital deductio n simpl y wa s no t wel l though t out . I t saile d throug h on th e wav e o f suppor t fo r th e income-splittin g plan , an d it s implica tions wer e no t carefull y scrutinized . Stanle y Surrey , Ta x Legislativ e Counsel fo r th e Treasur y Departmen t durin g enactmen t o f th e 194 8 amendments, observed : [T]he splittin g o f estate s an d gift s simpl y rod e i n unheralde d an d unin spected on the coattails of splitting of income.... The impact upon estat e planning, upon the disposition of property within the family, is immediate and startling. Yet on passage of the Act, only a relative handful o f attorneys close to the theater of operations even approached awareness of what these provisions involve, and it will be many months or even years before opera tive understandin g o f al l o f thei r ramification s i s achieved b y tax practi tioners.47 In additio n t o a n incomplet e understandin g o f th e 194 8 marita l deduction an d its consequences, Congress also may have had a strategic reason fo r downplayin g th e antidowe r incentiv e create d b y the marita l deduction. Presiden t Truma n an d th e Treasur y Departmen t oppose d the marital deductio n a s well as the income-splittin g schem e primaril y because of the revenue losses they would cause . In opposing the marita l deduction, Treasury Secretary John W. Snyder pointed ou t that it would disrupt th e customary pattern o f dower transfers, because dower trans fers would be taxed relatively unfavorably unde r th e marital deduction : Since it is a frequent practic e in common law States for a wealthy husband to give his wife a life interest in his estate with remainders to his children or other beneficiaries , equalit y o f treatmen t [betwee n community-propert y

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and common-la w residents ] woul d b e achieve d onl y b y interferin g t o a large extent with this long-established pattern of family dispositions. 48 Fearing tha t i t migh t ad d fue l t o thi s attac k o n th e marita l deduc tion, Congres s ma y hav e bee n reluctan t t o cal l to o muc h attentio n t o the antidower incentiv e of the marital deduction. Perhaps they believed that th e antidowe r incentiv e wa s a smal l pric e t o pa y fo r th e marita l deduction. Perhap s the y believe d tha t the y coul d figh t an d wi n th e antidower battle another da y (as they eventually did). The 194 8 marita l deductio n wa s flawe d i n th e eye s o f practitioner s and thei r clients , no t becaus e i t wa s base d o n a fictio n bu t becaus e i t required too much reality . In order to be taxed as if he shared his wealth with hi s wife , a husban d actuall y ha d t o ced e contro l o f hi s wealt h t o her. Completel y inadvertently , th e marita l deductio n strengthene d married women' s propert y right s by providing a tax incentive fo r hus bands to transfer wealt h to their wives. The fictio n o f marita l unit y ultimatel y provide d th e solutio n t o thi s "sorry mess, " as Professo r Surre y describe d it. 49 Th e firs t seed s o f th e fiction wer e planted b y Allan H . W. Higgins, chairman o f the America n Bar Association , Sectio n o f Taxation , Committe e o n Equalizatio n o f Taxes i n Community-Propert y an d Common-La w States , an d a n enthusiastic proponen t o f th e marita l deduction . H e argue d tha t eve n dower transfers—transfer s i n trus t i n whic h th e deceden t designate d the ultimat e beneficiarie s o f th e trus t propert y upo n hi s widow' s death—should qualif y fo r th e marita l deductio n i n th e decedent' s estate. H e furthe r propose d tha t th e trus t propert y b e taxe d t o th e widow upo n he r death , eve n thoug h sh e ha d n o contro l ove r disposi tion o f th e trus t property . H e note d "[i] t ha s lon g bee n th e custo m t o protect wive s by placing property i n trust. As long as the trust propert y is taxe d a t th e deat h o f th e survivin g spouse , th e marita l deductio n should appl y irrespectiv e o f th e varyin g provision s o f th e trust." 50 Higgins's claim , tha t transfer s b y a marrie d coupl e t o thir d partie s should b e taxed onl y once, no matte r whic h spous e control s th e trans fer, was based o n th e fictio n o f marital unity . Again, the fictio n provid ed a basi s fo r disregardin g th e allocatio n o f propert y right s betwee n husband an d wife for ta x purposes. Higgins's proposal tracked the logi c of incom e splitting . Transfers mad e b y husband s woul d b e deeme d t o be made by their wives as well. In this fashion, th e fiction serve d to jus-

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tify favorabl e ta x treatmen t fo r transfer s i n whic h husband s retaine d control even after deat h o f the ultimate disposition o f their property . Soon afte r th e 194 8 Act was passed, tax scholars began t o invok e th e fiction a s th e palliativ e fo r thei r anxiet y tha t marrie d wome n migh t acquire contro l o f their husbands ' property. In a 194 8 article, Professo r Surrey reiterated Higgins' s proposal, clothing it in the fiction o f marita l unity: Husband an d wif e ar e regarded a s a unit fo r incom e ta x purposes, and I would similarl y regar d the m a s a uni t fo r transfe r ta x purposes . Ther e would be no tax as long as the enjoyment o f property shifted fro m on e to the other within this unit. The transfer tax would apply only when property left thi s unit an d passed to the children o r others. The unit would cease to exist on death of the surviving spouse.51 Professor Surre y state d hi s view in neutral , if conclusory, terms : th e married coupl e i s a unit , an d propert y shoul d b e taxe d onl y upo n transfer fro m th e uni t t o a thir d party . However , i n a 195 0 article , Professor Surre y expressed his true concerns : Basically th e sorr y mes s w e no w fac e resulte d fro m th e illici t allianc e i n 1948 of transfer ta x reduction an d community property concepts.... The husband ha s t o choos e betwee n ta x saving s throug h releasin g hi s han d from th e control of the property on his wife's death and the risk that when she dies some alien hand will be guiding her actions. 52 Surrey use s th e fiction o f marita l unit y t o disguis e hi s rea l fea r tha t women woul d acquir e contro l o f wealt h an d hi s opinio n tha t wome n were too untrustworthy o r incompetent t o be wealth holders . Surrey's vision for the estate tax finally was realized by the Economi c Recovery Tax Act of 198 1 (ERTA). 53 ERTA made tw o majo r change s t o the marita l deduction . First , th e deductio n wa s mad e unlimite d i n amount, 54 whic h eliminate d th e 194 8 restrictio n tha t limite d th e deduction t o hal f o f th e decedent' s wealth . Second , dowe r transfer s were mad e deductibl e i n th e decedent' s estat e unde r a ne w deductio n for a qualifie d terminabl e interes t i n propert y (QTIP). 55 Th e QTI P rules further provide d tha t propert y i n a QTIP trus t woul d b e taxe d i n the widow's estate, even though sh e had no contro l over the dispositio n of the trust property upon he r death. 56 The legislative history of these provisions explains them by referenc e

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to th e notio n o f th e marrie d coupl e a s the taxpayin g unit : al l transfer s within th e uni t shoul d b e exempt , withou t an y limitatio n o n th e amount o f transfers. 57 Transfer s b y the marital uni t t o others should b e taxed onl y once , whe n th e propert y leave s th e marita l unit. 58 ERT A engrafted th e fictio n o f marita l unit y effortlessl y fro m th e incom e ta x to th e estat e tax : "Th e committe e believe s tha t a husban d an d wif e should b e treate d a s one economi c uni t fo r purpose s o f estat e an d gif t taxes, as they generally are for incom e tax purposes. Accordingly, no ta x should be imposed o n transfer s betwee n a husband an d wife." 59 After ERTA , th e estat e ta x fictio n o f marita l unit y quickl y becam e orthodoxy among tax academics: All quantitative limitations on the marital deduction wer e limited becaus e "a husband an d wife should be treated a s one economic unit fo r purpose s of the estate and gift taxes."... The QTIP provision is a natural extension of the [marita l deduction ] . . . given th e shif t i n emphasi s fro m mimickin g community property to taxing property only once each generation. 60 Viewed broadly, the unlimited marita l deductio n ha s the effect o f treatin g spouses as a single taxpayer wit h a lifetime equa l to the survivor's. In thi s light, th e transfer o f a lif e interes t fro m on e spous e t o th e othe r ca n b e regarded as the retention of a life interest by this notional taxpayer. 61 The substantive effect o f [th e 1981 ] changes is to treat the marital unit as a separate transfer tax unit with respect to interspousal transfers. 62 The fictio n o f marita l unity , however, camouflages th e tru e purpos e of th e QTI P rules . The QTI P rule s eliminate d th e antidowe r incentiv e inadvertently create d b y th e 194 8 marita l deduction , whic h enable d husbands t o rea p th e benefi t o f th e marita l deductio n whil e retainin g dead hand contro l of their wealth. Practitioners were quick to point ou t this benefit : [Eliminated i s the nagging anxiety that the surviving spouse will remarry and . . . divert th e marita l deductio n propert y fro m th e natural object s o f the decedent's bounty. 63 [T]he QTI P trus t i s attractiv e t o man y client s wh o wan t t o "handcuff " the survivin g spous e whil e a t th e sam e tim e qualifyin g fo r th e marita l deduction.64

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It i s n o longe r necessar y fo r a testato r t o mak e th e difficul t decisio n o f whether t o take advantage of the marital deductio n fo r hi s estate and give up control ove r the final disposition o f his property or foreg o th e marita l deduction and maintain control. Formerly,... and a more painful prospect , it was not possible for a testator to ensure that the marital deduction property would not end up in the hands of his successor, if the surviving spouse decided to remarry. 65 As th e practica l literatur e demonstrates , th e principa l attractio n o f the QTI P rule s i s that a husban d ca n retai n contro l ove r th e ultimat e disposition o f his wealth eve n afte r hi s death, while enjoyin g th e bene fits o f the marital deduction . The husband's desir e to handcuff hi s wif e is disguised b y invoking th e fictio n o f marita l unity . Under th e fiction , as lon g a s wealt h transfer s b y th e marrie d coupl e t o thir d partie s ar e taxed onl y once, the appropriat e resul t ha s been reached . Th e fac t tha t the husban d control s th e transfer , eve n afte r hi s death , i s obscure d b y the fiction .

T H E LEGAC Y O F T H E FICTIO N O F MARITA L UNIT Y

From it s ignobl e origin s a s a mean s t o procur e a ta x reductio n fo r married me n i n common-la w states , th e fictio n o f marita l unit y ha s been elevate d t o a first principl e o f taxation . I n 197 6 Professo r Bori s Bittker, one o f the most influentia l ta x scholars o f the twentieth centu ry, observed tha t "the 194 8 statutory principle o f equa l taxes for equal income marrie d couple s ha s bee n Almos t universall y accepted ' b y ta x theorists." 66 This fiction i s difficult t o challenge because of its status as a first principle . Thos e wh o objec t t o th e harm s inflicte d o n wome n b y the fiction bea r th e burden o f establishin g tha t thes e harms ar e seriou s enough t o requir e abandonin g thi s fiction tha t masquerade s a s a first principle. Income ta x scholars , for example , have note d tha t th e incom e taxa tion o f marrie d couple s a s unit s cause s labo r inefficiencie s an d biase s against wome n i n th e workforc e t o th e exten t tha t individual s an d no t couples mak e labo r decisions . Marrie d wome n ten d t o b e secondar y earners an d t o hav e high labo r suppl y elasticit y relative to that o f mar ried men . As a consequence , marrie d wome n ten d t o b e marginalize d

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in the workforce. Taxing married couple s as units only can exacerbat e this marginalization . Th e consequenc e i s tha t couple s ma y vie w th e first dolla r earned by a secondary worker as taxed at the marginal rate of the primary worker. Because it is more likely that secondary workers are marrie d women , i t i s mor e likel y tha t th e incidenc e o f thi s hig h marginal tax rate falls on them. This high rate of taxation, in conjunc tion with the relatively high labor supply elasticity of married women , helps to create barriers to the entry of married women int o the workforce an d thereb y serve s t o perpetuat e thei r marginalize d statu s a s workers.67 Despite th e uncontrovertibl e evidenc e o f th e marginalizatio n o f women i n th e workplac e cause d b y taxatio n o f marrie d couple s a s units, scholars who have challenged the current system of joint taxation have tended to approach the fiction with deference. Professor Pamela B. Gann, fo r example , argues tha t w e shoul d abando n join t taxatio n i n part becaus e o f the cost s to women i n th e workplace. 68 However , she treats the fiction o f marital unity cautiously and pays obeisance to it as an establishe d principl e o f taxatio n b y carefully marshalin g al l of he r arguments agains t it. 69 Professor Marjori e Kornhauser , who advocate s that marrie d peopl e be taxed individually , has studied empiricall y th e assumption underlyin g th e fictio n tha t marrie d couple s shar e thei r income.70 It seems the fiction ha s become so powerful tha t only scientific evidence can debunk it. In th e estat e tax , the fictio n o f marita l unit y ha s give n ris e t o th e principle that a s long as wealth transfers b y the marital unit ar e taxed only once, the allocatio n o f property right s within th e marital uni t i s irrelevant. Unde r th e aegi s o f th e QTI P rules , the dowe r transfe r ha s reascended to perpetuate the customary pattern of wealth transmission under which me n retai n contro l o f the ultimate dispositio n o f wealth and wome n no t onl y lac k control , but ar e viewe d a s undeservin g o r incapable wealth holders.71 I have argued elsewhere that the QTIP rules, along with other estate tax provisions buil t upo n th e fictio n o f marita l unity , undermine th e prospect o f women's achievin g equal status with me n a s wealth hold ers.72 Curiously , the empirica l evidence , however, appear s t o indicat e the opposite . Interna l Revenu e Servic e (IRS ) dat a appea r t o indicat e that wome n hav e becom e wealthie r i n recen t years . In 196 9 th e IR S reported tha t approximatel y 3 8 percen t o f th e to p 9 millio n wealt h

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holders were women.73 In 1989 the IRS reported that approximately 42 percent o f the top 3. 4 million wealth holders were women. 74 The idea that wome n ar e increasingl y wealth y ha s permeate d th e popula r press.75 Th e data , however , ar e misleading . The y obscur e th e tru e wealth holding s o f men an d wome n becaus e they are based o n estat e tax returns . On thes e returns , QTIP propert y i s now include d i n he r estate and accounted fo r a s her wealth. The effect o f this decision is to inflate th e wealt h holding s o f wome n artificially . (Wome n ar e mor e likely to be beneficiaries o f QTIP trusts, because women have a longer life expectancy than men and tend to be younger than their husbands.) At the same time, property transferred to a QTIP trust by a male decedent is excluded from hi s estate, even though h e may retain control of the ultimate disposition o f the property. The effect o f this is to under state the wealth holdings of men. To the uninitiated, women appear to be gaining ground . I n reality , we simply d o no t know . The fiction o f marital unit y ha s eliminate d ou r abilit y t o measure. 76 Throug h th e QTIP trust, the fiction has create d a n illusor y clas s of women wealt h holders. The purpose of this essay was to trace the development of the fiction of marital unit y in tax and t o demonstrat e it s dangers. As Bentham an d Maine might have predicted, the fiction of marital unity has obscured the costs of implementing the fiction and has hindered an appropriat e policy analysis. Once married men were deemed to share their incom e with their wives for income tax purposes, there no longer was an incentive for the m actuall y to shar e either by contract o r pursuan t t o stat e property laws . Onc e transfer s mad e b y eithe r husban d o r wif e wer e treated a s a transfer b y the marital unit , it no longer mattere d fo r ta x purposes that the husband would control the transfers. As Gray and Fuller warned, much of the danger of the fiction arises from th e failur e o f thos e relyin g upo n i t t o recogniz e it s fictional nature. On som e level, policymakers an d academic s seemed to believe that the fiction was true, that al l equal income couple s were equal fo r tax purposes, no matte r ho w the rights to that incom e were allocate d between husban d an d wife . The y seeme d t o believ e tha t taxin g th e wealth transfers b y the married coupl e should b e the same no matte r how control of that wealth was allocated between husband and wife. The fiction of marital unity continues to exert its influence toda y in

FICTION I N TA X 4

perpetuating th e dominance o f men a s earners and wealth holders. In describing th e medieva l fictio n o f marita l unity , a Charle s Dicken s character said , "[I]f th e law supposes t h a t . .. the n the law is an ass." 77 Modern ta x la w continue s t o embrac e thi s fiction , whic h no t onl y attests to its remarkable ability to endure but also stands as a reminder that our law, like that referred t o by Dickens, sometimes deserves to be called what it is. NOTES I am grateful t o Stephe n Garvey , Michael Klausner , and th e participants i n the University of Minnesota La w School's Taxin g America conferenc e fo r thei r helpfu l comment s o n earlie r ver sions of this essay. I also thank Christine Chase for her research assistance. 1. See Louise Harmon , Falling Off the Vine: Legal Fictions and the Doctrine of Substituted Judgment, 10 0 Yal e L.J . 1 (1990 ) (describin g th e histor y o f th e lega l fictio n debate) ; see also Theodore Silver , One Hundred Years of Harmful Error: The Historical Jurisprudence of Medical Malpractice, 199 2 Wis. L. Rev. 1193 n.20; Note, Expounding the Constitution: Legal Fictions and the Ninth Amendment, 78 Cornell L. Rev. 139,140-47 (1992). 2. 5 Jerem y Bentham , Elements of Packing As Applied to Juries, in Th e Work s o f Jerem y Bentham 92 (John Bowring ed., 1843) [hereinafte r Bentham] . 3. John Hamilton Baker, An Introduction to English Legal History 141 (3d ed. 1990). 4. Treas. Reg. §1.451-2. 5. See, e.g., William Blackstone, Commentaries on the Law of England 43 (1768). 6.1 Jeremy Bentham, A Fragment on Government, in Bentham, supra note 2, at 235 n.s. 7. Henry Maine, Ancient Law, in The Problems of Jurisprudence 371 (Lon Fuller ed., 1946). 8. John C. Gray, The Nature and Sources of the Law 37 (1921). 9. Id. 10. Lon Fuller, Legal Fictions 10-11 (1967). ll.Treas. Reg. §1.451-52. 12.I.R.C.§902. 13. E.g., Rev. Rul. 67-448,1967-2 C.B. 144. 14. Poev. Seaborn, 282 U.S. 101 (1930). 15. See generally Paula England, Households, Employment and Gender: A Social, Economic, and Demographic View (1986); Victor R . Fuchs, Women's Quest for Economic Equality (1988); Juanita M. Kreps, Sex in the Marketplace: American Women at Work (1971); Robert J. Lampman, The Share of Top Wealthholders in National Wealth (1962) ; Phylli s M . Palmer , Domesticity and Dirt: Housewives and Domestic Servants in the United States, 1920-1945 (1989). 16. Lucas v. Earl, 281 U.S. 111 (1930). 17. See Division of Tax Research, Dept. of Treasury, The Tax Treatment o f Family Income, in Revenue Revision s 1947-48 : Hearings Befor e th e Comm . o n Way s and Mean s o n Communit y Property and Family Partnerships, 80th Cong., 1st Sess. 846,867-69 (1947). 18. See, e.g., Estate of Lee v. Commissioner, 11 T.C . 141,144-45 (1948). 19. See Reduction o f Individua l Incom e Taxes : Hearing s o n H.R . 479 0 Befor e th e Senat e Comm. on Finance , 80th Cong. , 2d Sess . 26 (1948 ) [hereinafte r Senat e Hearings ] (statemen t o f John W. Snyder, secretary of the treasury).

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20. Revenue Act of 1942 , Pub. L. No. 77-753, § 402(b), 56 Stat. 798,942 (amending § 118(e) of the 1939 Code; repealed 1948). 21. See, e.g., Revenue Revisions, 1947-48: Hearings Before the Comm. on Ways and Means on Community Propert y an d Famil y Partnerships, 80th Cong. , 1s t Sess. 776-93 (1947 ) [hereinafte r 1947 Hearings ] (statement s o f Charle s E . Dunbar, Jr. , and Joh n G . Wisdom, attorney s fo r th e Louisiana Communit y Propert y Taxpayer s Committee) ; Senat e Hearings , supra note 19 , at 33 7 (statement of J. P. Jackson, representing State Rights Association of Houston, Texas). 22. See Revenue Revisions, 1947-48: Majority Repor t of the Special Tax Study Comm. Report to the Comm. on Ways and Means 1,12 (1947 ) [hereinafte r Specia l Report]. 23. See Revenue Act of 1948 , ch. 168, §§ 301-5,62 Stat. 110,114 (codified a s amended in scattered sections of 26 U.S.C.). 24. Id. at § 351 (b), 62 Stat, at 116. 25. See Revenue Revisions, 1947-48: Minority Report of the Special Tax Study Comm. to the Comm. o n Way s and Mean s 35 , 40 (1947 ) [hereinafte r Minorit y Report ] (describin g th e join t return as a "poorly disguised measure[]" to relieve high-income groups). 26. H.R. Rep. No. 1274, 80th Cong. , 2d Sess. 22-23 (1948) ; S. Rep. No. 1013 , 80th Cong. , 2d Sess. 23-24 (1948). 27. Special Report, supra note 22, at 12. 28. See id. 29. Id. (emphasis added). 30.1947 Hearings, supra note 21, at 914 (statement of Sen. Tom Connally of Texas). 31. See, e.g., id. at 834-35 (statemen t o f Wesley E. Disney, representing the Governor an d th e Tax Commission of the state of Oklahoma). 32. See, e.g., id. a t 77 5 (statemen t o f Charle s E . Dunbar , Jr. , attorne y fo r th e Louisian a Community Property Taxpayers Committee). 33. See, e.g., id. at 797 (memorandum o f James B. Howe, attorney, Seattle, Washington). 34. See id. at 11 (statement of John W. Snyder, secretary of the treasury). 35. Senate Hearings, supra note 19 , at 276 (statement of Paul J. Foley, attorney, CPA). 36. See Carolyn C. Jones, Split Income and Separate Spheres: Tax Law and Gender in the 1940s, 6 Law & Hist. Rev. 259 (1988). 37. See Message fro m th e Presiden t o f th e Unite d State s Returnin g Withou t Approva l H.R . 4790, 80th Cong. , 2d Sess . 4 (1948) [hereinafte r Messag e fro m th e President] ; Senate Hearings , supra note 19 , at 2 5 (statemen t o f Joh n W . Snyder, secretary o f th e treasury) ; Minority Report , supra note 25, at 59. 38. See Special Report, supra note 22, at 30. 39. See Message from the President, supra note 37, at 5; Minority Report, supra note 25, at 59. 40. See S. Rep. No. 1013, supra note 26, at 27-28. 41.1.R.C.§ 2056(b)(1). 42. Id. at § 2056(b)(5). 43. Charles Looker, The Impact of Estate and Gift Taxes on Property Disposition, 38 Cal. L. Rev. 44,62(1950). 44. Id. at 67. 45. John W. Beveridge, The Estate Tax Marital Deduction—Beneficent Intent, Baneful Result, 44 Taxes 284 (1966). 46. John J. Waldron, Implications of the Marital Deduction, 87 Tr. & Est. 523,523 (1948). 47. Stanley S. Surrey, Federal Taxation of the Family—The Revenue Act of 1948,61 Harv. L. Rev. 1097,1117(1948). 48. Senate Hearings, supra note 19 , at 26 (statement of John W. Snyder).

FICTION I N TA X 4

49. Stanley S. Surrey, An Introduction to Revision of the Federal Estate and Gift Taxes, 38 Cal. L. Rev. 1,14(1950). 50. Senat e Hearings , supra note 19 , at 31 6 (statemen t o f Alla n H . W . Higgins , chairman , American Ba r Association , Ta x Section , Committe e o n Equalizatio n o f Taxe s i n Community Property and Common-Law States). 51. Surrey, supra note 47, at 1162. 52. Surrey, supra note 49, at 14. 53. Economic Recovery Tax Act of 1981 , Pub. L. No. 97-34,95 Stat. 172. 54.1.R.C. § 2056(a). 55. Id. at § 2056(b)(7). 56. Id. at § 2044. 57. S. Rep. No. 144, 97th Cong., 1st Sess. 127 (1981), 1981-2 C.B. 412; H.R. Rep. No. 201, 97th Cong., 1s t Sess . 15 9 (1981) , 1981- 2 C.B . 352 ; Staf f o f Join t Comm . o n Taxation , Genera l Explanation of the Economic Recovery Tax Act of 1981,23 3 (Comm. Print 1981). 58. See, e.g., H.R. Rep. No. 201, supra note 57 at 160 ; Staff o f Joint Comm. on Taxation, supra note 57, at 234. 59. S. Rep. No. 144, supra note 57, at 127. 60. Howard E. Abrams, A Reevaluation of the Terminable Interest Rule, 39 Tax L. Rev. 1, 12-13 (1983). 61. Joseph Isenbergh , Simplifying Retained Life Interests, Revocable Transfers, and the Marital Deduction, 51 U. Chi. L. Rev. 1,32 (1984) . 62. Harr y L . Gutman, Reforming Federal Wealth Transfers after ERTA, 69 Va. L. Rev. 1183, 1220-21(1983). 63. Estate Tax Marital Deduction, 239-4th Tax Mgmt. Portfolio (BNA) , at A-58(3) (1990). 64.Jd.atA-42(1990). 65. The Uses of a QTIP Trust, 1 Tax Ideas f 42 2 (1990). 66. Boris I. Bittker, Federal Income Taxation and the Family, 27 Stan. L. Rev. 1389, 1395 (1974) (citation omitted). 67. See Edward J. McCaffery, Taxation and the Family: A Fresh Look at Behavioral Gender Biases in the Code, 40 UCLA L. Rev. 983 (1993); see also Edward J. McCaffery, Slouching towards Equality: Gender Discrimination, Market Efficiency, and Social Change, 103 Yale L.J. 595,600-35 (1993). 68. Pamela B. Gann, Abandoning Marital Status as a Factor in Allocating Income Tax Burdens, 59 Tex. L. Rev. 1,39-46,67 (1980). 69. Id. at 7,25. 70. Marjorie E . Kornhauser, Love, Money, and the IRS: Family, Income-Sharing, and the Joint Income Tax Return, 45 Hastings L.J. 63 (1993). 71. See Mary Louise Fellows, Wills and Trusts: The Kingdom of the Fathers, 10 Law & Ineq. J. 137 (1991); Wend y C . Gerzog , The Marital Deduction QTIP Provisions: Illogical and Degrading to Women, 5 UCLA Women's L.J. 301 (1995). 72. Lily Kahng, Gender Inequality and the Marital Deduction (unpublished manuscrip t o n fil e with author). 73. Se e Interna l Revenu e Service , U.S . Treasur y Department , Supplementa l Statistic s o f Income—1969: Personal Wealth, tables 2, 3 (of the top 9 million wealth holders in 1969 , 5.6 million were men and 3.4 million were women). 74. Barry W. Johnson & Marvin Schwartz, Internal Revenue Service, Personal Wealth, 1989,12 Stat. Inc. Bull. 105 ( Spring 1993). 75. See, e.g., Gar y Belsky , The Five Ways Women Are Often Smarter Than Men about Money, Money, June 1992 , at 75; Anne Matthews, Alma Maters Court Their Daughters, N.Y. Times, Apr. 7,

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1991, at § 6, at 40; Penelope Wang, Brokers Still Treat Men Better Than Women y Money, June 1994, at 108; Women: Financial Planners Turn to Untapped Market, Chi. Sun-Times, July 2,1995, at 37. 76. See Telephone Interview with Barry Johnson (Oct . 10,1995) (notin g that the IRS statistics do not reflec t distortion s cause d by the QTIP rules); but see Johnson & Schwartz, supra note 74, at 11 1 n. 11 (noting tha t th e 198 1 changes i n th e estat e ta x law s ma y affec t pattern s o f wealt h dispositions). 77. Charles Dickens, Oliver Twist 354 (Kathleen Tillotson ed., 1966).

2 DOROTHY A . BROW N

The Marriage Bonus/Penalty in Black and White

A marriag e penalt y occur s wheneve r a coupl e pays higher federal income taxes as a result of their marriage than they would pay if they remained singl e and filed individua l returns. A marriage bonus occurs whenever a couple pays lower federal incom e taxes as a result of marriage than they would pay if they remained single and filed individual returns. Marriage penalties are the greatest where there are two wage earners; marriage bonuses are the greatest where there is only on e wage earner. Although numerou s article s hav e been writte n about the marriage penalty, this essay provides a different perspective. 1 Here I will discuss the difference s betwee n blac k an d whit e house holds and will show how the tax consequences of marriage tend to differ fo r taxpayer s o f differen t races . Black taxpayers ar e mor e likel y to pay a marriage tax, whereas white taxpayers are more likely to receive a marriage bonus. 2 I will examin e th e ta x consequence s o f th e marita l decision i n the contex t o f curren t la w as well as in th e contex t o f th e Contract wit h America Ta x Relief Act of 199 5 (H.R . 1215) , as of thi s writing th e mos t recen t legislativ e proposa l t o addres s th e marriag e penalty. The first section describes how the marriage penalty currently operates under the Internal Revenue Code. It then explain s how H.R. 121 5 45

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would chang e current law . The second section , "The Tax Implications of the Marriage Decision," examines current dat a showing several differences observed in black and white households. It then analyzes that data to show the differing effect s o f the decision to marry on black and white households. The last section offers a method fo r eliminatin g the penalty associated with the decision to marry.

T H E MARRIAG E BO N US/PENALT Y

Empirical evidence suggests that economic factors, including tax liabilities, play a role in the decision to marry. 3 Accordingly, it is important to examine the circumstances under which a couple's tax liabilities can increase or decrease as a result of their decision to marry. Operation of the Marriage Bonus/Penalty The Interna l Revenu e Cod e i s no t marriag e neutral . Thi s i s a n unavoidable consequence , give n th e Code' s curren t structure . N o income tax system that both i s progressive and permits joint filing by married couples can be marriage neutral.4 All unmarried couples (both same-sex and opposite-sex) mus t file as two single persons. They cannot take advantage of the marriage bonus, nor can they suffer an y marriage penalty.5 The operation of the marriage bonus/penalty is set forth in the chart below.6 The calculations for the chart were made in the following man ner. The income tax is computed for two taxpayers filing as single persons and then as a married couple filing jointly. The difference betwee n the ta x liabilitie s i s th e marriag e penalt y o r bonu s indicate d i n th e chart. Fo r th e computations , th e taxpayer s wer e assume d t o hav e n o dependents o r exces s itemized deduction s an d t o be under th e ag e of sixty-five.7 As noted in the chart, the marriage penalty is greatest where total household income is split equally between the spouses.8 The marriage bonus is greatest where total household income is earned by only one wage earner. 9 However, these bonuses or penalties are not distrib uted evenl y across th e chart . Fo r example , the marriag e penalt y doe s not begin unti l one spouse earns 20 percent o f what the other spous e earns.10 In addition, lower-income taxpayers otherwise eligible for th e

THE MARRIAG E BONUS/PENALT Y 4

earned incom e ta x credi t ge t a smalle r credi t amoun t o r n o credi t amount a s a resul t o f th e decisio n t o marry . Th e earne d incom e ta x credit aggregates the incomes of husband and wife, which reduces benefits an d thereb y produce s a marriag e penalty. 11 Fo r certai n low income families, the marriage penalty can exceed $3,000.12 THE MARRIAGE TAX (PENALTY)/BONUS BY INCOME & ALLOCATION BETWEEN SPOUSES/SINGLES (1993) INCOME ALLOCATION 0%/100%

10%/90%

20%/80%

30%/70%

40%/60%

$20,000 $30,000

728 968

428 278

128

(173)

$40,000

1,148 1,882

(173) 321

(180) (180)

$50,000

2,268 3,282

(180) (180) (180)

1,075

425

(226)

(466)

$60,000

3,296

1,602

815

35

(1,285) (1,285)

Income $10,000

50%/50% (612) (180) (180) (180)

$70,000

3,596

1,568

555

(356)

(746) (1,266)

$80,000

3,896

1,708

428

(746)

(1,285)

(1,285)

$90,000

4,196

1,848

408

(1,032)

(1,285)

$100,000 $125,000 $150,000

4,497 4,695 5,945

1,990 1,590 1,887

390

(1,270) (1,570) (1,857)

(1,285) (1,284)

(411) (970)

(970) (1,195) (1,420)

$200,000 $500,000

5,990 6,164

(4,203)

(84) (8,789)

(3,364) (11,642)

(4,312) (13,442)

882

(1,857) (1,859) (4,312) (15,024)

To summarize , ther e i s alway s a marriag e penalt y fo r two-wage earner couple s wh o ear n roughl y equa l amounts . Ther e i s alway s a marriage bonus for single-wage-earner couples. Marriage Penalty Relief under H.R. 1215 H.R. 121 5 includes a marriage penalt y relief provision . Section 10 2 of the bill would provid e taxpayers with a nonrefundable credi t u p t o $145, whic h the y coul d us e t o offse t an y marriag e penalt y incurre d from bot h spouse s working. 13 Th e state d reaso n fo r th e chang e i s a concern "about the inequities of the marriage penalty and the potential work disincentive it causes."14 An additional stated reason is that "marriage penaltie s i n th e ta x law s undermin e respec t fo r th e famil y an d may discourage family formation." 15 A quick review of the chart above

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will establish tha t a $145 tax credit will reduce substantiall y th e mar riage penalty for most couples earning less than $50,000. 16 The propose d credi t i s limite d t o marrie d taxpayer s filin g a join t return wh o are subject t o the marriage penalty. The credit i s designed to assis t onl y those taxpayer s subjec t t o th e marriag e penalt y i n two wage-earner households . No t ever y coupl e subjec t t o th e marriag e penalty will receive a credit of $145. The legislative history does not discuss how Congress arrived at this figure other than by noting a desire to limit the cost to the Treasury to four billion dollars per year.17 Initially i t wa s thought tha t taxpayer s woul d b e require d t o mak e several calculations i n orde r t o determin e what portion , if any, of th e tax credit was available to them.18 The House, however, recently included in the relief provision a directive to the secretary of the treasury to provide a table tha t include s thos e calculation s t o assis t taxpayer s i n determining th e portion , i f any, of th e $14 5 nonrefundable credi t fo r which they would be eligible.19 As a result, taxpayers could simply look at the table to find the appropriate figure. However, the secretary of the treasury has not announced how the department will address the diffi cult issue of allocating deductions paid for by the husband and wife in those table calculations.20

T H E TA X I M P L I C A T I O N S O F T H E MARRIAG E D E C I S I O N

This section considers the effects of the marriage decision by examining the differences betwee n white and black households. The evidenc e suggests that ther e i s a difference i n th e impac t o f bot h th e marriag e bonus an d th e marriag e penalt y base d upo n race . Blac k familie s ar e more likely to pay a marriage penalty; white families ar e more likely to receive a marriage bonus. My analysis is limited to an investigation o f the differences betwee n black and white households. Without question, a richer, more complete examination ultimatel y mus t includ e Hispanic , Asian , Nativ e American, and other racial or ethnic groups. In that regard this essay is intended only as a first step in considering the racial and gender implications o f th e rat e structure . Thi s essa y als o make s th e simplifyin g assumption that there are no racially mixed households. That assump-

THE MARRIAG E BONUS/PENALT Y 4

tion does not distort the picture much, given that in 1985 , 98.9 percent of black married women and 96.6 percent of black married men had a black spouse.21 The Internal Revenu e Servic e does not kee p statistical informatio n according t o race , but th e Censu s Burea u an d th e Burea u o f Labo r Statistics do. Relying on their data, this section will begin by describing how married black women participate in the workforce a t higher rates than marrie d whit e women . I t als o wil l sho w tha t marrie d blac k women contribute a higher percentage of total household income than married whit e wome n an d tha t wag e discriminatio n result s i n whit e men's earnin g mor e tha n whit e women, black men , or blac k women . Finally, this section will demonstrate that because of the marriage rate for black women relativ e to that fo r whit e women, a disproportionat e number of black women are single heads of household, which suggests yet another path of inquiry. One commentato r estimate d tha t i n 199 4 th e averag e marriag e penalty pai d b y American couple s woul d b e $1,24 4 an d th e averag e marriage bonu s receive d b y America n couple s woul d b e $1,399. 22 Those figures mas k the racial and gende r implication s o f the joint ta x return. Furthe r analysi s o f th e dat a indicate s tha t blac k couple s ar e more likely to pay a marriage penalty, whereas white couples are more likely to receive a marriage bonus. Labor Force Participation Rates Based upon Gender and Race Black women historically have entered the workforce in larger numbers than whit e women an d hav e staye d ther e longer. 23 A 199 0 stud y showed tha t 7 3 percent o f marrie d blac k wome n wer e i n th e wage d labor force, compared to 64 percent for married white women.24 If the marriage penalt y exist s onl y i n household s o f two-wage-earne r cou ples, married black couples, with a higher percentage of two wage earners, ar e mor e likel y t o pa y a marriag e penalt y tha n whit e couples . Conversely, married white couples are more likely to receive a marriage bonus. A recent study found that married black women contribute approximately 40 percent o f their household's income. Married white women contribute only 29 percent of their household's income. 25 These statis-

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tics suggest that black couples not only are more likely to suffer a marriage penalty , bu t als o tha t the y wil l ten d t o pa y mor e i n marriag e penalties than their white counterparts with equal household income. 26 That stud y is valuable no t onl y for revealin g that women' s rate s of contribution t o household incom e vary across race but als o for high lighting gender essentialism in the tax literature. Married black women contribute a significant portio n o f total household income . Assuming that 40 percent is the average household contribution of married black women, it is possible, perhaps even probable, that certain married black women contribut e mor e tha n 4 0 percent o f tota l househol d income . Accordingly, marrie d blac k wome n canno t unequivocall y b e consid ered a marginal second wage earner in the way that curren t tax literature treat s al l marrie d women. 27 Fo r example , Professo r McCaffer y recently described working married women as follows: "[Historically, of course, wives have usually been the marginal earners .... [MJarrie d working women earn , on average, forty-six percen t o f what their husbands do." 28 McCaffery' s statistic s ma y b e mor e appropriat e whe n applied t o whit e marrie d women , althoug h h e di d no t s o limi t hi s analysis. If a significant portio n o f marrie d blac k wome n ear n mor e than 50 percent of household income, however, they cannot be considered margina l earners . Give n th e vas t difference s betwee n blac k an d white women' s workin g experiences , average s o f th e sor t McCaffer y used are wholly inadequate in understanding the operation of the joint tax return and suggest a path for future inquiry . If any group is likely to view themselves and be viewed as marginal wage earners, it is married white women, who on average contribute 29 percent o f tota l househol d income . Although blac k couple s ar e mor e likely to suffe r a marriage penalty , within th e marita l uni t i t i s white women as marginal wage earners who are more likely to feel the greater impact of the marriage penalty. This is so because as a marginal earner, the couple may understand the wife's wages as taxed at the highest marginal tax rate.29 In addition, if the marginal wage earner is a mother of young children, the couple also may view the increased child care costs as a n adde d cos t o f he r working. 30 O f course , this understandin g o f child care costs erroneously assumes that they are the costs of the working mother an d no t o f the working father. 31 Th e Code treats a famil y member's performance o f household services , including chil d care , as

THE MARRIAG E BONUS/PENALT Y 5

nontaxable imputed income . To the extent that married white couples are mor e likel y t o hav e onl y on e wag e earner , wit h th e wif e stayin g home and providing unwaged labor, the Code is more likely to reward them doubly . Not onl y are white couple s mor e likel y to enjo y a mar riage bonu s becaus e o f thei r househol d arrangement ; the y ar e mor e likely to enjoy an imputed income bonus from i t as well. Another importan t aspec t o f th e concep t o f th e margina l wag e earner concern s nontaxabl e impute d income . These tax bonuses ma y explain in part the differing labor participation rate s between marrie d black and white women. Married white women, as a result of their status as marginal wage earners, are more likely to support thei r familie s by providing nontaxed labor, such as child care. Given that black men may contribute less than 50 percent of household income, any analysis of the marginal wage earner in married black households would seem suspect. However, such an analysis surprisingly might revea l tha t blac k men , a s secondar y wag e earners , ar e mor e affected b y the marriage penalty than black women. This sort of analysis might provide one explanation fo r the declining labor participatio n rates of black men in recent years.32 Workforce participatio n fo r al l men, however, has declined over the past two decades, although this decline is more dramatic for black men than for white men. 33 Among younger white men, extended educatio n has been the primary cause for th e decline in their labor force participation. That explanation doe s not hold for black men, however, whose educational enrollments have declined. 34 The decline in labor participation rate s among black men als o may affect blac k women' s wage d labo r participation . Blac k women , wh o contribute 4 0 percent o f their households ' income, are less likely than white women t o be able to afford t o stay at home and rais e their chil dren while their husbands provide all of the family's waged income. The difference s i n wage d labor participatio n betwee n blac k an d white familie s jus t describe d shoul d no t b e viewe d a s static . Recen t trends indicate that more married white women are entering the labor force. Those trend s ar e attributabl e partially t o th e growin g nee d fo r both spouses to work for the couple to maintain the wage growth previously enjoye d b y traditiona l white , one-wage-earne r households. 35 Moreover, as a consequence of continuing efforts towar d wage equality

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5 2 DOROTH

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in the workforce across gender and race lines, it may be that more white couples in the future wil l suffer th e marriage penalty at rates similar to those historically experienced by married black couples. Wage Rates Based upon Gender and Race A more complete picture of the racial implications o f the marriag e bonus/penalty require s a n investigatio n o f th e difference s i n taxabl e income between blac k and white households. 36 As noted above , black families ar e more likely to pay a marriage penalty than whit e familie s because blac k wome n ten d t o contribut e a large r portio n o f thei r households' income than white women. One reason behin d tha t phe nomenon is employment discrimination . On average, black women's earnings are closer to black men's earnings than whit e women' s earning s ar e t o whit e men' s earnings. 37 Fo r every dolla r earne d b y a white man , a white woma n earne d 78C, 38 a black man earned 74.8C, 39 and a black woman earned 664. 40 Therefore, due to wage discrimination, even if all married women participated i n the labor force at the same rates, black families still would be more likely than whit e families t o pay a marriage penalty. Wage discriminatio n causes blac k me n an d wome n t o ear n roughl y equa l amounts , o r a t least amounts more equal than the amounts earned by white men an d women. Wage discrimination, o f course, is not th e only factor tha t tend s to equalize earnings between spouses in black families. High labor participation rate s b y black wome n als o ten d t o equaliz e spousa l earnings . The combination o f wage discrimination an d th e higher incidenc e o f two-wage-earner household s mean s tha t blac k me n an d wome n ten d to contribute nearly equal amounts to total household income. Within the U.S. tax rate structure, that means that black families are more likely to pay the highest marriage penalty, which occurs when total household income is split equally between the two spouses. Although wag e discriminatio n penalize s blac k families , i t benefit s white families. White me n ar e more likely than blac k men t o ear n a n income on which their families ca n live. This allows white women th e opportunity to remain at home and gives the opportunity for the couple to enjoy untaxed imputed income. Wage discrimination, then, helps to explain the differing rate s of contribution to total household income

THE MARRIAG E BONUS/PENALT Y 5

between blac k and whit e marrie d women . It als o helps to explai n th e differing labor participation rate s of black and white married women . Given whit e men' s wages , the lo w wages o f whit e wome n relativ e t o those o f white men , and th e ta x treatment o f impute d income , white married women's decisions to work outside the home are less likely to be related to economic survival than to personal preference. Thus, marriage acts to reduce the labor force participation rate s of white women, but not of black women.41 Although the impact of the marriage penalty is felt most severely by black families, as more white families have second earners in the labor force, i t wil l becom e a problem fo r whit e familie s a s well. Given th e decreased labor participation rates of white men and the fact that white women are being employed in areas that once were the province only of white men , whit e familie s ar e mor e likel y t o hav e tw o wag e earners . That means that in the forseeable future mor e white families may suffer the marriage penalty. Head of Household Rate Differences Based upon Race Married-couple familie s ar e muc h mor e economicall y prosperou s than familie s heade d b y women. As a result , th e increasin g number s of blac k single-paren t household s ha s cause d th e blac k povert y rate s to soar. 42 Although one study found tha t 55 percent of families headed by white women wer e either poo r o r ver y poor, i t als o foun d tha t 8 0 percent of families headed by black women were in poverty.43 That percentage for black women takes on special significance becaus e only 36 percent of black women were in married-couple households. 44 Thus, a substantial number of black women are heads of household. These statistics intensif y th e urgenc y fo r scrutinizin g federa l incom e ta x law s that penalize black women for marrying. The experience of black women in the labor market has been differ ent from tha t o f white women an d mus t be viewed separately. 45 Black female heads of household experience extreme poverty in part because of th e wag e discriminatio n tha t blac k wome n face . Unlik e blac k women, white women have entered middle-incom e jobs, 46 and durin g the 1980 s the y wer e mor e successfu l tha n blac k wome n i n breaking the glas s ceiling. 47 Mos t o f blac k women' s gain s i n th e employmen t sector have come in low-wage jobs, which helps to account for the dis-

3

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proportionate numbe r o f blac k femal e head s o f househol d i n pover ty.48 Black women have been concentrated in a few occupations with a very narrow wage range.49 Even controlling for the effects o f education, black women suffe r wag e discrimination i n areas where white women do not. 50 ENDING T H E MARRIAG E BO N US/PENALT Y

In 1986 , when th e marriag e penalt y deductio n wa s eliminated, th e marriage tax penalty had a remarkably low profile.51 Perhaps if the profile of the issue were raised, alternative proposals could be considered . Given the rhetoric of family values, if the marriage penalty is contributing to the disintegration of the family, whether it is black or white families, it should be eliminated once and for all. Since the marriage penalty occurs whenever there is a progressive tax system tha t permit s joint filing , ther e ar e three way s to eliminat e th e marriage bonus/penalty . Th e firs t i s by abolishing th e progressive ta x system and replacing it with a flat ta x system. Under a flat tax, neither spouse woul d b e penalize d b y paying taxe s a t a higher rat e tha n th e other. The second is through abolishin g the joint return . If tax returns were calculated for everyone on a single return basis, there would be no marriage bonus/penalt y becaus e liabilit y fo r a n individua l taxpaye r would not change upon his or her decision to marry. A third an d les s drastic alternative would be to target th e marriag e penalty relie f bette r t o thos e wh o pa y the highes t penalty , namel y t o those couple s whose income s ar e equal. In addition , som e consideration shoul d b e give n t o eliminatin g th e marriag e bonus , a t leas t fo r couples in high-income brackets. By eliminating or reducing the mar riage bonus/penalty, the tax law would be acknowledging and counter acting marketplace wag e discrimination base d o n gende r an d race . In contrast, t o leav e the marriag e bonus/penalt y intac t serve s to exacer bate marketplace wage discrimination. Understood fro m thi s perspective, the choice is clear.

THE MARRIAG E BONUS/PENALT Y 5

NOTES I would like to thank the participants at the University of Minnesota's Taxing America confer ence for thei r helpfu l comment s o n a n earlie r draft . A special thank s to Jerome McCrista l Culp , whose earlie r challeng e inspire d this essay . I would als o lik e to than k Mr . Rick Gohee n an d th e Institute for Policy Research for their research assistance. 1. See, e.g., Boris I . Bittker , Federal Income Taxation and the Family, 27 Stan . L . Rev. 138 9 (1975); Marjorie E . Kornhauser, Love, Money, and the IRS: Family, Income-Sharing, and the Joint Income Tax Return, 45 Hastings L.J . 63 (1993); Edward J . McCaffery, Taxation and the Family: A Fresh Look at Behavioral Gender Biases in the Code, 40 UCLA L. Rev. 983 (1993); Lawrence Zelenak, Marriage and the Income Tax, 67 S. Cal. L. Rev. 339 (1994). 2. See Nancy Staudt , Taxing Housework, 84 Geo . L.J . 157 1 (1996 ) (discussin g difference s between black and white women that previously have been ignored by tax scholars). Since submitting this essay for th e anthology, I have come to understand tha t Professo r Beverl y Moran o f the University o f Wisconsin La w School i s engaged i n a long-term projec t explorin g issue s of class, race, and gender in the tax law that considers the operation of the joint tax return as well as many other issues. 3. See James Aim & Leslie A. Whittington, Marriage and the Marriage Tax, in 199 2 Nat'l Tax Ass'n.Proc. 200 (1992). 4. See Bittker, supra note 1 , at 1395-96. 5. Se e 4 Bori s I . Bittker & Lawrence Lokken , Federa l Taxatio n o f Income , Estate s an d Gift s §111.3.6 (1992); Patricia A. Cain, Same-Sex Couples and the Federal Tax Laws, 1 La w 8c Sexuality 97 (1991); Toni Robinson & Mary Moers Wenig, Marry in Haste, Repent at Tax Time: Marital Status as a Tax Determinant, 8 Va. Tax Rev. 773, 792-95 (1989). 6. See John Brozovsky & A. J. Cataldo II, The Marriage Tax Penalty: Inequities and Tax Planning Opportunities, 52 Ohio CPA J. 21, 22 (Dec. 1993) (chart in text reprinted with permission of publisher). 7. Id. at 21. 8. See John Brozovsky & A. J. Cataldo II, An Historical Analysis of the Marriage Tax Penalty, 21 Acct. Historians J. 163,166 (1994). 9. Cf. Laura Ann Davis, Note, A Feminist Justification for the Adoption of a Joint Filing System, 62 S. Cal. L. Rev. 197,205 (1988) (pointing out that at the adoption of the joint filing requiremen t in 1948,8 0 to 85 percent of married couples had only one wage earner). 10. See McCaffery, supra note 1 , at 1016. 11. See M*. at 1015. 12. See Daniel R . Feenberg & Harvey S. Rosen, National Burea u o f Economi c Research , Inc., Recent Developments in the Marriage Tax 6-7 (Workin g Paper No. 4075) (1995). 13. H.R. Rep. No. 1215,104th Cong., 1st Sess. 12-13 (1995). 14. Id. 15. Id. at 13. 16. See Feenberg & Rosen, supra note 12 , at 11. 17. H.R. Rep. No. 1215, supra note 13 , at 280. 18. See Hearing on Middle-Income Ta x Cut Proposal s Before th e Senate Comm. on Finance , 104th Cong., 1st Sess. 10,11-12,45,47-49 (1995 ) (statement of Deborah H. Schenk, AAA-Olincy Professor of Law, New York University School of Law) [hereinafter Schenk]. 19. H.R. Rep. No. 1215, supra note 13 , at 13. 20. See Schenk, supra note 18.

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21. Robert G. Wood, Marriage Rates and Marriageable Men: A Test of the Wilson Hypotheses, 30 J. Hum. Resources 163,172 (1995). 22. Feenberg & Rosen, supra note 12 , at 11. 23. See Bette Woody, Black Women in the Workplace 37 (1992). 24. U.S. Comm'n o n Civi l Rights, Staff Repor t o n the Economic Statu s of Black Women: An Exploratory Investigation 10 5 (1990); Staudt, supra note 2, at 1612. 25. U.S. Comm'n on Civil Rights, supra note 24, at 100, table 8.6. 26. See Chart supra. 27. See, e.g., McCaffery, supra note 1, at 994. 28. See id. 29. See Zelenak, supra note 1, at 365-66. 30. See id. at 372-75. 31. For further discussio n of child care costs, see Mary L. Heen, Welfare Reform, the Child Care Dilemma, and the Tax Code: Family Values, the Wage Labor Market, and the Race- and Class-Based Double Standard, this volume. 32. See Woody, supra note 23, at 147. 33. See id. 34. See id. 35. See id. at 9. 36. Cf Abigai l Thernstrom, Two Nations, Separate and Hostile? N.Y. Times, Oct. 12 , 1995, at A15 ("The median income of black married couples with children is now only slightly lower than that for all American families") . 37. See Steven A. Holmes, Census Finds Little Change in Income Gap between Races, N.Y. Times, Feb. 23,1995, at A10. 38. See Gary Belsk y & Susan Berger , Women Could Be Big Losers If Affirmative Action Falls, Money, Aug. 1995, at 20. 39. See Proponents, Opponents of Affirmative Action Point to Statistics, Dail y Rep . for Exec . (BNA), Aug. 2,1995, available in WESTLAW, at § C; see also Reynolds Farley, The Common Destiny of Blacks and Whites: Observations about the Social and Economic Status of the Races, in Race in America 197,206- 7 (Herber t Hil l & James E. Jones, Jr., eds., 1993) ("overall, fully employed black men in 198 8 earned about three-quarters as much as white men"). 40. See Belsky & Berger, supra note 38, at 20. 41. See Woody, supra note 23, at 41. 42. See Farley, supra note 39, at 213. 43. See id. at 213-17. 44. See Felicity Barringer , Marriage Study That Caused Furor Is Revised to Omit Impact of Career, N.Y. Times, Nov. 11,1989, at A10; Farley, supra note 39, at 212. 45. See Annette Bernhardt et al., Women's Gains or Men's Losses? A Closer Look at the Shrinking Gender Gap in Earnings, 101 Am. J. Soc. 302,325 (1995). 46. See id. at 320. 47. See id. at 324. Cf. Belsky & Berger, supra note 38, at 20 ("Largely overlooked i n the debate about 'equa l opportunity ' vs . 'preferential treatment ' i s that women , particularl y white women, have bee n amon g th e bigges t beneficiaries o f 3 0 years ' wort h o f affirmativ e action.") ; Sherr y Bebitch Jeffe, The State; Civil Rights; Don't Count on the Chief Beneficiaries of Affirmative Action to Rescue It, L.A . Times , Mar . 26 , 1995 , a t 6 ("Anothe r report , issue d b y th e Glas s Ceilin g Commission, a federal pane l establishe d fou r year s ago to monito r th e progres s o f wome n an d minorities in business and industry , adds punch t o the contention tha t white women hav e been the principal beneficiaries o f affirmative-action programs . White women now account for 40% of

THE MARRIAG E BONUS/PENALT Y 5

the nation's work force . . . an d hold almost 40% of middle-management jobs . African America n women and men are still greatly underrepresented i n these positions"). 48. See Bernhardt et al., supra note 45, at 321. 49. See Woody, supra note 23, at 37. 50. See id. at 26. 51. See Harvey S. Rosen, Thinking about the Tax Consequences of Marriage, 41 Nat'l Tax J. 259, 260(1988).

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3 JENNIFER J . S . BROOK S

Taxation and Human Capital

This essa y explore s ho w t o measur e an d ta x income fro m huma n capital . Huma n capita l incom e i s though t t o include the value of leisure, services performed fo r oneself, choice, and opportunity, as well as cash income from wages. In our current tax system, wage s ar e taxabl e whe n received . Th e othe r values , sometime s referred to as psychic income, are set aside in conventional applications of incom e theor y a s too murky , to o difficult , an d to o impractica l t o measure and to include in real-life taxable income.1 The question of the tax treatment o f human capita l income has new relevance as Congress debates switchin g fro m incom e taxatio n t o taxatio n o f consumption . Some theorists, most notabl y Louis Kaplow, seeking to apply a definition o f idea l incom e t o huma n capital , conten d tha t individual s ar e endowed a t birth wit h a stock of wealth equa l to the present value of their future wage stream and that the receipt of this wealth is income at birth.2 That interpretation , which this essay rejects, leads to the asser tion tha t huma n capita l i s seriously undertaxed—an assertio n that , if accepted, has important consequences for the design of the tax system. If the distinction between waged and nonwaged human capita l is to be useful, w e must fac e th e difficul t proble m o f definition . Th e com mon usag e i n th e ta x literatur e o f th e term s human capital, psychic 58

TAXATION AN D HUMA N CAPITA L 5

income, and leisure often i s imprecise. This essay limits the term psychic income to the consumer surplu s arisin g from enjoymen t an d confine s the term leisure to include both rest and activities chosen for the enjoyment tha t the y confe r upo n th e individua l engagin g i n them , fo r instance, reading a novel. A careful definitio n o f human capita l i s the central task of this essay. The idea l income/huma n capita l argumen t i s simple . Variousl y referred t o a s idea l incom e o r th e accretio n model , th e 193 8 Haig Simons definitio n o f incom e include s i n annua l incom e th e valu e o f personal consumption plus net savings, which can be either an increase or a decrease in wealth.3 Under the Haig-Simons definition o f income, the right t o receive future incom e is discounted t o present value. This present valu e i s includable i n th e yea r th e righ t i s established. Unde r Kaplow's interpretation o f ideal income, the present valu e of a n indi vidual's future wag e stream is includable as income at birth. He argues that thi s treatmen t taxe s huma n capita l i n a manne r identica l wit h material capital, which he claims to be an appropriate result. Why bother thinking about this highly rarefied theoretical definitio n of income? No one argues that it is feasible to predict at birth a n individual's future wag e stream, although Kaplo w has described a computation tha t increase s (supercounts ) actua l wages by a factor reflectin g deferral.4 There is, however, increasing congressional focus on the consumption tax , which treats receipts from materia l or human capita l as income when consumed. In the past, critics have called this approach a naked wage tax that is unfair t o those who consume their wage income and wh o canno t affor d t o ow n materia l capital. 5 Recently , Kaplo w invoked the ideal income argument concerning wage income as a theoretical basis to disfavor idea l income taxation an d t o prefer consump tion taxation. In an analysis resting on the Haig-Simons definition, h e suggests that th e current treatmen t o f wages as income when receive d undertaxes human capital income by more than 40 percent when measured by the standard of the ideal income tax base. Kaplow argues that the Haig-Simons model requires human capita l and material capital to be treate d alik e an d bot h t o b e treate d a s wealth . Hi s definitio n o f wealth is based on the economic premise that all factors contributing to the production o f wealth be included i n the tax base. Arguing that th e present valu e a t birt h o f futur e wag e income i s equal t o th e stoc k o f human capita l at birth and , therefore, constitutes income at that time ,

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Kaplow concludes that incom e from labor is seriously undertaxed. He acknowledges the difficulty o f collecting a tax on newborns by devising a system of proxy taxation, which uses a multiplier of 1.4 2 to tax wages when earned . Alternatively, he proposes tha t seriou s consideratio n b e given to the consumption tax, which would tax wages when consumed. Consumption taxation, he contends, would leave the current treatment of wage s unchange d fo r mos t taxpayer s (thos e wh o consum e thei r wages when received) and is logically preferable to the ideal income tax for anyone who favors taxing wages when received. The argument that ideal income treatment of human capital properly includes in income-at-birth th e present value of future wage s raises interesting questions about the Haig-Simons definition an d its application. The more important piece of Kaplow's argument, however, is the notion that the current income tax undertaxes human capital. Any sensible exploratio n o f thi s assertio n ha s t o conside r th e definitio n o f human capita l as generally applied by income tax theorists. This essay concludes that significant value s usually assumed to arise from huma n capital in fact attach to material capital. The association between these values and material capital not only supports current income tax treatment o f receipt s fro m materia l an d huma n capita l bu t als o justifie s modifications tha t would tax material capital more heavily in some circumstances. There i s no basi s t o conclud e tha t incom e fro m huma n capital is undertaxed by 40 percent or otherwise. Contrary to Kaplow's analysis, careful applicatio n o f ideal income theory offers n o basis fo r support o f consumptio n taxatio n b y thos e wh o favo r taxin g wage s when received.

T H E TAS K O F D E F I N I N G I N C O M E

A pur e o r idea l definitio n o f incom e tha t consistentl y an d fairl y includes all value creation probably is not possible, even in theoretical terms.6 Perfect measuremen t o f an individual's lifetime incom e migh t be possible only in a Rawls-inspired prebirth auction, where individu als who had tota l foreknowledg e o f future event s were able to bid fo r particular lives , including al l th e benefit s an d detriment s o f occupa tion, health, socia l status , and materia l wealth. 7 Th e price s se t by th e auction woul d b e considere d ne t income , and ta x would b e impose d

TAXATION A N D H U M A N C A P I T A L 6

and collected at birth. All other attempts at definition mov e very quickly from th e all-inclusiv e theoretica l t o th e fa r les s inclusiv e practical . Economic historians interested in the theory of the state assert that the search fo r a perfect definitio n o f income is irrelevant. They claim tha t what i s relevant i s the search fo r th e definition o f income that i s least susceptible to manipulation, adverse selection, moral hazard, signaling, and othe r troublesom e behavio r b y bot h citizen s an d th e state—i n other words, the construct tha t maximize s the well-being of the com monwealth.8 The task of defining incom e thus invokes two possibilities. The first is that even the most rigorous theoretical definition ha s an unacknowledged politica l component . Th e secon d i s tha t a definitio n locall y accepted a s accurate ma y be applie d consciousl y o r unconsciousl y i n accordance wit h convention s tha t violat e th e stipulate d definition . The Haig-Simons definition itself , the competing consumption model , and an y othe r definitio n offere d a s correc t theor y ar e influence d b y the definer' s poin t o f view. Even the mos t widel y approved theor y of income may be found faulty in succeeding generations. The "Common Meaning of Income" What di d the framers o f the 191 3 income tax law mean by income? There was no definitio n i n th e origina l legislation . Queried i n debat e on the House floor, a sponsor answered that "what is meant by'income' is the commo n meanin g o f 'income*—the commo n understandin g o f the word."9 It is not clear now, and probably was not then, exactly what people commonl y understoo d th e wor d income to mean . Th e mos t likely meaning is returns on capita l received annually, especially interest, rents , an d dividends . Novel s o f th e time , whic h revea l commo n understandings t o som e extent , refe r t o incom e wit h thi s apparen t meaning. Salarie s an d wages , too , wer e understoo d t o b e income , although th e earl y incom e ta x di d no t reac h wage s o r mos t salaries . Irving Fisher , th e grea t consumption-bas e proponen t i n economics, wrote som e o f hi s most compellin g piece s a t the tur n o f th e century . His writing s ma y hav e influence d peopl e t o thin k i n term s o f cas h receipts rather than i n terms of inchoate accruals. One fact seem s certain: in 191 3 the 193 8 Haig-Simons definition o f income was not within the "original intent" of the drafters o f the income tax law.

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We should not limit the definition o f income to the common under standing of the term in 1913. The world has changed too much to make that a sensibl e constraint . Th e moder n securitie s market , wit h hun dreds of innovative financial instruments created in only the last twenty years, bears little resemblance to the securities market o f 1913 . Not only have we embraced a variety of ne w forms o f capita l investment , but w e have als o accepte d ne w interpretations o f incom e t o adap t t o these new forms. The zero-coupon bond, breathtaking in its simplicity, demonstrated t o ta x policymakers th e nee d t o includ e i n incom e th e invisible annual accruals that we now are willing to call interest. Thus, it certainly is possible for a n economic definition o f income, articulated in 193 8 and further develope d by Kaplow and others, to influence ou r understanding o f the term income. I t also is possible that a particular definition ma y com e t o contro l ou r understanding . T o som e extent , this has already occurred. Tax academics and tax policy economists have been trained to think in Haig-Simon s terms . The so-calle d comprehensiv e incom e ta x base rests o n th e Haig-Simon s model. 10 Th e academi c literatur e contain s significant, powerfu l argument s fo r practica l us e o f a pure accretio n model, fro m th e mark-to-marke t argument s o f Slawson 11 an d Shakow12 to a variety of proposals, including Kaplow's. 13 A persistent minority vie w urged b y Andrews14 an d Bradford 15 ha s been th e con sumed-income base, which drops the savings component o f the HaigSimons definition an d treats consumption a s the appropriate measur e of income. Notice that last sentence: the words "drops the savings component o f the Haig-Simons definition" demonstrate the dominance of the accretio n theory , a dominanc e s o pervasiv e tha t i t i s difficul t t o articulate the consumption model in any way other than as a truncated Haig-Simons definition . The dominance of the Haig-Simons definition o f income is puzzling given its analytical shortcomings . One of the weaknesses o f the HaigSimons definition i s insistence o n categorizin g al l expenditures eithe r as savings or as consumption. Not all expenditures lend themselves easily to thi s categorization . I s i t clear , for example , that donation s t o a charity are consumption? Is an expenditure for medical care always, or only, consumption? Purchases of medical care seem in many ways to be an investment in human capital. 16 Beyond th e inheren t problem s wit h th e Haig-Simon s definitio n o f

TAXATION AN D HUMA N CAPITA L 6

income is the question whether the description o f income for tax purposes should be determined by a 1938 economic formulation. It is easy to cede authority to a definition tha t presents itself in a neutral and scientific way . But the 191 3 tax law was not derive d fro m economi c science. It was developed by people largely without training in economics in an era not blessed with the Haig-Simons definition . Th e drafters o f the income tax conceived of it as an instrument o f social policy. Many of its terms and concepts are rooted i n early twentieth-century under standings of social life. Some of these concepts—for example , the idea that there is a bright line between income and property—no longer are appropriate to describe contemporary market transactions. The definition o f incom e an d othe r importan t term s use d i n ta x la w ough t t o evolve t o mee t changin g circumstance s an d t o serv e changin g socia l needs. To some exten t th e Haig-Simon s definitio n wa s a response t o changed circumstances and the need for a coherent economic description of income. Yet, a definition o f income tied ineluctably to economics o f sixt y year s ag o offer s to o limite d a visio n o f th e relationshi p between law and society. Even if we accept the Haig-Simons definitio n as appropriat e withi n th e contemporar y socia l context , w e shoul d interpret an d appl y it accordin g to the purposes o f a modern incom e tax. The Purposes of an Income Tax The U.S. income tax arose in the context of the turn-of-the-centur y economy out of a populist, even Marxian, movement. Although a hundred year s ag o a n antipopulis t Suprem e Cour t hel d i n Pollock v. Farmers' Loan & Trust Co.17 that the income tax was unconstitutional, Congress reenacte d i t i n 191 3 afte r a constitutiona l amendment . Originally reaching only about the top 5 percent of income earners, the tax was redistributiv e i n it s inten t an d application . Th e ter m income was understood popularly as the accruals to material capital received in the form o f interest, dividends, and rents. Wages were taxed only in the case o f high-leve l salarie d executives , who ofte n wer e th e owner s o f material capital. The expansio n o f th e incom e ta x to reac h averag e an d eve n lowe r incomes, along with th e increasing rate s of taxation, suggests that th e needs and purposes of the income tax have evolved. But the notion that

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tax rates should ris e with incom e (vertica l equity ) continue s to play a role i n th e America n conceptio n o f a n incom e tax . Even th e genera l popularity of a flat tax probably is interpreted best as a reaction against the complexity of the current income tax rather than against the idea of vertical equity. In addition, another basic purpose of the income tax, to underwrite th e spending choices of government, remains well accepted. Thus, a redistributive policy , however changed , stil l i s an integra l part of the structure of the current income tax. At th e tur n o f th e century , th e populis t conceptio n o f owner s o f material capital , who derive d thei r annua l income s fro m tha t capital , stood in stark contrast to that of wage earners, who were forced to labor for subsistence . I n thi s pictur e o f society , the owner s o f capita l wer e identified a s those wit h th e abilit y t o pay . It remain s tru e tha t thos e with wealth are better able to pay taxes than those without it. In an essay published posthumously, Joseph Pechman reported tha t the ga p betwee n ric h an d poo r ha s bee n widenin g steadil y ove r th e last thirty years.18 Although the twentieth century has seen the rise of a salaried middl e class , in recent years both highe r income s and greate r wealth have become concentrated i n fewer hands. This picture of society, of th e have s an d th e have-nots , is strikingly lik e the turn-of-the century perception s tha t le d t o th e enactmen t o f th e incom e tax . Pechman argued for reinforcement o f the income tax and for return to laws that carry out its original redistributive purposes. He described the brutal povert y tha t ha s develope d i n man y urba n area s an d warne d against th e socia l consequence s o f perpetuatin g economi c disenfran chisement. Society is different today , but it remains true that those with large amounts of material capital are better off than those who have little in the way of material capital. The purposes o f the incom e ta x and th e socia l context i n which i t operates should inform decision s about its design. If the income tax is to continue as a revenue source premised on the ability to pay, then we must undertak e t o defin e incom e wit h referenc e t o actua l circum stances that lead people to being more or less able to pay. We should not assume that increasing the tax burden o n labor is appropriate withou t convincing evidence that labor is undertaxed. The assertion that labor is undertaxed is based on the contention that ideal income includes the present value , endowed a t birth , o f futur e wages . The validity o f thi s

TAXATION AN D HUMA N CAPITA L 6

assertion i s inextricably linked t o our understandin g o f social life an d common economic circumstances. Consider, fo r example , two identica l twins , separated a t birth , on e adopted b y a wealthy famil y an d th e othe r adopte d b y a famil y tha t immediately falls into straitened circumstances. The wealthy twin never needs to work for a living but enjoys the best society can offer in the way of food, shelter , education, and leisure . The poor twin , deprived fro m his most tender years of adequate food, shelter, education, and leisure, moves from on e low-wage job t o another . The availability of materia l capital has ensured to the wealthy twin an access to opportunities forever closed to the other. The absence of material capital has ensured to the poor twin the omnipresent, unrelenting necessity to work for survival . The poor twin's work produces cash wages that are taxable when paid. If the wealthy twin lives on an identical amount of taxable dividends and interest, are their incomes equal? Are material and human capital suffi ciently identical tha t th e incom e o f eac h shoul d b e taxed i n th e sam e way, or i s ther e significanc e t o th e differenc e betwee n tim e spen t i n work and time spent in leisure? If so, should we take this difference int o account when defining human capital, material capital, and income?

T H E INEXAC T PARALLE L BETWEE N MATERIA L AND HUMA N CAPITA L

Work Much o f th e previou s literatur e abou t taxatio n an d huma n capita l has dealt with issues like the deduction o f educational expense s or the excludability o f persona l injur y damag e recoveries. 19 Mor e recently , Kaplow ha s argue d tha t wage-measure d huma n capital , like materia l capital, is wealth. Seeking a unified concep t o f incom e tha t consider s economic value and callin g wage-measured huma n capita l "the dominant component of most individuals' wealth,"20 he concludes that ideal income includes this wealth in income-at-birth.21 Hi s proposal reaches a foundationa l questio n o f th e incom e tax : Are materia l an d huma n capital enough alike to justify identical treatment under an income tax? The answer is no. Even if future wage s were absolutely foreseeable, their present value

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would not constitute an at-birth increas e in wealth. Why? Because the work that will produce the wages remains to be performed. Newborn s must one day perform the services that will entitle them to wages twenty years o r mor e i n th e future . A comparison o f a future prospec t o f wage income i f services are performed an d the future prospec t of payment unde r a zer o coupo n bon d i s usefu l t o understan d wh y th e requirement o f work makes a difference. I f both prospects ar e equally certain an d i f both hav e the sam e future payout , which i s more valuable—the on e tha t require s tim e an d work , o r th e on e tha t require s only time ? Th e accretio n mode l include s a s incom e present-value d future sum s that require merely time to mature. There is no reason to construe i t to includ e sum s that requir e time and work. I f wage-measured value is to be included at birth, at a minimum ther e would seem to be some discount require d fo r th e comparatively lower value of a n asset that canno t b e transformed int o mone y terms without labor . In most (bu t no t all ) cases , the futur e labor incom e i s likel y t o b e dis counted to zero. A Closer Look at the Definition of Human Capital The familia r analysi s o f huma n capita l incom e assume s tha t ther e are four aspect s to human capital : leisure, choice, ability, and opportu nity. Like others, Kaplow sets aside the value of leisure as inconvenient to tax, although he acknowledges it as a proper subject of income taxation.22 H e dismisses choice as irrelevant t o th e argument , because hi s analysis that labor is undertaxed applies only to wages actually received; supercounting wage income does not force people to work.23 He treats ability as wealth onl y to the exten t tha t i t is used t o produce wages. 24 Opportunity, h e concludes , directl y affect s idea l income , becaus e a n investment in human capital has positive value only when the opportunity t o ear n incom e fro m tha t investmen t exists . I t is , he says , "the availability of the opportunity rathe r tha n th e investment itsel f [that ] produces th e chang e i n wealth." 25 Thus , fo r Kaplow , opportunit y i s reflected in an increase in cash income. If human capita l comprises leisure, choice, ability, and opportunity , we shoul d giv e som e seriou s though t t o ho w thes e fou r aspect s ar e distributed amon g wag e earners . Notwithstandin g th e emphasi s o f the incom e ta x o n ability-to-pa y questions , one o f th e weaknesses o f

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Kaplow's analysis as well as of the accretion mode l is that both ignor e this issu e (a s if ever y human ha d a n equa l shar e o f thes e attributes) . Before we accept the notion that the presence at birth of foreseeable o r predictable futur e wage s represent s a present increas e i n wealth , i t i s useful t o loo k a t th e contex t i n whic h peopl e exercis e thei r so-calle d human capital. It seems likely that ability is distributed throughou t societ y without regard t o ownershi p o f materia l capita l bu t tha t leisure , choice , an d opportunity ar e linke d closel y t o materia l wealth . A wage-measure d definition o f human capita l sweeps aside any aspect o f human capita l that is not transformed int o wages. But if an ideal concept of income is to includ e al l economi c value , it i s necessary t o reconside r excludin g nonwage incom e generate d fro m (an d producing ) huma n capita l a s inconvenient to measure. Is there economic value to ability that is never used to generate wages, to the opportunity to earn wages from huma n capital even though those wages are never generated, to the leisure that is the antithesi s o f wag e production , o r t o th e choice whether t o us e human capita l t o engag e i n waged work, when t o d o so , and fo r ho w long? If these aspects of human capita l have value not capture d by futur e wages, perhaps they ought to be accounted for separately. The problem is not only that the ideal income model ignores them, but also that they are traditionally associated exclusively with human capital. If these values are distributed i n direc t relatio n t o material wealth, then fo r pur poses o f incom e definitio n i t i s inappropriate t o subsum e the m int o human capita l as psychic income. Instead, these values are more accu rately described as conventionally uncounted income flowing from th e ownership of material wealth. How valid i s the argumen t tha t noninnat e huma n capita l values— roughly defined a s leisure, choice, and opportunity—are distributed in direct relation to material wealth? To answer this question it is useful to return to the example of the identical twins, separated at birth, who are raised in different materia l circumstances. Obviously, there is a leisure difference betwee n th e wealth y twi n an d th e poo r twin . I s ther e a n opportunity difference betwee n the two? An empirical approach to this problem migh t compare , fo r example , th e incidenc e o f earl y deat h among resident s i n area s with hig h propert y value s with tha t amon g residents in areas with low property values. Do males under the age of

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twenty-one have the same death rate in Framingham as in New Haven? Recent studie s hav e show n markedl y highe r deat h rate s fo r youn g males, especiall y youn g blac k males , i n poore r urba n area s tha n i n wealthy suburban districts. 26 If not dying is one prerequisite for having opportunities, then perhaps ownership of material wealth significantl y increases opportunity. It als o appear s tha t wealt h create s opportunitie s tha t abilit y alon e may never contemplate. Evidence is quite strong that people in poverty do not have the same chances for participation in society as those born into material wealth. Children i n New York school districts experience a very different qualit y of education depending on the property values in each locale. Annual spending per pupil ranges from about $11,300 in districts with high property values to about $5,600 in districts with low property values. This difference, which is correlated to material wealth, translates int o th e differenc e betwee n school s wit h eighteen-to-on e student-teacher ratios , computers, music, drama, and art classes, and a 97 percent colleg e admissio n rate , and school s with forty-five-to-on e student-teacher ratios , plaste r fallin g fro m th e ceiling , no t enoug h chairs o r book s t o g o around , an d a dropou t rat e exceedin g 5 0 per cent.27 Thes e statistic s leav e little doub t tha t materia l capita l make s a difference i n the opportunities an d choices available to the children in different schools . Material wealth gives one twin an opportunity edge. The questio n whethe r ther e i s a parallel betwee n so-calle d huma n and material capital presses us to notice what society is like. Perhaps a guiding principle of the income tax—ability to pay—involves attention to difference s betwee n th e live s of peopl e wh o hav e enoug h materia l capital to guarantee them a n adequat e income stream, or access to an attractive career , an d peopl e wh o hav e n o materia l capita l an d mus t work merely to subsist—the choice aspect often associated with human capital. No matter how much idea l income can be earned by someone committed to scrubbing the maximum number of floors humanly possible in a day, her life experience is not the same as that of someone who has the same ideal income from a n annuity. The choice of whether t o work, and unde r wha t conditions , more likely belongs to th e annuit y holder. I s th e annuity-holde r twi n "significantl y wealthie r i n a tax relevant sense" 28 than th e floo r scrubber ? I f we notice that on e works forty hours a week and the other lies in a hammock sipping margaritas,

TAXATION AN D HUMA N CAPITA L 6

there i s a difference. A s Kaplow notes , a "true believer " in measurin g income would include the value of leisure—an aspect of human capital closely linked to the ownership of material wealth. The Inaccuracy of Relegating Leisure to Human Capital It is tempting, when defining income, to exclude from consideratio n human capita l that neve r is transformed int o wages. But the existenc e of non-wage-measure d huma n capita l i s relevan t t o th e questio n o f wealth, income, and th e abilit y to pay . There ar e at least two obviou s relationships between non-wage-measured huma n capital and income. First, there is the connection between the ownership of material capital and th e powe r t o spen d huma n capita l i n way s that d o no t produc e wages (leisure). Second, there is the connection between the absence of material capita l an d th e requiremen t tha t huma n capita l b e spen t i n ways that do produce wages (work). The traditional explanatio n o f the failure t o consider these connections is that psychic income is not easil y taxed. Some income theorist s say that it is inappropriate to include as income the value of leisure or of consumer surplus, which is the additional enjoyment o r benefit tha t an individua l obtain s i n exces s o f th e pric e pai d fo r a good o r a service.29 Others, Kaplow included, agree that the value of leisure properly is includable in income. The inaccurat e assumptio n tha t ther e i s a n equivalenc e betwee n price and consumer value bears on the problem o f human capita l that never i s transformed int o wages . To ignore the presence o f consume r values in excess of the uniform pric e for wages invites us to ignore the value o f leisure—which w e do—because i t i s convenient t o d o so . To ignore the shortfall of the uniform pric e for wages, compared to the real human cost of earning wages, invites us to ignore the additional cost of working—which w e do—again, because i t i s convenient t o d o so . To ignore thes e importan t socia l fact s (includin g economi c circum stances) i s to ignor e th e connectio n betwee n th e presenc e o f materia l capital and the power to spend human capita l in ways that do not produce wages (leisure ) a s well as the connection betwee n th e absence of material capita l an d th e requiremen t tha t huma n capita l b e spen t i n ways that do produce wages (work).

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The situation o f a working singl e mother o f a young chil d usefull y demonstrates thi s point . I n additio n t o th e obviou s inconvenienc e o f working, she bears th e cos t o f chil d care . Beyond th e cas h outla y fo r child car e while working, sh e als o bears additiona l costs , such a s th e loss of time that could be spent enjoying her child (for which the market price may not compensat e her) , the extra demand s o n he r energ y and physica l strengt h tha t resul t fro m parentin g afte r a lon g da y a t work, and in many cases, the additional loss of leisure that flows fro m the need to perform task s involving manual labor i n connectio n wit h child rearing . Eve n i f sh e coul d affor d t o pa y someon e t o d o al l th e things include d i n he r dail y routine , th e par t o f bein g a paren t tha t requires engagement with children i s something that good parents are not willing to purchase 10 0 percent o f the time. In short, it is unlikely that a working single mother can enjoy the consumer benefits available to a nonworking single mother with equal money income. The issue s involve d i n thi s exampl e g o beyon d thos e o f impute d income from the performance o f child care by a parent at home, which theoretically is includable under either an ideal income or an ideal consumption tax. 30 I f th e nonworkin g paren t obtain s chil d car e fo r a n equal amount of time, the difference betwee n the two parents clearly is more tha n on e o f impute d incom e fro m service s performe d i n th e home, because they now have the same money costs and the same disposable cas h income . Instead , th e differenc e betwee n th e tw o i s th e leisure available to the nonworking parent. It i s impractica l t o measur e i n mone y term s th e valu e gaine d i n leisure and lost in working. This is why income tax theorists find it convenient to ignore leisure and other consumer surplus and costs. Kaplow acknowledges, however, that "a true believer i n taxing ideal income— or consumption—woul d includ e leisure." 31 Despit e thi s insight , hi s interpretation o f idea l incom e t o includ e th e presen t valu e o f futur e wages accepts the convention of disregarding the value of leisure. If the undeniable benefits of not working are to be excluded from incom e for convenience reason s alone, what ca n b e don e t o compensat e fo r th e inaccuracy? An offsetting deductio n fo r the real human cost s of working is impractical an d unlikely . If we are to arrive at an approach tha t achieves equivalence between material and human capital , it is appropriate to make some accommodation for the failure to count as income the leisur e tha t ownershi p o f materia l capita l permits . Th e first ste p

F I C T I O N I N TA X 7

in this approach i s to depict accuratel y the values conventionally associated with human capital. A More Accurate Depiction of Human Capital The value s o f leisure , choice, an d opportunit y shoul d b e strippe d away from the definition o f human capital and, at the very least, treated as independent value s theoretically includabl e i n income . Wage-measured human capital might be referred t o as labor capital to distinguish it from th e conventional use of the term human capital But are leisure, choice, an d opportunit y trul y independent ? Ownershi p o f materia l capital permits leisure, creates opportunities for personal development, and offer s choice s that ar e absent o r foreclose d t o th e childre n o f th e poor. It takes a much greate r amoun t o f ability for a person born int o poverty (where leisure, choice, and opportunity are in short supply) to earn the same income as a person bor n int o material wealth. Material capital, then, includes a component tha t enhance s th e value of innat e ability. The values o f leisure , choice, and opportunit y ar e mor e accu rately depicted as attaching to material rather than to human capital. The example of identical twin s raised i n different materia l circum stances emphasizes the connection betwee n nonwag e "human capital " values and materia l capital . The on e twin's materia l wealt h include s a set o f choice s an d opportunitie s th e othe r twi n doe s no t have . Surely these additional values are relevant for tax purposes. The ideal income argument describes labor as undertaxed if labor capital is omitted fro m income-at-birth an d leads to Kaplow's description o f a system to capture th e omitte d incom e b y supercounting actua l wages . But associa tion o f th e value s o f leisure , choice , an d opportunit y wit h materia l capital raise s th e possibilit y tha t material capital i s undertaxed. I f we are serious abou t definin g income , we ought t o discove r a method t o measure these values. The claim of an exact parallel between material and human capital is the foundatio n fo r Kaplow' s syste m o f supercountin g wag e income . Like treatment o f like cases is the underlying theme of this argument . But there is not a n identit y between materia l an d huma n capital . The distribution i n societ y o f noninnat e value s conventionall y associate d with huma n capita l correlate s closel y with th e ownershi p o f materia l capital—so much so that equal treatment of material and human capi-

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tal require s acknowledgmen t o f thei r inheren t inequality . Perhap s income fro m material capital shoul d b e supercounte d t o captur e th e additional value that materia l wealth creates . Perhaps that i s what th e income tax is about.

ALTERNATIVES

Defining income to include the values of leisure, choice, and oppor tunity is easier than measuring these values. Apart from discret e applications (imputed incom e from services , for example) , actual measurement, if not impossible , is impractical. A more feasible approac h i s to identify surrogate s fo r th e value s o f leisure , choice, and opportunity . The suggestion that we could supercount income from materia l capital is a wa y t o attac k th e measuremen t problem , bu t supercountin g income presents a new problem of determining the correct multiplier. Kaplow's analysis suggests a way to assign a multiplier. He assumes that th e endowmen t o f huma n capita l equa l t o th e presen t valu e o f future wage s earns interest an d is consumed i n annual amounts equa l to a level payment annuity. 32 The level payment, which is equal to the amount of wages, is deemed to consist of both interest and capital. This means that in every year except the year of endowment, ideal income is less than the amount of wages. It is only his decision to treat wage-measured huma n capita l a s income-at-birt h tha t lead s Kaplo w t o super count wag e income (a s a proxy for taxin g income-at-birth) . To adapt this system to an income definition tha t associate s leisure, choice, and opportunity with material capital, we would ignor e the initial endow ment of wage-measured huma n capital . This suggestion i s in line with conventional approache s t o definin g income , whic h ignor e bot h at birth labo r capita l and at-birt h materia l capital, as well as the at-birt h endowment of leisure, opportunity, and choice. This approach, in combination wit h th e res t o f Kaplow' s analysis , would resul t i n th e dis counting of wage income. Ideal income would be close to 10 0 percent of wage s i n th e earl y year s o f wor k an d woul d declin e t o abou t 1 0 percent o f wages in later years. Although thi s approach ma y have the disadvantage o f reducin g th e ta x base, it woul d allo w pur e accretio n treatment (economi c depreciation ) o f labor capital . The resul t woul d

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be t o increas e th e ta x burde n o n materia l capital . Thi s solutio n i s implied by the work of Richard Goode, 33 who, Kaplow notes, does not include the present value of wage-measured huma n capita l in at-birt h income.34 A second way to capture the values of leisure, choice, and opportunity (with no promise of accuracy) is to modify the current income tax to eliminate som e o f th e ta x benefits associate d wit h materia l capita l o r otherwise to impose a heavier tax burden o n material capital. Use of a more carefully tailore d rat e structure, for example , might be a reasonable alternative. The rate structure might be altered in several ways: • Expan d the zero bracket amount • Expan d the zero bracket amount fo r taxpayers who live in propert y tax districts with low property values or with low per capita spend ing on education • Increas e the tax rate for taxpayer s who live in property tax districts with high property values or with high spending on education • Den y the property tax deduction • Increas e the tax rate on unearned incom e The unintended incentiv e effects o f these approaches would have to be evaluated carefully. Using per capita spending on education, for exam ple, could discourage spending in wealthier districts. Amounts spent on private education would have to be counted. Use of local property values may be subject t o manipulation a s residents become awar e of th e federal tax consequences, thus raising compliance costs. A third approach is to modify the current law's definition o f income by allowing deductions for work-related costs of human capital. It may be difficult, however , to tailor th e deductio n appropriately . Already in the current law is the refundable earne d income tax credit, which provides a deduction substitut e ( a credit rather than a deduction) t o lowincome workers. This provision serve s some of the same purposes as a deduction for work-related costs of human capital. A fourth tacti c is to eliminate aspects of the current incom e defini tion tha t inappropriatel y shelte r materia l capita l fro m taxation . Th e following idea s have been propose d befor e an d hav e obvious politica l problems:

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• Eliminat e the realization requirement • Repea l section 101 4 and make unrealized appreciation includable in income at death • Integrat e the corporate and individual income taxes but compensat e for th e los t corporat e ta x revenues by a windfall ta x o n ol d equit y and a higher tax on unearned income It is interesting to observe that these politically infeasible proposals typically have been justified a s leading to more accurate measurements of income. All tend to increase the tax burden on material capital. A fifth alternative, probably less feasible tha n th e others , is to alte r the ta x syste m i n mor e radica l ways . The mos t dramati c o f change s would b e t o enac t th e invers e o f a consumption tax . The invers e ta x would defin e incom e a s return s o n materia l capital . Thi s definitio n does not attempt to measure the value of leisure, choice, and opportu nity attache d t o materia l wealt h bu t instea d increase s th e burde n o n material capital by exemption o f wage income from th e tax base. This method indirectly captures non-wage-measured huma n capital values. But wage incom e i s income, too, and no t t o coun t i t distort s th e ta x base. Moreover, a capital base probably is too small to fund reasonabl e government spendin g needs . I t seem s likely , however , tha t thi s ide a is consisten t wit h th e origina l conceptio n o f th e incom e tax . Time s change. A less radical systemi c chang e i s to combin e a traditional incom e tax with a consumption tax. This proposal would place most taxpayers on a cash-flow consume d incom e tax (with a substantial zero-bracke t amount) an d woul d reserv e th e accretion-mode l incom e ta x fo r taxpayers wit h nonwag e incom e abov e a substantia l zero-bracke t amount.35 Fo r example , a famil y o f fou r wit h wage s unde r $30,00 0 and minima l saving s woul d pa y n o tax . A family o f fou r wit h wag e income above $30,000 but below $70,000 would pay tax under a consumption model . A family o f four wit h incom e abov e $70,000 would pay ta x o n bot h wag e an d nonwag e incom e a t progressiv e rates , although perhaps scaled differently fo r the wage and nonwage income. The disadvantage of this system would be the increased complexity of using tw o rat e schedules . The greate r simplicit y o f th e consumptio n tax for taxpayers subject onl y to it, however, might make the proposal as a whole attractive.

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The difficult y wit h al l o f thes e alternative s t o direc t measuremen t and inclusion o f the values of leisure, choice, and opportunit y i s their inaccuracy. T o the exten t tha t thes e surrogat e approache s assum e a n association between the ownership of material capital and the economic values of leisure, choice, and opportunity, they may do rough justice. At a minimum, stripping these currently untaxed values away from th e description o f human capita l and acknowledgin g thei r relationshi p t o material capital offer a theoretical basis for the taxation of income fro m material capital, which a consumption tax would not reach. If we begin b y asking what th e centra l problem s ar e tha t th e ta x law addresses, we see both the need for revenue and an underlying concern for th e distributio n o f th e ta x burden (i f no t a frankly redistributiv e spirit). Pechman' s partin g essa y sounde d a warning . H e calle d fo r a restructuring o f ta x la w t o revers e th e increasin g ga p betwee n wag e earners and the wealthy. This seems an unlikely social context in which to increas e th e ta x burden o n labo r b y 40 percent, which a system o f supercounting wag e incom e woul d do . The fact s o f socia l lif e shoul d alert us to the improbability that labor income is undertaxed and cause us to examine carefully th e assumptions that lead to this assertion an d to its consequences for the design of the tax system. If increasing the tax burden on labor is "not attractive," Kaplow says that th e logica l alternativ e t o idea l incom e i s a consumption tax . He suggests that people who dislike an ideal income analysis that increases the tax burden on labor should embrace an ideal consumption analysi s that decreases the tax burden o n capital. This is a false dichotomy. It is ironic that those reluctant to increase labor's tax burden directly should do so indirectly by embracing a model that eliminate s the tax burden on capital . Moreover, ther e i s no reaso n t o accep t th e argumen t tha t material and labor capital should be treated as identical. Finally, there is a soun d basi s t o interpre t Haig-Simon s incom e t o exclud e fro m income-at-birth th e present value of future wages . As long as the work is still to be performed, ther e i s no presen t increas e i n th e newborn' s wealth. There are at least three implication s o f this exploration o f taxatio n and human capital. The first implication is that the conventional defin ition o f huma n capita l i s overinclusive . Values commonl y associate d with human capita l may in fact be additional, untaxed values attached

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to materia l capital . This implicatio n suggest s tha t ther e i s a trade-of f between th e untaxe d at-birt h presen t valu e of futur e wage s and non wage-measured "huma n capital " values . Furthe r exploratio n o f thi s hypothesis, drawin g o n empirica l studie s develope d i n othe r disci plines, is necessary t o bolste r th e roug h correlatio n suggeste d i n thi s essay. If the hypothesis proves accurate, this critique offer s a justification fo r taxin g materia l capita l mor e heavil y tha n wage-producin g human capital. The second implication i s that we should rejec t th e asserted conse quences o f th e idea l incom e argumen t fo r desig n o f th e ta x system . Labor incom e i s no t currentl y undertaxe d whe n compare d t o idea l income. Furthermore , th e us e o f a n idea l definitio n o f incom e t o provide theoretica l suppor t fo r a consumptio n ta x i s misleading . A consumption ta x eliminates from th e tax base material-capital incom e not spent for personal consumption. Although much of this income is currently untaxe d o r undertaxe d whe n measure d agains t th e Haig Simons definition, 36 shiftin g t o a pure consumptio n ta x would elimi nate entirel y th e ta x burde n o n unconsume d receipt s fro m materia l capital. In ligh t o f th e clos e connectio n betwee n materia l wealt h an d untaxed value s o f leisure , choice, and opportunity , th e consumptio n model as now articulated appear s also to be an inaccurate descriptio n of income. The third implication i s that the community of tax academics must engage i n a discussio n o f alternat e definition s o f income . Why hav e income tax theorists allowed the Haig-Simons definition t o corner the market on income definitions? Although the connection between theoretical formulations an d their underlying assumptions about society is nearly invisible, there is a connection. Tax policy has no more claim to neutrality tha n an y othe r fiel d o f stud y create d b y huma n beings . Weltanschauung grips u s all . It i s time fo r ta x academic s t o seve r th e bonds that limit our ability to think about income other than by reference to a stipulated definitio n tha t emerge d fro m economi c theory in 1938. What aspect s o f th e socia l an d economi c environmen t shoul d w e take into accoun t i n ou r alternativ e definition s o f income? Pechman' s final essay counsels us to look carefully a t the disproportionate distribution throughout society of material wealth, cash income, opportunity, and choice . "What i s income?" is a broader questio n tha n mos t o f u s

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have been willin g to ask . To answer thi s question , we ought t o notic e who gets to participate in society and in economic life. We should identify the values that enable that participation. In the end, any definitio n we adopt reflects how we see the world. Perhaps it also shapes what that world might become.

NOTES Earlier draft s o f this articl e benefite d fro m th e comment s o f participant s i n th e AB A Tax Section's Teaching Taxation Committee program on human capital held in August 1995 , of participants in Taxing America: A Conference o n the Social and Economic Implications of Tax Reform, University o f Minnesot a La w School (Nov . 3-5, 1995) , and o f participants i n a December 199 5 faculty worksho p a t Georg e Maso n Universit y La w School . I a m particularl y gratefu l fo r th e detailed comment s o f Glen n Cove n o f Willia m an d Mar y La w School , Gwe n Handelma n o f Washington & Lee Law School, and Louis Kaplow of Harvard Law School. 1. See, e.g., Boris I. Bittker et al., A Comprehensive Tax Base? A Debate (1968); Comprehensive Income Taxation (Joseph A. Pechman ed., 1977); Nicholas Kaldor, An Expenditure Tax app. to ch. I,at58n.9(1954). 2. See, e.g., Louis Kaplow, Human Capital under an Ideal Income Tax, 80 Va. L. Rev. 1477 (1994) (arguing that th e initial endowment o f human capita l a t birth constitute s incom e in an amoun t equal to the present value of the newborn's future wages [income-at-birth]) . 3. See Robert M . Haig, The Concept of Income—Economic and Legal Aspects, in The Federa l Income Tax 1, 7 (Robert M . Haig ed., 1921 ) (articulating the savings element); Henry C. Simons, Personal Incom e Taxation 5 0 (1938); see also Kaplow, supra note 2 , at 147 7 n.l (notin g tha t th e ideal income definition usuall y is drawn from Simons' s definition, but that the ideal income definition may not reflect Simons's intent). 4. See Kaplow, supra note 2, at 1507-12 (describing a system of supercounting wages as a proxy for taxing the endowment at birth of the present value of a future wage stream). 5. See, e.g., Alvin Warren, Would a Consumption Tax Be Fairer Than an Income Tax? 89 Yale L.J. 1081 (1980); Alvin Warren, Fairness and a Consumption-Type or Cash Flow Personal Income Tax, 88 Harv. L. Rev. (1975) (replyin g t o Willia m D . Andrews, Fairness and the Personal Income Tax: A Reply to Professor Warren, 88 Harv. L. Rev. 947 (1975) [hereinafte r Andrew s 1975 ] and William D. Andrews, A Consumption-Type or Cash Flow Personal Income Tax, 8 7 Harv. L. Rev. 111 3 (1974) [hereinafter Andrews 1974]). 6. See Kaldor, supra note 1 , at 70 ("[T]he problem o f defining individua l Income , quite apart from an y problem of practical measurement, appears in principle insoluble"). 7. See John Rawls , A Theory o f Justic e (1977 ) (explainin g th e "origina l position " i n whic h social rules are established prebirth with no one knowing what his or her position in society would be). 8. See, e.g., Yoram Barzel, An Alternative Approach to Analysis of Taxation, 84 J. Pol. Econ. 1177 (1976). 9. 50 Cong. Rec. 502-14 (1913). 10. See sources cited supra note 1. 11. See, e.g., W. David Slawson , Taxing as Ordinary Income the Appreciation of Publicly Held Stock, 76 Yale L.J. 623 (1967).

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12. See, e.g., David J. Shakow, Taxation without Realization: A Proposal for Accrual Taxation, 134 U. Pa. L. Rev. 1111(1986). 13. See, e.g., Noe l B . Cunningham & Deborah H . Schenk , Taxation without Realization: A "Revolutionary" Approach to Ownership, 47 Ta x L . Rev . 72 5 (1992) ; Mar y Louis e Fellows , A Comprehensive Attack on Tax Deferral, 88 Mich. L. Rev. 722 (1990). 14. See Andrews 1975 , supra note 5; Andrews 1974, supra note 5. 15. See David F . Bradford & U.S. Treasury Tax Policy Staff, Blueprint s fo r Basi c Tax Refor m (1977). 16. See Charlotte Crane , Shifting from an Income Tax to a Consumption Tax: Effects on Expenditures for Education, thi s volume ; Gwe n Thaye r Handelman , Acknowledging Workers in Definitions o/Consumption and Investment: The Case of Health Care, this volume; Denise D. Roy, Consumption in Business/Investment at Home: Environmental Cleanup Costs versus Disability Access Costs, this volume. 17.157 U.S. 429, aff'd. on reh'g, 158 U.S. 601 (1895). 18. Joseph A. Pechman, The Future of the Income Tax, 80 Am. Econ. Rev. 1288 (1990). 19. See, e.g., William S . Vickrey, Agenda fo r Progressiv e Taxatio n 123-2 6 (1947) ; Loretta C . Argrett, Tax Treatment of Higher Education Expenditures: An Unfair Investment Disincentive, 4 1 Syracuse L. Rev. 621 (1990) ; Evelyn Brody, Paying Back Your Country through Income-Contingent Student Loans, 31 San Diego L. Rev. 449 (1994); Jennifer J. S. Brooks, Toward a Theory of Damage Recovery Taxation, 14 Wm. Mitchell L. Rev. 759 (1988); David S. Davenport, Education and Human Capital: Pursuing an Ideal Income Tax and a Sensible Tax Policy, 42 Case W. Res. L. Rev. 793 (1992); David S. Davenport, The "Proper" Taxation of Human Capital, 52 Tax Notes 140 1 (1991); Joseph M. Dodge, Taxing Human Capital Acquisition Costs —Or Why Costs of Higher Education Should Not Be Deducted or Amortized, 54 Ohio St. L.J. 927 (1993); Daniel I. Halperin, Business Deductions for Personal Living Expenses: A Uniform Approach to an Unsolved Problem, 12 2 U. Pa. L. Rev. 859 (1974); John K. McNulty, Tax Policy and Tuition Credit Legislation: Federal Income Tax Allowances for Personal Costs of Higher Education, 61 Cal. L. Rev. 1 (1973); Christopher R. J. Pace, The Problem of High-Cost Education and the Potential Cure in Federal Tax Policy: "One Riot, One Ranger", 20 J.L. & Educ . 1 (1991) ; Bernar d Wolfman , The Cost of Education and the Federal Income Tax, in Proceedings of the 29th Annual Judicial Conference, 42 F.R.D. 437,535 (1966). 20. Kaplow, supra note 2, at 1500. 21. See id. 22.Sgeirf.atl507n.73. 23. See id. at 150 6 (supercounting wage s means multiplyin g wages by a factor tha t compen sates for deferring taxation of human capital income-at-birth until wages are received). 24.Seefrf.atl496n.31. 25. Id. at 1495-9 6 (discussin g table 3, which shows an investment i n human capital) ; see also id. at 1489,1504 (asserting that opportunity affects ideal income). 26. See generally Andrew Hacker, Two Nations: Black and White, Separate, Hostile, Unequal 249-62 (Statistical Sources) (1995) (collecting statistics showing opportunity differences b y race). 27. See Jonathan Kozol, Savage Inequalities 83-132 (1991). 28. Kaplow, supra note 2, at 1504. 29. See id. at 1504 n.61,1507 n.73. 30. See, e.g., William A. Klein & Joseph Bankman, Federal Income Taxation 121-2 2 (10t h ed . 1994) (noting that the performance of services in the home often i s described as a form of income, albeit administrativel y infeasibl e t o tax) ; Kaplow , supra note 2 , at 150 7 n. 73 . For a delightfu l exploration of imputed income issues, see Noel B. Cunningham & Deborah H. Schenk, The House that Jack Built, 43 Tax L. Rev. 447 (1988).

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31. Kaplow, supra note 2, at 150 7 n.73. 32. See id. at 1483 , table 1. 33. See Richard B. Goode, The Individual Income Tax 93 (rev. ed. 1976). 34. See Kaplow, supra note 2, at 149 9 n.48. 35. See Andrews 1974 , supra note 5, at 1185-8 8 (suggesting a similar hybrid system). 36. See I.R.C. § 101 4 (leads to untaxed incom e because i t permanently exclude s appreciatio n on propert y owne d b y a taxpayer a t deat h fro m ta x by increasing th e property's basi s to it s fai r market value as determined at the taxpayer's death).

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How Government Tax and Housing Policies Have Racially Segregated America

Because the spatial location and form of housing are importan t indicator s o f individua l an d collectiv e acces s to social , economic, and political resources , the prevalence of racial segregatio n in the metropolitan United States and the patterns of home ownershi p tied to it are extremely problematic. Based upon its location and form , housing become s "muc h mor e tha n shelter : i t provide s socia l status , access to jobs, education an d othe r services , a framework fo r th e con duct of household work, and a way of structuring economic, social and political relationships." 1 The location o f one's housing signifie s acces s to or denial of resources and social, political, and educational opportu nity structures. Furthermore, home ownership and equity are the most important sources of wealth to the individual American. The racialization o f hom e ownershi p an d hom e equity , therefore , cement s racia l segregation acros s tim e an d generation s becaus e wealt h largel y indi cates "individual an d famil y acces s to life chances . .. [as ] it is used t o create opportunities, secure a desired stature and standard of living, or pass class status along to one's children." 2 The racialization of space in metropolitan America developed out of a need fo r ne w constructs to preserve racial hierarchy and hegemony . The concurrent demis e of formal discriminatio n an d ris e of minorit y 80

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migration into metropolitan America created a new urban landscape in which the physical, social, economic, and political relations of the races were to be played out. Whereas once the marginalization o f the racia l Other wa s clearl y implemente d an d evidence d throug h formal , lega l separation, destruction o f these forma l implement s o f discriminatio n threatened the racial hierarchy and structures that facilitated thi s marginalization. White America responded t o this threat with the concur rent significatio n o f urba n spac e along racial, political, and economi c lines: "as urbanization of the colonized accelerated, so the more urgently wer e thos e racialize d force d t o occup y a spac e apar t fro m thei r European(ized) masters." 3 Initially, racial minorities were segregated by neighborhoods within the metropolitan city. As the sheer magnitude of minority migratio n mad e thi s infeasible , white s fled th e cit y fo r th e suburbs, closin g th e doo r o n minoritie s behin d them . Thus , spac e became racialize d alon g cit y an d municipa l line s rathe r tha n alon g neighborhood lines. At the same time, politics and public policy were shaped around this new constructio n o f racialize d space . Politica l entitie s an d ta x struc tures wer e delineate d b y cit y an d municipalit y unde r th e ostensibl y race neutra l principl e o f "local solution s t o loca l problem s wit h loca l programs funded b y taxes on local property."4 In reality, the fragmenta tion of metropolitan politics and policies concretized the boundaries of racial spac e and ensure d tha t resource s an d opportunit y di d no t flow between them : "the racia l poor wer e simultaneously rendere d periph eral in terms of urban locatio n an d marginalize d i n terms of power." 5 This imposition o f artificial loca l divisions upon metropolita n region s created a framework i n which "the fate of the city becomes not a shared interest, bu t par t o f a battl e ove r ho w resource s wil l b e distribute d across political boundaries."6 The resilienc y o f thi s spatia l arrangemen t ove r tim e an d acros s generations wa s als o strengthene d throug h th e publi c an d privat e denial o f hom e ownershi p t o th e marginalize d minorities . Govern ment-led lendin g policie s ensure d tha t minoritie s wer e denie d th e potential fo r socia l and economi c advancemen t tha t adhere s to hom e ownership b y precludin g wide-scal e hom e ownershi p i n th e centra l city. Simultaneously , governmen t zonin g polic y exclude d minoritie s from th e "lender-friendly " suburba n area s an d th e opportunitie s fo r home ownership that abounded there.

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Over time , racialized spatia l line s have shifted outwar d t o "accommodate" th e continue d growt h o f metropolita n area s an d thos e minorities who have accumulated the economic ability to move out of the centra l city . Thus, suburban Americ a ha s als o become racialized . Blacks ar e littl e mor e integrate d i n th e suburb s tha n the y ar e i n th e cities, the biggest difference bein g the level of poverty in the neighbor hood. Although Black s have move d t o th e suburbs , they hav e largel y moved into areas predominantly populated by minorities that are contiguous to large concentrations of poor minorities in the central cities. The spatial divisions of metropolitan America and the exclusion and deprivation that accompany them have in turn created a dual reality for the white majority and the racial Other. Concentrating minorities in the inner city and excluding them from resources , power, and the potential for advancemen t ha s led to th e concentratio n o f poverty, crime, poor education, an d othe r sever e antisocia l phenomena . Conversely , whit e suburbanites have been largely shielded from the effects of this deprivation an d the public cost of confronting them . In essence, the racialization o f spac e ha s subsidize d whit e suburba n Americ a a t th e sever e expense of minorities. The deviant , antisocia l trait s foun d i n th e inne r cit y hav e i n tur n provided whit e Americ a wit h a justificatio n fo r th e exclusio n an d deprivation that have caused them: "The poverty of the inner city infrastructure provide s a racia l sig n o f comple x socia l disorders , o f thei r manifestation whe n in fact it is their cause;... [Ijdealize d racia l typifications [are] tied to notions of slumliness, physical and ideological pollution o f th e bod y politic , sanitatio n an d healt h syndromes , lawlessness, addiction , an d prostitution." 7 Th e rol e tha t socia l contex t an d segregation pla y in th e creatio n o f thes e condition s i s ignored a s th e inner cit y becomes viewed as the space in which these aberrant thing s happen rathe r tha n th e intersectio n o f condition s tha t caus e thes e things to happen. The causal chain is reversed so that the effect i s perceived t o determin e an d justif y th e cause . In a self-perpetuating an d obscuring manner, "the reinforcement o f racial identities solidifies th e boundaries between groups and makes existing societal rules for classifying people into racial groups appear natural and immutable." 8 Racial explanations based on segregative effects ignor e not onl y the isolation and exclusio n tha t hav e caused th e realitie s of the inne r city , but als o the role that opportunities an d resources directed exclusively at whites

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have played in the realities of the suburb. The inner city is perceived as the natura l resul t o f shiftless , criminal , antisocia l Blacks , whereas th e suburb i s perceived a s the natural resul t o f honest, hardworking, selfsufficient whites . The federa l governmen t i s strongly implicate d i n th e developmen t and current realit y of metropolitan America. The federal government , through a variety of programs an d policies , has penalized th e Africa n American communit y an d subsidize d th e white community by subsidizing and reifying racial segregation and racial inequality in the distribution o f resource s i n th e Unite d States . Taxatio n i s on e vehicl e through whic h the federal governmen t ha s contributed t o racial separation an d perpetuate d thi s separatio n vi a subsequen t "neutral " policies. The government's tax policies, such as deductions for home mortgages an d investmen t incentive s fo r ne w businesses , hav e racialize d space by encouraging and enabling widespread disinvestment from th e central citie s an d communitie s o f color . Furthermore , b y denyin g minorities acces s t o wealt h vi a hom e ownership , an d th e benefit s of suburba n location , ta x policie s hav e solidifie d thi s segregation . Government housin g policie s an d program s (includin g th e federa l home mortgage loan), public housing programs, land use policies, and federal highwa y constructio n hav e als o exacte d a ta x fro m minorit y communities and delivered a benefit t o white suburban enclaves. These policies overburde n centra l citie s with societa l cost s t o th e benefi t o f suburban communities , who avoi d thei r shar e o f thes e cost s throug h the localized power model. This essa y wil l detai l th e racializatio n o f America n metropolita n space and the effects i t has had upo n th e majority an d minority areas. After chartin g th e spatia l developmen t o f metropolita n Americ a an d the effects o f segregation within it, it will focus primarily upon the role of the federal government in these phenomena. T H E G R O W T H O F M E T R O P O L I T A N A M E R I C A AN D WHITE MIGRATIO N T O T H E S U B U R B S

In the mid-twentieth century , metropolitan Americ a experience d a significant surg e i n population . A substantia l portio n o f thi s urba n influx wa s the migratio n o f Africa n American s fro m th e rura l Sout h

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to th e urba n North 9; a smalle r par t resulte d fro m th e emigratio n of Latinos , Asians, and peopl e fro m th e Caribbean. 10 Wit h thi s floo d of newcomers , America's centra l citie s reache d thei r zenit h i n term s of housing the metropolitan population . A study of 16 8 metropolitan areas found tha t in 195 0 70 percent of America's metropolitan popula tion resided in central cities. 11 As this migration of minorities accumulated, white city residents responded by ensuring that minority population growt h occurre d withi n segregate d neighborhoods , and "areas of acceptable blac k residenc e becam e mor e an d mor e narrowl y circum scribed."12 The shee r magnitud e o f minorit y migratio n cause d minorit y enclaves to expand, threatening the borders of established racial neighborhoods, and s o a second mas s movemen t occurre d i n whic h whit e urban dweller s with economi c means fled th e central city for th e suburbs. Following World War II the unsatisfied deman d fo r housing and government fundin g fo r hom e mortgage s fuele d thi s flight. 13 B y 1990 60 percent o f the population o f 320 metropolitan area s resided i n th e suburbs14 a s a result o f thi s "racially motivated 'Whit e Flight.'" 15 Th e Kerner Commission , establishe d b y Presiden t Lyndo n B . Johnson t o study the causes of racial tension i n urban America in the wake of the riots of 1968 , found tha t between 195 0 and 196 6 98 percent of African American population growt h occurred within metropolitan areas , primarily within the central cities. Conversely, between 196 0 and 196 6 78 percent o f white population growt h occurred i n suburban portion s of metropolitan America. 16 Metropolita n Americ a ha d bee n racialize d along neighborhood lines , but i t was now racialized alon g the borders of the city and the suburbs. By 197 0 metropolita n area s followe d a genera l pattern : " a largel y black central city surrounded by predominately white suburbs."17 As of 1990 67.8 percent of African America n metropolitan resident s lived in central citie s a s opposed t o a mere 3 3 percent o f whit e metropolita n residents.18 Although some middle-class Blacks have been able to move to the suburbs as well,19 this has had little effect o n the levels of black exclusion fro m wealt h an d whit e communities . Pattern s o f "tipping " (the phenomeno n o f white s tendin g t o fle e neighborhood s a s Blacks move int o them) 20 hav e carrie d int o th e suburb s t o th e poin t wher e black suburbanizatio n i s merel y a sig n o f th e expandin g ghettos. 21 Whether located in the city or in the suburb, a neighborhood's distance

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from a black-identified neighborhoo d i s highly predictive of its chance s of whit e an d blac k populatio n gai n an d loss. 22 I n fac t suburb s wit h large blac k population s ten d t o b e mor e lik e centra l citie s tha n lik e other suburbs : [SJuburbs that attrac t black residents tend to be older areas with relativel y low socioeconomic statuses and high population densities . Black suburban neighborhoods ar e typically adjacen t t o o r nea r th e centra l cit y and rela tively unattractive to white renters and home buyers. Often the y are older, manufacturing suburb s characterize d b y weak ta x bases , poor municipa l services and high degrees of debt. Black suburbs spen d a disproportionat e amount of their revenues on social services. In a less extreme fashion, therefore, black suburbs replicate the conditions of inner cities. 23 Alongside th e racializatio n o f spac e i n metropolita n Americ a ha s been a signification o f urban spac e economically. The physical confine ment o f Blacks to the central city has coincided with the economic con finement o f Blacks to poverty. In 194 4 87 percent o f black families live d below th e federa l povert y lin e compare d t o 4 8 percen t o f whit e fami lies, an d pe r capit a blac k incom e wa s 3 9 percen t o f pe r capit a whit e income. 24 Although genera l levels of poverty diminishe d du e to a period o f economi c growt h beginnin g wit h Worl d Wa r II , i n 196 4 blac k families wer e stil l fou r time s a s likel y a s whit e familie s t o b e livin g i n poverty. 25 Thi s disparit y ha s persiste d t o th e presen t day . For example , in 198 4 3 1 percen t o f blac k familie s live d i n povert y compare d t o 1 1 percent o f white families, and black family rea l income was only 57 percent o f that fo r whites. 26 Relatedly, wealth disparitie s acros s metropoli tan areas correlate with racial disparities. Controlling for educatio n an d occupation, a blac k person' s ne t worth , measure d i n term s o f hom e equity an d financial assets , is , on average , $43,14 3 les s tha n tha t o f a white person. 27 Accompanying an d stimulatin g thi s shif t i n populatio n an d wealt h has bee n a shift i n productio n activitie s mirrorin g th e movemen t o f middle- an d upper-clas s white s t o th e suburbs. 28 Manufacturer s hav e left older , les s efficien t factorie s an d move d t o suburba n locations. 29 This movement i s inextricably linked t o the racializatio n o f metropoli tan space : firms ar e lure d t o th e suburb s becaus e o f th e economi c deprivation o f th e centra l cit y an d th e economi c subsidizatio n o f th e suburbs a s manifested b y the "inferior publi c service s i n centra l cities ,

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[and] wea k househol d purchasin g powe r o f inner-cit y residents. 5'30 Retail an d consume r service s have also largely abandoned th e centra l city a s businesse s "followe d thei r traditiona l middle - an d upper income patrons to the suburbs."31 T H E E F F E C T O F METROPOLITA N S E G R E G A T I O N ON URBA N BLACK S

The racial an d economi c segregatio n o f metropolita n Americ a ha s severely advers e consequence s fo r Black s livin g i n th e centra l cities . This fact i s tightly linked t o th e localizatio n o f metropolita n politica l and tax structures. State delegations of power have given local governments authority over basic public services, such as police and fire protection, sanitation , publi c healt h services , an d schools ; th e powe r t o finance these services through revenue s generated from loca l property taxes; an d th e powe r t o regulat e lan d usag e throug h zoning. 32 Thi s fragmentation o f power over issues of regional import has dammed the flow o f metropolitan resource s and created vast reservoirs of opportu nity in the suburbs. It has created a set of "legal rules that permi t an d sustain th e insulatio n o f suburb s fro m regiona l problems," 33 concen trating these problems in the central city. One of the major effects of this racially and economically segregative system upon the central city is that it has led to erosion of the local tax base. This has had numerous negative effects upon the central city. One particularly injuriou s resul t i s that littl e money i s available fo r publi c services in the area where there is the greatest need for them. Because of the numerous socia l ills (discussed later) tha t accompan y segregation , "the cost[s ] o f providin g polic e an d fire protection , judicial systems , public hospitals, and jails are much higher in low-income areas." 34 This weak ta x base ha s als o resulte d i n a poor qualit y o f educatio n bein g offered t o central city children, given that education is funded primari ly through local property taxes. Yet another effect is the neglect of infrastructure in central cities. With the exception of highways, most urba n infrastructure, fro m transi t system s to water an d sewag e treatment, is outdated an d "wel l beyon d [its ] usefu l life." 35 Substantia l reductio n within th e last few decades in the amount o f federal grant s for publi c works ha s exacerbate d thi s problem. 36 Th e hig h cos t o f thes e publi c

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services an d th e departur e o f industr y an d commerc e hav e led t o th e highest tax rates' falling upon that sector of the population least able to bear them, as well as to inadequacy in the services provided. 37 A particularly troublesome effec t o f the chasm between centra l city tax revenue capacity and public service needs is that it has caused central citie s t o engag e i n debilitatin g biddin g war s with on e anothe r i n order to generate public revenue. This competition ha s led to a lowering o f wages , health an d safet y standards , and environmenta l regula tions as cities try to entice investment.38 The result is that cities, and the minorities confined there, pay more of the hidden costs of the economy in th e for m o f injuries , los t wages , an d environmenta l harms . Fo r example, minorities in the United States are more likely than whites to live near sources of pollution and in areas where levels of ambient pollutants, such as lead and carbon monoxide, are elevated.39 In fact race is the factor mos t closel y connected t o proximity to these hazards, more than income or other socioeconomic factors. 40 Severe social effects result from the concentration of race and poverty i n centra l cities : "[I]n concentratin g poverty , . . . segregation als o concentrates condition s suc h a s drug use , joblessness, welfare depen dency, teenag e childbearing , an d unwe d parenthood , producin g a social contex t wher e thes e condition s ar e no t onl y common , bu t th e norm."41 Thi s "social context " has th e tendenc y t o perpetuat e multi generational poverty . Lackin g peer s wit h stron g educationa l back grounds and internalizing the perception o f ghetto schools as inferior , inner cit y student s ten d t o los e thei r sens e o f "destin y control " an d develop a feeling o f powerlessness , resigning themselve s t o thei r cur rent situation. 42 A related phenomenon , cause d b y a lack o f employ ment opportunities and a consequent lack of employed role models, is that inne r cit y resident s ten d t o develo p a "weak labor forc e attach ment" and a propensity for antisocial behavior. 43 The advers e effect s o f segregatio n an d concentrate d povert y hav e proliferated. Segregatio n ha s led to an inadequate housing market fo r minorities. Give n tha t segregatio n an d discriminatio n limi t housin g options i n th e centra l city , a n artificia l housin g marke t i s created , in whic h deman d exceed s supply . The declinin g stoc k o f centra l cit y housing, couple d wit h discriminator y hom e mortgag e lendin g prac tices, forces minorities to pay inordinately high prices for substandar d housing.44

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Metropolitan segregatio n ha s led t o a dramatic increas e i n violen t crime rates among Blacks, despite a decrease in crime rates for societ y as a whole. In fact , th e degre e o f black-white segregatio n i s the mos t important variabl e in determining levels of black crime, far mor e significant than income, poverty, education, occupation, age composition, population size , or region. 45 Th e relationshi p betwee n racia l segrega tion, concentrate d poverty , and violenc e i s dramatic an d undeniable : "[B]y concentratin g th e persistentl y poo r i n certai n neighborhoods , segregation has created a 'street orientation,'... a social world characterized b y hig h level s o f interpersona l hostilit y an d aggression." 46 Furthermore, "t o surviv e o n th e street s o f segregated , inner-cit y America, on e mus t learn , an d t o a significan t exten t internalize , th e code of violence. In this way violent behavior is passed from perso n to person and parents to children in a self-feeding, escalating fashion." 47 Segregation an d th e departur e o f commerc e an d industr y fo r th e suburbs hav e create d wha t ha s bee n terme d a "spatia l mismatch, " whereby mos t ne w job creatio n ha s occurre d i n area s inaccessibl e t o low-income centra l cit y residents. 48 I n particular , low-skilled job cre ation i s occurrin g mainl y i n suburba n factorie s an d shoppin g malls , whereas th e minorit y poo r ar e concentrate d i n th e centra l city. 49 Because most job information i s disseminated via word of mouth, poor minorities ar e less likely than whites to learn o f these opportunities. 50 Furthermore, these opportunities ofte n ar e not viable for the minority poor becaus e o f thei r distanc e fro m th e centra l city . Ca r ownershi p rates ar e lo w fo r centra l cit y residents , an d publi c transportatio n i s often designe d so as not to make the suburbs accessible from th e inner city. For thos e wh o d o ow n cars , "these job s ofte n d o no t pa y hig h enough wages to compensate for the cost of the commute."51 An inadequacy of health car e in the central cities has resulted fro m segregation:" [N] early one in four blacks remains outside private health insurance o r Medicai d coverage." 52 Eve n fo r thos e wh o ca n affor d t o pay, health care is still difficult t o obtain because of an "overcrowding of public hospitals, clinic closures, and 'runaway hospitals' that have eliminated o r reduce d medica l service s in centra l cities , and a shortage o f physicians and dentists willing to practice in urban minority neighborhoods."53 It is ironic, in view of the Herculean burden that segregation and the

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concentration o f povert y place upo n th e centra l city , that segregatio n operates as a subsidy for exclusive suburbs. By concentrating the costly effects o f poverty in the central cities , white suburbs ar e able to avoid their shar e o f th e "poo r burden. " Shielde d b y th e moa t o f localize d political and tax structures surrounding them, suburbs avoid the costs of confronting crime , poverty, and the numerous social ills of the central city . In other words , localization o f policies allows the suburb s t o exclude "undesirables" from residin g within their bounds and absolves them of any responsibility once they have done so. 54

FEDERAL POLICIE S T O ENCOURAG E SUBURBA N MIGRATION O F P O P U L A T I O N AN D R E S O U R C E S

Although th e private, commercial, and industria l transitio n t o suburbia i s often considere d t o be the natural resul t o f technological an d market forces, in reality the movement has been subsidized by an array of federal policies. 55 All levels of government are implicated in the creation of urban segregatio n and the resultant concentration o f race and poverty. Various governmen t program s an d policies , man y o f whic h continue today, through their instigation of discriminatory practices or their accommodatio n o f discriminatio n an d intentiona l segregation , have aide d i n th e spatia l racializatio n o f metropolita n America . Significant amon g these practices are government policies about taxing and fun d allocation , particularl y governmen t policie s o n mortgag e assistance an d hom e ownership , an d governmen t an d judicia l lan d zoning practices and policies. Government subsidies for home mortgages and tax deductions connected t o hom e ownershi p hav e playe d a larg e rol e i n creatin g an d maintaining raciall y segregate d neighborhood s an d perpetuatin g th e racially discriminator y distributio n o f resources . I n 193 3 the federa l government establishe d th e Hom e Owners ' Loa n Corporatio n (HOLC). As a result of the Great Depression, many home owner s had defaulted o n their home mortgages and many more were in danger of default. HOLC was created to refinance mortgage s in danger of defaul t and provid e low-interes t loan s t o thos e wh o ha d los t thei r home s t o foreclosure.56

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Redlining One endeavo r o f th e federa l official s wh o administere d HOL C wa s to promot e uniformit y amon g financia l institutions , includin g uni form appraisa l standards. 57 A s the y di d so , the standard s tha t HOL C officials implemente d introduce d th e practic e o f redlining : raciall y o r ethnically divers e centra l cit y neighborhood s wer e systematicall y undervalued an d deeme d to o risk y fo r investment. 58 Area s wit h eve n the smalles t o f blac k population s wer e give n th e wors t possibl e ratin g to indicate a high ris k of default. 59 The effec t o f HOLC' s racis t practice s wa s greatl y increase d b y HOLC's influenc e o n th e underwritin g practice s o f othe r governmen t programs and private financial institutions . In particular, HOLC set th e tone fo r th e operatio n o f th e mortgag e insuranc e progra m o f th e Federal Housin g Administratio n (FHA) . Th e FHA , establishe d b y Congress in 193 4 "to bolster th e economy and increas e employment b y aiding the ailing construction industry," 60 was given the power t o guar antee hom e loa n mortgages . Th e impac t o f thi s progra m wa s enor mous: "Lenders , jitter y afte r year s o f hig h rate s o f loa n default s an d foreclosures, coul d originat e hom e loan s fre e fro m th e ris k o f loss . By 1972 th e FH A ha d insure d eleve n millio n hom e purchas e mortgag e loans an d twenty-tw o millio n hom e improvemen t loans." 61 Th e FH A followed th e lead of HOLC's appraisal standards an d discourage d lend ing i n integrate d an d minorit y neighborhoods. 62 It s underwritin g manual explicitly reflected thi s policy: Areas surrounding a location are [t o be] investigated to determine whether incompatible racial and social groups are present, for the purpose of making a prediction regarding the probability of the location being invaded by such groups. If a neighborhood is to retain stability, it is necessary that properties shall continue to be occupied by the same social and racial classes.63 The FH A als o encourage d municipalitie s t o enac t exclusionar y zonin g ordinances and raciall y restrictive covenants. 64 The impac t o f th e FHA' s policie s o n metropolita n Americ a canno t be overemphasized : Locked ou t o f th e greates t mass-base d opportunit y fo r wealt h accumula tion i n American history, African American s who desired and were able to

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afford hom e ownership found themselve s consigned to central-city communities wher e thei r investment s wer e affecte d b y th e self-fulfillin g prophecies of the FHA appraisers: cut off from sources of new investment their homes and communities deteriorated and lost value in comparison to those homes and communities that FHA appraisers deemed desirable.65 The Levittown, New York, housing development in Long Island provides a stark illustratio n o f the FHA' s role in racializin g metropolita n space and home ownership. Mass scale affordable housin g was built in Levittown a s a result o f FHA financing, makin g the American Drea m accessible to thousands of middle-class Americans. However, as late as 1960, not on e of Levittown's 82,000 residents was black.66 B y defining creditworthy neighborhoods by their "whiteness," HOLC and the FHA ensured tha t hom e ownershi p woul d occu r solel y in th e suburb s an d that it would be solely available to whites. Redlining practices introduced by HOLC and continued by the FHA impacted the practices of private lenders as well. HOLC officials adopt ed the practice of circulating their redlined maps throughout the lending industry to assist private lenders in the identification o f risky loan areas.67 Th e action s o f privat e lender s wer e als o influence d b y th e refusal o f the FHA to guarantee loans in minority neighborhoods an d by its active advocacy of segregation. The practice of redlining in the private lending industry has continued to the present day. Studies show that, controlling for factors such as education an d financia l resources , banks ar e les s willing t o len d t o a prospective entrepreneur who locates in a central city community, particularly a perso n o f color. 68 Furthermore , dat a obtaine d unde r th e Home Mortgag e Disclosur e Ac t (HMDA) 69 reveal s tha t lendin g dis crimination i s no t restricte d t o minorit y neighborhood s bu t instea d attaches to minorities wherever they may go. In general, people of color are two to three times more likely to be rejected for loans than similarly situated whit e applicants. 70 On e stud y conclude d tha t white s ar e accorded a "general presumption o f creditworthiness" that ha s caused lenders to overlook flaws in their credit record, while minorities benefi t from n o such presumption. 71 The effect o f this widespread redlining in the home mortgage industry is that the opportunity for minorities to become home owners, and thus obtain home equity wealth, has been severel y curtailed. A look at

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neighborhoods withi n metropolita n area s reveal s that th e proportio n of the population that is black is highly determinative of home ownership rates. 72 As of 1960 , when the FHA was in full stride, 60 percent of white households were home owners as compared to only 35 percent of black households.73 The disparity between black and white home ownership rates has remained virtually constant ove r time: as of 198 9 69.4 percent o f white households owned homes as compared t o 43 percent of black households.74 The effect o f this disparity upon minorities is particularly egregious given the significance o f home ownershi p an d hom e equit y wealth t o financial securit y and potential social advancement: "[H]ome equity is the key way that families accumulat e wealth. As more families borro w against their homes for college tuition, new business capital, and othe r purposes, th e ownershi p ga p exacerbate s black-whit e difference s i n access t o capital." 75 Thus, no t onl y ha s discriminatio n i n th e hom e mortgage industr y helpe d t o creat e segregate d metropolita n area s by discouraging integration; it has also helped to perpetuate this segregation an d th e dir e economi c condition s o f centra l citie s b y denyin g minorities a primar y vehicl e fo r socia l advancemen t an d economi c stability. When combined with other racist, wealth-denying practices tracing back t o slaver y and Ji m Cro w laws, the denia l o f hom e ownershi p t o Blacks ha s cause d wha t ha s bee n referre d t o a s a "sedimentation o f racial inequality" : "th e effec t o f thi s 'generatio n afte r generation ' o f poverty and economic scarcity for the accumulation of wealth has been to 'sediment ' thi s kin d o f inequalit y int o th e socia l structure." 76 Thi s inequality no t onl y penalize s Black s wh o ar e denie d th e benefit s o f home ownership , but i t als o subsidize s whites . Whereas "black s hav e had 'cumulativ e disadvantage, ' white s hav e ha d 'cumulativ e advan tages.'"77 White s disproportionatel y rea p th e benefit s o f governmen t fund allocatio n and are freed fro m competin g for scarce resources with an entir e sector o f the population. Thus, "the accumulation o f wealth for whites is intimately tied to the poverty of wealth for blacks."78 Tax Benefits of Home Ownership The tax system as a whole has operated to the benefit o f members of the uppe r incom e levels . Th e larg e an d widenin g ga p tha t exist s between th e lowes t an d highes t incom e grouping s expand s eve n fur -

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ther after taxes. Between 198 0 and 199 5 the bottom two income deciles suffered preta x losses of 8.4 percent and 2.3 percent of income, whereas the to p incom e decil e experience d a 37.1 percent increas e i n income . After taxes, this gap widened as the bottom two deciles' losses increased to 10. 3 percen t an d 3. 4 percent , whil e th e to p incom e decile' s gain s increased to 41.1 percent.79 In particular , becaus e hom e ownershi p i s highl y correlate d wit h race, subsequent "neutral" tax deductions benefiting home owners have operated t o th e disproportionat e benefi t o f whites , exacerbatin g th e disparity between black and white opportunity structures. 80 Tax benefits for home owners include interest deductions for home mortgages, favorable capital gains treatment, tax-free impute d income, and deductions for local real estate taxes. Home owners are permitted t o deduct the interest on debt incurre d to finance the acquisition o f a home.81 This deduction applie s to both the acquisition o f a principal residenc e an d th e acquisitio n o f a vacation home 82 an d i s subjec t t o th e generou s limitatio n tha t onl y th e interest o n $ 1 million o f debt between th e two homes is deductible. 83 Home owner s ar e als o abl e t o deduc t th e interes t o n hom e equit y indebtedness u p t o deb t o f $100,000. 84 Thes e ta x benefit s serv e t o spread the gap between black and white opportunity structures. Given that the home equity loan was designed to assist parents sending their children t o college , and tha t i t applie s t o an y expenditure , includin g business expenditures (fo r which there is no limit on the deductibilit y of interest),85 it directly expands life-advancing opportunitie s for white home owners without an y concurrent benefit t o Blacks who have been denied home ownership opportunities. Capital gains preferences benefit hom e owners in several ways. First, gains from the sale of a home are not recognized if reinvested in a home of equal o r greater wort h withi n tw o years. 86 Also, home owner s over fifty-five year s old may take a one-time exclusion of gain on the sale of a principal residence (i.e. , a permanent deferra l o f capital gains) u p to $125,000.87 Furthermore, capital gain s preferences pas s generationall y as the successive owner of a home, following a taxpayer's death, takes a basis in the home equal to its fair marke t value at the time of death. 88 Thus, a successive owner avoids taxes on any appreciation i n the value of a home between the original owner's acquisition and the time of his or her death. Home owner s als o benefi t fro m Congress' s failur e t o ta x impute d

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income. Home owner s who d o no t ren t thei r home s receiv e impute d income in the form o f the fair marke t value of the use of their home . The value of this use, the impute d income , is not subjec t t o taxation . Renters also gain the fair marke t value use of the home that they rent. However, they pay taxes for this usage as their income devoted to rental payments i s subjec t t o taxation . I n othe r words , wherea s th e hom e owner wh o choose s no t t o ren t give s u p onl y th e fai r marke t renta l value of his or her home, the renter gives up the fair market rental value of the home (in the form of rental payments) plus the taxes paid on the income used to pay that rent. A final tax benefit tha t accrues for hom e owners is the tax deduction for local real property taxes.89 Given the magnitude of these tax breaks and the discriminatory distribution o f hom e ownership , federa l ta x benefit s fo r hom e owner s have led to prodigious savings for upper-income taxpayers. Over half of the savings generated by these benefits accru e to people with income s above th e ninety-firs t percentile. 90 Th e hom e mortgag e interes t an d property tax deductions alon e amoun t t o $5 4 billion, with abou t $2 0 billion of this going to the top 5 percent of taxpayers. 91 In 199 3 $150.2 billion worth of capital gains were reported by taxpayers and 72 percent of this total was reported by the top 1 percen t of tax filers, the remainder of the capital gains being reported by a scant 6 percent more of taxpayers (i.e. , 93 percent o f taxpayer s receive d n o benefi t fro m capita l gains preferences). 92 Th e prioritie s embedde d i n thi s ta x structur e become eviden t whe n on e consider s that , despit e th e grea t nee d fo r low-income housing , federa l spendin g fo r low-incom e housin g ha s consistently bee n onl y a fractio n o f th e revenu e forgon e i n favo r o f home owners. In 1993 , for example, home owner tax preferences represented $72. 8 billion i n forgone revenue , while the federal governmen t spent only $18 billion to subsidize low-income housing ( a four-to-on e ratio).93 Th e federa l governmen t ha s opte d t o us e th e ta x syste m t o enhance th e whit e suburba n opportunit y structur e rathe r tha n t o address the tremendou s wealt h differentia l tha t exist s between Black s and whites : "The effec t o f th e ta x code's 'fiscal welfare ' i s to limi t th e flow of tax relief to blacks and direct it to those who already have assets. This seemingly race-neutral tax code thus generates a racial effect tha t deepens the economic gulf between blacks and whites."94 Economists hav e lon g maintaine d tha t hom e ownershi p i s over subsidized.95 Effort s t o restric t availabilit y o f thes e ta x deductions ,

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however, hav e com e a t th e expens e o f low - an d moderate-incom e households an d faile d t o addres s the disparit y with whic h th e benefi t is distributed. 96 Th e Tax Reform Ac t of 198 6 provides a case in point . Even thoug h th e ac t reduce s th e overal l siz e o f th e hom e mortgag e interest deduction, the top 1 2 percent of the home-owning populatio n still receive s 5 4 percent o f th e subsidy. 97 Furthermore , b y raisin g th e standard deductio n an d reducin g th e numbe r an d amoun t o f non housing expense s tha t ma y b e itemized , th e ac t reduce s th e valu e o f the home mortgage interest deduction fo r those households, predominately low- and middle-income, that have a high ratio of loan to home value.98 Federal Funding of Infrastructure Federal spendin g an d policie s i n area s othe r tha n hom e mortgag e programs have also racialized metropolita n America . The federal gov ernment, at the behest of suburbanizing, middle-class whites, has facilitated an d hastene d th e fligh t t o th e suburb s throug h massiv e fund s allocated fo r publi c highwa y construction. 99 Th e federa l governmen t has spen t $12 3 billio n fo r highwa y construction , a s wel l a s billion s more on infrastructure expansio n and maintenance for the developing suburban areas. 100 Coupled with "subsidized cheap fuel and mass-produced automobiles," massive highway construction has helped to make "living on the outer edges of cities both affordable an d relatively convenient."101 The developmen t o f highways , i n additio n t o aidin g residentia l "white flight, " has fuele d industria l an d commercia l abandonmen t o f the central cities. By the 1970 s the ring of expressways encircling cities had generate d ne w commercia l an d industria l centers. 102 Federa l ta x policies helped t o get central cit y businesses o n th e road by making it economically advantageous fo r firms to relocate in the suburbs rathe r than mak e capital improvements o n existing plants. 103 Thus, not onl y has th e federa l governmen t contribute d t o th e racia l stratificatio n o f metropolitan Americ a b y facilitatin g "Whit e Flight, " i t ha s als o con tributed significantl y t o th e "spatia l mismatch " that ha s cause d mos t new jo b growt h t o occu r i n area s inaccessibl e t o centra l cit y resi dents.104 Governmen t financing o f highwa y constructio n withou t comparable funding fo r public transportation ha s created a metropoli-

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tan transportation syste m "designed to transport suburban household s from thei r home s t o th e centra l business district , . . . not designe d t o move central households to suburban worksites." 105 This lac k o f publi c transportatio n an d th e distanc e betwee n hom e and potentia l employmen t hav e create d a dependency upo n automo biles for central city residents who desire such employment.106 However, these largely low-paying jobs mak e i t extremel y difficul t fo r would-b e workers to cover the cost of owning a car: "[A]utomobile ownership in the cor e area s o f thes e citie s i s s o expensiv e relativ e t o th e actua l o r potential income s o f thei r disadvantage d resident s tha t mos t canno t afford thi s increasingl y essentia l mean s o f securin g an d maintainin g blue collar employment." 107 Statistics on car ownership rates for black central city residents illustrate thi s conundrum . Fo r example , i n Philadelphia , 50. 9 percen t o f black central city households ar e without cars , in Boston 51. 3 percent are earless, and in New York a staggering 69.3 percent o f black centra l city household s d o no t hav e a ca r an d th e potentia l fo r suburba n employment tha t come s wit h one. 108 Congres s ha s don e nothin g t o alleviate the great cost of car ownership fo r centra l city residents. The tax code consistently has been interprete d t o den y taxpayers a deduction for the cost of commuting between home and work.109 This denial is predicated upo n th e erroneou s assumptio n tha t individual s choose where they live relative to their work place, ignoring the fact that segregation and discrimination deprive minorities of this choice. The design of transportation system s to serve the interests of suburban residents is manifested i n cement and steel throughout metropoli tan America. In Detroit the highways built in the aftermath o f the 1968 riots tak e commuter s fro m downtow n skyscraper s t o th e whit e sub urbs, without providing any exits into black central city Detroit. In New York highway overpasses i n som e area s have been constructe d s o low as t o preven t buses , an d th e centra l cit y resident s tha t the y carry , from passin g beneat h them . Portion s o f th e publi c rai l syste m i n Chicago that once served affluent suburba n neighborhood s hav e been torn dow n t o preven t acces s fo r low-incom e centra l cit y residents . Consistent with governmental indifference t o central city residents, the location o f these highways has damaged minoritie s i n another respec t as urban neighborhoods have been destroyed or extremely devalued by the construction of overpasses. Furthermore, these highways have been

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used a s physica l barrier s t o separat e raciall y identifiabl e neighbor hoods.110 Federal spendin g o n publi c housin g an d "urba n renewal " project s has also contributed t o segregation. The Housing Act of 1949 111 began the proces s o f "urba n renewal " throug h it s Divisio n o f Slum s an d Urban Redevelopment. Urban renewal has razed entire neighborhood s of tenements and rowhouses and replaced them with large, high-density public housing projects, 112 creating an "institutional mechanism fo r concentrating larg e number s o f poo r peopl e i n a smal l geographi c space."113 One of the major flaws of the Housing Act is that it gave local authorities, rather tha n federa l authorities , the power t o locate publi c housing sites, and in doing so gave suburban municipalities the option of not participating.114 Consequently, public housing was concentrated in the central cities where land was more expensive. Because of "strong resistance t o encroachmen t b y white neighborhoods , a strict govern ment unit-cos t formula , shrinkin g federa l slu m clearanc e subsidies , and high land costs," high density "multistory elevator towers on slu m sites" became th e inevitabl e en d o f urba n renewal. 115 Furthermore , within th e inne r cities , public housing was built i n th e least desirabl e and mos t segregate d areas. 116 Thus, urban renewa l "turned ou t t o b e nothing short of'warehousing 5 the racially marginalized"117 in order to keep the m i n discret e location s awa y from whit e neighborhood s an d away from thos e areas of the city where suburban white s continued t o work. These public housing projects cam e to embod y th e racialize d con ception of black central cities. Congress introduced admission s criteria requiring tha t thes e project s b e fille d wit h onl y th e extremel y poor . Originally, residency was limited to those "who are in the lowest income group an d wh o canno t affor d t o pa y enoug h t o caus e privat e enter prise" to build adequate housing. 118 Currently, congressional mandate s require that 7 5 percent of occupants of existing public housing and 85 percent o f occupants of new public housing earn a maximum incom e of 5 0 percen t o f th e area' s media n income. 119 I n addition , Congres s allocated n o funds fo r th e maintenance o f newly created publi c housing, and rental payments were insufficient t o cover maintenance costs. This caused the quality of public housing to decline rapidly. 120 Urban renewal in the form o f public housing "has fostered th e concentration o f poverty i n inner-cit y neighborhoods , sometimes single -

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handedly creatin g massiv e ghettos." 121 Curren t statistic s fo r publi c housing show that the median income of residents is $6,500, and threefourths o f nonelderl y familie s livin g i n publi c housin g ar e below th e poverty line. 122 No t surprisingly , publi c housin g i s als o ver y raciall y segregated: two-thirds of the nonelderly residents are black and another one-fifth ar e Latino.123

STATE P O L I C Y AN D F E D E R A L C O M P L I C I T Y IN DISCRIMINATOR Y Z O N I N G P R A C T I C E S

One of the major ways in which the racial and economic segregation of metropolita n Americ a ha s been preserve d i s through th e abus e o f zoning power . The powe r t o regulat e lan d us e i s vested i n th e polic e power o f th e state. 124 Thi s power ha s been delegate d b y the state s t o individual municipalities through zonin g enabling acts under the auspices o f th e localize d powe r model , whic h assert s tha t loca l govern ments are best able to serve the interests of their constituents. With the stratification o f metropolitan America , individual municipalitie s hav e used this virtually unfettered delegatio n of power to enforce and maintain economic and racial segregation through the practice of exclusionary zoning. The only restriction o n municipal zoning authority is that municipalities us e it to benefit th e "general welfare." 125 As will be discussed later, this generally has turned out to be no restriction at all. Exclusionary zonin g take s th e for m o f lan d us e requirement s designed t o preven t integratio n b y precludin g th e developmen t o f housing for low - and moderate-incom e persons . The specific type s of zoning provision s use d t o exclud e minoritie s ar e man y an d various , although ther e ar e som e commo n ones . On e commo n metho d o f exclusion i s throug h overzonin g fo r nonresidentia l purposes : zonin g boards wil l zon e portion s o f thei r municipalit y fo r commercia l an d industrial development to a degree that far exceeds projected growth in those areas.126 Also, within those areas zoned for residential uses, exclusive municipalities wil l generally zone most , if not all , of th e are a fo r single-family, detache d dwellings , partially o r wholl y prohibitin g les s expensive, multiuni t housing. 127 Cost s ris e furthe r withi n residentia l zones through minimu m hous e siz e requirements tha t greatl y exceed those considere d necessar y fo r healt h reasons 128 an d throug h mini -

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mum lo t siz e and frontag e requirements. 129 Numerou s othe r device s have been employed, for example , requiring unnecessary impact stud ies and application fees, restricting the number of bedrooms permitted, and mandating expensive housing adornments. 130 Despite the requirement tha t municipalities us e their zoning power to benefit th e "general welfare," state and federal official s hav e failed t o regulate municipa l lan d us e practices significantl y enoug h t o preven t discrimination: By delegating control over zoning and other land use powers to municipal officials, whos e immediate loyalty is to the existin g residents o f a town, many state legislatures have permitted the emergence of a balkanized land use syste m tha t i s so arbitrarily segregate d b y race, economic clas s and housing cost that it would surely be unconstitutional if it had been centrally designed.131 Attempts a t gaining judicial redress have also been ineffectiv e becaus e the judiciary has been very accommodating of exclusive suburbs. In 191 7 the Supreme Court declared that land use restrictions based explicitly on race violated the Fourteenth Amendment. 132 I t reconciled this decision with other s that maintaine d segregatio n b y emphasizin g that the Fourteenth Amendment specificall y protecte d propert y right s but did not protect so-called social rights. 133 Despite this longstanding declaration of de jure segregation as unconstitutional, the judiciary has done littl e t o preven t d e fact o segregatio n i n lan d use . The Suprem e Court's 192 6 decision in Village of Euclid v. Ambler Realty Co.134 has set the tone for a history of deferential review of zoning ordinances that do not contain explicit racial classifications. In Euclid the Court articulated the standard that the provisions of a zoning ordinanc e ar e unconstitutiona l onl y i f "suc h provision s ar e clearly arbitrar y an d unreasonable , havin g n o substantia l relatio n t o the public health, safety, morals or general welfare."135 Although Euclid did no t involv e a segregation-relate d challenge , th e Court' s benig n approach ha s eliminate d th e Fift h an d Fourteent h Amendment s a s viable source s fo r redres s o f th e injurie s o f exclusionar y zoning . Two cases i n particular , decide d i n th e 1970s , mad e thi s a fait accompli: Warth v. Seldin 136 an d Village of Arlington Heights v . Metropolitan Housing Development CorpP7 Warth was an attempt to gain low- and moderate-income housing in

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Penfield, Ne w York, an exclusiv e suburb o f Rochester . The Cour t dis missed th e plaintiffs ' claim s fo r lac k o f standing . Relyin g o n th e Constitution's "case or controversy" requirement an d general concerns of justiciability, the Court stated that to have standing to bring a constitutional claim, a plaintiff "mus t allege a distinct and palpable injury t o himself."138 Becaus e th e plaintiff s wer e seekin g relie f base d upo n th e generally exclusionar y natur e o f Penfield' s zonin g ordinanc e rathe r than a particular, discrete action take n by the municipality, the Cour t concluded tha t "th e fact s allege d fai l t o suppor t a n actionabl e causa l relationship between Penfield's zoning practices and petitioners' asserted injuries."139 The Court concluded that the failure of the low-income plaintiffs t o fin d housin g i n Penfiel d wa s "a consequenc e o f th e eco nomics o f th e housing market , rather tha n o f respondent' s assertedl y illegal actions." 140 I t reache d thi s conclusio n despit e knowledg e tha t Penfield's zonin g ordinance allocate d 9 8 percent o f th e town's vacan t land for single-family detache d housing with substantial minimum lot and building requirements, and made 0.3 percent of the land available for multifamily structures. 141 Two years later, in Arlington Heights, the Court again heard a constitutional challeng e t o exclusionar y zoning . Th e plaintiff s i n thi s cas e avoided th e standin g problem s o f Warth by proposing a low-incom e housing development, seeking a rezoning so that it could be built, and having their rezonin g request denied . The Court rejecte d thi s case on the merits , however , base d o n it s recentl y create d principl e tha t t o establish a Fourteent h Amendmen t violatio n a plaintif f mus t sho w discriminatory inten t o n th e par t o f th e governmenta l entit y bein g sued.142 Th e Cour t wen t o n t o elucidat e circumstantia l evidenc e tha t may b e regarde d a s showin g discriminator y intent , includin g devia tions from established procedure.143 The sophistication of exclusionary zoning practices by 1977 guaranteed that no such deviations would be found. The net effect of these two cases is that the Court has precluded constitutional challenge s to exclusionar y zoning. By requiring a narrowly focused, discret e injury , th e Cour t misconstrue s th e natur e o f exclu sionary zoning and ignores the discriminatory context in which seemingly neutral decisions take place. The racialization o f space in metropolitan areas, combined with the localization of power, creates a lens of racism through which colorless decisions become colored. Focusing on

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the decision rather than its effect ignore s this fact. In Arlington Heights, for example , the Court attribute d n o significance t o the scant numbe r of black residents resulting from th e zoning practice, 27 out of 64,000, according to the 197 0 census.144 The Court's remedial jurisprudence make s it improbable that, even if a successful clai m were brought, significant redres s could be had. In Milliken v. Bradley, 145 a school desegregation case, the Court stated that "the controllin g principl e consistentl y expounde d i n ou r holding s i s that the scope of remedy is determined by the nature and extent of the constitutional violation." 146 In view of the Court's practice to narrowly define a violation, linking the remedy to the magnitude of the violation ensures tha t a systemi c solutio n suc h a s dismantlin g o f th e zonin g scheme rarel y wil l b e gained . Thus , exclusionar y zonin g challenge s brought unde r th e Constitutio n ar e high-cost , high-risk , piecemea l weapons against a systemic problem. 147 Congress's most significant attemp t to confront exclusionar y zoning and othe r form s o f housin g discrimination , th e Fai r Housin g Ac t (FHA),148 has also proved ineffective. This resulted from a weak statute created by legislative compromise and ineffective judicia l enforcement . To facilitate passag e o f th e FHA , Sen. Everett Dirkse n o f Illinoi s dra matically weakened its enforcement mechanism s by eliminating HUD's authority t o hol d hearings , issu e complaints , an d publis h ceas e an d desist orders. Senator Dirksen's amendment als o reduced penalties fo r violations o f th e FHA. 149 Moreover , i f HU D coul d no t resolv e a dispute, the FHA only allowed for referral o f the case to the U.S. attorney general if there was evidence o f a "pattern o r practice " of discrimina tion or if the alleged discrimination raise d an issue "of general impor tance."150 Enforcement official s rarel y determined tha t individua l act s of discrimination satisfie d these criteria.151 According to a study by the U.S. Commission on Civil Rights, HUD referred onl y 10 percent of the cases it could not resolve to the attorney general. The attorney genera l pursued a very small percentage of the referrals. 152 In a n attemp t t o overcom e th e inadequacie s o f the FHA , Congress amended it in 1988 . The amendments extended the time to file a housing discriminatio n complain t fro m 18 0 day s t o tw o years , allowe d attorney's fee s and cour t cost s to be recovered by successful plaintiffs , and raise d punitiv e award s to te n thousan d dollar s fo r a first offense . They also authorized th e attorne y general , the Departmen t o f Justice,

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and HU D t o tak e a more aggressiv e approac h t o addressin g housin g discrimination.153 Courts have acted to strengthen the FHA's ability to confront exclu sionary zoning . Appellate court s agre e that exclusionar y zonin g chal lenges brought under the FHA do not require a showing of discriminatory intent.154 These cases also take a broader view of the type of injur y necessary t o provid e standin g t o sue . They find a legall y cognizabl e injury in the "adverse impact on a particular minority group and harm to the community generally by the perpetuation of segregation." 155 Despite thes e step s take n b y Congres s an d th e judiciary , th e FH A continues t o be an ineffectiv e mechanis m fo r eradicatin g segregation . The amended FH A continues to target discret e acts of discriminatio n in a larger race neutral framework. Yet the invidious effect o f systemic and systemati c discriminatio n continue s t o be ignored. Furthermore , the succes s o f th e FHA' s piecemeal approac h hinge s largel y upo n th e extent t o whic h th e attorne y general , th e Justic e Department , HUD , and the president wish to advance its goals. 156 One election ca n reorient the antidiscrimination convictio n o f one or all of these offices an d thus hav e a dramati c impac t upo n th e efficac y o f th e FHA . Th e November 199 4 congressiona l election s provid e a cas e i n point . Th e newly elected grou p i s now attempting t o eliminate , for example , the Justice Department's powe r t o bring "pattern o r practice" cases on it s own initiative under the FHA.157 Litigation under the FHA has not been more effective tha n litigation under th e Constitutio n i n curtailin g exclusionar y zoning . Th e FH A continues t o us e th e tor t an d crimina l liabilit y model s tha t requir e identification o f a violation, detectio n o f a perpetrator, an d proo f a t trial tha t th e perpetrator' s ac t constitute s a statutor y violation . Thi s standard o f proo f continue s t o mak e exclusionar y zonin g litigatio n time consuming. The requirements for standing make litigation expensive because a would-be plaintiff mus t propose an unsuccessful devel opment in order to suffer th e requisite injury . The net result of these inadequacies is that only a few of the meritorious cases have been litigated, and even fewer have resulted in a favorable decision for the claimant.158 Furthermore, remedies are modest because courts d o no t redres s th e systemi c damag e cause d b y individual acts . "[I]nstead of ordering a rezoning and invalidating the town's restriction on multi-family housing, the usual case will involve a remand to the trial

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court to weigh alternative sites. Remedies usually will be limited to one development i n one jurisdiction rathe r than wholesale changes in zoning ordinances." 159 Thus , th e case-by-cas e approac h articulate d b y Congress in the FHA and practiced by the judiciary continues to accommodate th e overarchin g syste m o f residentia l segregatio n an d racia l inequality by misconstruing the nature of housing discrimination a s an aggregation o f discret e act s taken agains t individua l minorities , rather than recognizin g i t a s a systemi c problem wit h broa d rangin g effect s upon minorities as a group.

F E D E R A L AN D STAT E P O L I C I E S CREAT E AN D CONSTRAIN INDIVIDUA L C H O I C E

The role of governmental policies in the segregation of metropolitan America refutes the accepted myth that segregation is the result of personal preference s an d choice . Reasonabl e examinatio n demonstrate s that choic e canno t explai n segregate d housin g pattern s i n th e Unite d States. As this essay has evidenced, the purportedly "natural" process of suburbanization ha s been heavil y subsidized an d encourage d throug h taxing an d spendin g policies , whil e th e exclusio n o f minoritie s ha s been enable d throug h th e delegatio n o f zonin g an d propert y ta x disbursement powers . Nonetheless , i t i s argue d that , afte r nearl y thirt y years of integrationist efforts, if minorities remain spatially concentrated it is a reflection o f their ow n preferences. 160 Fro m this perspective, today's housing markets no longer reflec t state-sponsore d discrimina tion but instead signify the aggregated choices of millions of Americans to liv e in area s that contai n thei r preferre d racia l balance. 161 Suc h a n argument misapprehends the manner in which choice is informed an d constrained by political policies and their consequences. At a deeper level the choice argument ignore s a substantial body of literature tha t help s u s to ascertai n whe n preference s ar e legitimatel y effectuated i n a democracy.162 Proponents of deliberative justice163 and social choice164 theory argue that the participation o f affected individ uals is essential to the legitimacy of decisions. From this perspective the preference o f most whites, or for that matte r o f most Blacks, to live in same-race neighborhoods cannot be effectuated legitimatel y absent the meaningful participatio n o f thos e injure d b y the disastrou s effect s o f

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segregation. Pu t anothe r way , eve n assumin g tha t housin g pattern s merely reflec t Americans ' preferences , i t doe s no t necessaril y follo w that suc h preferences shoul d be effectuated. A s a society we constrain, coerce, and infor m individua l choic e through publi c polic y o n front s ranging from traffi c regulatio n to drugs to antitrust. In this way policy contributes t o constructio n o f socia l meaning. 165 Give n tha t segrega tion demonstrabl y exact s extrem e cost s o n American society , and o n black America i n particular , publi c polic y should addres s rathe r tha n accede to segregationist preferences . However, public polic y ha s opposed , no t supported , integrationis t choices. By contributing to a social meaning in which a black neighborhood signifie s urba n woe s an d a white neighborhoo d signifie s socia l opportunity, federal and state policies have informed th e segregationist decisions reached by individuals. Just as a residence is essentially linked to an opportunity structure, residential choices take place within a larger structure of opportunity. Indeed, federal an d state policies have created individual "choices," by whites and Blacks, in significant an d interrelated ways. Federal and state policies have simultaneously created choice for and choices by whites. That is , by producing segregate d housin g markets , federal an d state policies allow whites to select their preferred residen tial option , an all-whit e o r mostl y white neighborhood. 166 Moreover , by subsidizing suburbanization an d sponsoring disinvestment in cities, federal an d state policies have created whites' choices by ensuring that there is only one rational option. For the white home seeker there is really no choice. The "option" of locating in the city is accompanied by a long refrain o f burdens: higher taxes an d inadequat e governmen t services , poo r schools , negativ e investment consequence s i f the home-seeke r i s a buyer, higher crim e rates, scarce and overprice d retai l outlet s an d consume r services , and limited employmen t options . At the same time the "option" of subur ban locatio n reflect s al l the benefits o f federa l an d stat e largesse. The decision is, in effect, already made. Meanwhile minorities ' choice s ar e constraine d an d denied . Although th e preferred neighborhoo d compositio n o f all whites is all, or predominantly, white, the expressed preference of most Blacks is for a neighborhoo d tha t i s half-black, half-white. 167 Blac k home-seeker s do no t hav e th e optio n o f selectin g thei r preferenc e becaus e suc h

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neighborhoods ar e virtually nonexistent. Indeed, when the exercise of Blacks' choice s result s i n a neighborhoo d whos e compositio n eve n approaches thei r preferre d balance , white s overwhelmingl y elec t t o move t o a mor e exclusiv e area . Thi s phenomeno n o f tippin g i s well documented.168 It is engendered and enabled by the existence of exclusive communities an d rendere d rationa l by the consequences tha t fol low when space is racialized and identified a s black. However, i t i s argue d tha t Blacks ' behavior belie s thei r expresse d preference fo r integrated neighborhoods. It has also been asserted that arguments like that offered i n this chapter denigrate non-whites by failing to respect minorities' decisions to live within their own communi ties.169 Both arguments fail to perceive the extent to which minorities' residential choices are framed an d limited by the opportunity structur e in which they are made. Racial minorities effectively ar e denied choice. For th e racia l poor , choic e i s foreclosed . B y definition ther e i s n o economic acces s t o exclusiv e neighborhoods . Africa n Americans , i n particular, live in poverty (deriving less than 30 percent of area median income) an d have severely constrained housin g options. In effect the y are limited t o subsidized housing , which i s disproportionately locate d in neighborhoods with high concentrations of racialized poverty, 170 or the severel y distressed surroundin g areas . To the exten t othe r option s might be available, the racial poor lack the information an d mobility to explore them . Economic s an d rac e constrai n th e housin g choice s o f poor African Americans. 171 Although poor whites are more numerou s than poor Blacks, they rarely live in areas of concentrated poverty. 172 It is clear that even though poor whites have some of the same economic constraints, they nonetheles s hav e mor e acces s to credi t an d housin g markets than middle-class Blacks.173 The limite d succes s o f th e sectio n 8 voucher an d certificat e pro grams (tha t provid e low-cos t housin g fo r person s i n poverty) , which are intende d t o enhanc e choic e fo r subsidize d households , illustrate s the conundrum fo r the racial poor. A number o f studies have demonstrated th e difficultie s vouche r an d certificat e holder s hav e in findin g suitable housing and the tendency of black recipients to remain in concentrated area s whe n the y d o locat e housing. 174 Again , som e migh t argue that these results reflect a preference to remain in black communities. However, a number o f system feature s i n the administration o f section 8 operate to defeat th e program's utilit y for enhancin g choice.

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In particular, the proliferation o f public housing authorities organize d at th e smalles t practica l level s ha s create d an d sustaine d barrier s fo r section 8 recipients seeking to move to a new neighborhood.175 Within this fragmented structure , residency preferences an d separat e applica tion procedures keep urban applicant s on long waiting lists. 176 Once a household has obtained a voucher, it must locate housing within a limited time or lose it. Yet, no provision i s made to assist families seekin g residential location s outsid e o f th e issuin g authority' s jurisdiction. I n fact the issuing authority will lose administrative fees if the household locates outside its jurisdiction.177 Indeed, until 198 7 subsidized households could not move outside of the issuing jurisdiction without losing their subsidy. 178 The power of choice/no choice for the racial poor can be seen by the success of affirmative choic e programs. Demonstration program s tha t correct som e o f thes e feature s hav e increase d residentia l mobility. 179 Significantly, mobility counseling and provision of simple information , such a s th e availabilit y an d locatio n o f suitabl e units , ar e th e mos t important factor s i n successful programs. 180 To date, such demonstra tion program s hav e reache d onl y som e twelv e thousan d households , whereas nearl y si x millio n Africa n American s liv e i n neighborhood s with high concentrations of racialized poverty. 181 Those wh o conten d tha t racia l concentratio n i n poo r neighbor hoods merely reflects th e preference o f Blacks point t o the concentra tion of middle- and upper-income Blacks in predominantly black suburbs. Th e availabilit y o f greate r economi c resource s t o thi s group , however, doe s no t insur e tha t i t ha s th e sam e freedo m o f housin g choice enjoyed b y whites. In the late 1960s , for example , 50 percent of affluent Black s and 40 percent of middle-class Blacks moved into houses formerly occupied by whites.182 These households did not choose to experience segregation . Their expectatio n o f integratio n wa s defeate d by the resegregation caused by white flight. The context in which housing decisions are made, moreover, cannot be overemphasized. Survey data indicate that mos t African American s are reluctant to be the first to cross the color line. 183 Entrenched segregation foreclose s th e choic e o f a n integrate d neighborhoo d withi n a significant blac k population . I n th e absenc e o f integrate d neighbor hoods, African American s ten d t o locat e i n primaril y blac k areas , a choice constraine d b y an ongoin g histor y o f exclusio n an d rejection .

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On the one hand, the black home-seeker ma y contend with the "steering" practices o f discriminator y rea l estat e agents , credi t discrimina tion, hostility from ne w neighbors, the chai n reactio n o f tipping, and other forms o f discrimination. On the other hand they may relent and move into a predominantly black area. The choice is effectively preor dained.

P R O S P E C T S FO R D E ' R A C IALIZI NG METROPOLITAN SPAC E

It is clear from the preceding discussion of metropolitan segregatio n that an y hop e o f de-racializin g metropolita n spac e an d promotin g racial, social, and economic justice requires not so much that we remedy individual act s of discrimination, but tha t we deconstruct th e frag mented localize d mode l tha t perpetuate s th e systemi c segregatio n plaguing metropolitan America. It is only through this that we can fuse the separate and disparate opportunity structures currently available to Blacks and white s into on e just opportunit y structur e availabl e to all. Although this has yet to happen in a systematic way, there are some isolated example s o f chang e tha t w e migh t hop e t o dra w fro m i n thi s endeavor. One example is the New Jersey Supreme Court's attempt to promote regional "fai r share " housing. Thi s court' s approac h t o housin g dis crimination, exclusionar y zonin g i n particular , wa s uniqu e i n severa l ways. First, the court recognized that exclusionary zoning and the segregation it maintained were systemic problems that did not necessaril y reveal themselve s throug h discrete , discriminator y actions . Conse quently, the court found tha t a municipality's action would violate the requirement tha t i t zon e fo r th e genera l welfar e i f evidenc e o f exclu sionary zonin g technique s wer e present. 184 Furthermore , th e cour t recognized tha t housin g segregatio n wa s a regiona l proble m tha t transgressed local political boundaries. Consequently, it mandated tha t each municipality allow for low - and middle-incom e housing "at least to th e exten t o f th e regiona l nee d therefor." 185 Anticipatin g problem s with noncompliance, the court went so far as to authorize lower courts to mandat e zonin g provision s an d t o approv e specifi c projects. 186 As might be expected, the far-reaching, progressive nature of this doctrine

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was very controversial, and it led to the New Jersey legislature's passage of th e Fai r Housin g Act, 187 which usurpe d oversigh t o f th e fai r shar e doctrine and weakened its requirements and enforcement . It i s difficul t t o evaluat e th e individua l succes s o f th e court' s fai r share doctrin e apar t fro m Ne w Jersey' s Fai r Housin g Act , bu t i t i s evident that much housing has been built as a result of the two. A study of fifty-four municipalitie s fro m 198 3 to 198 8 found tha t a s of 198 8 22,703 unit s wer e schedule d fo r production , 2,83 0 unit s ha d alread y been built, and 11,13 3 units were in the process of development.188 The sheer magnitud e o f this remed y obviously eclipses any gains that on e might hop e t o mak e through th e piecemeal litigatio n availabl e unde r Title VIII. Despite its successes, New Jersey's approach to fair housing is flawed. First, the doctrine fails to incorporate race as a factor t o determine the effects of , o r remedie s for , exclusionar y zoning . Consequently , man y municipalities wer e abl e t o mee t thei r fai r shar e obligatio n throug h economic, but no t racial , integration. 189 Second , the doctrin e ha s no t been successful in creating housing for the very poor. This shortcoming is due largely to th e doctrine' s relianc e o n th e private market . Privat e developers buildin g fai r shar e units , give n thei r profit-maximizin g agenda, have priced thei r unit s s o that the y are affordable onl y to th e very top of the eligible income groups.190 A judicial order that this type of housing be built could not benefit th e very poor, because only a legislature could provide the subsidy necessary to enable the very poor to acquire high-priced units. 191 Furthermore, because the fair shar e doctrine evaluate d eligibilit y base d upo n curren t income , i t faile d t o account for wealth disparities that lead to chronic poverty. Thus, many municipalities fulfilled thei r obligation by providing housing for "many persons who are income-poor onl y because of predictable, short-term life-cycle circumstances (e.g., students or young married couples)." 192 John Charle s Boge r ha s propose d a Nationa l Fai r Shar e Ac t tha t builds upon the successes of the fair share doctrine and remedies some of it s weaknesses . Buildin g upo n Ne w Jersey' s regiona l fai r shar e model, Boger has suggested a legislative remedy that create s financial incentives an d disincentive s fo r complianc e an d noncompliance : i n addition t o providing federa l subsidie s fo r thos e municipalitie s seek ing to meet their fair share burden, Boger would corral noncomplian t municipalities b y progressivel y denyin g th e hom e mortgag e interes t

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deduction an d loca l property ta x deduction fo r thei r constituents. 193 Boger would also incorporate racial calculations into the computatio n of a municipality' s fai r shar e nee d t o insur e integratio n an d urba n deconcentration.194 Michigan's reconstructio n o f schoo l financing provide s anothe r example of the type of solution necessary to address regional problems. In 199 3 Michigan revampe d it s funding o f education i n an attempt t o shrink the gross disparity in educational funding cause d by traditional funding based upon local property taxes. Under the old system, property taxe s accounte d fo r abou t 6 5 percen t o f Michigan' s educationa l funding an d created an educational syste m in which richer school districts spent a s much a s ten thousand dollar s per student annuall y an d poorer schoo l districts spen t a s little as thirty-five hundre d dollars. 195 Under th e ne w Proposa l A, 196 "th e stat e control s th e distributio n o f about 79 % of education funds , while locally collected an d distribute d property taxe s contribut e 20 % an d federa l ai d supplie s 1%." 197 Although the new plan does not create complete equality among school districts, it does significantly reduc e the educational gap, and it ensures that every student receives a "basic foundation allowance " guaranteeing a minimal level of expenditure. 198 Although neithe r Ne w Jersey' s fai r shar e doctrin e no r Michigan' s Proposal A is sufficient t o de-racialize metropolitan spac e and provid e equal acces s to opportunit y i n a comprehensive way , they d o provid e glimpses of the kind of solution that must som e day be proffered. Th e solution would deconstruct artificially created local power enclaves and address and rethink metropolitan segregatio n on a regional level. Such a broad-based solution is imperative if we ever hope to provide all metropolitan resident s wit h rea l lif e choic e an d meaningfu l acces s t o opportunity.

NOTES John a. powell would lik e to thank Gavin Kearney , University of Minnesota La w School Class of 1997 , for hi s outstanding research . His critical insigh t an d har d wor k tremendously improve d the quality of the essay. 1. John O. Calmore, Spatial Equality and the Kerner Commission Report: A Back-to-the Future Essay, 71 N.C. L. Rev. 1487, 1489 (1993) (citin g Critical Perspective s on Housin g xviii (Rachel G. Brattetal.eds., 1986)).

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2. Melvin L. Oliver & Thomas M. Shapiro, Black Wealth/ White Wealth: A New Perspective on Racial Inequality 2 (1995). 3. David Theo Goldberg, Racist Culture: Philosophy and the Politics of Meaning 187 (1993). 4. Richard Briffault, Our Localism: Part II—Localism and Legal Theory, 90 Colum. L. Rev. 346, 349(1990). 5. Goldberg, supra note 3, at 188. 6. John O. Calmore, Racialized Space and the Culture of Segregation: "Hewing a Stone of Hope from a Mountain of Despair? 143 U. Penn. L. Rev. 1233, 1251 (1995) (citin g Margaret Weir, From Equal Opportunity to "The New Social Contract? in Racism , th e City , an d th e Stat e 93 , 10 4 (Malcolm Cross & Michael Keith eds., 1993)). 7. Goldberg, supra note 3, at 198. 8. David R . James, The Racial Ghetto as a Race-Making Situation: The Effects of Residential Segregation on Racial Inequalities and Racial Identity, in Law & Social Inquiry, 407,420 (Arthu r F. McEvoyetal. eds., 1994). 9. John Charles Boger, The Urban Crisis: The Kerner Commission Report Revisited, 71 N.C. L. Rev. 1289,1298(1993). 10. Henry Cisneros , Meeting the Challenge of Urban Revitalization, 27 U. Mich. J.L. Ref. 633, 634 (1994); see also Keith Aoki, Race, Space, Place: The Relation between Architectural Modernism, Post-Modernism, Urban Planning, and Gentrification, 20 Fordham Urb. L.J. 699,750-51 (1993). 11. David Rusk, Cities without Suburbs 5 (1993). 12. Douglas S. Massey & Nancy A. Denton, American Apartheid: Segregation and the Making of the Underclass 32 (1993). 13. Mat44. 14. Id. 15. Anthony Downs, New Visions for Metropolitan America 29 (1994). 16. Boger, supra note 9, at 129 8 (citing Report of the National Advisory Commission o n Civil Disorders 12-13 (Bantum Books 1968), which is known as the Kerner Commission Report). 17. Massey & Denton, supra note 12 , at 61. 18. Boger, supra note 9, at 131 0 (citing Bureau of the Census, U.S. Department o f Commerce, Series P-60, No. 175 Poverty in the United States: 1990 Current Population Reports 77 (1990)). 19. Dougla s S . Masse y & Nanc y A . Denton , Suburbanization and Segregation in US. Metropolitan Areas, 94 Am. J. Soc. 592,593-94 (1988). 20. Oliver & Shapiro, supra note 2, at 40. 21. Massey & Denton, supra note 12 , at 70. 22. Id. at 79 & table 3.5. 23. Massey & Denton, supra note 19 , at 593. 24. Norman Krumholz, The Kerner Commission Twenty Years Later, in The Metropolis in Black and White: Place, Power, and Polarizatio n 3 1 (George C. Galster an d Edwar d W. Hill eds., 1992) [hereinafter Metropolis] . 25. Id. 26. Id. at 32. 27. Oliver & Shapiro, supra note 2, at 8. 28. Donald A. Hicks, Revitalizing Our Cities or Restoring Ties to Them? 27 U. Mich. J.L. Ref. 813, 824-25. 29. Id. 30. Georg e C . Galste r & Edwar d C . Hill , Place, Power, and Polarization: Introduction, in Metropolis, supra note 24, at 1,10 .

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31. John D. Kasarda, Urban Change and Minority Opportunities, in The New Urban Reality 33, 41 (Paul Peterson ed., 1985). 32. Richard Briffault, Our Localism: Part I—The Structure of Local Government Law, 90 Colum. L. Rev. 1,19(1990). 33. Briffault, supra note 4, at 349. 34. Downs, supra note 15 , at 48. 35. Peter Dreier, America's Urban Crisis: Symptoms, Causes, and Solutions, 71 N.C. L. Rev. 1351 , 1370(1993). 36. Id. at 1317. 37. Downs, supra note 15 , at 48; see also Boger, supra note 9, at 1299. 38. Dreier, supra note 35, at 1373. 39. Ke n Saxto n & Kennet h Olden , Environmental Justice: The Central Role of Research in Establishing a Credible Scientific Foundation for Informed Decisionmaking, 9 Toxicology & Indus. Health 685 (1993). 40. Robert Bullard & Beverly Wright, Environmental Justice for All: Community Perspectives on Health and Research Needs, 9 Toxicology & Indus. Health, 821, 824 (1993). 41. Boger, supra note 9, at 1317-18. 42. Id. at 129 9 (citing James S. Coleman et . al., U.S. Department o f Health, Educ, & Welfare, Equality of Educational Opportunity 23 (1966)). 43. William J . Wilson, The Truly Disadvantaged : Th e Inne r City , the Underclass , and Publi c Policy 57-58 (1987). 44. Boger, supra note 9, at 1300. 45. Dougla s S . Massey, Getting Away with Murder: Segregation and Violent Crime in Urban America, 143 U. Penn . L . Rev. 120 3 (1995 ) (citin g Rut h D . Petersen & Lauren J . Krivo, Racial Segregation and Black Urban Homicide, 71 Soc. Forces 1001,1013 (1993)). 46. Id. at 121 9 (citing Elijah Anderson, The Code of the Streets, Atlantic Monthly, May 1994, at 81,83). 47. Id. at 1221 . 48. Boger, supra note 9, at 1317-18. 49. Galster & Hill, supra note 30 at 4. 50. Id. 51. Mat 5 . 52. Oliver & Shapiro, supra note 2, at 24. 53. Boger, supra note 9, at 1329-30. 54. Briffault, supra note 4, at 355. 55. Dreier, supra note 35, at 1355. 56. Michael H. Schill & Susan M. Wachter, The Spatial Bias of Federal Housing Law and Policy: Concentrated Poverty in Urban America, 14 3 U. Penn. L. Rev. 1285,1308 (1995). 57. Id. at 1309. 58. Massey & Denton, supra note 12 , at 51. 59. Schill & Wachter, supra note 56, at 1309. 60. Oliver & Shapiro, supra note 2, at 17. 61. Schill & Wachter, supra note 56, at 1309. 62. Mat 1310 . 63. Id. (citing Dennis R. Judd, The Politics of American Cities: Private Power and Public Policy 281 (1979) (quoting FHA Underwriting Manual)). 64. Oliver & Shapiro, supra note 2, at 18.

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65. Id. 66. Id. 67. Massey & Denton, supra note 12 , at 52. 68. Timothy Bates, Small Business Viability in the Urban Ghetto, 29 J. Regional Sci. 625,635-37 (1989). 69. Pub. L. No. 94-200,84 Stat. 1125 (1975). 70. See Alicia H . Munnel l e t al. , Mortgage Lendin g i n Boston : Interpretin g HMD A Dat a 1 (Federal Reserve Bank of Boston) (Oct. 1992). 71. Id. 72. Wilhelmina A. Leigh, Home Ownership and Access to Credit 10 (Dec. 3,1993) (unpublishe d manuscript, on file with Institute on Race and Poverty, University of Minnesota Law School). 73. Id. at 11 . 74. Id. 75. James Candill, Racial Differences in Homeownership and Housing Wealth, 1970-1986, 30 Econ. Inquiry 83,99 (1992). 76. Oliver & Shapiro, supra note 2, at 51. 77. Id. 78. Id. 79. Thomas Edsall & Mary Edsall, Chain Reaction 219-20 (1991). 80. Oliver 8c Shapiro, supra note 2, at 42. 81.1.R.C.§ 163(h)(3)(B) . 82. Id. at § 163(h)(4)(A). 83.Jd.at§163(h)(3)(B)(ii). 84. Id. at § 163(h)(3)(C). 85. Id. at § 163(h)(2)(A). 86. Id. at §1034. 87. Id. at §121. 88. M at §1014 . 89. Id. at § 164(a)(1). 90. Peter J. Salsich, A Decent Home for Every American: Can the 1949 Goal Be Met? 71 N.C. L. Rev. 1619,1627-28(1993). 91. Oliver 8c Shapiro, supra note 2, at 44. 92. Id. at 43. 93. Salsich, supra note 90, at 1627-28. 94. Oliver & Shapiro, supra note 2, at 43. 95. See James R. Follain 8c David C. Ling, The Federal Tax Subsidy to Housing and the Reduced Value of the Mortgage Interest Deduction, 44 Nat'l Tax J. 147 (1991). 96. Id. at 157. 97. Id. 98. Id. at 149. 99. Massey 8c Denton, supra note 12 , at 44. 100. Dennis Judd 8 c Todd Swanstrom, City Politics: Private Power and Publi c Policy 180-81 , 207-9,392(1994). 101. Oliver 8c Shapiro, supra note 2, at 16. 102. Aoki, supra note 10, at 793-94. 103. Oliver 8c Shapiro, supra note 2, at 16. 104. Dreier, supra note 35, at 1376-77. 105. Galster 8c Hill, supra note 30, at 10.

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I 3

106. Kasarda, supra note 31, at 55. 107. Id. 108. Id. at 56. 109. See, e.g., Commissioner v. Flowers, 326 U.S. 465 (1946); McCabe v. Commissioner, 688 F.2d 102 (2nd Cir. 1982). 110. Dreier, supra note 35, at 1376-77. 111. Pub. L. No. 81-171,63 Stat. 413 (1949). 112. Aoki, supra note 10 , at 765-73. 113. Douglas S. Massey & Shawn Kanainveni, Public Housing and Concentration of Poverty, 74 Soc.Sci.Q. 109,120(1993). 114. Schill and Wachter, supra note 56, at 1292. 115. Goldberg, supra note 3, at 191. 116. Schill & Wachter, supra note 56, at 1295. 117. Goldberg, supra note 3, at 191. 118. Schill & Wachter, supra note 56, at 129 5 (citing Pub. L. No. 74-412, § 2(1), 50 Stat, at 888 (1995)). 119. Cranston-Gonzalez Nationa l Affordabl e Housin g Act, Pub. L. 101-625, § 511, 104 Stat. 4079,4194(1990). 120. Schill & Wachter, supra note 56, at 1296. 121. Id. at 1292. 122. Id. at 129 9 (citin g Conni e Casey , Characteristic s o f HUD-Assiste d Renter s an d Thei r Units in 1989 68 (1992)). 123. Id. (citing Casey, supra note 122 , at 44). 124. Florenc e Wagma n Roisma n 8 c Phili p Tegeler , Improving and Expanding Housing Opportunities for Poor People of Color: Recent Developments in Federal and State Courts, 24 Clearinghouse Rev. 312,343 (1990). 125. See Village of Euclid v. Ambler Realty Co., 272 U.S. 365,387 (1929). 126. Southern Burlington Cty. NAACP v. Township ofMt. Laurel (Mount Laurel I), 67 N.J. 151, 202,336 A.2d 713,740 (1975)(Passman, J. concurring). 127. Id. at 200,336 A. 2d at 739. 128. Id. at 197,33 6 A. 2d at 737. 129. Id. at 199,336 A. 2d at 738. 130. John M . Payne, Title VIII and Mount Laurel: Is Affordable Housing Fair Housing? 6 Yale Law & Pol'y Rev. 361,365 (1988). 131. Roisman 8c Tegeler, supra note 124 , at 343. 132. Buchanan v. Warley, 245 U.S. 60,82 (1917). 133. Id. at 74; see also Plessy v. Ferguson, 16 3 U.S. 537,550-51 (1896). 134. Village of Euclid v. Ambler Realty Co., 272 U.S. 365 (1929). 135. Mat395. 136. Warth v. Seldin, 422 U.S. 490 (1975). 137. Village of Arlington Heights v. Metropolitan Hous. Dev. Corp., 429 U.S. 252 (1977). 138. Wbrf/i,422U.S.at501. 139. Mat 507 . 140. Mat 506 . 141. Mat495. 142. Arlington Heights, 429 U.S. at 264-65. 143. Id. at 267. 144. Id. at 255.

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145. Milliken v. Bradley, 418 U.S. 717 (1974). 146. Id. at 744. 147. Arlington Heights, 429 U.S. at 262. 148.42 U.S.C. § 3601 et seq. (1988 & Supp. I 1989, Supp. II1990). 149. Massey & Denton, supra note 12 at 193. 150. George Metcalf, Fair Housing Comes of Age 3-14,85-86 (1988) . 151. Id. 152. Massey & Denton, supra note 12, at 197. 153. Id. at 210-11. 154. See, e.g., Metropolitan Hous. Dev. Corp. v. Village of Arlington Heights, 558 R2d 128 3 (7th Cir. 1977), cert, denied, 434 U.S. 1025 (1978); Resident Advisory Brd. v. Rizzo, 564 R2d 26 (3rd Cir. 1977). 155. Arlington Heights, 558 F.2d at 1290. 156. Massey & Denton, supra note 12 , at 212. 157. H.R. 1362,104th Cong. 1st Sess. §§ 145,147 (1995). 158. John Charle s Boger, Toward Ending Residential Segregation: A Fair Share Proposal for the Next Reconstruction, 71 N.C. L. Rev. 1574,1584 (1993). 159. Michael H . Schill , Deconcentrating the Inner City Poor, 6 7 Chi.-Ken t L . Rev. 795 , 836 (1991). 160. See, e.g., David J . Armor, Force d Justice : Schoo l Desegregatio n an d th e La w 127-14 6 (1995). 161. See id. 162. See, e.g., Jurgen Habermas, Morality and Ethical Life, Does HegeVs Critique of Kant Apply to Discourse Ethics, 83 Nw. U. L. Rev. 38 (1989); Lawrence Lessig, The Regulation of Social Meaning, 62 U. Chi . L . Rev . 94 3 (1995) ; Richar d H . Pilda s & Elizabet h S . Anderson , Slinging Arrows at Democracy: Social Change Theory, Value Pluralism and Democratic Politics, 90 Colum. L. Rev. 2121 (1990). 163. See, e.g., Habermas, supra note 162. 164. See, e.g., Frank I. Michelman, Law's Republic, 93 Yale L.J. 1013 (1984). 165. See Lessig, supra note 162 , at 944-49. 166. See Armor, supra note 160 , at 132-41; Massey & Denton, supra note 12 , at 88-96. 167. Armor, supra note 160; Massey & Denton, supra note 112. 168. See, e.g., Massey & Denton , supra note 12 ; Rober t H . Sander , Individual Rights and Demographic Realities: The Problem of Fair Housing, 82 Nw. U. L. Rev. 874,894-902 (1988). 169. See, e.g., Michael R . Tein , The Devaluation of Nonwhite Communities in Remedies for Subsidized Housing Discrimination, 140 U. Penn. L. Rev. 1463 (1992). 170. Massey & Kanainveni, supra note 113 , at 120 ; see also John Goerin g et al., The Location and Racial Composition of Public Housing in the United States 28-52 (HUD, Office of Policy Dev. and Research ) (Dec . 1994) ; John Goerin g e t al. , Promoting Housin g Choic e i n HUD's Renta l Assistance Programs: A Report to Congress 6-12 (HUD , Office of Policy Dev. and Research) (Apr. 1995). 171. Massey & Denton, supra note 12 , at 84-88 ; John Charle s Boger, Race and the American City: The Kerner Commission in Retrospect —An Introduction, 71 N.C . L . Rev . 1289 , 1336-3 7 (1993). 172. David T. Ellwood, Poor Support: Poverty in the American Family (1988). 173. See id.; George C. Galster, Residential Segregation in American Cities: A Contrary Review, 7 Population Res. & Pol'y Rev. 93,103-8 (1988); Sander, supra note 168 , at 886 nn.99-101.

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I 5

174. See, e.g., Housing Vouchers for the Poor: Lessons from a National Experiment (Raymon d J. Struyk and Marc Bendick Jr. eds., 1981). 175. Phillip Tegeler et al., Transforming Section 8: Using Federal Housing Subsidies to Promote Individual Housing Choice and Desegregation, 30 Harv. Civ. R.- Civ. L. L. Rev. 451,456-58 (1995). 176. Id. 177. Id. 178. M 179. Mat 458 . 180. Id. at 458-59; see also Paul B. Fisher, Racial and Locational Patterns of Subsidized Housing in the Chicago Suburbs, 1 Geo . J. on Fighting Poverty 384 (1994); Barbara Sard, The Massachusetts Experience with Targeted Tenant Based Rental Assistance for the Homeless: Lessons on Housing Policy for Socially Disfavored Groups, 1 Geo . J. on Fighting Poverty 1 6 (1994). 181. George E . Peterson & Kale Williams, Housing Mobility: What Has It Accomplished and What Is Its Promise, in Housing Mobility: Promise or Illusion (Alexande r Polikoff ed. , 1995 ) (cit ing Pau l A . Jargowsky, Ghetto Poverty among Blacks in the 1980s, 1 3 J. Pol'y Analysis & Mgmt. 288-310(1994)). 182. Sander, supra note 168 , at 887. 183. Massey & Denton, supra note 12 , at 89; Sander supra note 168 , at 887-88. 184. Mount Laurel 1,67 N. J. at 180-181,33 6 A.2d at 728. 185. Id. at 174,33 6 A, 2d at 724. 186. Southern Burlington Cty N.A.A.C.P v. Township of Mount Laurel (Mount Laurel II), 92 N.J. 158,285-86,456 A.2d 390,455 (N.J. 1983). 187. N.J. Stat. Ann. § 52:27D-301-29 (West 1986). 188. Lamar et al., Mount Laurel at Work: Affordable Housing in New Jersey, 1983-88, 41 Rutgers L. Rev. 1197,1210(1989). 189. Mat 1256 . 190. M at 1261 . 191. Mat 1261-62 . 192. Boger, supra note 158 , at 1598-99. 193. Mat 1608 . 194. M at 1612 . 195. Recent Legislation, 108 Harv. L. Rev. 1411 (1995). 196. Mich. Comp. Laws Ann. § 211.27a (West Supp. 1994). 197. Recent Legislation, supra note 195 , at 1411-12. 198. Mat 1412 .

5 GWEN THAYE R HANDELMA N

Acknowledging Workers in Definitions of Consumption and Investment The Case of Health Care

The incom e ta x i s bille d a s advantagin g wag e earners in various ways, from redistributing wealth through progressive rates t o conferrin g governmen t largess e i n th e for m o f ta x subsidies . Heading th e lis t o f ta x subsidie s i s the nontaxatio n o f employer-pai d health benefits , whic h th e Join t Committe e o n Taxatio n identifie s a s the larges t federa l "subsidy " provided i n th e for m o f forgon e ta x revenue. These advantages are illusory. The distributio n o f th e ta x burde n ultimatel y i s a functio n o f the definitio n o f terms . The incom e ta x incorporate s conception s o f income grounde d no t i n th e experience s o f workin g peopl e bu t i n unrealistic assumptions of economists and abstractions of legal academics.1 The result is a tax law that systematically disfavors earnings fro m labor. Entrepreneurs are taxed on net income, with deductions allowed for the costs of producing that income. In contrast, all living and famil y expenditures ar e define d a s nondeductibl e consumptio n withou t regard to whether they facilitate wor k or leisure. 2 Distributional table s based o n a definition o f income tha t exaggerate s wage earners' ability to pay give a distorted view of the allocation of the tax burden by failing to account for all of the costs of producing wage income. Tax subsidies

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that purportedly tilt the tax system in favor o f working people actually only partly compensate for a biased definition o f income. Prosavings ta x refor m proposal s woul d substitut e a ta x bas e eve n more unfavorable t o people who generate social product through thei r labor. Wit h gran d appellation s lik e "Th e Freedo m an d Fairnes s Restoration Act," an array of tax reform proposal s sound the theme of encouraging savin g and investment . It is a maxim o f macroeconomi c policy that only by increasing domestic saving will the nation be able to generate the investment revenues necessary to fuel national growth. Its corollary state s tha t savin g i s favored ; consumptio n i s disfavored . However, the definitio n o f th e pivota l term s consumption and investment proceed from account s of history and society that, at best, ignore the contributions and experience of workers and, at worst, betray hostility to workers , particularly t o organize d workers . As under curren t law, the proposals generally treat a worker's expenditures on mental or physical development an d fitness as consumption, whereas for a business t o deplet e natura l resource s t o produc e virtuall y an y product , whether wit h beneficia l o r harmfu l socia l an d environmenta l effects , counts as investment. These definitions hav e harsh consequences for working people who devote their resource s primaril y to employment-relate d expense s an d to investmen t i n thei r productiv e capacity . The prosaving s proposal s would magnif y th e significanc e o f th e definitio n o f consumptio n because the y would ai m taxe s at consumptio n i n orde r t o encourag e individuals t o tur n ove r fund s t o entrepreneur s fo r investment . I n essence, they seem to have less to do with encouraging investment an d more to do with who is to make investment decisions . Thus, the likely primary beneficiaries o f the prosavings proposal s will not b e worker investors but entrepreneurs. The Contractors with America did not inven t these peculiar defini tions o f consumptio n an d investment . Use d i n les s evangelisti c rhetoric, they have been aroun d fo r som e time and will prevail in this Congress an d man y mor e t o com e unles s differen t account s o f American histor y and societ y are recognized. In Irving Howe's words, the productiv e rol e an d experienc e o f workin g peopl e hav e bee n "block[ed] ou t of our national consciousness." 3 In his introduction t o the visually powerful Images of Labor, Howe urged recognition "in ou r social arrangements an d ou r cultura l experienc e [of ] th e centrality of

ACKNOWLEDGING WORKER S I

the American workin g class." 4 This essay argues for acknowledgin g i n our tax policy the individual lives and collective role of working people in American society . Otherwise, tax reform wil l exacerbate the unfair ness and the distortions existing under current law. This essa y explores ways that ta x policy has "blocked out " workers and considers alternative approaches with a particular focus on the tax treatment of worker health care costs. Part 1 o f the essay shows how the late Stanley Surrey's intellectually and politically influential ta x expenditure analysi s ignore d th e perspectiv e o f workers i n accommodatin g theory t o practice . Ta x expenditur e analysi s i s "firml y ensconce d i n the ta x polic y literature , i n th e la w schoo l curriculum , and , vi a th e Congressional Budget Act, in federal law." 5 So, too, is the habit of blocking out workers from ta x policy. Part 2 shows that the most prominen t proposals for fundamental ta x reform targe t wage earners out of disregard for their productive role. Part 3 shows that tax reform, rationalized by negative stereotypes of workers, would accelerat e shifting o f industrial production cost s to them. Part 4 urges acknowledging the contributions and experience of workers by recognizing as investment man y expenditures currentl y designate d a s consumption. This last part use s health care expenses to illustrate the approach. Despite challenges by legal academics and economists of the stature of Willia m Andrews, 6 Bori s Bittker, 7 Josep h Pechman, 8 an d Davi d Bradford,9 classificatio n o f healt h car e expenditure s a s consumptio n has assume d th e statu s o f objectiv e an d unassailabl e fac t i n ta x an d health polic y discours e an d appear s t o constitut e th e officia l federa l government position . Thi s essa y conclude s tha t expense s o f workers ' necessary healt h car e shoul d no t b e treate d a s consumptio n and , accordingly, that employer-provided healt h car e should not be subjec t to tax under either an income- or consumption-based tax. This conclusion woul d see m t o bolster argument s fo r eliminatin g rule s that pro hibit discriminatio n i n favo r o f highly compensated employee s unde r employee benefi t plans . If exclusio n o f employer-provide d benefit s i s appropriate i n calculatin g ne t economi c income , the n regulatin g th e distribution o f employe e benefit s unde r nondiscriminatio n rule s would seem unjustified. 10 However, eliminatio n o f nondiscriminatio n rule s woul d b e a mistake because, despite thei r shortcomings , the y hav e facilitate d broad , though fa r fro m universal , distributio n o f socia l insuranc e benefit s

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through th e private secto r i n th e form o f employer-pai d medica l an d retirement program s an d othe r benefi t arrangements. 11 Absen t th e nondiscrimination requirements , man y employer s likel y woul d dro p coverage o f rank-and-fil e worker s unde r healt h an d retiremen t pro grams. Market forces are inadequate to cause employers to assume the full social costs of their enterprises because of externalities and serious inequalities i n bargainin g powe r betwee n labo r an d management . Therefore, employe e benefi t nondiscriminatio n requirement s ca n b e justified a s a n incentiv e fo r employer s t o internaliz e thes e enterpris e costs. Requiring employers to internalize their costs will cause employers to assume responsibility for the social implications of their actions.

I . IGNORIN G TH E PERSPECTIV E O F WORKER S UNDER TA X E X P E N D I T U R E ANALYSI S

The tax expenditure concept begins with the ethical proposition that the public is entitled to a fair contribution from it s members to financ e public functions, based on their ability to pay as measured by income. People who have equal incomes are to pay equal tax (horizontal equity) and peopl e wh o hav e mor e ar e t o pa y mor e (vertica l equity) . "Tax expenditure" is a term o f ar t fo r ta x rules that fo r reason s othe r tha n administrative feasibilit y d o no t accuratel y measure th e abilit y to pa y taxes. The term was chosen to connote that deviations from the abilityto-pay standard are the equivalent of a government subsidy in the form of tax relief rather than a direct payment. 12 Generally, excusing taxpayers from payin g their fair share by levying tax o n les s tha n thei r ful l economi c incom e i s a ta x subsid y o r ta x expenditure. Nevertheless , one-tim e assistan t secretar y fo r ta x polic y Stanley Surrey , wh o introduce d th e concep t o f th e ta x expenditur e budget, recognized that a tax system in the real world cannot be based on an entirely theoretical definition o f income. Thus, under tax expenditure analysis , the practical definitio n o f income employe d i s "somewhat less comprehensive than the economists' approach."13 One issue of administrative feasibility i s the taxpaying public's perception o f fairness. If the tax system seems arbitrary and alienatin g to taxpayers, the accuracy of self-assessments will suffer. Thus, if a receipt is not recognize d i n commo n understandin g a s increasing economi c

ACKNOWLEDGING WORKER S I

well-being, definitiona l adjustment s ma y b e justifie d eve n if , unde r economic theory, the amount should be counted as an increase in ability to pay. In adjustin g fo r taxpayers ' perceptions o f fairness , however , tax expenditure analysi s reflects unacknowledged , and surel y unintentional, class bias. Higher-income taxpayer s are the principal beneficia ries of thes e prudential adjustment s t o th e definitio n o f income . The experiences and perceptions of working people are not taken similarl y into account. On feasibilit y grounds , tax expenditure estimate s do not includ e as income gifts, the rental value of the use of one's own property (impute d income), or unrealized appreciation in the value of property. Taxpayers do not perceive enjoyment o f these economic benefits a s income-producing events , even though the y represent clea r instances of increase s in economic power. Those with incom e in this form enjo y substantia l tax saving s relativ e t o thos e wh o hav e incom e i n th e for m o f wages. The former pay no tax on gifts or the value of their use of a residence or other consume r durables , whereas wage earners pay income tax on all wage income (withou t an y compensating deduction i f they rent property that the y cannot affor d t o own). Further, deferral o f tax on value acquired i n th e for m o f unrealize d increase s i n th e value o f propert y (rather than i n the form o f taxable wages) allows an economic benefi t to th e owne r o f th e propert y tha t i s equal t o th e interes t tha t ca n b e earned on the amount not paid in tax currently. That benefit increase s with th e lengt h o f tim e betwee n th e poin t a t whic h th e valu e o f th e property increase d (whe n a worke r woul d hav e pai d ta x o n a lik e amount paid in wages) and the time of sale when the gain is recognized for ta x purposes . Wealthie r taxpayer s ow n mor e valuabl e consume r durables and investmen t propert y and giv e and receiv e more substan tial lifetim e an d testamentar y gift s tha n th e les s well-to-do . Conse quently, upper-income household s enjo y a much greate r incidenc e o f nontaxable incom e i n the form o f gifts, imputed income , and unreal ized appreciation. Tax expenditure analysi s does not sho w a similar solicitud e towar d the perceptions o f fairness o f taxpayers who have much les s wealth i n property but wh o hav e employment-derived benefits . Nontaxatio n o f pension accumulation s i s a prominen t ta x expenditure . Yet, pensio n savings, a form o f wealth worker s ma y have accumulated, i s no mor e likely to be regarded by a taxpayer as income, prior to actual payment,

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than is unrealized appreciation. Similarly, it is doubtful that workers see payments to maintain physica l or mental health a s representing som e sort of advance in economic well-being. Yet, nontaxation o f employeeprovided health care benefits is treated as a tax expenditure. The bia s i n ta x expenditur e analysi s reflect s wha t Irvin g How e described as the "dominant American myth of a nation of independent craftsmen, smal l farmers , sturd y businessmen , usuall y self-employed , sometimes hirin g a few 'hands,' but mostl y succeedin g throug h thei r own industriousness an d sobriety." 14 That myth has "disabled us fro m seeing what is there in front of our collective nose," that is, wage earners who actually perform the productive work.15 A jolting example of erasing workers from account s of American lif e appears in a property law hornbook, which explains that generally "personalty is created specifi cally for sal e or us e by the creator and clearl y belongs to it s producer. Thus, a new automobile i s the property of the manufacturer . .. [!]" 16 The aut o worker' s contribution , eve n hi s o r he r existence , i s no t acknowledged. If workers are not recognized as producers, it follows, as Surrey vehemently insisted , that th e cost s o f producin g incom e fro m labor, such as health care expenditures, properly are treated differentl y from the costs of producing income from material and financial capital.

2 . IGNORIN G TH E PRODUCTIV E ROL E O F WORKER S UNDER TA X R E F O R M

Similarly, i n th e account s o f histor y an d societ y propellin g th e prosavings proposals, the entrepreneur i s ascribed central social value; the contributions of workers are not valued at all. The economic theory of Jean-Baptiste Say (1768-1832), who coined the word "entrepreneur," propels th e supply-sid e economic s behin d muc h o f prosaving s ta x reform.17 Say's theory of the law of supply and demand posits that production open s demand fo r products. Say's Law often i s summed u p as "supply creates its own demand." Say asserted that all goods produced by society are consumed eithe r by the producer, or by another maker of goods, or by a third party who trades fo r curren t outpu t wit h a promis e t o pa y wit h equivalen t amounts of future output. For example, producers of food and clothing will consum e eac h other' s productio n throug h trade . Ne w entrepre -

ACKNOWLEDGING WORKER S I

neurs borrow food an d clothing from already-establishe d producer s of those goods and promise to pay for the goods in the future with equivalent amounts of their output plu s interest. According to Say's Law this means that the overall value of what people produce creates the wealth necessary to buy the goods and services that people make. Say's accoun t o f growt h make s supplier s th e critica l actor s i n th e economy and leads supply-side economic policy to focus upon producers rathe r tha n consumers. Supply-sid e economist s conclud e tha t lo w rates of taxation on production will yield the greatest increases in productivity an d growth . Producer s wil l creat e an d trad e mor e good s i f taxes are limited because lower taxes will increase the incentive to produce. Workers do not figure prominently in this story because supplyside economic s implicitl y equate s productio n wit h entrepreneuria l activity rathe r tha n wit h th e labor o f th e invisibl e worker. It remove s workers from the category of producer and categorizes expenditures by workers as disfavored consumptio n rathe r than a s favored investment . As currently conceived, the three major proposed approaches to funda mental restructurin g o f th e ta x system—th e fla t tax , the value-adde d tax, an d th e consumed-incom e tax—ignor e th e productio n o f wag e labor. The Flat Tax Among the major ta x reform proposal s currently being debated ar e several variation s o n th e flat-rat e incom e tax . A flat-rate incom e ta x would replace the graduated system with a single, low rate. In order fo r a flat-tax system to generate the same revenue as the current system, the tax base would hav e to be broadened. I n othe r words , the ta x syste m would have to tax a broader range of transactions. The Freedom an d Fairnes s Restoration Act of 1995, 18 sponsored by House Majority Leader Richard K. Armey and Sen. Richard Shelby, 19 is based on the flat tax proposed by economist Rober t E. Hall and political scientis t Alvi n Rabushka , a s describe d i n The Flat Tax. 20 The ta x would appl y to busines s incom e an d t o wages . Income fro m interest , dividends, and capital gains would be nontaxable to individuals on the ground tha t the y ar e taxed a t th e busines s level . Businesses would b e taxed on total receipts minus payments the business makes to workers and suppliers. Thus, deductions for the cost of earning income general-

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ly would be allowed to reduce the business income subject t o tax. The costs o f employe e benefit s othe r tha n contribution s t o retiremen t plans, however, would not be deductible and therefore woul d be taxed at the employer level. The wage tax would b e impose d o n wage s i n exces s of a n exemp t amount. Wages equal total compensation, other than employee benefits taxed a t the employer level , plus retirement pla n distributions . Under the bill , single taxpayer s woul d b e allowe d a $10,70 0 allowance , an d head of household filer s would be allowed $14,000. Married taxpayer s would b e allowed $21,400 . The bill would allo w an additiona l $5,00 0 deduction fo r eac h dependent . Proponent s clai m tha t th e allowance s make the system progressive, but other features o f the flat tax have the opposite effect . Worker s would no t b e allowe d an y deduction fo r th e costs of earning income . Also, because o f their weak bargaining posi tion in the current labor market, employees likely would end up paying the tax on benefits i n the form o f reduced wages, even though th e tax nominally i s imposed o n employers. 21 Employee s als o migh t en d u p paying a n eve n greate r portio n o f th e business-leve l tax . Economist s disagree as to whether investors, consumers, employees, or a combination woul d bea r business-leve l taxes. 22 A t th e minimum , tha t con sumers an d employee s migh t bea r a t leas t som e o f th e business-leve l tax mus t b e take n int o accoun t whe n evaluatin g th e distributiona l effects of the flat tax. In form th e flat ta x is not purel y a consumption ta x because of the tax o n busines s incom e a t th e busines s level . However , th e fla t ta x would operate as a consumption ta x to the extent that consumer s an d employees woul d bea r th e busines s tax . Indeed, it s author s acknowl edge that th e "logic" of the flat tax , "stripped t o basics," is to tax consumption, measure d a s income minu s investment . According t o Hal l and Rabushka, "[t]he public does one of two things with its income— spends i t o r invest s it. " Under thi s logic , businesses an d shareholder s invest, whereas workers spend. 23 Fo r wage earners, nothing count s a s investment.24 Consumption Tax Proposals Various proposal s mor e frankl y directe d t o taxin g persona l con sumption comman d considerabl e suppor t a s encouraging saving . Tax

ACKNOWLEDGING WORKER S I

reformers who believe that it is fairer to tax what individuals take out of the economy (consumption) rathe r than what they put in (investment ) favor consumptio n taxes . However , consumptio n taxe s ten d t o b e regressive becaus e consumptio n fall s a s a percentag e o f incom e a s income rises. 25 The regressivity may be alleviated by providing exemptions or lower rates for food, medicine, and other necessities. Moreover, if expenditures necessary to maintain and to develop worker fitness fo r employment were recognized a s investment, taxing only consumptio n might not prove regressive. The Value-Added Tax. A consumption-based value-added tax (VAT) that extends through th e retail stage is essentially a multistage equiva lent o f a retail sales tax. The retail sales tax is a tax on sale s to households, collected onl y at th e retai l leve l at th e tim e o f purchas e b y the ultimate consumer . I n contrast , a VAT is collected a s the good s mov e through th e variou s stage s o f productio n an d distribution . A VAT would tax the value of all goods and service s consumed i n the United States a s that valu e i s added i n increment s alon g the productio n an d distribution chain , up to and includin g purchase by the ultimate con sumer. Participant s i n th e chai n woul d pa y the ta x o n th e valu e tha t they add to the product. For example, a manufacturing busines s "adds value" to a product if the market value of its product is greater than the cost of the crud e materia l require d t o manufactur e tha t product . Th e manufacturer woul d pay tax on that "value added." 26 VATs take two forms. Under the "credit method," there is actually no calculation o f a firm's value added. Instead, the tax is collected o n th e firm's gros s receipts from sales , with a credit allowed fo r th e VAT paid by suppliers. This is the for m o f VAT favored b y European Economi c Community nations. Under the "subtraction method, " the VAT is measured b y calculatin g th e differenc e betwee n th e firm' s receipt s fro m sales o n on e han d an d outlay s fo r equipmen t an d inventor y o n th e other. The United Saving s Allowance Tax Act (US A Tax), 27 sponsored by Senator s Nun n an d Domenici , include s a "cashflow tax " on busi nesses, simila r t o a subtraction-metho d VAT . Th e US A Ta x woul d impose an 1 1 percent tax on a business's net cash flow plus compensation, interest , an d dividend s paid , wit h a credi t allowe d fo r Socia l Security and Medicare taxes paid.28 The Consumed-Income Tax. A consumed-incom e ta x i s a ta x o n persons, not o n sales . The intellectual architec t o f curren t consumed -

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income tax reform proposal s is David Bradford, professor o f econom ics a t Princeto n University , forme r economi c adviso r t o Presiden t George Bush , an d forme r deput y assistan t secretar y fo r ta x polic y under Presiden t Jimm y Carter . Durin g th e Carte r administratio n Bradford authore d Blueprints for Basic Tax Reform. 29 Th e origina l Blueprints and a 198 4 revision 30 giv e the basi c argument s i n favo r o f overhauling the current income tax system and present several alternatives, one of which has evolved into a proposal under the USA Tax plan. The Nunn-Domenic i US A Tax includes a graduated consumptio n tax, at rates ranging from 8 to 40 percent. It would ta x individuals o n receipts i n exces s o f persona l exemptio n an d standar d deductio n amounts. Additional deductions would be allowed for amounts invested in financial assets and for home mortgage interest, charitable contributions, and alimony . The proposal woul d allo w a limited deductio n for higher education tuition. To address regressivity associated with the consumption base , th e US A ta x woul d allo w employee s a credi t fo r Social Securit y an d Medicar e taxe s paid. Unlik e th e fla t tax , the USA Tax is designed to have no effect o n the current allocatio n o f tax burdens acros s incom e classes . Its purpose i s to simplif y th e curren t ta x system an d t o encourag e savin g withou t sacrificin g progressivity . However, the definitions of savings, investment, and consumption would further entrenc h th e inequity and th e distortion i n the tax law that i s attributable to disregarding workers as producers of economic growth.

3 . S C A P E G O A T I N G W O R K E R S I N TA X R E F O R M

Casting wag e earner s a s choosin g t o consum e rathe r tha n t o sav e leads to allocating to workers primary responsibility for financing public functions. Characterizin g all workers' expenditures as consumption also provides the rationale for using the tax law to impose on workers, rather than on entrepreneurs, the social costs of production. As I show below, tax law changes contemplate d unde r th e prosaving s proposal s likely would resul t i n man y employers ' abandoning responsibilit y fo r maintenance o f the welfare o f their workforce an d shifting t o workers the cost o f protection "agains t th e common misfortune s o f industria l society."31 Sinc e World Wa r I I employer-pai d health , retirement , an d other benefit s hav e provide d muc h o f tha t protection . Th e employ -

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ment relationshi p ha s serve d a s the primar y institutiona l mechanis m through which the United State s has provided incom e security, health care, and other determinants of well-being.32 The employment-base d socia l welfare syste m gre w ou t o f postwa r collective bargainin g aime d a t requirin g employer s t o internaliz e th e costs o f maintainin g an d renewin g th e workforce . Union s addresse d the anomaly that "[e]very well-operated company sets aside money for depreciation, repair , an d replacemen t o f machinery " bu t onl y infre quently make s "simila r provision s fo r th e car e o f it s employees — human beings." 33 Speakin g a s genera l counse l fo r th e Congres s o f Industrial Relations , Arthur Goldber g observe d tha t "the provision o f minimum insuranc e coverage for employees and their dependents [is ] a responsibility o f the employer o f precisely the same character a s the responsibility t o provid e saf e workin g conditions , adequat e lighting , reasonable safety devices, etc."34 In short, employee benefits ar e part of every business' s productio n costs . I t i s elementar y economic s tha t employers shoul d bea r th e ful l cost s o f productio n i n orde r tha t th e market fo r thei r product s functio n efficiently . Employe e benefit plan s are a means t o achiev e this end . Employers, however, are reluctant t o pay for employee benefits; they balk at workers' and unions' attempts to gain employe e benefit s a s unnecessarily drivin g u p productio n costs . The recent tax reform proposal s have adopted the employers' position. In consequence , antiworke r an d antiunio n sentiment s permeat e th e rhetoric o f tax reform, obscurin g an d distortin g the rol e of employe e benefit programs in our economy and our society. The Role of Employee Benefit Plans An employment-based benefit syste m was a fallback option even for organized labor , whic h advance d it . Governmen t program s suc h a s those in Western Europ e might hav e addressed socia l insurance need s better a s an infrastructur e expenditur e t o suppor t privat e enterprise . However, powerfu l politica l oppositio n bot h t o liberalizin g Socia l Security an d t o nationa l healt h insuranc e le d th e labo r movemen t t o hold employers and industries individually accountable for the welfare of the labor force from which they profit. Although the tax treatment of employee benefit plans had little to do with their evolution o r design, 35 the tax law has facilitated internaliza -

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tion o f labor cost s by employers through employe e benefit programs . Contributions b y a sponsorin g employe r t o employe e benefit s ar e deductible business expenses for purposes of calculating tax liability. 36 The covere d employe e doe s no t pa y taxes o n th e value o f retiremen t plan contributions, 37 health insurance coverage, 38 health benefits pro vided unde r self-insure d plans, 39 and othe r welfar e benefits. 40 T o the extent that benefits are funded throug h a qualified trust, accumulations are not taxed. 41 One importan t conditio n o f obtainin g favorabl e ta x treatmen t fo r employee benefit plans is that, for nonunion workplaces, the plans may not discriminat e i n favo r o f "highl y compensate d employees." 42 Th e nondiscrimination rule s serv e t o encourage employer s t o internaliz e the costs of maintaining the welfare of the rank and file, who might not otherwise have sufficient bargainin g strength to obtain suc h employe e benefits.43 The Effect of Proposed Tax Reform Prosavings tax reform would encourage businesses to shift their production cost s t o workers . A s unde r curren t law , retiremen t benefit s would not be taxed until distribution under either the flat tax or a consumption tax , but th e nondiscrimination rule s that currentl y provid e tax incentive s t o exten d coverag e unde r qualifie d retiremen t plan s t o rank-and-file worker s woul d los e thei r forc e becaus e employer s an d executives woul d b e allowe d expande d tax-fre e saving s opportunitie s outside qualifie d plans . Other dramati c change s t o employe e benefi t plans als o woul d occur . Flat-rat e incom e ta x proposal s woul d ta x employer-paid healt h and life insurance, dependent care , and all other employee benefit s excep t retiremen t contributions . A consumption based syste m als o woul d ta x man y employer-pai d benefit s suc h a s health care. Studies predict that changing the tax treatment of employee benefits "would significantl y affec t th e comprehensivenes s o f employer-pai d benefits."44 For example, taxation is likely to add to health care costs for workers even if the tax is imposed at the employer level. Employers can be expected to follow already-established patterns of response to health care cos t increases—rais e deductible s an d copayment s o r eliminat e health benefits altogether . Thus, tax reform predictabl y will accelerat e

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the recent trend in benefit structure s to shift labo r cost responsibilitie s and risk s onto workers . Defined contributio n saving s plans that yield an uncertai n retiremen t incom e hav e replace d define d benefi t pen sions.45 Specifie d healt h coverag e ha s give n wa y to define d contribu tion spending accounts, which allow benefit cost increases to be allocated entirel y t o employees . Th e ta x refor m proposal s exacerbat e thi s pattern of cost-sharing without profit-sharing . Although th e effec t o f comprehensiv e refor m proposal s o n th e employment-based socia l welfare syste m i s incidental, risk-shifting t o workers is the purpose of the "Medical Savings Accounts" (MSAs) proposed b y Way s an d Mean s Committe e chai r Willia m Arche r an d included i n severa l legislativ e proposals . With MSAs , the forc e o f th e tax law would be added t o the pressures shifting risk s onto individua l workers by encouraging employers to provide only catastrophic rathe r than comprehensive health coverage. MSAs would us e individua l saving s account s simila r t o individua l retirement account s (IRAs ) to address medical needs. Individuals covered only by a catastrophic health pla n coul d mak e annual deductibl e contributions, o r alternativel y exclud e contribution s mad e b y a n employer, up to the lesser of the deductible under the catastrophic plan or $5,000 ($2,500 for individuals) . An individual's contribution woul d not b e treate d a s a n itemize d deductio n bu t instea d woul d b e deductible to determine adjuste d gros s income. A catastrophic pla n is defined a s a health plan that has a deductible amount of at least $3,600 ($1,800 fo r individua l coverage) . MSAs would permi t nontaxatio n o f health care expenses only to the extent they are prefunded. Withdrawals from a n MS A would b e ta x fre e i f use d fo r medica l expense s fo r th e individual, spouse, or dependents. Although earnings on accounts and withdrawals for nonmedical purposes would be taxable, deductible (o r excludable) contributions to the account could be saved indefinitely fo r use for other purposes. Stories about Workers The rationale behind MSA s reveals misperceptions abou t th e realities o f workers ' lif e experienc e an d hostilit y towar d worker s seekin g health care. Proponents of MSAs in effect blam e workers for the country's healt h car e cos t crisis . In a n analysi s o f th e legislation , th e Join t

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Committee o n Taxatio n staf f report s tha t proponent s argu e tha t th e current ta x system, particularly the unlimited exclusio n fo r employer provided healt h benefits , encourage s th e overconsumptio n o f healt h care.46 A Congressional Budget Office report on health reform concurs: Because workers who receive health insurance as a fringe benefit are shielded from much of the cost of that insurance, they have been slow to switch to lower-cost providers of insurance and health maintenance organizations. People who are covered by more expensive (that is, more comprehensive) insurance are more concerned about the quality of care they receive and less concerned about its cost. As a result, the rapid growth in the consumption of medical services and in medical expenditures has been able to proceed relatively unchecked.47 These accounts scapegoa t workers, in particular unionize d worker s who most successfully have bargained for comprehensive benefits full y financed b y thei r employers . Thes e account s urg e u s t o believ e tha t fully insure d employee s have caused skyrocketin g health car e costs by their excessiv e demand fo r medica l attention. Left unexplaine d i s why having access to health benefits woul d encourag e employee s to obtai n more medical care than they need when there is no advantage in excessive care. In fac t ther e ar e disincentives (suc h a s time, inconvenience, discomfort, and fear) to obtaining even needed care that are not necessarily apparent t o those who view the lives of working peopl e fro m a distance. Furthermore, there is little basis for believing that individual s effectively ca n supervis e th e medica l decision s an d charge s o f healt h care providers. The argument s underlyin g MSA s mak e sens e onl y t o thos e wh o deny that worker health care costs are costs of producing labor income. Antiunion, antiworke r attitude s ar e th e premise s fo r th e conclusio n that employment-base d healt h coverag e an d nontaxatio n o f healt h benefits are responsible for the country's health care cost crisis. If, however, health care costs were regarded as equivalent to an entrepreneur' s costs o f producin g income , nontaxation o f workers' health car e cost s would not be blamed so easily for rising health care costs.

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A. I N C L U D I N G W O R K E R S I N TA X R E F O R M

Acknowledging worker s an d thei r productiv e rol e i n th e America n economy will lead to different conclusion s abou t what constitute s a tax expenditure, consumption , an d investment , whic h i n tur n wil l lea d t o different direction s fo r ta x reform . Th e nee d t o acknowledg e workers ' contributions an d experience s withi n ta x polic y become s eve n mor e urgent a s the ne w employmen t an d politica l orde r shift s entrepreneur ial risk s (bu t no t entrepreneuria l profits ) t o workers . I n thi s environ ment fairnes s demand s that the concept o f net income be applied even handedly to entrepreneurs an d t o wage earners . A concept o f incom e tha t relie s exclusively on wha t come s i n fail s t o account fo r difference s i n purchasin g power . Traditiona l ta x policy , therefore, has developed a concept o f income that account s for th e use s of income an d allow s the system to tax income a s a measure o f what a n individual ca n buy—tha t is , consumptio n o r addition s t o wealth. 48 This comport s wit h th e ethica l principl e o f th e incom e ta x syste m tha t tax liabilit y shoul d b e apportione d accordin g t o abilit y t o pa y a s mea sured b y income ne t o f th e expense s o f producin g incom e rathe r tha n by gross receipts. Most o f ta x polic y build s upo n th e Haig-Simon s definitio n o f income i n implementin g th e use s vie w o f income . Accordin g t o thi s model a n individual' s incom e i s th e su m o f wha t th e individua l con sumes durin g th e year (consumption ) an d th e increas e i n th e individ ual's wealth (investmen t o r saving). Professor Bradfor d observes : Most people are at first puzzled by [the Haig-Simons definition o f income]. They not unreasonabl y thin k o f income as something that come s in, such as wage or interest receipts . But the concept o f income appropriate for ta x purposes somehow must be related to the well-being of the person receiv ing it, and that depends on what the person obtains with purchasing power, not where he got it. 49 The definitio n o f consumptio n inevitabl y i s an ethica l an d politica l matter. 50 Consumptio n i s calculate d b y referenc e t o specifi c transac tions. 51 Althoug h certai n activities , suc h a s attendin g a movie , ca n easily be recognize d a s consumption , othe r activitie s ar e no t classifie d so easily. 52 A s a result , thei r ta x treatmen t i s a functio n o f polic y an d not predetermine d unde r th e Haig-Simon s o r an y economi c model .

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Whether an activity should be classified as consumption depends upon what valu e i s place d o n tha t transactio n withi n th e large r system . The Haig-Simon s mode l doe s not indicat e whether medica l expense s should b e classifie d a s consumption. 53 Tha t classificatio n depend s upon what ethical and political perspectives are brought to bear on the construction of the tax rules. Human capital includes value acquired through individual expenditures on education, health care, and other human-development activi ties. Henry Simons's "quite limited discussio n o f the practical applica tion of an income tax" did not specify the tax treatment o f these types of expenditures. 54 Contemporar y ta x polic y analyst s simpl y hav e assumed tha t expenditure s b y workers ar e consumptio n rathe r tha n investment. Fo r example , Prof. Stephen Ut z totall y disregard s invest ments in human capita l in calculating "net product," which he define s as ne w wealt h minu s economi c resource s consumed . H e recognize s that "[s]ome productive activities benefit mor e if the person perform ing them i s equipped wit h a n education , training, or muscl e tha t ha s deliberately been acquired for productivity's sake." 55 Yet he asserts that, when labo r alon e i s the sourc e o f ne w wealth, th e ne w wealth "owe s nothing to existing economic resources."56 The first step in acknowledging workers in tax reform i s to reject the false dichotomy between investment and consumption. Individuals do not hav e "two personalities: one a seeker afte r profi t wh o ca n deduc t expenses i n tha t search ; the othe r a creature satisfyin g hi s need s a s a human and those of his family but who cannot deduct such consumption an d relate d expenditures." 57 I n fac t deductio n o f man y employ ment-related expenditure s an d huma n capita l investment s ha s bee n disallowed o n th e groun d o f th e impossibilit y o f distinguishin g between their personal and business elements.58 Of course, human capita l is not identical to material capital, but the differences d o no t justify systemati c disregar d o f lifelon g investment s for incom e productio n i n ourselve s an d ou r children. 59 Tha t huma n capital investments necessarily benefit th e whole person does not justify such disregard. Studies indicate that for a majority o f both full-tim e and part-time workers, work is their primary life activity. Thus, a working person's employment-related an d human-capital expenditures may be regarded justifiably as primarily directed to the activity of work. For entrepreneurs, expenses motivated primarily by a business pur -

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pose ar e allowe d a s a deductio n fro m taxe d income . Fo r example , although persona l gratificatio n ma y b e a substantia l motivatio n o r consequence, if the primary purpose is business, tax law allows deductions fo r cost s suc h a s travel, entertainment, o r comfortabl e furnish ings.60 Limit s o n th e deductibilit y o f busines s expense s unde r stan dards o f reasonableness , an d inquir y int o whethe r th e expenditur e i s "lavish and extravagant, " attempt t o exclude outlays with onl y remote connection to producing income or no business purpose whatsoever. 61 Generally, however, the tax law defers to entrepreneurial judgment as to the appropriateness o f an expenditure for business purposes. Workers' investment decisions are entitled to similar respect. Current law recognizes that the cost of sustaining and renewing the labor forc e i s a business cost . Fo r example , employers ar e allowe d t o deduct their costs of recruiting, training, and retaining a workforce an d can deduc t throug h depreciatio n thei r investmen t i n a "workforce i n place."62 When undertake n b y the employer , man y worke r educatio n and maintenance outlays are excluded from employe e income, which is the equivalent of allowing the worker a deduction. Disallowing deductions fo r simila r outlay s tha t worker s decid e t o inves t i n themselve s indicates either distrus t o f workers' judgments, or an inten t t o advan tage entrepreneurs over workers, or both. The Case of Health Care If maintenance expense s on a manufacturer's capita l equipmen t o r the utility bills of a shopkeeper can offset thes e entrepreneurs' business income, i t seem s logica l tha t th e cos t o f medica l car e t o maintai n a worker's fitness ough t t o offse t tha t worker' s earning s fro m labor . Business an d investmen t outlay s ar e entitle d t o a deductio n becaus e not doin g s o woul d resul t i n doubl e taxatio n o f amount s taxe d a s income when originall y received. For example, if $100 is taxed at a 15 percent rate, $85 remains. If the taxpayer uses the $85 to buy materials to produce a product that sells for $90, the taxpayer has taxable gain of only $ 5 ($9 0 i n receipt s minu s $8 5 expenditure s mad e t o generat e receipts). The taxpaye r shoul d no t hav e t o pa y ta x agai n o n th e $85. Income tax should be imposed only on net increases in wealth. Under th e Haig-Simon s definitio n o f income , any expenditur e fo r medical care is a decrease in wealth and so should reduce income sub-

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ject to tax unless it is consumption rathe r than investment . Just as tax law generally defers to an entrepreneur's business judgments as to what costs are appropriate t o incu r t o produc e income , a worker's medica l expenses shoul d b e presumed "necessary " for work . Contrar y t o cur rent law, health care costs should not need to be "extraordinary" to justify a deduction o r exclusio n fro m income. 63 An exception, of course , generally should be made for medical care expenditures that are lavish or extravagant , suc h a s sp a treatment s o r lavishl y appointe d healt h facilities. Any expenditure to secure health insurance also represents a decline in wealth because it represents an immediate volitional loss for the purpose of avertin g a later potentially catastrophi c one . Correspondingly , obtaining coverag e through employmen t i s not a gain transaction bu t merely serves to preserv e th e statu s quo . In thi s regard , acquisition o f health insurance is no different fro m medica l expenditures incurred t o preserve or to restore health. In the absence of an increase in economic power, there shoul d b e n o ta x o n coverage . Although healt h benefit s provide access to money or services, they merely insulate the recipien t from economi c calamity. Indeed, the money or services may be accessed only in the rather narrow circumstance of seeking treatment for a medical condition. Coverage to prevent rather than to treat injuries or illness is no mor e a n exercis e o f dominio n an d control . Instead , i t i s actio n taken unde r th e dures s o f threa t o f harm . Thus, current la w allowing workers to pay no income or employment taxe s on the value of health coverage provide d throug h employmen t i s appropriate . Contrar y t o prevailing tax policy analysis, the deduction of health care costs and the exclusion o f employment-provided healt h car e benefit s ar e no t ta x expenditures equivalent to a government outlay. The Role of Nondiscrimination Rules In the nonunion workplace, the favorable tax treatment accorded to employee benefi t plan s generall y i s conditione d o n satisfyin g certai n requirements, which includ e nondiscriminatio n rule s circumscribin g favoritism t o highl y compensate d employees . Prof . Edwar d Zelinsk y has argued that, if the current law' s treatment o f employee benefits i s consistent with taxation of economic income rather than a tax subsidy, then regulation of the distribution of the subsidy through nondiscrim -

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ination rules unnecessarily and unjustifiably complicate s the tax law.64 What Professor Zelinsky may have failed to take into account is that the complexity o f th e nondiscriminatio n rule s i s attributabl e largel y t o employers' insistenc e o n retainin g flexibilit y i n designin g compensa tion packages . Simple means to compl y with nondiscriminatio n rule s are available under curren t la w at the employer's option. The real failing o f curren t nondiscriminatio n rule s i s tha t the y allo w to o man y workers, notably contingent workers, to be denied employer-paid ben efits tha t higher-pai d employee s enjoy . Thi s suggest s a n expanded , rather than a contracted, role for nondiscrimination conditions . Professor Zelinsk y als o fail s t o conside r ho w nondiscriminatio n rules operat e t o interven e i n th e marke t t o requir e employer s t o bea r the socia l cost s o f thei r activities . I n theor y a n efficientl y operatin g market woul d operat e t o internaliz e worke r welfar e costs . However , when th e negativ e effect s ca n b e externalize d an d gros s disparitie s i n bargaining powe r exist , th e labo r marke t malfunctions. Th e nondis crimination rule s provid e incentive s fo r employer s t o bea r thei r ful l labor costs in nonunion workplace s where market force s ar e the mos t likely to fail because of unequal bargaining power. The portion of the workforce covered by collective bargaining agreements has declined, and "steadily declining union membershi p i n this country contributes to growing inequality" between labor and management.65 Employer s ar e hirin g reluctantl y an d ar e announcin g layoffs . This affect s th e bargainin g climat e b y intimidatin g employee s fro m negotiating wag e an d benefi t improvements , eve n a t th e bargainin g table. With many people out of work and looking for jobs, job security is a bargainin g priority . Employmen t relation s hav e becom e furthe r attenuated because of expansion of the use of independent contractor s and other contingent employment arrangements . The escalating cost of health car e also has undercut workers' ability to bargain effectively ove r wages. Increased levels of funding hav e gone only t o retainin g an d no t t o improvin g benefits . I n som e case s eve n retention of benefits has not been possible. "Job lock" resulting from a n inability to replac e employer-sponsored healt h coverag e (becaus e of a preexisting conditio n o r th e unavailabilit y o f affordabl e coverag e through alternativ e employmen t o r i n th e individua l insuranc e mar ket) ha s impaire d worke r mobilit y seriousl y an d ha s underscored th e dependent statu s o f employees . Meanwhile , employer s increasingl y

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withdraw fro m responsibilit y fo r th e well-being o f thei r worker s an d shift labor cost responsibilities and risks onto workers. The nondiscrimination rule s are a recognition o f the differences i n bargaining powe r betwee n highl y compensate d employee s an d th e rank and file. The nondiscrimination requirements assure that the rank and file share the benefits of the bargaining power wielded by the highly compensated employees . If a plan fails to meet certain participatio n requirements, highly compensated employees will be taxed on the value of their pla n benefits . Thus , employers ar e encouraged t o assum e th e costs of maintaining the welfare o f the rank and file to save on executive compensatio n costs . I f th e ta x saving s t o highl y compensate d employees ar e sufficientl y great , i t wil l b e i n a n employer' s busines s interests t o exten d benefit s broadly . Benefits t o rank-and-fil e worker s can b e pai d ou t o f th e "surplu s generate d t o highl y compensate d employees and employers" by nontaxation.66 As the prosavings proposals recognize, tax law may be used productively to correct marke t inadequacie s t o generate appropriat e level s of investment. In Corporate Investments in Human Capital: How Financial Accounting Standards Undermine Public Policy,67 Russell Coff an d Eric Flamholtz persuasively argue for an active government rol e in encour aging huma n capita l investmen t becaus e externalitie s o r marke t fail ures justify governmenta l involvemen t with the economy. Markets fai l to reac h th e sociall y optima l equilibriu m whe n eithe r "(1 ) th e socia l cost of a given behavior exceeds the cost borne by the actor, or (2 ) the social benefit o f a behavior exceeds the benefit realize d by the actor." 68 Without governmenta l intervention , firms may underinvest i n worker human capital for both of these reasons as well as because of the ineffi ciency o f th e labor market . Employer s ma y no t inves t i n worker s because the firm may not realize a return on its investment in any particular worke r o r specifi c childre n supporte d b y worker s (wh o bea r many of the costs of renewing the workforce). In addition, because the labor market is impaired seriously by inequalities in bargaining power, workers currentl y ar e no t abl e t o requir e employer s t o bea r th e ful l costs of their enterprise. Given th e risk s that firms "may behave in a manner whic h consis tently undermine s th e greate r socia l good, " th e governmen t mus t "guide investment policies with a keen understanding of how and why

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the market migh t be failing." 69 Huma n capita l investment i s the ofte n ignored cornerston e o f economi c competitiveness , an d publi c policy , particularly ta x policy , ough t t o encourag e businesse s t o inves t i n human capital acquisition and to recognize the value they have in their workforce. A s Cof f an d Flamholt z note , "by ignorin g huma n assets , policymakers have a skewed perception of the problem." 70 Government might guide investment in human health best by mandating employer s t o provid e healt h benefit s t o al l employees . Thes e should no t b e regarde d a s unfunded mandates ; they ar e funde d wit h employer returns on the labor of their employees. If the employer cannot make a profit while paying for employee health care, then the enterprise i s costin g societ y mor e tha n i t i s contributing. 71 However , th e recent failur e o f healt h refor m effort s indicate s tha t employe r man dates—or th e alternative , nationa l healt h insurance—wil l b e lon g i n coming. I n th e interim , nondiscriminatio n rule s compensat e fo r th e unequal bargainin g position s o f labor an d managemen t an d provid e protections agains t sociall y irresponsibl e behavio r tha t ma y resul t when businesses do not bear the full economic costs of their decisions. Joseph Bankma n ha s argue d tha t nondiscriminatio n rule s actuall y diminish worke r welfare , an d tha t wage s woul d b e highe r i n thei r absence.72 The experience o f th e country' s contingen t workforc e sug gests otherwise. Eliminating nondiscrimination requirement s does not result in higher wages if workers lack bargaining power. Nondiscrimination rule s generally do not appl y to part-time an d temporary workers and t o thos e classifie d a s independent contractors . These worker s generally receive no benefits and actually are paid at lower rates of cash compensation tha n thei r full-tim e counterparts . Th e reaso n i s thei r weak bargaining position. Prof. Arne Kalleberg' s studie s contradic t th e comfortabl e assump tion that part-time employment ha s mushroomed t o satisfy a demand generated b y women' s increasin g participatio n i n th e workforc e an d their suppose d preferenc e fo r flexibilit y an d a lesse r wor k commit ment.73 Professo r Kalleberg' s dat a sho w tha t full-tim e an d part-tim e workers are about equally committed to their employers and that parttime workers are just a s likely to designate work as their mos t impor tant lif e activity. 74 I n fact , contingen t wor k arrangement s hav e no t evolved t o accommodat e a les s committe d componen t o f th e work -

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force, bu t instea d the y hav e evolve d t o disadvantag e unfairl y man y workers who have no other choice. Women are taking temporary work because o f thei r "lac k o f bargainin g powe r an d limite d employmen t alternatives."75 Professor Kalleberg' s wor k show s tha t contingen t employmen t i s spawning a n underclas s o f workin g American s b y contributin g t o polarization i n incom e an d benefit s a s wel l a s i n noneconomi c jo b rewards. H e report s tha t part-tim e worker s ear n roughl y hal f th e hourly cash wages of full-time workers. 76 A breakdown by occupational categor y showe d th e sam e 5 0 percen t differentia l i n wages. 77 Temporary worker s ar e similarl y disadvantaged . Temporar y worker s earn 20 percent less on average than permanent employees. 78 The inapplicability o f nondiscriminatio n rule s doe s no t translat e int o highe r wages for workers but only into denial of benefits. Most part-time workers are not covered under employment-provid ed healt h o r retiremen t incom e plans . Involuntary part-tim e worker s are approximatel y thre e time s a s likel y no t t o hav e healt h insuranc e than thos e who work part-time voluntarily. 79 Fo r Professor Kalleberg , the "pattern of disadvantage for part-timers with regard to fringe benefits i s clear : person s workin g part-tim e obtai n fewe r fring e benefit s than full-timers , eve n afte r controllin g fo r thei r education , age , race, length of experience with their employer, occupational level, authority position, employe e o r self-employe d status , an d th e siz e o f thei r employing establishment." 80 Althoug h som e part-tim e worker s hav e health insuranc e unde r th e famil y coverag e provide d throug h th e employment o f a spous e o r othe r famil y member , studie s sho w tha t close to hal f o f part-tim e worker s hav e no direc t o r indirec t employ ment-based healt h coverage. 81 Amon g temporar y employees , th e Employee Benefits Research Institute has estimated that 30 percent lack any health insurance. 82 The data show both that the contingent workforce lack s bargaining power an d tha t read y resort b y employers to contingen t employmen t arrangements furthe r undermine s th e bargainin g powe r o f full-tim e workers. I n thes e circumstance s th e labor marke t canno t fulfil l th e function o f allocating social costs to those who generate them, and government intervention is necessary. Given the preference of our political culture for economi c pressure over legal mandates, accounting for th e full huma n cost s o f enterprise s an d providin g fo r investmen t i n th e

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productive capacit y o f worker s mus t b e achieve d fo r th e presen t through the tax incentive of nondiscrimination rules . Irving Howe lamented tha t "[t]he working class, both a s actuality and idea, has never been wholly accepted in American society or adequately reflected i n American culture." 83 We too easil y "slip into the cliches of 'individualist' nostalgi a an d blan d denial , ignorin g th e realit y o f th e American workers , pretendin g the y hav e littl e o r n o share d experi ence."84 U.S. tax policy has suffered a s a result, and the prosavings proposals would perpetuate and magnify, rather than remedy, the economic an d ethica l distortion s unde r curren t ta x law . A remed y require s wholesale reconsideratio n o f ta x polic y i n ligh t o f workin g people' s lives and contributions. This essay has begun to consider how acknowledging workers in the tax law might chang e the tax policy discussion s of working people's health care costs. Other technical questions need to be explore d befor e ta x la w change s base d o n thi s approac h ca n b e adopted. Issues that nee d investigatio n includ e whether th e definitio n of medica l car e shoul d b e revise d t o limi t nontaxatio n t o medicall y necessary care ; whethe r som e portio n o f medicall y necessar y car e should be deemed personal consumption; whether the portion of medical care allocated to consumption should rise with income as the likelihood o f unnecessary health care spending increases; and how to apply nondiscrimination rule s to deductibility of medical expenses as well as to exclusion of employer-paid health benefits. Acknowledgment o f workers in tax law, of course, has implication s beyond healt h car e costs. It will affect analysi s o f othe r employment related expenditures , such a s those fo r chil d care , commuting, educa tion, clothing, food, and housing. Acknowledging workers in tax policy also means reevaluatin g th e treatmen t o f child-rearin g costs . Huma n productive capacity does not come cheap, let alone free. Finally, acknowledging workers in tax policy should lead to a reconsideration o f ta x proposal s designe d t o pu t economi c pressur e o n workers to hand over their money to entrepreneurs to make American society's investmen t decisions . Th e economi c choice s o f worker s t o develop thei r productiv e capacit y an d tha t o f th e futur e workforc e deserve respect. This reconsideration seem s crucial for a de-industrializing society that urgently requires investment in human potential.

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NOTES The autho r acknowledge s wit h grea t appreciatio n th e assistanc e o f Rache l E . Berr y o f th e Washington an d Lee University law class of 1996 ; Jack Van Doren, professor o f law, Florida Stat e University; and editors Karen B. Brown and Mary Louise Fellows. The author also wishes to thank the othe r contributor s t o thi s antholog y wh o participate d i n th e conferenc e Taxing America: A Conference on the Social and Economic Implications of Tax Reform, Novembe r 3-5 , 1995 , Minneapolis, Minnesota. 1. See, e.g., Stephen G . Utz, Tax Policy: An Introduction an d Surve y of the Principa l Debate s 112 (1993) ; Jeanne M . Dennis, The Lessons of Comparable Worth: A Feminist Vision of Law and Economic Theory, 4 UCLA Women's L.J. 1 (1993) . 2. See I.R.C.§ 262(a). 3. Irving Howe, Introduction to Images of Labor 1 3 (Moe Foner ed., 1981). 4. Id. at 15. 5. Edwar d A . Zelinsky , Qualified Plans and Identifying Tax Expenditures: A Rejoinder to Professor Stein, 9 Am. J. Tax Pol'y 257,261 (1991) (citations omitted). 6. See, e.g., William Andrews, Personal Deductions in an Ideal Income Tax, 86 Harv. L. Rev. 309 (1972) (arguing that the cost of restoring one's good health reduces ability to pay taxes). 7. See, e.g., Bori s I . Bittker, Accounting for Federal "Tax Subsidies" in the National Budget, 2 2 Nat'l Tax J. 309 (1969) (arguin g that nontaxation o f health benefits ma y be treated as "'ability-topay' structural provisions rather than tax concessions"). 8. See, e.g., Joseph A. Pechman, Federal Tax Policy 92 (5th ed. 1987) (recognizing that "a medical deduction i s needed to equalize 'ability to pay' an income tax between a family with an illness and a family without an illness"). 9. See, e.g., Davi d F . Bradford, Untanglin g th e Income Ta x 20 (1986 ) (observin g tha t "[t]w o taxpayers whose outlays would be the same except that one has larger medical bills than the other might reasonably be described as enjoying the same level of consumption"). 10. See, e.g., Edward A. Zelinsky, The Tax Treatment of Qualified Plans: A Classic Defense of the Status Quo, 66 N.C. L. Rev. 315 (1988). 11. See generally U.S. Dept. of Labor, Retirement Benefits of American Workers: New Findings from th e Septembe r 199 4 Curren t Populatio n Surve y (1995 ) (reportin g finding s o f Burea u o f Census Survey on retiree pension and health benefits). 12. See Congressional Budge t an d Impoundmen t Contro l Ac t o f 1974 , Pub . L . 93-344 , § 3(a)(3), 88 Stat. 297,299 (codified at 2 U.S.C.§ 622(3)). 13. Stanley S. Surrey, Pathways to Tax Reform: The Concept of Tax Expenditures 1 8 (1973). 14. Howe, supra note 3, at 12. 15. Id. 16. John E. Cribbet & Corwin W. Johnson, Principles of the Law of Property 11 (3d ed. 1989). 17. See Leonard Silk, Economic Scene: Classical Laws Debated Anew, N.Y. Times, Dec. 23,1983, at D2; Supply-Side for Beginners, Invest. Bus. Daily, Feb. 3,1995, at Bl; Voodoo Doctors, Invest. Bus. Daily, June 8,1995, at Bl. 18. H.R. 2060,104th Cong., 1st Sess. (1995); S. 1050,104th Cong., 1st Sess. (1995). 19. See, e.g., John Godfrey, Flat Tax Backers Stress Simplicity, but Devil Remains in the Details, 67 Tax Notes 167 (1995). 20. Robert E. Hall & Alvin Rabushka, The Flat Tax (2d ed. 1995). 21. See, e.g., Bradford, supra note 9, at 134-35 , 205-6; Service Employees Int'l Union , Out of Control, into Decline: The Devastating Twelve-Year Impact of Healthcare Costs on Worker Wages, Corporate Profits , an d Governmen t Budget s 1 (1992) ; Josep h Bankman , The Effect of Anti-

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Discrimination Provisions on Rank-and-File Compensation, 7 2 Wash. U. L.Q. 597, 603-5 (1994) . But see Norman P. Stein, Qualified Plans and Retirement Policy: A Reply to Professor Zelinsky, 9 Am. J. Tax Pol'y 225, 240-43 (hypothesizin g circumstance s i n which ta x would no t be passed o n to workers). 22. See, e.g., Bradford, supra note 9, at 136-47. 23. Hall & Rabushka, supra note 20, at 55. 24. Id. 25. See U.S . Treasury Dep't , Ta x Reform fo r Fairness , Simplicity , an d Economi c Growth — Value-Added Tax 19 (1984). 26. See id. sit 5-U. 27. S. 722,104th Cong., 1st Sess. (1995). 28. See, e.g., Barbara Kirchheimer, Nunn, Domenici Introduce "USA" Tax to Replace Income Tax, 67 Tax Notes 592 (1995). 29. David F. Bradford & U.S. Treasury Tax Policy Staff, Blueprints for Basic Tax Reform (1977) . 30. David F. Bradford 8 c U.S. Treasury Tax Policy Staff, Blueprints for Basic Tax Reform (2 d ed. rev. 1984). 31. Alan Derickson , Health Security for All? Social Unionism and Universal Health Insurance, 1935-1958,80 J. Am. Hist. 1333,1335 (1994). 32. See, e.g., Mary E. O'Connell, On the Fringe: Rethinking the Link between Wages and Benefits, 67Tul.L.Rev. 142 1 (1993). 33. Derickson, supra note 31, at 1349 ; see Edmund F . Wehrle, "For a Healthy America": Labor's Struggle for National Health Insurance, 1943-1949, 5 Lab.'s Heritage 28 (1993). 34. 1 Stanle y S. Surrey et al., Federal Income Taxation: Cases and Materials 13 9 (1972) (quot ing a talk given by Arthur J. Goldberg). 35. See Association o f Private Pensio n an d Welfare Plans , Benefits Bargain : Why We Should Not Tax Employee Benefits 16-1 7 (1990) [hereinafte r APPWP]. 36. See, e.g., I.R.C. §§ 162(a), 404,419,419A. 37. See id. at § 402. 38. See id. at §106. 39. See id. at § 105 . 40. See , e.g., id. at § § 7 9 (excludin g employer-provide d grou p ter m lif e insuranc e u p t o $50,000), 125 (governing tax treatment of flexible benefit arrangements) , 12 9 (excluding employer-paid dependent care). 41. See id. at § 501(a). 42.Seeid.at§414(q). 43. See discussion infra, "The Role of Nondiscrimination Rules. " 44. Deborah J. Chollet, Background on the Tax Treatment of Employee Benefits: An Overview of the Issues, in Employee Benefi t Researc h Inst. , Why Tax Benefits? 3 , 14-2 1 (1984 ) [hereinafte r EBRI]; see APPWP, supra note 35 , at 57-64; Paul B. Ginsburg, The Potential Effects of Changes in the Tax Treatment of Employers' Health Insurance Contributions, in EBRI, supra, at 71, 71-72. 45. Se e Everett T . Allen, Jr. , Trends Resulting from the Current Tax Treatment of Employee Benefits, in EBRI , supra note 44 , at 25 , 26; Harr y G . Smith , The Reasons Employers Provide Employee Benefits and the Influence of Tax Treatment on Employer Decisions, in id. at 35, 37. 46. See Staff o f Joint Comm. on Taxation, 104t h Cong., 1s t Sess., Description an d Analysis of H.R. 1818 (The Family Medical Savings and Investment Act of 1995) ( Comm. Print 1995) . 47. Congressional Budge t Office, The Tax Treatment of Employment-Based Healt h Insuranc e xi(1994). 48. See Bradford, supra note 9, at 15.

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49. See id at 16. 50. See id. at 20. 51. See id. 52. See id 53. See id 54. SeeUtz, supra note 1 , at 113. 55. /d 56. Id at 91. 57. Stanle y S . Surrey & William C . Warren, Case s o n Federa l Income Taxatio n 27 2 (1960 ) (quoted in United States v. Gilmore, 372 U.S. 39,44 (1963)). 58. Se e Jennifer J . S . Brooks , Developing a Theory of Damage Recovery Taxation, 14 Wm . Mitchell L. Rev. 759 (1988). 59. See, e.g., Brian E. Lebowitz, The Mistaxation of Investment in Human Capital, 52 Tax Notes 825(1991). 60. SeeI.R.C.§ 162(a). 61. See, e.g., id. at § 274. 62. Id. at § 197 ; see Ithaca Industries, Inc. v. Commissioner, 1 7 F.3d 68 4 (4t h Cir . 1994) , cert, denied, 11 5 S. Ct. 83 (1994) (explaining rationale for deduction for workforce in place). 63.1.R.C. § 213(a) (medical care expenses of the taxpayer, the taxpayer's spouse, or dependent, not otherwis e compensate d for , ar e deductible onl y i f the y excee d 7. 5 percen t o f th e taxpayer' s adjusted gros s income). 64. Zelinsky, supra note 10 , at 315. 65. Bennett Harrison , Lea n an d Mean : The Changin g Landscap e o f Corporat e Powe r i n th e Age of Flexibility 195 (1994). 66. Bankman, supra note 21, at 597. 67. Russel l W Cof f & Eri c G . Flamholtz , Corporate Investments in Human Capital: How Financial Accounting Standards Undermine Public Policy, 5 Stan. L. & Pol'y Rev. 31 (1993). 68. Id. 69. Id. 70. Id. 71. See, e.g., Harrison, supra note 65, at 20-26. 72. Bankman, supra note 21. 73. Arne L. Kalleberg, Part-Time Work and Workers in the United States: Correlates and Policy Issues, 52 Wash. & Lee L. Rev. 771 (1995). 74. Id. at 777-78. 75. Eilee n Appelbaum, Introduction: Structural Change and the Growth of Part-Time and Temporary Employment, in Economic Policy Inst., New Policies for the Part-Time and Contingen t Workforce 1, 4 (Virgini a L. duRivage ed., 1992) [hereinafter EPI] ; see Richard S. Belous, The Rise of the Contingent Workforce: The Key Challenges and Opportunities, 52 Wash. & Lee L. Rev. 863, 871 (1995). 76. Kalleberg, supra note 73, at 780-82. 77. Belous, supra note 75, at 874, table 5; see Jonathan P. Hiatt & Lynn Rhinehart, The Growing Contingent Work Force: A Challenge for the Future, 10 Lab. Law. 143, 148 (1994) (reportin g tha t studies show that a part-time worker identical in industry, occupation, sex, age, and other characteristics to a full-time worke r still earns an average of from 1 0 percent to 15 percent less per hour). 78. Hiatt & Rhinehart, supra note 77, at 148-49. 79. Id. at 149; see Kalleberg, supra note 73, at 782. 80. Kalleberg, supra note 73, at 782-83.

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81. See Belous, supra note 75, at 875, table 6 (reporting that from 4 8 percent to 49.5 percent of part-time worker s hav e n o coverag e unde r a n employe r plan) ; Chri s Tilly , Short Hours, Short Shrift: The Causes and Consequences of Part-Time Employment, in EPI, supra note 75, at 15,2 2 (citing the Employe e Benefit s Researc h Institut e repor t tha t approximatel y 4 2 percent o f part-tim e workers have no direct or indirect employment-based healt h coverage). 82. Francoise J. Carre, Temporary Employment in the Eighties, in EPI, supra note 75, at 45,56. 83. Howe, supra note 3, at 12. 84. Mat 13 .

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Shifting from a n Income Tax to a Consumption Tax Effects on Expenditures for Education

The existin g incom e ta x syste m relie s heavil y upon an appearance of objectivity and upon its potential for economi c neutrality. Neither would be possible if the tax law did not limit itself to values that normally are subject to market transactions and if it did not adhere to an internal logic that requires that all previously taxed investments be allowed a s offsets t o incom e derive d fro m marke t activities . Concerns abou t economi c neutrality , however , hav e le d t o call s t o transform th e income tax base to tax only consumption. Many proponents of the consumption base have observed that the income tax could identify consumptio n easil y merely by allowing a deduction fro m th e existing incom e ta x bas e fo r al l value s receive d an d directe d towar d anticipation o f futur e marke t income , regardless o f whe n tha t futur e income migh t b e received . Thus , a consumptio n ta x woul d allo w a deduction fo r al l personal saving s and fo r al l investment i n plant an d equipment. Onl y value s no t reinveste d an d therefor e assume d t o b e consumed would be subject to tax. Both the existing income tax and the proposed consumption tax rely on the distinction betwee n expenditure s that anticipat e futur e marke t participation, commonly thought of as "business" or "investment," and expenditures tha t d o not , usuall y denote d "persona l consumption. " I 46

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Taxpayers ma y deduc t fro m th e ta x base onl y those investment s tha t they expect to yield future taxabl e income. However, we cannot divid e human activit y so easily. This is especially true for activities relating to the development of individual human potential, which this essay loosely refers t o as education. Thus, it is not surprisin g tha t th e tax law has difficulty when it encounters investments in human potential. Parts 1 and 2 of the essay outline the ways in which the traditiona l income ta x relie s o n th e presenc e o f marke t activit y an d ta x logic t o ensure the appearance of objectivity and to pursue economic neutrality and the inherent limitations on the tax law's efforts t o achieve this neutrality. Part 3 then explores the ways in which the traditional tax law has responded to educational activities undertaken i n anticipation o f both market and nonmarket transactions. Finally, parts 4 and 5 suggest ways in which the transformation o f the income tax into a consumption tax, without furthe r consideratio n o f the appropriate taxatio n o f expenditures fo r education , would fal l fa r shor t o f the goal of economic neu trality with respect to expenditures for education .

I . T H E LOGI C O F T H E I N C O M E TA X

The income tax has long enjoyed a considerable degree of popularity within th e ranks of liberal academics, both insid e law schools (a t least among those who know anything at all about the income tax) and outside. One source of that popularity is its potential for income redistribution, especially in the absence of a broad-based federal wealth tax. The income tax, however, remains popular even with those who would prefer to de-emphasize it s potential fo r wealt h redistribution. One source of this intellectual popularit y i s the sens e that, although i t is far fro m perfect, the income tax is logical and thus perfectible. This sense of perfectibility derives in part from th e assumption that the income tax, if it were define d properly , coul d b e a rationa l ta x implemente d entirel y through the rule of law. The ideal tax would take all values into account and would ascertai n a person's tax liability with neithe r th e arbitrari ness inherent in particularized classifications, which is the bane of customs and excise taxes, nor the lack of precision an d subjectivity inher ent i n assessmen t o f values , whic h i s th e weaknes s o f propert y ta x schemes. Of course, the income ta x has not avoide d eithe r pitfall , bu t

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reformers ordinaril y se e these problem s a s unfortunate detail s i n th e implementation o f the tax that d o not affec t th e soundness o f the tax system. This apparen t perfectibilit y o f th e definitio n o f th e incom e ta x i n turn derive s from th e prevailing economic model for the tax base. The model, usually attributed to Henry Simons but not uniquely his contribution, insist s tha t enhancement s i n wealt h an d al l consumptio n b e included i n th e ta x base. 1 An incom e ta x unde r tha t mode l i s one i n which all values relevant to the tax are taxed but are taxed only once. If taxpayers mak e investments tha t ar e likely to produc e additiona l tax able incom e i n th e future , the y must identif y th e investment s s o tha t they ca n offse t the m agains t late r incom e t o ensur e tha t onl y ne w wealth is taxed. The model allows a logical reference point from whic h to define the base. Under it, the identification o f the values, the timing of thi s identification , an d accountin g fo r value s previously subjec t t o tax are the critical issues. Within it s logic the Simons model promise s resolution of all uncertainties regarding base definition. The model , within certai n boundarie s explore d mor e full y below , allows the income tax to aspire to economic neutrality, in the sense of creating as little interference with productive economic activity as possible. It allows economic activit y to take place on a level playing fiel d without distortion s resultin g fro m th e operatio n o f th e tax . What i s more, partisan politics and the whim of the tax collector need play no role i n th e desig n o r implementatio n o f th e tax . Governmen t ca n impose the taxes needed for its support entirely through the operation of law. Thus, the base-defining rules of the income tax provide it with a logical structure amenable to deductive legal reasoning. This logical structure generally is not available to sales taxes, which can operate only on arbitrarily limited bases, or property taxes, which not onl y operate o n limited bases but als o construct value s where no market ha s operate d to reveal them. The claim of income tax logic has allowed intricate tax rules t o develo p withou t (yet ) collapsin g entirel y fro m thei r ow n weight. We can interpre t th e languag e o f th e Interna l Revenu e Cod e (Code) not just by looking at its inelegant prose but also by referring to its internal logic. However, regardless of whether any particular exegesis of the Code limits itself to the text, the logical structure of the Code remains available.

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Tax logi c als o ha s provide d a semblanc e o f unifor m enforcemen t because ever y transactio n i s analyze d i n term s o f th e sam e logic . If we could gather enough fact s to understand th e true economic consequences o f th e transaction s a t hand , th e logi c would produc e correc t answers to any issue that arises. If the Code fails to achieve the correct answer for an y given case, it is because Congress has enacted languag e that seem s t o reac h a different result . If, however , Congres s endorse d the economi c mode l mor e full y an d stoppe d tryin g t o writ e detaile d statutory language that intentionall y o r unintentionall y invite s exceptions to the logic, the Code could reach the correct answer. Tax logic is not the sole reason for the success of the income tax as a source of revenue; certain nonlogical aspects of the income tax, including wage withholding, are equally important. However , we must hav e an appreciation of tax logic to understand the appeal of the income tax. It is no accident that the income tax has flourished durin g the same era in whic h th e lega l process movemen t ha s been mos t successful . Bot h phenomena rel y upo n a belief i n th e perfectibilit y o f lega l outcome s through th e rationa l applicatio n o f objectiv e principles . Bot h allo w reliance on a similar notion of the rule of law, which operates abstractly and without the need for subjectiv e judgment, at least until the details must be considered.

2 . T H E MARKETPLAC E LIMITATION S

Several practica l limitation s preven t th e achievemen t o f economi c neutrality. Perhap s th e mos t commonl y acknowledge d limitatio n relates t o th e timin g o f incom e an d th e consequen t offset s t o tha t income tha t creat e a ga p betwee n th e bas e define d unde r th e con straints of realization an d the base defined unde r a true accretio n tax . The tax law strives to treat all returns on investment and effort i n anticipation of market returns equally. However, the income tax cannot tax returns to investment an d effort a t the same rate unless it can identif y with precision the time at which the returns occur. There is a more fundamental limitatio n on economic neutrality and perfectibility o f th e incom e ta x tha t proposal s fo r refor m les s ofte n address. The income tax base cannot be economically neutral regarding human behavior unless it includes all anticipated returns to that behav-

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ior. Generally , th e traditiona l incom e ta x account s onl y fo r return s derived fro m participatio n i n th e marketplace . I t taxe s onl y value s received i n marke t transaction s an d count s a s investments onl y those made in anticipation o f market transactions. When we use market criteria as a sole referent fo r the values subject to tax, we overlook return s toward which we intentionally have made prior investments, which we may make inside or outside the marketplace. We overlook anticipate d nonmarket o r househol d returns . Thes e overlooke d return s includ e those self-created values commonly referred to as imputed income, such as the value of doing one's own laundry , of mowing one' s lawn, or of entertaining oneself by playing a musical instrument. We also are likely to fail to account fo r investment s in the potential to create nonmarke t returns. The market criteria overlook the efforts o f parents raising children, of the public formally educating children, and of individuals' own efforts t o improve their persona l potentia l i n ways that d o not antici pate immediate market returns. There surely is nothing wrong with decidin g to overlook these values. If we choose to do so, however, we no longer can pretend that th e income tax has no impact on economic behavior. The effect o n human behavior wil l depend upo n whethe r taxpayer s respon d t o thes e over looked return s b y investing mor e heavil y in the m tha n the y would i f these return s wer e no t overlooked . Bu t i f we choos e no t t o overloo k these values, we must develo p criteri a outsid e o f marke t transaction s for identifying an d for measuring them. If we do not use market criteria, implementatio n o f th e incom e ta x wil l requir e subjectiv e judg ments, if only to determine what tangibl e things and intangibl e state s we should count as taxable returns. It i s just a t thi s poin t tha t th e objectiv e an d economicall y neutra l income ta x founders . Th e incom e ta x mus t measur e an d includ e all returns in the tax base if it is to affect all investment o r return-seekin g activity equally. There are, however, limits on what the income tax can count a s returns an d ho w it can measur e thos e returns . The tax base, without sacrificin g it s purporte d objectivity , canno t includ e thos e things for whic h there is no independen t measure . Independent mea surement require s a system o f commensurabl e value s s o that return s can be compared to each other. Market transaction s establishin g price s allo w for meaningfu l com parisons of the value of returns. The income tax simply cannot include

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those things that normally are not subject to market transactions or for which there are no ready market substitutes without losing its claim to objectivity. Comfort , companionship , pleasure , an d entertainment , while al l being susceptibl e t o marke t transactions , ar e fa r mor e ofte n enjoyed withou t participation i n the market. Thus the nonmarket values toward which most human effort i s expended are beyond the reach of an income tax that requires market transactions. In truth, despite its aspiration to include all new wealth and all consumption, the income tax can identify an d can measure only intermediate goods. It can include only the amounts tha t we choose to spen d on things that we expect to make us comfortable an d to entertain us. It must limit its scope to those items of commerce used as means toward nonmarket ends . The ta x la w presumes tha t ther e i s no valu e excep t those values revealed through marke t transactions. The tax law thus is forced t o ignor e value s produce d an d consume d entirel y outsid e th e marketplace. It doe s not coun t good s o r service s create d an d enjoye d without marke t participation , eve n when a market fo r thos e goods o r services is identifiable. Just a s an y investmen t propert y ha s n o valu e excep t tha t whic h i s derived fro m it s anticipate d cas h flow, item s o f commerc e hav e n o inherent value except for their ultimate anticipated consumption value. The tax law presumes that intermediate values revealed through market transactions ultimately provide an equivalent amount of consumptio n value. I t therefor e ignore s value s los t o r gaine d afte r taxpayer s ente r into marke t transaction s b y presumin g tha t taxpayer s realize d al l expected returns and no more than expecte d returns on investment i n consumer goods. This weaknes s i n identifyin g th e precis e retur n included i n th e income tax need no t b e a fatal flaw. The income tax has survived an d can continu e t o surviv e merel y b y finessin g instance s i n whic h th e determinations o f mor e particularize d valu e ar e th e hardes t an d b y substituting presumption s tha t minimiz e intolerabl e error . Simon s himself wa s acutel y awar e o f th e limitation s o n th e definitio n o f income an d henc e o n th e nee d fo r presumptions . On e o f hi s majo r contributions to the ongoing debate about the income tax base was that he outlined those presumptions that we should use and identified criteria fo r evaluatin g whethe r th e error s produce d b y th e presumption s were tolerable given the public policy of income redistribution. 2

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These presumption s ar e implici t i n mos t o f th e basi c rule s distin guishing consumptio n fro m investment . Thus , the ta x la w presume s that a n employe e wh o i s require d t o accep t lodgin g o n th e busines s premises acquires no consumption value. It does not presume that she experienced a negative return for her services, which might be the case, for instance , if she has young childre n an d mus t pa y someone els e to care for them. It also does not presume a positive return, which migh t be the case if she has no famil y an d th e business premises are a fanc y resort hotel . Th e ta x la w presumes tha t anyon e purchasin g durabl e consumer goods has extracted the anticipated return fro m th e asset, at least in the absence of a casualty. Therefore, it presumes that an owner of a pleasure boa t tha t succumb s t o dr y ro t ha s extracte d a t leas t a s much retur n fro m th e boa t a s sh e anticipate d whe n sh e pai d fo r it , regardless o f he r actua l us e of the boat. The tax laws take the marke t price o f th e consume r goo d a s an adequat e substitut e fo r return s o n investment, regardles s o f th e tim e perio d ove r whic h th e consume r enjoys the good. 3 A similar presumption i s implicit in the notion that any investment, whether busines s o r personal , that th e taxpaye r canno t sho w t o pro duce a specific finit e retur n o r usefu l lif e produce s a n infinit e return . The tax law presumes, for example , that investment s i n goodwil l an d related intangibles or in land used for waste disposal produce a limitless return, becaus e taxpayer s canno t establis h a finit e return . Althoug h many o f th e har d case s in whic h thi s presumptio n migh t b e invoke d have bee n resolve d o r reverse d b y statute , th e operatio n o f th e pre sumption to avoid an impossible factual determination about the duration o f th e retur n i s common . Fo r instance , th e presumptio n denie s recovery for the cost of landfills that will be filled someday and for skillspecific professional trainin g that will produce income for many years. Through th e us e o f thes e type s o f simplifyin g presumptions , th e income tax has proved robust. The presumptions, however, result only in obfuscatin g th e wea k spot s i n ta x logic ; the y d o no t resolv e th e conundrums. Because th e incom e ta x alway s has bee n associate d wit h a t leas t a nominal degre e o f progressivity , w e migh t assum e tha t relianc e o n market transaction s an d th e monetize d value s tha t accompan y the m simply i s a functio n o f it s redistributiv e potential . Th e limitation s inherent i n reliance on market transactions, however, would be neces-

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sary even if the income tax abandoned all pretense of serving a redistributional purpose . Moreover, the income tax operates o n th e principl e that i t should measur e onl y those return s that taxpayer s ca n liquidat e readily. Otherwise, the tax laws might lea d t o liabilities tha t taxpayer s either could not pay, or could pay only if they engage in additional economic activity. Despite the considerable attention give n to the problems associate d with the timing of income and returns from traditional financial transactions, commentators have given relatively little attention to the more profound inabilit y o f the incom e ta x to take int o accoun t nonmarke t values. I t i s no t b y acciden t tha t ta x logi c ha s downplaye d certai n aspects of the tax law's inability to treat al l returns o n investmen t an d effort neutrally . Most of those theorists who devoted their time to questions of base definition likel y made significant investment s only where market values were a sufficient, i f not the principal, return motivatin g their own investment. Like Mr. Banks in Mary Poppins,4 these theorists were able to treat as inconsequential any investment that did not anticipate a return of values tradable in a market. Mr. Banks could not imagine a world in which it might be more important to feed the birds than to deposit twopence at interest. Similarly, most of those who have contributed to income tax theory have not imagined a world that include s significant choice s betwee n househol d an d marke t production . Th e economic neutralit y consequence s o f ignorin g thi s aspec t o f huma n investment seemed, when noticed at all, to be just another clearly tolerable error.

3 . T H E D E V E L O P M E N T O F HUMA N POTENTIA L UNDER T H E C U R R E N T I N C O M E TA X

Some education occurs in the context of regularized market transactions. People do buy through musi c lessons, yoga classes, and job skills training classe s a significan t amoun t o f education . I n man y o f th e market contexts , th e supplier s o f education , takin g int o accoun t th e costs of providing the education, which include alternative uses for the resources devoted , se t price s belo w whic h the y wil l no t provid e th e education. Prospectiv e buyer s o f educatio n mak e rationa l choice s about whether to purchase education, by taking into account the costs

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of the education, both in terms of time and of after-tax investment, and the benefits o f the education, both immediate and future, in achieving both intermediate market and ultimate personal values. The great bulk o f education , however, is provided outsid e the nor mal operatio n o f competitiv e markets . This occur s a s a resul t o f th e diversion to education o f private resources within the family as well as of governmenta l resources . Parents d o no t a s a general rul e monito r their child-rearin g effort s an d resource s t o assur e tha t the y d o no t exceed the benefits received. Formal education outside the home is not likely to be subject to a competitive market. Public elementary and secondary schools are among the most suspec t o f institution s thes e days precisely because the rigors of the market econom y only incompletely affect them . Even when private resources appear to be bidding openl y for education , fo r instance , i n th e marke t fo r colleg e education , th e price charged rarely reflects the producers' costs, and the price actually paid by any purchaser is not likely to reflect ordinar y competitive market forces. Not only is investment i n education ofte n mad e in contexts that d o not resembl e competitiv e markets , bu t investmen t i n educatio n fre quently i s made withou t a clear sens e o f whethe r th e retur n o n tha t investment will result in taxable market activity or will result in a nonmarket, nontaxable return . Indeed , it frequentl y i s difficult t o classif y education a s an intermediate, rather than as an ultimate, good. Does a parent plac e a child i n da y care to allo w the paren t fre e tim e t o ear n wages (a n intermediat e goo d leadin g to taxabl e values), to enric h th e child's future lif e (an intermediate good leading to nontaxable values), or t o entertai n th e chil d (a n ultimat e nontaxabl e good) ? D o thos e enrolled i n adult-education compute r course s expect to enhance their personal lif e (a n intermediat e goo d leadin g t o nontaxabl e values) , to improve thei r job skill s (a n intermediat e goo d leadin g to taxabl e values), or simply to be entertained (a n ultimate nontaxable good)? When faced with questions about the creation and transfer o f values concerning huma n potential , th e incom e ta x doe s no t wor k well . I t simply cannot accoun t fo r activitie s that tak e place without an y semblance o f marke t activity , fo r example , activitie s entirel y withi n th e family. It accounts very poorly for thos e situations i n which ther e ar e either expenditure s t o acquir e educatio n o r othe r transfer s o f valu e associated with the acquisition o f education tha t occur where markets

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likely do not operate, for example, in public and private formal educa tion. Perhaps eve n mor e significantly , th e ta x laws rarely ca n identif y investments i n educatio n a s investment s primaril y directe d towar d future marke t activity or as investments primarily directed toward personal or household activity. The presumptions made regarding the transfer o f values concerning the development of human potential are among the least satisfactory of any of those adopted by the income tax. Although there are some deviations, the ta x la w treats virtuall y al l investment mad e othe r tha n b y employers i n huma n potentia l a s consumption . I t treat s al l amount s expended b y parents o n behal f o f thei r childre n a s the parents ' con sumption. It attributes mone y paid t o other s to teach one' s own chil dren as consumption. It does not view the training and disciplining of children by parents and other family members as a taxable transfer. The law ignores parents' expenditures fo r their childre n a s well as the children's receipt of the benefits o f those expenditures. It does not allo w a loss t o parents , even i n th e fac e o f a casualty, i f the y fai l t o realiz e a return o n their investment i n the upbringing an d formal educatio n o f their children. The tax law accounts for children by allowing parents a dependency exemption, but its operation bears little resemblance to accounting fo r the costs of raising a child as an investment. 5 I t also allows a relatively small credit for child care purchased in the marketplace6 or, alternatively, allows a relatively small exclusion for employer-provided child care.7 Neither reflects the value given or received through the preschool education o f children , whethe r i t take s plac e i n th e hom e o r elsewhere . Similarly, the accounting for costs of elementary and secondary education allowed through the deduction o f local property and state income taxes is hardly an accurate surrogat e fo r a n accounting fo r th e huma n potential value created or received. The presumption tha t al l development o f huma n potentia l i s consumption, rather than investment leading to taxable income, prevails in all but a very few limited contexts . In some instances it can be argued plausibly tha t th e denia l o f a deductio n fo r job-relate d educatio n results not only from th e presumption tha t the expenses are consumption but also from the presumption that they produce a yield of unlimited duration . Unde r th e incom e tax , eithe r presumptio n justifie s a denial of an offset t o income for the investment. The tax law does allow

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a few taxpayers to deduct the cost of investment in their own training. However, only taxpayers who are already employed may treat their personal investment in education as an investment in future market activity, and even then they may do so only if the anticipated effec t o n their productive lives is relatively minor. In contrast, those who are employed and who receive training fro m their employer may exclude its value under the presumption that non e of the training in fact amounts to consumption. This preference i s not explicit in the rules as written. The rules purport to apply the same test to education expenses provided by employers and to education expenses paid for by employees. 8 Nevertheless, it is easy to find challenge s to the claim s fo r educatio n expense s o f individua l employee s i n th e reported cases, whereas challenges to education expense s of employers are rare.9 Even if they were rigorously subject to the same standards, the tax law s allo w employee s t o exclud e educatio n expense s pai d b y employers withou t regar d t o th e constraint s o n itemize d deductions , but thos e constraint s d o apply to deductible employee-pai d expenses . For taxpayers who do not own their homes and therefore hav e limited itemized deductions , th e deductio n fo r itemize d educatio n expense s frequently is worthless. The traditional notio n tha t the tax laws should exclud e scholarshi p income is a more significant exceptio n to the presumption that all education is in fact consumption. Notably, however, this exclusion is treated under the tax expenditure budget as an expenditure, which indicates that it is unjustified unde r tax logic and represent s a government sub sidy to the taxpayer.10 Since 1986 the Code has limited the exclusion to those expenses that clearly do not substitute for ordinary consumption expenses for housing and food. If others, whether the educational institution o r thir d parties , are willing to subsidiz e a n individual' s educa tion, that individua l nee d no t tak e those amount s int o accoun t whe n determining income. Perhaps the best explanation fo r the existence of this exceptio n i s th e distinc t possibility , give n th e marke t i n whic h scholarships are used as subsidies, that the nominal value transferred i n the name of the student does not represent its equivalent dollar value to the studen t i f tha t valu e ha d bee n mad e availabl e t o th e studen t fo r consumption. What students actually pay for an education at any given private institutio n doe s no t indicat e wha t the y woul d hav e pai d ha d there been open-market bidding for all educational opportunities. The

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stated tuition at any institution, whether public or private, simply is not a goo d surrogat e eithe r fo r th e amoun t tha t an y studen t woul d hav e been willing to pay for education at that institution o r for the value she received fro m tha t education. In the absence of a scholarship, those at private institution s migh t wel l no t hav e bee n willin g t o pa y th e ful l stated price, much less the actual price of producing the education they receive. Those a t publi c institution s migh t wel l hav e bee n willin g t o pay more tha n th e state d tuitio n price , given th e larg e public subsid y many o f th e student s enjoy. 11 Thi s explanatio n means , however, tha t for scholarship s th e ta x law abandons th e presumptio n tha t amount s apparently spen t fo r consumptio n actuall y have yielded a n equivalen t amount of consumption. The ta x law' s curren t treatmen t o f th e developmen t o f huma n potential raise s serious questions concerning economic neutrality. The Code ordinaril y doe s no t distinguis h betwee n persona l investmen t i n one's ow n abilit y t o produc e i n anticipatio n o f marke t activitie s an d any other consumption value, despite the fact that only the former will subject the investor to tax at a later stage as well. Neither does the Code distinguish betwee n thos e wh o contribut e thei r ow n o r famil y fund s for highe r educatio n an d thos e wh o benefi t fro m th e contributio n of othe r taxpayer s withi n thei r state , o r thos e wh o benefi t fro m th e largesse o f scholarship-providin g foundations , eve n thoug h onl y th e former hav e include d thes e values as consumption i n their income . If taxpayers us e thei r ow n funds , the y ma y tak e a deductio n fo r th e amount spen t o n educatio n onl y i f the y alread y hav e acquire d suffi cient skill s t o b e employed , an d the n onl y when th e enhancemen t i n their education i s incremental and is not likely to result in a change in job definition. Only if an employer has paid these expenditures directly are they likely to be fully honore d a s expenditures with n o consump tion component. These rules and presumptions, furthermore, embod y a ver y restrictiv e vie w o f huma n activity . The y appl y mor e easil y t o individuals wit h on e se t o f skill s who ar e likely to us e those skill s fo r production i n one activity for one employer. Of course, the impossibility o f distinguishin g betwee n developmen t o f huma n potentia l tha t creates marketplace values, which will be taxed, and the development of human potential that creates nontaxed values adequately explains these rules. Jus t becaus e thes e error s ar e unavoidabl e doe s no t mea n the y should not be acknowledged as errors.

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4 . P U S H I N G TA X L O G I C : T H E ELIMINATIO N O F T H E INVESTMENT C O M P O N E N T O F I N C O M E

If we do not take the income tax too seriously, we need not see many of its logical dead ends , perhaps eve n those dealing with th e development o f huma n potential , a s intolerabl e flaws . Ta x logi c serve s th e income tax well. The structure allow s the tax law to remain internall y coherent an d therefore self-perpetuating . Th e logic allows for lawyers' arguments about the meaning of particular statutory language. We can prefer a particular reading of a statute because we think it produces the least tensio n wit h th e overal l logic of th e ta x law. The logic also provides a language useful for internal critiques. Reformers can promote a statutory change on the ground eithe r that it is consistent with the tax logic and that it moves the tax base closer to the ideal, or that the proposed change, although not consistent with the tax logic, is a deviation made necessary by some other imperfection i n current practice. But we can take tax logic too far. It has led relatively friendly critic s of the income tax to suggest that Congres s could improve the incom e tax by eliminating the wealth enhancement o r investment componen t of the traditional ta x base. Several persistent proposal s urg e that onl y values deemed t o hav e been consume d shoul d b e included i n th e ta x base.12 Congress could transform the traditional income tax into a consumption ta x relatively easily by allowing deduction s fo r al l amount s devoted t o business purposes o r otherwis e investe d i n contemplatio n of a future taxabl e return. Under a cash-flow consumption tax, taxpayers could deduct fro m th e tax base any amount investe d i n a way that anticipated a taxable return, but they later must include the amount in the ta x bas e whe n the y realiz e th e return . Busines s meals , compute r purchases, an d stoc k investment s woul d b e deductible , becaus e the y represent investment s mad e wit h futur e taxabl e incom e i n mind , regardless o f when tha t incom e actuall y might b e realized. Only consumption—that is , expenditure s no t recognize d a s investment s i n anticipation o f futur e marke t production—woul d remai n i n th e ta x base. The proponents o f a consumption ta x contend tha t i t would allo w the income tax to be economically neutral in its effect upo n decision s between savings and consumption. Those with a preference for savings no longer would have that preference hindere d b y a tax on the retur n

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from savings . The flaw inherent i n th e incom e ta x resultin g fro m th e disincentive t o save , at leas t i n th e ways that coun t a s savings fo r th e purpose of the tax, would be eliminated. Proponents claim that anoth er advantage of the consumption tax is that it would eliminate the myriad accountin g problem s tha t resul t fro m tryin g t o determin e whe n investments are made and when returns are realized. Less than perfec t resolution o f eac h o f thes e timin g problem s inevitabl y detract s fro m the economic neutrality of the current income tax. The disincentive to save inherent in the income tax derives from th e prevailing presumptio n tha t whateve r valu e result s fro m a taxpayer' s choice t o accelerat e consumptio n shoul d no t b e included i n th e ta x base. Unless the value of accelerated consumption i s taxed, the income tax induces a potential save r to accelerate consumption , a componen t of which, if it has any value, remains untaxed. Since 1986, by including loan proceeds in the tax base without allowing a deduction for interes t paid with respect to that debt, the value of some of this acceleration has been include d i n the incom e ta x base, albeit incompletely . This treat ment o f loan proceeds still fails to tax those who accelerate consump tion by consuming immediately upon realizing spendable values. Indeed, th e proponent s o f a cash-flo w consumptio n ta x conten d that the current ta x laws fail to account properl y for th e consumptio n value that is forgone when a realized value is not consumed but saved. Accordingly, they argue that th e traditional incom e ta x imposes a tax on the same value twice. For example, a taxpayer has income when she earns $1,000 . Eve n thoug h sh e i s taxe d upo n earnin g th e $1,00 0 because sh e i s abl e t o consum e th e $1,00 0 immediately , whe n sh e chooses t o sav e thes e fund s an d t o ear n $100 , the ta x la w take s th e increase in her cash position into account but not the detriment result ing from he r deferred consumption . She is in some senses no better off after th e passage of time than sh e was before sh e decided t o save , and yet she is taxed on the full amoun t o f her interest earned. Two alternatives could rectify this situation and avoid the disincentive to save. First, the tax law could charge all those who realize values but who consume them immediatel y wit h th e retur n the y coul d hav e received—tha t is , impute interest forever on all values received. Second, the tax law could ignore the returns received by those who choose to delay consumption. The latter is the choice most often urged within academic circles and is the only one to emerge in any political proposal.

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These proposals for alterin g the income tax base thus would elimi nate th e disincentiv e t o sav e when tha t savin g would produc e value s that later would be included in income. The consumption ta x proposals would result in a substantial contraction of the tax base and a related increase in the rate to be applied to that contracted base. In addition, with only consumption lef t i n the base, eliminating the disincentive to save would onl y plac e mor e pressur e o n th e fault y mean s tha t hav e been developed for distinguishing investment from consumption .

5 . APPLYIN G T H E EXTENDE D TA X L O G I C O F T H E C O N S U M P T I O N TA X T O T H E D E V E L O P M E N T O F HUMAN POTENTIA L

Most proponents o f a cash-flow consumptio n ta x do not anticipat e other substantia l change s in the traditional approac h t o base-definin g problems.13 Several academic discussions have noted the problems but have not addressed them rigorously. Few of the current proposals even bother to mention issues relating to the distinction between consumption an d investment. If anything, the proponents anticipat e an overal l simplifying effect . Thus , the presumption tha t all expenditures that d o not anticipate a market return directly lead to consumption would likely survive these proposed changes. The proponent s o f th e mov e t o a consumption ta x appea r no t t o have considered whether the resulting errors regarding the taxation of investments i n human potentia l woul d remai n tolerable . On th e con trary, they cite the inabilit y to accoun t fo r huma n capita l a s an addi tional justification fo r the move to a consumption tax . In one exercise supporting th e mov e to th e consumptio n tax , Louis Kaplo w demon strates that, under his simplifying assumptions , the current income tax favors the returns on human capital over the returns on financial capital (use d her e t o refe r t o tangibl e an d intangibl e assets) . He suggest s that this favorable tax treatment prevails even though returns on most financial capital are subject t o realization rule s that tax them relativel y late, wherea s return s o n huma n capita l generall y ar e taxe d upo n receipt.14 He argues that human capita l should be taxed as it accumu lates because that treatmen t parallel s the general tax treatment o f th e accumulation o f financial capital. Thus, he concludes that th e incom e

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tax should tax each individual in a way that acknowledges the presence of human capital at birth. Kaplow does not propose that the Code actually impose a tax a t birth , but instea d h e propose s tha t th e Cod e ta x wages at a higher rate to compensate for the failure to tax the accumulation of human capita l in a timely fashion. Kaplow's scheme does not account fo r an y costs , marke t o r otherwise , o f tha t huma n capita l except fo r th e relativel y trivia l forgon e wage s an d cas h outlay s tha t may occur at later stages in the wage earner's life. These outlays have a relatively smal l impac t o n th e tota l valu e presen t a t birth , because , in general, they represent onl y a relatively small shift i n the timing of the consumptio n o f th e valu e received . Also problemati c i s Kaplow' s assumption tha t huma n an d financia l capita l ar e unrelated an d easil y distinguished. H e doe s no t consider , fo r instance , that taxpayer s ma y transform th e returns on their effort int o returns on financial capital . Kaplow's presentatio n is , in fact , onl y a n elaboratio n o n th e argu ments of others. The proponents o f a cash-flow consumptio n ta x fre quently argue that curren t la w already taxes returns t o human capita l on a consumption-tax basis ; that is , it taxes wages as they ar e earne d rather than when the potential to earn wages develops. Under this view returns to human potentia l are favored, because the tax law fails to tax the huma n capita l fro m whic h wage s arise. Some have suggested tha t the Code's failure to allow a deduction for the costs of human capital, at least in the case of tuition pai d for forma l education , compensates fo r the Code's failure to tax the acquisition o f value in the form o f human capital as the education occurs . They note that tax laws do not allo w a deduction for the interest paid on loans to fund education. 15 These two offsetting error s may produce a tolerable result. Noteworthy is that the economic literatur e suggest s tha t n o definitiv e answe r i s possibl e regarding th e questio n o f bia s agains t o r i n favo r o f investmen t i n human capital. 16 However, even o n it s ow n terms , there ar e flaw s i n th e argument' s logic. To the extent that we use human capital to contribute to the value of financial capital, returns to the combined investmen t enjo y some of the same benefits under the income tax that would be available under a consumption tax. 17 A failure t o accoun t fo r th e acquisitio n o f huma n capital justifies a move to a consumption ta x only if we assume bot h that onl y relativel y smal l addition s t o huma n potentia l ar e acquire d with after-tax value s and that wages and ultimate consumption value s

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are the only return to human capital . Indeed, it is entirely possible that given the incentives present unde r the current incom e tax, the contri bution of human capital to the value of financial capita l and to returns on that combined capital is in the same order of magnitude as the wage return t o huma n capital . Proponents o f th e consumptio n ta x canno t justify a move to it in terms of the relative advantage enjoyed by human capital under the income tax without taking a more careful loo k at the effect o f the move on behaviors remainin g subject t o tax. If only consumption i s included in the tax base, the stakes involved in presumin g that al l expenditure s seekin g a n increas e i n huma n potentia l reflec t consumption would obviously be greater, if only because rate increases necessarily must accompany base narrowing. The severity and undesirability of the tax base change would depend upon th e identit y o f th e particula r taxpayer s mos t severel y affected . The greates t impac t woul d likel y fall o n thos e who spen d a relatively large portion o f their after-ta x incom e o n educatio n tha t seem s mos t closely related to income production, for instance, night school tuition and chil d care . Fo r a taxpaye r earnin g $25,00 0 a yea r an d spendin g $5,000 on night school tuition, the proposed change would increase the rate a t whic h th e taxpaye r i s taxed erroneousl y o n 2 0 percent o f he r income. For a taxpayer earning $20,000 a year and paying $5,000 a year for child care, the proposed change would exacerbate an error affectin g 25 percent o f her income. Few of the proposals offer an y features tha t would mitigate the effect of these errors. Although the increased stakes for many taxpayers would lead to calls for furthe r refinemen t o f the lines between investmen t an d consump tion, th e presumptio n tha t al l ambiguou s expenditure s relatin g t o human potentia l ar e consumptio n woul d tak e o n particula r impor tance under the consumption tax. Could the familiar presumption tha t virtually all individual taxpaye r investmen t i n human potentia l i s not likely to resul t i n a taxable retur n surviv e th e pressur e tha t th e con sumption tax would place upon it? Given the scholarly attention to the issue, one might think that the presumption was barely holding its own even under the traditional income tax.18 Any increased tendency to treat expenditures such as child care and tuition as investments in market wages might threaten to leave little tax base at all. At some level, child car e and tuitio n diffe r fro m foo d an d shelter only in that they are not share d by all taxpayers. It may not b e

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easy to establish the degree to which any particular taxpayer purchase s those items in anticipation of future income , nor may it be easy to distinguish thos e item s fro m othe r cost s that taxpayer s would no t incu r except for the need to earn in the market. One writer has even used the impossibility of excluding investment in human potential under a consumption tax as proof o f the inappropriateness o f viewing it as investment under the income tax at all.19 Ignoring th e income-relate d componen t o f a n educatio n expendi ture, however, is more difficult t o justify under a consumption tax than under a n incom e tax . Unde r th e consumptio n tax , investment s i n human capital would be subject to tax, but all other investments would enjoy a n immediat e deduction . Investment s i n huma n capita l n o longer woul d shar e th e sam e advers e ta x treatmen t a s othe r invest ments for which there appears to be no finite return. Instead, under the consumption tax , investmen t i n ou r own , o r ou r family's , huma n potential woul d becom e th e onl y investmen t tha t w e mus t mak e i n after-tax values. Expenditures for education that we can explain fully by their potential to produce taxable income and for which the consumption compo nent appear s trivia l demonstrat e mos t clearl y wh y issue s regardin g investments i n huma n capita l woul d b e exacerbate d unde r th e con sumption tax . Tuitio n fo r a n advance d degre e i n actuaria l scienc e achieved as a night student at a commuter campu s might be an example o f a n educationa l expenditur e havin g a negligibl e consumptio n component. Th e consumptio n tax , just lik e th e presen t incom e tax , would allo w a deduction fo r cas h expenditure s fo r th e tuition , i f th e taxpayer spent the money in anticipation of immediate taxable income. However, the consumption tax should allow a deduction for any expenditure i n anticipatio n o f an y futur e taxabl e income , no t jus t thos e expenditures promisin g a n immediat e marke t return . I f th e taxpaye r anticipates only future income , we can justify the failure to provide any amortization deductio n fo r th e tuitio n unde r th e incom e ta x o n th e grounds bot h tha t th e appropriat e amortizatio n perio d i s s o lon g a period tha t th e deductibl e amount s ar e trivia l an d tha t ther e i s n o decline in the value of the acquired potential over the taxpayer's life. On either ground an y error inheren t i n not allowin g amortization deduc tions i s tolerable. No simila r justification s ar e availabl e fo r failur e t o allow a deductio n unde r th e consumptio n tax . Neithe r duratio n o f

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return no r uncertaint y o f declinin g value should preven t a deductio n for investmen t unde r a cash-flow consumptio n tax . Consequently, the error involved in invoking a presumption that all education is ultimately consumption would have far greater impact under the consumptio n tax. Allowing an immediate deduction for a broad range of expenditures relating t o educatio n an d othe r huma n developmen t probabl y woul d not be satisfactory either. As is the case with the use of certain arguably excludable fringe benefits under the current income tax, such a deduction coul d entic e taxpayer s t o construc t transaction s tha t appea r t o meet educational investment criteria to avoid taxation on its consumption component. Canny taxpayers easily could contrive returns on educational expenses that, in fact, include large, but har d to identify, con sumption components . Fo r example , executiv e retreat s a t busines s schools an d parents ' event s a t privat e college s migh t wel l las t week s instead of days. The tendency under a consumption tax for taxpayers to seek cash investments that provide returns in the form of consumption might be a problem of relatively minor significance in defining the consumption ta x base . Thi s for m o f ta x avoidance , however , woul d b e available fa r mor e readily , a s man y fring e benefit s ar e now , to thos e with relativel y greater disposabl e incomes . The errors made i n resolv ing these uncertainties coul d well have undesirable distributional con sequences. Perhaps th e lac k o f attentio n t o issue s relatin g t o educatio n an d other nonmarket values under a consumption tax comes from a general sens e tha t inappropriat e result s woul d b e to o unsystemati c t o b e worthy of attention. This perception is not surprising to the extent it is held b y those analyst s who rarel y deal with th e problem s inheren t i n defining th e individua l ta x base . Alternatively , perhap s th e lac k o f attention i s base d o n th e assumptio n tha t th e continuatio n o f th e familiar presumptions would have tolerable impacts. In some cases this may be true. The continued lack of deduction fo r tuition, for instance, in absolute dollar amounts, would affect mos t severely those who have the choice to pay high tuitions to private institutions. If the consumption ta x retaine d an y pretens e t o redistribution , thi s woul d b e a n acceptable result . However , lookin g exclusivel y a t absolut e dolla r amounts obscure s othe r redistributiona l issues . Th e continue d pre sumption tha t al l tuition payment s shoul d be treated a s consumptio n

SHIFTING FRO M A N INCOM E TA X T O A CONSUMPTIO N TA X I

would affect mos t keenly those who do not have the financial means to attend privat e college s o r universities , that is , those whos e before-ta x paycheck migh t hav e covere d bot h communit y colleg e tuitio n an d housing, but whose after-tax paycheck clearly cannot. The acceptability of the errors resulting from a continuation o f the presumption tha t virtually all individual taxpayer spending for educa tion is consumption would be even more questionable if its companion presumption, that all investment in human capital directed by employers is investment, also survived. The combined effect o f these presumptions would b e that thos e whose skills allowed them t o obtai n jobs in the first place could receiv e additional employer-provide d o r -funde d training ta x free , wherea s thos e withou t job s woul d suffe r unde r th e presumption tha t thei r expenditure s wer e mer e consumptio n an d therefore must be made with after-tax dollars. Although th e proponents o f a consumption ta x acknowledge thes e problems, they do not acknowledge the consequences of the presumption in human terms. David Bradford, for example, considers the anticipated effect s o f a move to a consumption ta x on incentive s t o inves t in huma n potential. 20 Hi s principa l contentio n i s that th e mov e t o a consumption ta x would no t chang e th e "descriptio n o f th e taxation " of education, although it would change "the description of the taxation of interest," and that, consequently, it is not necessary to view the diffi culties in developing this description a s an obstacle to the move to the consumption tax . Accordin g t o Bradford , th e problem s inheren t i n developing th e descriptio n ar e presen t i n bot h taxe s an d therefore , should not trouble the proponent of the consumption tax. Bradford illustrate s the problem i n the income tax by outlining th e mechanism b y whic h th e failur e t o allo w a deductio n fo r educatio n under the income tax would result in more investments in human capital that can be made in pretax dollars. He demonstrates that the investment mad e in after-tax dollar s clearly would be disfavored whe n com pared t o the investment i n the form o f forgone earnings . However, he does not tell us much about the mechanism by which the investment in forgone earning s woul d b e accomplished . H e simpl y assert s tha t th e pretax investment of forgone earnings would "take the form of reduced earnings i n my current job." Is the earnings reductio n th e resul t o f an employer's decision to substitute training for cash wages or the result of the individual taxpayer's decision to invest her own pretax efforts out -

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side the marketplace? Bradford doe s not tell us, but he assumes there to be no difference relevan t to the choice of tax base. More importantly, he fails to note that the effect o f the disparity between after-tax and pretax investment under the income tax would be exaggerated under the consumption tax. Investments in human potential would be the only aftertax investments under the consumption tax. With a consumption tax that, like the traditional income tax, continued to rely on market transaction s an d th e presumption tha t al l individual investment in human potential is consumption, taxpayers likely would attemp t t o obtai n tax-fre e consumptio n value s usin g eithe r o f the two strategies just suggested. They could try to extract consumption values through cash investments that appear to anticipate marketplac e returns, or they could invest in human potential using untaxed values, that is , investing effor t entirel y outsid e th e marketplace . Nonmarke t efforts likel y mean investmen t i n th e famil y throug h nonmarke t an d household activities . Thus, the force of the logic behind the consumption tax , t o eliminat e th e disincentiv e t o sav e afte r realizin g marke t returns, would inevitabl y exaggerat e th e disincentiv e t o participat e i n market transactions at all. Why earn a wage to pay for a child's lesson, rather tha n sta y home and teach the lesson (albeit poorly) oneself, if the wage is to be so heavily taxed tha t th e lesso n canno t b e afforded ? Fo r man y o f th e propo nents of the consumption tax, this disincentive to market participation, even when exaggerate d unde r th e consumptio n tax , is of littl e consequence, becaus e th e choic e t o participat e i n marke t activitie s seem s hardly a choice t o them . I f marketplac e participatio n i s unavoidable , investment in marketplace participation will be made almost regardless of how adversely it is taxed. For some women, however, market participation still appears to be a choice that requires conscious investment to pursue. Unlik e thei r mal e counterparts , som e wome n constantl y ar e reminded o f how their decision to invest in marketplace returns is disfavored, even without a n income tax bias. Inappropriately, heavy taxation o f their investmen t i n marketplac e activitie s i s far mor e likel y to affect the level of their investment. In summary , th e enhance d preferenc e unde r th e consumptio n ta x for investmen t in untaxed values that in turn yield nonmarket return s would be likely to induce even more nonmarket investment that probably would no t lea d t o marketplace returns . Similarly, we could expec t

SHIFTING FRO M A N INCOM E TA X TO A CONSUMPTIO N TA X I

an increas e i n employer-provide d education , whic h i n effec t woul d allow a n investment o f pretax value s i n human potential , becaus e it would receive preferred tax treatment. In contrast, we could expect personal investment in education and in other form s of human capita l to decline under the greater relative burden it would bear under the consumption tax. Those who are not in a position t o respond t o this chang e i n the incentive to participate in the marketplace, but for whom an increase in th e relative pric e o f investment i n marketplace skill s woul d affec t the level of investment tha t i s possible, would fee l eve n worse effects . Many remain compelle d to participate in market transactions for cash returns even though the tax law treats their investments in their ability to s o participat e a s consumptio n an d require s the m t o mak e tha t investment i n after-ta x values . Thes e individual s ma y have ver y few choices for enhancing their earning capacity, but they are likely to fin d that th e one choice tha t the y d o have, investing wage s in education , would be the least favored us e of their after-ta x value s under the consumption tax . Only thes e investment s woul d remai n subjec t t o the double tax on investment that prompted the move to the consumptio n tax in the first place.

M O R E M O D E S T A S P I R A T I O N S FO R T H E I N C O M E TA X

Tax logic has served the income tax well, and, if employed onl y to answer those questions that aris e within a tax base, the principal con tours of which are established through external criteria, it can continue to serve a useful purpose. It simply is not useful in establishing the contours themselves. Tax logic tells us nothing about whether th e tax law should favor investment in human potentia l or investment in financial capital. The desirability o f additional investmen t i n human potentia l and the form tha t investment takes are policy decisions that we should make independent of tax logic.

NOTES 1. See Henry C. Simons, Personal Income Taxation 50 (1938). 2. See, e.g., id. at 54 ("[the] drasti c expedien t o f treating all outlays for augmenting persona l

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earning capacity as consumption" is a presumption that "has little more than empty, formal, legalistic justification"); id. at 12 0 (supporting the presumption tha t consumption mus t be measured by the dollar value of goods). 3. See Daniel I . Halperin, Valuing Personal Consumption: Cost versus Value and the Impact of Insurance, 1 Fla . Tax Rev. 1 (1992) . 4. Pamela L. Travers, Mary Poppins (1934). 5.SeeI.R.C.§151. 6. See id. at §21. 7. See id. at §129. 8. See id. at § 127 (allowing employers to provide both trainin g and mone y to pay for educa tion); see also S. Rep. No. 1263,95th Cong., 2d Sess. 98 (1978) (explaining that §127 was enacted to avoid the difficulties o f applying the standards of the treasury regulations to courses taken unde r the direction of and paid for by employers). 9. See, e.g., Love Box Co., Inc. v. Commissioner, 842 F.2d 121 3 (10th Cir.), cert, denied 488 U.S. 820 (1988) (denying deduction for costs taxpayer incurred in sponsoring seminars on self-relianc e attended by employees). 10. For further discussio n o f tax expenditures, see Gwen Thayer Handelman , Acknowledging Workers in Definitions o/Consumption and Investment: The Case of Health Care, this volume. 11. See Charlotte Crane, Scholarships and the Federal Income Tax Base, 28 Harv. J. on Legis. 63, 69-74(1991). 12. See, e.g., Irvin g Fisher , The Spendin g Tax , 18-2 0 (Bulleti n o f th e Nat' l Ta x Ass'n 1921) ; Nicholas Kaldor , An Expenditure Ta x (1955) ; William Vickery , Agenda fo r Progressiv e Taxatio n (1947); Irvin g Fisher , Income in Theory and Practice and Income Taxation in Practice, 5 Econometrica 1 (1937) ; see also David F . Bradford & U.S. Treasury Ta x Polic y Staf f Reform , Blueprints fo r Basi c Tax Reform (2 d ed . Rev. 1984 ) ( a more recen t an d influentia l contributio n that includes analysis of the relationship of the consumption tax base to the traditional income tax base); Robert E . Hall 8c Alvin Rabushka , Low Tax, Simple Tax, Flat Tax (1983) (popularizin g th e concept o f the flat tax) ; William D . Andrews, A Consumption-Type or Cash Flow Personal Income Tax, 87 Harv. L. Rev. 1113 (1974) (an influential contributio n that, like Bradford's, includes analysis of the relationship of the consumption tax base to the traditional income tax base). 13. See, e.g., Richard L. Doernberg, A Workable Flat Rate Consumption Tax, 70 Iowa L. Rev. 425, 456-57 (1985 ) (notin g with approva l th e Hall-Rabushk a proposal' s failur e t o eve n mentio n th e problem, althoug h commentin g upo n th e disparit y betwee n th e likel y treatmen t o f employe r investment and employee investment); Michael J. Graetz, Implementing a Progressive Consumption Tax, 9 2 Harv . L. Rev. 1575 , 158 9 (1979 ) (notin g tha t educatio n i s more likel y to be deductibl e under the consumption tax) ; George K. Yin, Accommodating the "Low-Income" in a Cash-flow or Consumed Income Tax World, 2 Fla. Tax. Rev. 445, 453 (1995 ) (notin g th e substantia l stake s fo r low-income students). 14. See Louis Kaplow, Human Capital under an Ideal Income Tax, 80 Va. L. Rev. 1477 (1994). 15. See, e.g., Mar y Louis e Fellows , A Comprehensive Attack on Tax Deferral, 8 8 Mich. L. Rev. 722,780-83(1990). 16. See George R. Zodrow & Charles E. McLure, Direct Consumption Taxes, 46 Tax L. Rev. 407, 449n.l30. 17. See Andrews, supra note 12, at 1145. 18. See, e.g., Lorett a C . Argrett, Tax Treatment of Higher Education Expenditures: An Unfair Investment Disincentive, 4 1 Syracus e L . Rev . 62 1 (1990) ; Davi d S . Davenport , Education and Human Capital: Pursuing an Ideal Income Tax and a Sensible Tax Policy, 42 Case W. Res. L. Rev. 793 (1992); David S. Davenport, The "Proper" Taxation of Human Capital, 52 Tax Notes 140 1 (1991);

SHIFTING FRO M A N INCOM E TA X T O A CONSUMPTIO N TA X I

Joseph Isenberg, The End of Income Taxation, 45 Tax L. Rev. 283, 310 (1990); Brian Lebowitz, On the Mistaxation of Investment in Human Capital, 52 Tax Notes 825 (1991); Christopher R. J. Pace, The Problem of High-Cost Education and the Potential Cure in Federal Tax Policy: "One Riot, One Ranger," 20 J.L. & Educ. 1 (1991) ; Clifford Gross , Comment, Tax Treatment of Education Expenses: Perspectives from Normative Theory, 55 U. Chi. L. Rev. 916 (1988). 19. See Joseph M . Dodge, Taxing Human Capital Acquisition Costs—Or Why Costs of Higher Education Should Not Be Deducted or Amortized, 54 Ohio St. L.J. 927,957-59 (1993). 20. See David F. Bradford, Untangling the Income Tax 205-6 (1986).

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Consumption in Business/Investment at Home Environmental Cleanup Costs versus Disability Access Costs

A recent Interna l Revenu e Servic e (IRS ) rulin g exposes the inadequacies o f the personal/business dichotom y that i s a mainstay in traditional tax analysis. On June 2,1994, the IRS ruled that expenses of removing PCB-contaminated soil from a taxpayer's property and backfilling wit h uncontaminate d soi l may be currently deduct ed.1 Th e publi c rulin g ende d a controversy tha t bega n whe n th e IR S ruled privately that the cleanup costs should be capitalized.2 Stunned by the capitalization ruling , taxpayers reacted swiftly and unanimously in arguing that capitalizatio n (1 ) doe s not clearl y reflect incom e an d (2 ) would discourage cleanup efforts in contravention of U.S. environmental policy. 3 The y reacte d wit h indignatio n t o a legislative proposa l t o allow rapid (three- to five-year) amortizatio n of cleanup costs, a significant improvement over the IRS's initial position.4 After soliciting reactions from taxpayers and wrestling with the issue for more than a year, the IRS finally capitulated and issued Rev. Rul. 9438. Framing the issue as one of timing, the IRS ruled that the cleanu p expenses are analogous to "repair" expenditures that ma y be currentl y deducted rathe r tha n capitalized . I n reachin g th e curren t deductio n outcome, th e IR S ignore d a bifurcatio n approac h tha t woul d hav e required capitalizatio n o f a portion o f th e expenditure . This bifurca tion approac h ha s been use d when taxpayers , due to physical disabiliI 70

CONSUMPTION I N BUSINESS/INVESTMEN T A T HOM E I

ties, renovate their homes to make them accessible. 5 The different treatmen t of environmental cleanup costs and disability access costs is a function o f different assumption s about the productivity of expenses incurred i n the business and in the personal realms. In starting with the timing question, the traditional business deduction analysis assume s tha t al l nonpersona l busines s expense s produc e income, thereby sidesteppin g th e fundamenta l questio n whethe r suc h expenditure shoul d b e deducte d agains t incom e a t all . According t o economic definitions of income, that fundamental questio n requires an inquiry into whether the expense is for the production of income or for consumption. Th e personal/busines s dichotom y make s a n inquir y about consumption in the business-expense context appear irrelevant. This essay criticizes the personal/business dichtomy by showing how it contribute s t o th e anomalou s distinctio n betwee n th e treatmen t o f certain expenditure s relatin g t o medica l car e an d th e treatmen t o f environmental cleanu p costs . It conclude s tha t th e personal/busines s dichotomy derive s it s strengt h fro m it s reflectio n an d promotio n o f certain myths underlying the public/private split in American jurisprudence. Of particular relevance to this discussion are the myth that productivity is, and should be, the only goal of the business realm and the myth that productivity is limited to the business realm. Our continue d uninterrogated acceptanc e o f th e personal/busines s dichotom y a s a n objective principle of income measurement can be traced to our failur e to appreciat e it s value-lade n rol e i n allocatin g powe r an d conferrin g legitimacy. Uncovering the inadequacies of the dichotomy and the role it plays in taxation ha s broad polic y implications. As this essay shows, the equation of business with productivity is as much embedded in the structure o f consumption ta x proposals as it is in the structure o f ou r income tax rules. Whether w e choose to mov e to a consumption bas e or continue t o rel y primarily o n a n incom e tax, the personal/busines s dichotomy will continue t o mas k politica l choice s abou t th e scop e of our tax base.

THE PERSONAL/BUSINES S DICHOTOM Y

The deduction analysis on which the Internal Revenue Code (Code) is premise d generall y hold s (amon g othe r things ) tha t t o measur e

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income accurately , business expenses , which produc e income , must b e deducted, whil e persona l expenses , whic h reflec t consumption , mus t not b e deducte d (th e personal/busines s dichotomy) . The dichotom y i s incorporated int o th e Cod e throug h provision s lik e section 162 , which allows a deductio n fo r "al l th e ordinar y an d necessar y expense s . . . i n carrying o n an y trad e o r business, " an d sectio n 262 , which disallow s any deduction fo r "personal, living, or family expenses. " The personal/busines s dichotom y i s justifie d o n incom e measure ment ground s i n virtuall y ever y introductor y federa l incom e ta x text book. 6 Th e textboo k I assig n t o m y students , Federal Income Taxation by Willia m Klei n an d Josep h Bankman , ha s thre e chapter s o n th e deductibility o f expenditures : "Personal Deductions , Exemptions , an d Credits, " "Allowances fo r Mixe d Busines s an d Persona l Outlays, " an d "Deductions for the Costs of Earning Income." 7 As the authors describ e it, th e first chapte r addresse s allowance s "associate d wit h purel y per sonal circumstance s o r objectives, " th e thir d addresse s allowance s "associated with purely business o r investment circumstance s o r objec tives," and the second examines "the somewhat perplexin g intermediat e ground." 8 Klei n an d Bankma n explai n th e significanc e o f th e person al/business dichotom y i n thei r sectio n o n "Th e Rol e o f th e Persona l Deduction:" Personal deductions are those that have nothing to do with the production of income O n the one hand, a deduction may be a proper allowance in arriving at a definition o f income that accord s with our sense of justice; it may be a proper refinement o f the concept of income as a measure of ability to pay. On the other hand, a deduction may be intended not as a refinement o f th e concep t o f incom e s o muc h a s a n expres s approva l of , o r encouragement to , particula r kind s o f expenditures , i n whic h cas e th e deduction can sensibly be analogized to a direct subsidy. 9 From thes e readings m y students learn that expenditure s fal l alon g a range between persona l an d business deductions , with business deduc tions being allowe d a s a matter o f justice (i f on e accept s th e ability-to pay rational e fo r th e incom e tax ) an d persona l deduction s bein g allowed, i f a t all , a s a subsidy . Th e allowanc e fo r busines s expense s i s based o n objective , neutra l (an d therefor e indisputable ) principle s o f income measurement , wherea s an y allowanc e fo r persona l expense s i s based o n subjective , value-laden (an d therefor e disputable ) judgment s

CONSUMPTION I N BUSINESS/INVESTMEN T A T HOM E I

of the legislature. Business deductions are allowed as a matter of right; personal deduction s ar e allowed, if at all , only as a privilege. Business expenses are productive; personal expenses are not. The personal/busines s dichotom y form s th e basi s fo r man y o f th e items included in the tax expenditure budget, which is published annually by the Joint Committe e o n Taxation an d by the Administration. 10 "The tax expenditure budget depends on the notion that there is a natural, neutral o r norma l incom e ta x an d tha t i t i s possible t o identif y departures without great difficulty o r dissent." 11 According to the Joint Committee on Taxation's tax expenditure budget for 1995-99 , "departures" from th e "natural, neutral or normal" income tax include exclusions o r deduction s fo r healt h car e (includin g th e deductio n fo r dis ability access costs) and other personal expenses, such as child care, but do not include environmental cleanup costs or other ordinary and necessary business expenses. 12 Although "there is much legitimat e debat e over and genuine uncertainty about the proper contours of an income tax, . . . there doe s seem t o be substantial agreemen t tha t mos t o f th e items o n th e publishe d list s deserv e t o b e there—tha t the y achiev e some purpose ... other than the measurement of net income." 13 Again, the message is that the personal deductions included on the list provide a "subsidy " equivalen t t o a cas h transfe r payment , wherea s busines s deductions excluded from th e list are allowed to arrive at the "natural, neutral or normal" net income base. Despite it s persistent an d centra l rul e i n ta x analysis, the personal / business dichotomy i s both to o narro w an d to o broad wit h respec t t o its apparent goa l of accurate measurement o f income. It is too narro w in its implication that personal expenses are never productive. It is too broad i n presumin g tha t busines s expense s ar e alway s productive. I n either realm, it remains appropriate to inquire instead whether expenses are fo r consumptio n o r fo r productio n o f income . Economists , a t least in their analysis of the individual income tax,14 have recognized its inadequacies, but th e dichotomy's inadequacie s see m to be ignored i n the deductio n analysi s that i s commonly use d b y lawyers an d policy makers. Moreover, ther e appear s t o b e n o roo m fo r consumptio n i n economists' definition o f taxable business income. 15 The personal/busines s dichotom y i s als o misleadin g i n suggestin g that business expenses must be allowed as a matter of objective, neutral justice, but that personal deductions are ideologically based and there-

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fore vulnerable to repeal and limitation. Again, some economists have recognized tha t incom e i s subjectiv e an d tha t administrativ e conve nience, rather than truth, justifies use of objective definitions. 16 Other s have noted the philosophical an d political issues raised in distinguish ing between consumptio n an d investmen t expenditures. 17 As the for mulation o f th e ta x expenditur e budge t demonstrates , however , ta x policy analysts persist i n treating income measuremen t a s a matter o f science rather than political choice. This essay reveals and challenges the fundamental presumptio n tha t the personal/busines s dichotom y achieve s objectiv e incom e measure ment by contrasting the tax treatment of two kinds of expenditures: (1) expenditures t o remov e PCB-contaminate d soi l fro m th e taxpayer' s property and replace it with uncontaminated soi l (cleanup costs) 18 and (2) "expenditures fo r removin g structura l barrier s i n a personal resi dence for the purpose of accommodating it to the handicapped condi tion of the taxpayer, taxpayer's spouse, or dependents who reside there" (access costs). 19 By focusing o n a business expense that doe s not hav e any personal element, this essay goes beyond the mixed personal/business expense critiqu e to challeng e the cor e presumption tha t al l non personal business expenditures are productive.

C O M P A R I S O N O F C L E A N U P C O S T S AN D ACCESS COST S

Working Example/Overview Cleanup costs and access expenditures appear to be quite similar. In each cas e the tax policy problem i s posed mos t sharpl y i n th e cas e of expenditures tha t increas e th e valu e o f th e propert y t o whic h the y relate (related property) but by less than the amount of the total expenditure. Each kin d o f expenditur e ca n thu s b e broke n dow n int o tw o components: (1) the portion increasing the value of the related property (investmen t portion ) an d (2 ) th e portio n i n exces s o f th e valu e added t o th e relate d propert y (exces s portion). For instance , for eac h type of expenditure, one thousand dollars spent may cause an increase in th e value o f th e relate d propert y of , say , seven hundre d dollars , so that the one thousand dollars can be broken into a seven-hundred-dollar investmen t portio n an d a three-hundred-dollar exces s portion. I n

CONSUMPTION I N BUSINESS/INVESTMEN T A T HOM E I

each case it appears the expense should be bifurcated, wit h the investment portio n capitalize d an d th e excess portion deducte d if , an d onl y if, there is some justification fo r allowing a deduction. Nonetheless, only the access expenditures are treated in a bifurcate d manner. Th e portio n causin g a n increas e i n th e valu e o f th e relate d property i s capitalized , an d th e exces s portion i s deductible , i f a t all , only as a personal medical expense.20 Cleanup costs, on the other hand, are fully deductible in the year paid or incurred.21 Although policy staff studying th e cleanu p expens e issu e considere d a simila r bifurcatio n approach,22 th e IR S eventually side d wit h taxpayer s i n allowin g a ful l deduction. In the following sections I examine the so-called Haig-Simons defin ition o f economic income. I apply this definition t o cleanup costs and access costs to determin e whethe r th e result s chang e i f the deductio n analysis begins, not with the personal/business dichotomy, but with the fundamental questio n whethe r a n expenditur e i s for consumptio n o r for production of income. I then consider whether environmental policy considerations justif y th e differenc e i n treatmen t betwee n cleanu p and access costs. Economic Income Measurement Principles. Accordin g t o th e Haig-Simon s definition , economi c income o f a n individua l equal s th e su m o f consumptio n an d saving s (the ne t accretio n i n th e valu e o f th e individual' s stor e o f propert y rights).23 Under ou r incom e tax system, the Haig-Simons definitio n i s modified i n two major ways: by the annual accounting principle and by the realizatio n doctrine. 24 Tha t is , income i s measure d a t th e en d o f every taxable year, and net changes in wealth are taken into account as they are realized in market transactions rather than when they occur. I a m usin g th e Haig-Simon s definitio n o f economi c income , a s modified b y the realization doctrine and the annual accounting principle, as a basis for criticizing the personal/business dichotomy. By doing so I do not want to suggest, however, that these principles ar e any less value-laden an d subjective tha n th e personal/business dichotomy . The consumption/investment dichotom y i s itsel f questionable, 25 a s i s th e use o f objectiv e (e.g. , market ) rathe r tha n subjectiv e measure s o f value.26 Others have noted th e artificia l natur e o f the realizatio n doc -

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trine, questioned the need for it, and pointed out the benefit it provides to owner s o f capita l ove r workers. 27 B y holding othe r feature s o f th e income tax system constant, however, I can focus attention on the personal/business dichotomy to show that it cannot be justified by income measurement consideration s eve n within the conventional framewor k of analysis. According to the Haig-Simons understanding o f economic income, as modified , wealt h o f th e taxpaye r ca n b e expende d i n on e o f tw o ways. It either disappears in consumption, or it is converted to another form, sometimes for th e purpose o f creating additional wealth for th e taxpayer. Althoug h consumptio n expenditure s caus e a reductio n i n wealth, they cannot be deducted as losses because the taxpayer gets the benefit o f the consumption. The expenditures also cannot be deducted against futur e incom e becaus e th e consume d wealt h disappears , an d therefore th e futur e incom e canno t b e a retur n o f th e consumptio n expenditure in a different form . In contrast, the economic income paradigm holds that expenditures that convert wealth from one form (e.g. , cash) t o anothe r (e.g. , stock) mus t eventuall y be deducte d fro m tota l wealth to ensure that only net increases in wealth are treated as taxable income. To the extent new wealth is just old wealth converted to a different form , th e taxpaye r i s no wealthier . Expenditures incurre d con verting existing wealth to a different for m ar e deductible but, in accordance with realization rules , only when income from (o r a loss of) th e new form o f wealth i s realized. In sum , the paradigm denie s a deduction a t an y time fo r consumptio n expenditure s an d permit s a deduction fo r expenditure s tha t conver t on e for m o f propert y righ t int o another form o f equal value, but allows that deduction only in the year the new investment yields realized income (or a realized loss). Application to Two Costs. The relationshi p betwee n persona l expenses an d th e productio n o f income , althoug h no t adequatel y reflected in our federal income tax system, has received some attention. In a broad sense a large fraction o f what is called consumption may be considered a cost of production in that it is necessary in order to sustain an efficient labo r force . Th e impossibilit y o f distinguishin g clearl y between th e part of household expenditure that serves to make possible further produc tion an d th e par t tha t constitutes , in Adam Smith' s phrase , "the sol e en d and purpose of all production " raises philosophical questions. 28

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The question o f uncovering th e personal aspect s of business expense s also has been addressed , a s Klein an d Bankman' s chapte r o n "mixed " business and personal expenses reflects. The distinct (at least historically) question this section raises is whether certain business expenses may be neither persona l no r fo r productio n o f income . Are there nonper sonal business expenses that are actually for consumption ? Applying an economic understanding of income, as modified b y the realization doctrin e an d th e annua l accountin g principle , t o cleanu p and acces s expenses reveal s that the y are more difficul t t o distinguis h than traditional deduction analysis would suggest. The following illustrations wil l facilitat e th e explanatio n o f th e distinctio n betwee n th e two type s o f expenses . O n Januar y 1 , 1995 , a calendar-yea r taxpaye r spent one thousand dollar s in cash to clean up land, causing the value of the land to increase by seven hundred dollars. On the same day, a calendar-year taxpaye r wit h a weak hear t spen t on e thousan d dollar s t o install a n elevato r i n her hom e a t the directio n o f her doctor , causin g the value of the home to increase by seven hundred dollars . The question i n eac h cas e is whether th e cost s are for consumptio n o r conver t wealth from one form to another. Investment Portion. In bot h instances , t o th e exten t o f th e seven hundred-dollar portio n o f th e one-thousand-dolla r expenditure , th e taxpayers have converted wealth in the form of cash to wealth in another form . On e converte d cas h fo r cleane r lan d an d th e othe r fo r a n upgraded home . The valu e o f eac h taxpayer' s tota l stor e o f propert y rights neithe r increase d no r decrease d i n 1995 , and neithe r taxpaye r consumed any value in 1995 . Where wealth is converted from on e form to another, there i s no nee d fo r a deduction unles s and unti l th e ne w wealth produces gross income, from whic h the earlier investment must be deducte d t o preven t doubl e taxatio n o r i t i s los t i n a realizatio n event. Instead, the expenditure should be capitalized and deducted only as the property produces realized income or loss. The mere investment of the seven hundred dollar s does not warrant an y positive (inclusion ) or negative (deduction) adjustment t o taxable income. According to conventional capitalization analysis, there is one significant differenc e betwee n th e investmen t portio n o f cleanu p cost s an d the investment portio n o f access costs. The investment portio n o f th e cleanup expenditur e restore s valu e los t becaus e o f th e pollutio n bu t does not increase the value of the land relative to its original prepollu -

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tion state. In contrast, the investment portio n o f access costs increases the value of the home above its original predisability value. According to th e tes t i n Plainfield-Union Water v. Commissioner^ expenditure s that merel y restor e valu e ar e t o b e deducte d a s repai r expenditures , whereas expenditures that add new value are to be capitalized. Does the distinction betwee n restoratio n o f lost value and creatio n of new value withstand scrutiny under our modified understandin g of economic income ? The answer i s no fo r tw o reasons. First, as already noted, expenditures merely restoring value are nonetheless investmen t expenditures that convert wealth from one form to another. The expenditure itsel f doe s no t ad d t o o r subtrac t fro m economi c income . Allowing a deduction in the year of the expenditure because it restores value lost in a prior period effectivel y allow s a deduction fo r th e prior unrealized loss , contrary to th e realizatio n doctrine . Moreover, allowing it in a year other than the year in which the loss was realized contradicts the annual accounting principle. The secon d reaso n th e distinctio n fail s i s that th e seven-hundred dollar investment portion of the access expenditure appears to add new value to the taxpayer's home only by reference to an objective, marketbased understandin g o f value . I f th e analysi s instea d focuse d o n th e subjective valu e of the home t o the taxpayer with th e weak heart, the expenditure would also be revealed to restore value lost to the taxpayer when she could no longer use the stairs in her home. From this standpoint, the home is no more valuable to her following installation of the elevator than it was before sh e contracted heart disease. Indeed, it may be less valuable to her because elevators are slower and less reliable than stairs. T o th e exten t i t doe s no t increas e th e valu e o f th e hous e th e seven-hundred-dollar portion of the expenditure should be analyzed in the same manner as the three-hundred-dollar exces s portion. The taxpaye r incurrin g cleanu p cost s ma y als o argu e tha t cleanu p costs do not produce any subjective increase in value because the property i s no bette r suite d fo r th e taxpayer' s us e cleane d u p tha n i t wa s when contaminated . Tha t observatio n doe s no t lea d inevitabl y t o a deduction o f th e expens e bu t shoul d lead , instead , t o th e questio n whether th e expenditur e wa s fo r consumptio n o r fo r productio n o f income. In other words, if economic income principles are applied with reference t o objective valuation, both kinds of expense convert wealth from on e form t o another an d therefore shoul d be capitalized. If sub-

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jective valuation is taken into account, both taxpayers may have experienced a loss, and th e questio n remain s whethe r th e loss was for con sumption or production of income. Excess Portion. In considering th e three-hundred-dolla r portio n o f the cleanu p expenditur e tha t exceed s th e increas e i n th e value o f th e cleaned up land, the question, again, is whether the three hundred dollars is consumed or invested to produce income at some point in time. Given tha t th e exces s portio n o f th e cleanu p expenditur e doe s no t increase the value of the related property, it should avoid the consumption characterizatio n onl y if the excess portion ca n be found reflecte d somewhere els e in the taxpayer's stor e of property rights , even if only momentarily. In this regard it is revealing that attempts at applying traditional matchin g analysi s ar e indeterminat e wit h respec t t o thes e expenses. The concep t o f matchin g i s a corollar y t o th e realizatio n doctrin e and the annual accounting principle. 30 It is used to identify (o r justify ) the prope r perio d fo r reportin g incom e an d expenses . What i s being matched to what usually goes unstated or unanalyzed, however, beyond a vague generalization.31 The purpose of matching in the expense context is to determine what portion of the taxpayer's gross income should be deducte d a s a retur n o f capital . Thi s i s the sens e o f th e Suprem e Court's long-ter m benefi t tes t fo r capitalization—i f a n expens e wil l generate income over more than one taxable year, the deduction for the expense must be allocated among the years of income production.32 To allow a current deduction of the expenditure would understate income in the year o f deduction an d overstat e incom e i n the remainin g years over which the expense continues to produce income. Applying this formulation o f matching to excess cleanup costs does not work, however, because there is no income produced by the excess cleanup costs . First , accordin g t o taxpayer s commentin g o n th e ta x treatment o f cleanu p costs , such cost s d o no t produc e an y economi c benefit an d businesse s ar e capabl e o f operatin g a t ful l productivit y without incurrin g th e cleanu p expenditures. 33 If what thes e taxpayer s say is true, cleanup costs do not contribute to an increase in profit bu t reduce the net profit o f a business. The conclusion that the excess portion of a cleanup expenditure does not produce income is supported by the fact that the costs did not have to be incurred concurrently with the income-producing activitie s that produce d th e pollution necessitatin g

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the cleanup. It is also supported by the fact that federal regulatio n has been needed to force taxpayers to take responsibility for cleaning up the ground and water polluted by their toxic dumping. 34 Still, it may be possible to identify intangible economic benefits fro m cleaning up polluted property . For instance, the business ma y enjoy a public relation s boost . I n addition , i t ma y be argue d tha t complyin g with environmental regulations permits the business to continue operations, providing a survival benefit.35 Eve n so, these long-term benefit s are not consisten t with a current deductio n an d instea d suppor t capi talization o f th e exces s portion o f cleanu p costs. 36 Interestingly, mos t cases involving the question whether expenses imposed by government regulation ar e current o r capital land on the side of capitalization. 37 I t appears the courts have had difficulty identifyin g an y income-production benefit othe r than a long-term survival benefit an d therefore hav e refused t o link the expenditures to income produced in any one year. However, if the taxpayers are correct in claiming that environmenta l cleanup does not provide any economic benefit, a different wa y of looking at matching has to be conceived to make use of the concept at all. In fact, there are two possible approaches. Expenses could be matched t o the income from th e activity giving rise to the expense. In the alterna tive, expenses could be matched to the income from which the expense is to be recovered. The first approach to cleanup costs would match the expenses backward i n time t o the activitie s tha t create d th e pollutio n necessitating cleanup; the second approach would match the expense s into the future when they will be recovered from incom e of the taxpayer. (Taxpayer s commentin g o n th e cleanu p issu e focuse d o n th e first approach in arguing that a current deduction shoul d be allowed as the next-best substitute for matching backward in time.)38 Neither of these alternative formulations o f matching is justified b y the goal of accurately measuring income. The first makes sense from a financial accounting perspective, where the goal is to provide investors with a n accurat e vie w of th e profitabilit y o f th e enterprise. 39 Incom e and profit, however, should not be synonymous. If an expense is a byproduct of income production rather than an input to income production, it is a consumption expense and should not be allowed as a deduction o n incom e measuremen t grounds . Th e secon d approac h make s sense from a budgeting standpoint, where the goal is to make sure that the expens e i s affordable . Expense s an d deductions , however , shoul d

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not be synonymous. If an expense reduces profit withou t contributin g to an increase in profit, it is a consumption expens e and should not be allowed as a deduction on income measurement grounds. In sum , ther e ar e a t leas t thre e way s i n whic h matchin g coul d b e applied: matchin g expense s t o th e incom e the y generate ; matchin g expenses to the income from the activity giving rise to the expense; and matching expenses to the income from which the expense is recovered. Only th e firs t formulatio n make s sens e i f th e goa l o f matchin g i s t o determine what portion of income should be deducted as a recovery of capital. Yet, i f commentin g businesse s ar e accurat e i n claimin g tha t cleanup costs produce no economic benefit, th e first formulatio n can not be applied to the excess portion of those costs. Even if cleanup costs produce intangibl e publi c relation s o r surviva l benefits , the y shoul d not b e deducte d immediatel y bu t capitalized . Th e indeterminac y o f applying th e matchin g principl e i n thi s contex t reveal s tha t cleanu p costs, to the extent that they do not restore value to the related proper ty, may be viewed as a form o f consumption. In contras t t o cleanu p costs , the lin k betwee n exces s expenditure s and the production of income in the case of access costs is not difficul t to identify . Again , no establishe d test s help wit h th e analysis , because traditional deduction analysis assumes that this kind of expense is personal an d appropriatel y categorize d a s consumption. Access expenditures can be seen more readily as an input to income production for the wage earner, however, than cleanup expenses can be seen as an input to income production for the business. The link between the food a worker consumes and the physical and mental energy put into the labor by which sh e generate s incom e illustrate s mos t clearl y why a portion o f many persona l expense s shoul d b e deductibl e a s inputs t o income . A similar, but less obvious, link can be made between th e living circumstances o f th e labore r an d he r income . I n orde r t o work , the labore r must fre e u p sufficien t tim e an d energ y t o mee t th e demand s o f he r employer. In many cases the access expenditure will be a prerequisite to a disable d worker' s income-producin g activities . Th e nee d fo r th e expenditure i s no t a by-produc t o f wor k bu t i s a n inpu t t o work . Although thi s kind o f expens e will also likely serve a host o f nonpro ductive functions, thos e should no t negat e the productive functio n o f the expenditure . As with othe r expenses , such a s food, shelter , educa tion, commuting, child care, and clothing, there is undoubtedly a con-

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sumption component . Ther e is , nonetheless, also a n incom e produc tion component. To deny any income measurement deductio n fo r th e productive element o f access costs and othe r personal expenditures as cited above, is to deny the productive function o f home and family. 40 Administrative convenience does not explain the difference i n treatment betwee n cleanu p an d acces s costs . Application o f a bifurcatio n analysis t o acces s cost s force s appraisa l o f th e relate d property—th e very result the realization doctrine is purported to prevent. Why should bifurcation b e any more difficult o r less desirable in the environmental cleanup context? It is the difference i n the initial productivity presumption, rather tha n th e inheren t difficult y o f lin e drawing , that explain s the absolute denial of income measurement deductions in the personal realm but not in the business realm. How Does Traditional Analysis Fail? As we have seen, application o f principles of economic income suggests that cleanu p an d acces s cost s shoul d b e treate d consistentl y fo r income tax purposes. Each expenditure should be bifurcated, wit h the portion addin g valu e bein g capitalize d an d th e portio n i n exces s o f added value being analyzed, in the case of cleanup costs , as a possible consumption expenditure , or, in the cas e of acces s costs, as a possible expense of producing income. Traditional deduction analysis, however, provides tha t cleanu p expenditure s ma y be full y deducted , includin g the portio n causin g a n increas e i n value . In contrast , th e investmen t portion of access expenses must be capitalized and only the excess portion can be deducted. Thus, for cleanup costs the deduction i s allowed as a matter of income measurement and extends to the investment portion o f the expenditure. For access costs the deduction i s allowed a s a matter of grace and does not extend to the investment portion. If incom e measuremen t doe s no t adequatel y explai n th e differen t approaches to the two expenditures, what does? One explanation ma y be th e relianc e o n th e personal/busines s dichotom y t o distinguis h between consumption an d investment expenditures . In the absence of a personal benefit o r motive, the traditional deduction analysi s simply presumes tha t a n expenditur e b y a busines s i s investe d t o produc e income and moves on to the timing or matching analysis. That mean s the starting point for analysi s is different fo r business expenses than i t

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is for personal expenses. Personal expenses are presumed to be for consumption and therefore ca n fail to be deductible at all. Business deductions are presumed t o be for production o f income, and the taxpayers that incur them risk only capitalization. These initia l presumption s carr y throug h th e entir e traditiona l deduction analysis to lead to different outcome s for very similar expenses. Medical expenses are not considered deductible as a matter of justice in measurin g income . They ar e persona l an d no t associate d wit h th e production o f income. Because allowing any deduction fo r acces s costs is constructe d unde r th e analysi s a s a subsidy , Congres s an d th e IR S determined tha t i t was reasonabl e t o exclud e fro m th e deductio n an y expenditure causin g a n increas e i n th e taxpayer' s property . Eve n wit h that limitation, the taxpayer is viewed as having received a benefit fro m the governmen t b y being allowe d a deduction fo r th e exces s portion . From this viewpoint, the tax result appears favorable to the taxpayer. On the other hand, cleanup costs are business expenses providing no hint o f persona l benefit . Th e justificatio n fo r busines s deduction s i s accurate measurement of income. They are not a subsidy from the government but a matter of right originating in the selection of income as the ta x base . There i s n o doub t unde r traditiona l deductio n analysi s that a busines s incurrin g cleanu p cost s i s entitle d (unde r objectiv e income measuremen t analysis ) t o a cos t recover y allowanc e a t som e point in time for the entire expenditure and is further entitle d to take a business deduction fo r the portion no t addin g value. The policy question addresse d b y Rev . Rul . 94-3 8 focuse d o n whethe r th e taxpaye r should als o be allowed t o deduc t th e portio n tha t adde d valu e t o th e property. To resolve this issue favorably for the taxpayer, the answer had to provid e a current deductio n fo r th e entir e expenditure . Requirin g capitalization o f eithe r al l o f th e expenditur e o r th e portio n tha t increased value would be viewed as an antitaxpayer result. What would happen if instead we began the analysis for each type of expenditure with the same question—Is this expenditure for consumption o r productio n o f income ? B y identifying an y incom e relate d t o the expenditure an d examinin g the nature an d timin g of the income / expenditure relationship , w e ma y identif y consumptio n element s i n business transactions. Alternatively, we might find that the only reasonable link is to a long-term intangible benefit s o that capitalization can not be avoided. If we start from the possibility that a nonpersonal busi-

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ness expense could be nondeductible, we would lower the expectations of business taxpayers that they are entitled to deductions a s matter o f right. In turn, this starting point would giv e policymakers mor e flexi bility in resolvin g comple x interpretatio n problems . Asking the question i n the context o f personal expenses , we might fin d link s between the expenditure and income production, revealing not only productivity in the personal realm but also the dependence of the business realm on th e personal . Befor e explorin g th e questio n o f wh y w e persis t i n relying o n th e personal/busines s dichotom y t o distinguis h consump tion fro m investmen t expenditures , the questio n o f whether environ mental policy explains the difference i n treatment between cleanup and access costs must be addressed. Environmental Policy There i s n o doub t tha t cleanin g u p hazardou s wast e site s is , an d should be, a major priority in this country. According to recent hearing testimony o n th e tax treatment o f environmental cleanu p costs , there are more than forty federal (an d numerous more state) statutes requiring remediatio n o f environmenta l contamination. 41 I t ha s bee n esti mated that there are as many as twenty-five thousan d hazardous waste sites requiring remediatio n unde r th e Comprehensiv e Environmenta l Response, Compensation and Liability Act of 198 0 alone.42 A report by the accounting firm of KPMG Peat Marwick concluded that the potential liability for cleanin g up existing hazardous waste sites reached th e trillion-dollar range by 1993. 43 Given the magnitude o f the problem, perhaps a full curren t deduc tion fo r cleanu p costs can be justified a s an incentive to clean up hazardous wast e sites . Taxpayer s commentin g o n th e environmenta l cleanup issue uniformly argued that requiring capitalization of cleanup costs woul d undermin e U.S . environmental policy , becaus e i t woul d create a disincentive to clean up by making those activities more expensive.44 This argument seem s misdirected give n that tax regulators have neither the authority nor the expertise to devise environmental policy. Moreover, close r examinatio n o f th e environmenta l polic y issu e sug gests three reasons why environmental policy cannot explain the differ ence between the tax treatment of cleanup and access costs. First, th e ta x la w provide s n o incentiv e t o clea n u p soone r rathe r

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than later. Under Rev. Rul. 94-38 a business can get a current deductio n whether it cleans up annually or allows toxic waste to accumulate over a number o f years into a massive remediatio n project . I n fac t Rev . Rul. 94-38 ensure s a deductio n fo r deferre d cleanu p cost s wher e som e uncertainty might have existed before, increasing the incentive to delay beyond what it was before the IRS began examining this issue. There is no reaso n t o believe , based o n thei r practice s befor e th e ruling , tha t businesses wil l begi n cleanin g u p soone r o r complet e th e tas k faste r because of the deduction. Second, allowing a current deductio n i n order to reduce the cost of pollution cleanup makes less sense if we consider a business's incentives before i t engage s i n pollutin g activities . I n a cost-benefi t analysi s o f future operations, allowing a current deduction reduces the cost of pollution and may tip the scales in favor o f polluting. In fact this concern has been used in defense o f legislation t o deny deductions for cleanu p costs in other contexts, most notably the Exxon Valdez oil spill. "If corporate polluters can ruin th e environment an d the n tak e a tax deduction i f they get caught, why comply in the firs t place ? . . . The curren t system encourage s companie s t o tak e risk s wit h th e environmen t because ultimatel y the y ar e no t hel d responsibl e fo r th e ful l cost s o f cleaning u p thei r mess." 45 "[These bill s denyin g a deductio n fo r th e costs of cleanup] stat e loud and clear that the costs of cleaning up pollution ca n no longer be passed off fro m polluter s to general taxpayers. Those wh o pollut e ou r water , ou r air , an d ou r lan d mus t b e hel d accountable."46 (W e coul d cal l thi s "toug h love " fo r businesses , t o extend the welfare reform rhetori c to the corporate welfare metaphor. ) By contrast, a tax rule that increase d th e cost of cleaning up pollu tion accumulated over a number of years relative to the cost of ongoing prevention and regular cleanup would more likely lead to environmentally responsibl e plannin g decisions . Furthermore, b y denyin g a subsidy for environmenta l cleanu p costs , we would ensur e that investors , consumers, and other s intereste d i n th e busines s full y internaliz e th e costs of the business's activities in their assessment of profitability.47 I n fact, environmenta l regulatio n outsid e th e ta x are a ha s move d i n th e direction o f usin g incentive s t o preven t pollutio n rathe r tha n relyin g on cleanup efforts. 48 Third, the effec t o f an y environmental incentiv e ma y be relate d t o the assumptions about tax entitlement, as illustrated by taxpayers' reac-

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tion to the congressional proposal to allow three- or five-year amortization o f environmenta l cleanu p costs . Ha d taxpayer s believe d tha t they ran a risk that cleanu p expense s coul d be labeled nondeductibl e consumption expenditures , the y ma y hav e laude d th e amortizatio n proposal a s a welcome incentiv e t o clea n u p pollution . Becaus e the y believed their choice to be current deduction o r capitalization, however, the capitalization proposa l seeme d unenticing , even with relativel y fast amortization . Thus, the starting point fo r analysi s shapes the taxpayers' perception o f whethe r the y ar e being encourage d o r discour aged, helped or harmed, by a tax policy proposal. Perhaps, though, denyin g a deductio n fo r cleanu p expense s send s the wrong message about th e responsibility o f businesses for cleanin g up th e pollutio n the y cause . Does identifyin g suc h expense s a s con sumption suggest they should not be incurred by for-profit enterprises ? Perhaps thi s i s just th e kin d o f analysi s tha t support s th e vie w tha t cleanup is an externality. To the contrary, the myth that all expenditures by businesses are, and must be, productive may hinder internalizatio n by businesses of costs that would otherwise be borne by others (e.g., the local community or the larger society) in the absence of governmenta l intervention. It is only due to the myth of productivity that consump tion leaves off being descriptive and becomes value laden, taking on the taint of inefficiency. B y acknowledging that businesses consume, we do shift the cost of some of their activities from the general taxpaying public to thos e intereste d i n th e business, but w e also recogniz e tha t i t is normal and expected for such activities to be undertaken by businesses. Finally, and in contrast, it is worth noting that social welfare consid erations suppor t providin g ta x benefit s t o encourag e taxpayer s wit h disabilities to live productively and independently. "By almost any definition, Americans wit h disabilitie s ar e uniquel y underprivilege d an d disadvantaged. They are much poorer , much les s well educated[,] . . . have fewe r amenitie s an d hav e a lower leve l o f self-satisfactio n tha n other Americans." 49 Federal legislation ove r the past twenty-fiv e year s has reflecte d a policy o f openin g acces s to jobs an d publi c place s fo r persons with disabilities. In 1973 the U.S. Congress enacted section 504 of the Rehabilitation Act of 197 3 in a "conscious effort t o include individuals with disabilities as productive members of society." 50 Congress expanded thi s effor t wit h th e mor e comprehensiv e American s wit h Disabilities Act of 1990, which prohibits discrimination against persons

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with disabilitie s in the areas of employment, public accommodations , public transportation , an d telecommunications. 51 Allowin g a ful l deduction fo r acces s cost s woul d b e consisten t wit h thes e effort s t o eliminate barriers to productivity for persons living with disabilities. THE PERSISTENC E O F TH E PERSONAL/BUSINESS DICHOTOM Y

If the personal/business dichotom y doe s not accuratel y capture th e distinction betwee n deductibl e an d nondeductibl e expenditure s an d leads t o anomalou s results , wh y d o w e continu e t o rel y o n i t i n ta x analysis? I would suggest that one reason i t appears to be useful i s that the dichotom y reflect s deepl y hel d belief s abou t th e difference s between th e personal an d business realm s and th e prominence o f th e business realm. If I am right, then the next question to ask is How does the personal/business dichotom y maintain an d perpetuate the personal/business hierarchy? There are at least three ways in which the treatment o f the person al/business dichotom y a s an objectivel y accurat e means o f measurin g ability to pay obscures the role of the tax law in creating and maintaining the hierarchy. The first is by shifting some of the burden of taxation from thos e who can take business deductions to those who rely on personal deductions , al l unde r th e guis e o f "fairness. " Th e secon d i s by reflecting an d reinforcin g th e view that business activities are productive and therefor e valuabl e an d tha t persona l activitie s ar e a drain o n the econom y an d therefor e trivia l o r eve n damaging . The thir d i s by rationalizing deference on the part of the government toward the business realm while justifying regulatio n of the personal realm. Shifting th e ta x burde n o n th e basi s o f th e personal/busines s dichotomy privilege s businesse s b y awardin g the m ta x benefit s a s a matter of right. The choice to tax income is said to be justified b y fairness. Incom e purportedl y measure s th e taxpayer' s abilit y t o pay . Whether th e incom e ta x achieves it s aspiration, however , depends o n the component s o f it s definition . I f th e deduction s allowe d t o reac h taxable income are too generous for some taxpayers and too restrictive for others , then t o tha t exten t th e burde n o f taxatio n wil l be shifte d from th e first grou p t o th e secon d an d th e goa l o f fairnes s wil l b e

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undermined. B y maskin g consumptio n i n th e busines s real m an d ignoring investmen t i n th e persona l realm , th e personal/busines s dichotomy contribute s t o undertaxatio n o f owner s an d manager s o f businesses while overtaxin g workers an d thei r families , a t least t o th e extent th e benefi t o f busines s deduction s i s no t passe d throug h t o workers in the form of higher wages or lower prices. If the implementation o f th e incom e ta x fall s fa r enoug h shor t o f a n idea l measur e o f ability to pay, then the message that fairness explain s the choice of the income tax base is a public relations scam ranking right up there with the message that a flat ta x will make life simple r fo r workin g middle class Americans. The second way the personal/business dichotomy privileges business is b y it s unquestionin g associatio n o f persona l wit h consumptio n expenditures an d busines s wit h investmen t expenditures . These link ages carry a potent messag e tha t canno t b e dismisse d a s an innocen t convenience. The dichotomy helps define th e relative roles and values of familie s an d businesse s b y perpetuating th e myt h tha t productiv e activity is limited to the business realm and the myth that the business realm i s and shoul d b e only about productivity . In s o doing, it reifie s and insulates from scrutin y the business realm while marginalizing and exposing to scrutiny the personal realm. 52 Who inhabit s thes e realms ? Accordin g t o th e personal/busines s dichotomy, the business realm is inhabited by those who invest, namely the owner s o f capital . The personal real m consist s o f those who con sume, namely workers and their families, as well as the families o f the owners. In othe r words , both clas s and gende r division s underli e th e separation of the world into personal and business realms. In reality of course, both businesses and families are comprised of people with myriad goal s and motivations , making i t inevitabl e tha t businesse s inves t and consume and families consume and invest. Moreover, the relationship o f the tw o realm s to eac h othe r mak e the business an d persona l realms interdependent and interlocking. The third wa y the personal/business dichotom y privileges busines s is by allowing the tax base to be determined b y deference t o busines s judgments. Jus t a s th e concep t o f privac y separate s th e worl d int o a sphere that ma y validly be regulated (th e public) an d a sphere tha t i s protected fro m governmenta l regulatio n (th e private), 53 the personal/ business dichotom y serve s th e functio n o f carvin g ou t territor y tha t

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should not be regulated, as that term i s understood within the income tax system. Ironically, in the tax world, activities in the sphere of business ar e mor e protecte d fro m governmen t interventio n (regulation ) than activitie s i n th e spher e o f home . Deferenc e i s given t o busines s judgments whe n characterizin g expense s a s deductibl e busines s expenses.54 Critical examination o f the privacy concept along with the tax law helps reveal that those who have power in the home and in the marketplace enjo y relativ e libert y i n bot h spheres—the y ca n invok e privacy notion s t o avoi d regulatio n a t hom e (e.g. , allowing domesti c violence to go unprosecuted) and public benefit notion s (productivity ) to avoid regulation in business and obtain benefits as a matter of right. It is no coincidence that the IRS ruled favorably on the cleanup cost issue, which "affects nearl y every taxpayer engage d i n manufacturing , natural-resource extraction, transportation an d related industries." 55 A powerful arra y of taxpayers stood their ground firmly in favor of a current deduction , holdin g th e IR S hostage wit h thinl y veile d threat s t o slow down remediation effort s i f required to capitalize cleanup costs. 56 With th e personal/business dichotom y o n thei r side , they could insis t that cleanu p costs have nothing to do with the production o f income, yet fear no result worse than capitalization. They could scoff at three- to five-year amortization . By contrast, the taxpayers affected b y the bifur cation rul e applicable to access costs wield little political o r economi c power.57 It i s not enoug h t o identif y al l the ways business activitie s provid e personal benefit o r ar e for persona l purposes , although w e could cer tainly use more work in that direction. It is the formulation o f the issue as a contras t betwee n persona l an d busines s expenses , rathe r tha n between consumptio n an d investmen t expenses , that reifie s th e vie w that there are different realm s with different goal s and values. Without the unquestionin g associatio n o f th e differen t expenditure s wit h th e different realms , it would be harder to maintain the distinction at all. LOOKING AHEA D

Diligence t o th e personal/busines s dichotom y i s likely to continu e unabated i n an y reform involvin g substantia l relianc e o n a consumption tax . In refor m discussion s thu s far , the problem o f definin g con -

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sumption remains virtuall y unexamined . Fo r instance , th e Armey Shelby flat tax proposal58 would allow a deduction against "gross active income" for "the cost o f business inputs." 59 Cost o f business inputs is defined a s the amounts paid fo r "property sold or used i n connectio n with a business activity" and "services ... in connection with a business activity."60 Th e ac t explicitl y exclude s fro m "busines s inputs " thos e "items for personal use not in connection with any business activity." 61 It thu s maintain s th e distinctio n betwee n busines s an d persona l expenses a s a substitut e fo r definin g consumption . Furthermore , i t allows immediate expensin g of all business expenses 62 and denie s any deduction t o individual s fo r medica l expenses, 63 widenin g th e ga p between cleanup and access expenditures. Other consumption tax proposals similarly leave untouched the presumption tha t busines s expenditure s b y busines s taxpayer s ar e fo r investment an d expenditure s b y nonbusines s taxpayer s ar e fo r con sumption. Th e Nunn-Domenici Unlimite d Saving s Account Ta x proposal allows businesses to deduct all their payments to other firms from their gros s incom e fro m sale s an d services. 64 Individual s ar e allowe d only designated deduction s fo r saving s and certai n expenditure s categorized a s personal . Th e cash-flo w consumptio n ta x describe d i n Blueprints for Tax Reform would leav e i n plac e th e provision s o f th e current Code that create the personal/business dichotomy. 65 In sum, all the consumption ta x proposals share this feature: they rely on the distinction between the business and personal realms to define consump tion rather than defining it independently. The purpose of this essay is not to persuade that cleanup costs are primarily consumption expenditure s o r that acces s expenditures ar e primarily for production o f income. Rather its purpose is to question th e soundness o f th e personal/business dichotom y an d t o revea l th e rol e the dichotomy plays in privileging the business realm and in devaluing the contribution s o f worker s an d thei r familie s t o ou r econom y an d society. Were our ta x analysis to begin wit h th e questio n whethe r th e expenditure a t issu e i s fo r consumptio n o r fo r th e productio n o f income, without regard to whether the expenditure is personal or business, we would b e led t o acknowledg e an d valu e both th e productiv e functions o f the personal realm and the consumption function s o f the business realm.

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9I

NOTES 1. Rev. Rul. 94-38,1994-1 C.B. 35. 2. Priv. Ltr. Rul. 93-15-004 (Apr. 16,1993). 3. See, e.g., Letter from Donald C. Alexander to Assistant Secretary (Tax Policy) Fred Goldberg, in 92 Tax Notes Today 198-3 6 (Sept. 30, 1992); William L . Raby, Two Wrongs Make a Right: The IRS View of Environmental Cleanup Costs, 5 9 Tax Notes 109 1 (1993); Benjamin H . Shiao & Philip J. Holthouse, Deductibility of Environmental Cleanup Costs: The Debate Continues, 21 J . Real Est . Taxes 3 (1993); ABA Tax Section Midyear Meeting: IRS's Carrington Defends Asbestos Abatement Ruling, 58 Tax Notes 834 (1993); Does the IRS Need to Clean Up Its Ruling on Cleanup Costs? 59 Tax Notes 728 (1993); Environmental Cleanup Ruling Gets Mixed Reviews, 93 Tax Notes Today 99-12 (May 7,1993). 4. Miscellaneou s Revenu e Proposals : Hearing s Befor e th e Subcomm . o n Selec t Revenu e Measures of the Hous e Comm. on Ways and Means , 103 d Cong., 1s t Sess. 1445, 1470, 1475-76, 1604-46, 2513-17 (1993 ) [hereinafte r Miscellaneou s Revenu e Proposals] ; see also Staff o f Join t Comm. o n Taxation , 103 d Cong. , 1s t Sess. , Descriptio n o f Curren t Revenu e Proposal s 72-7 4 (Comm. Print 1993) . 5. Treas. Reg. § 1.213-l(e)(l)(iii) . 6. See, e.g., Jame s J . Freeland e t al. , Fundamentals o f Federa l Income Taxatio n 48 3 (8t h ed . 1994); Michael J. Graetz & Deborah H . Schenk, Federal Income Taxation: Principles and Policie s 262-65 (3 d ed . 1995) ; Sanfor d M . Gueri n & Philip F . Postlewaite, Problem s an d Material s i n Federal Income Taxation 449-50 , 691-92 (4th ed . 1994) ; see also Marvin A . Chirelstein, Federa l Income Taxation: A Guide t o th e Leadin g Case s and Concept s 90-9 1 (7t h ed . 1994 ) ( a popula r study aid). 7. William A. Klein & Joseph Bankman, Federal Income Taxation (10th ed. 1994). 8. Id. at 523. 9. Id. at 474. 10. See Jonathan Barr y Forman, The Income Tax Treatment of Social Welfare, 26 U. Mich. J.L. Ref. 785,799-804 (1994); Stanley S. Surrey, Tax Incentives as a Device of Implementing Government Policy: A Comparison with Direct Government Expenditures, 83 Harv. L. Rev. 705, 706-13 (1970). 11. Klein & Bankman, supra note 7, at 25. 12. See, e.g., Staff of Joint Comm. on Taxation, Estimates of Federal Tax Expenditures for Fiscal Years 1995-1999,103d Cong., 2nd Sess. 3-5,17-18 (1994) . 13. Klein & Bankman, supra note 7, at 25. 14. See Richard Goode, Th e Economi c Definitio n o f Income , in Comprehensiv e Incom e Taxation 1,1 5 (Josep h A. Pechman ed., 1977) [hereinafter Pechman] . 15. See E. Car y Brow n & Jerem y I . Bulow , The Definition of Taxable Business Income, in Pechman, supra note 14 , at 241, 243 (accretion i n net worth o f the firm plu s distributions, net of capital contributions, to owners). 16. See, e.g., Goode, supra note 14 , at 5-15. 17. See, e.g., id. at 15 ; David F . Bradford & U.S. Treasury Tax Policy Staff, Blueprints for Basi c Tax Reform 28 (2d ed. rev. 1984). 18. Rev. Rul. 94-38, supra note 1. 19. Rev. Rul. 87-106,1987-2 C.B. 67. 20. See Treas. Reg. § 1.213-1 (e)( 1 )(iii). 21. Rev. Rul. 94-38, supra note 1. 22. Telephon e conversatio n wit h Rober t Kilinskis , ta x specialist , Offic e o f Ta x Legislativ e Counsel, Department of Treasury (Oct. 28,1993).

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23. Henry C. Simons, Personal Income Taxation 50 (1938). 24. See Charlotte Crane, Matching and the Income Tax Base: The Special Case of Tax-Exempt Income, 5 Am. J. Tax Pol'y 191,197 (1986). 25. See Goode, supra note 14 , at 15. 26. See id. at 5 (summarizing theory of Sir John Richard Hicks). 27. See, e.g., Mar y Louise Fellows, A Comprehensive Attack on Tax Deferral, 8 8 Mich. L. Rev. 722, 726-2 8 (1990) ; Gwe n Thaye r Handelman , Acknowledging Workers in Definitions of Consumption and Investment: The Case of Health Care, this volume. 28. Goode, supra note 14 , at 15. 29. 39 T.C. 333 (1962). 30. See generallyCrane, supra note 24. 31. See Newark Morning Ledger Co. v. United States, 113 S. Ct. 167 0 (1993) ; Indopco, Inc. v. Commissioner, 503 U.S. 79,84 (1992). 32. See Indopco, Inc. v. Commissioner, 503 U.S. 79,87-88 (1992). 33. See, e.g., Letter from Moshe Schuldinger (on behalf of electric industry) to Robert Kilinskis, Tax Specialist, Office of Tax Legislative Counsel, Department of Treasury, 9 4 Tax Notes Toda y 42-4 3 (Feb. 8,1994); Letter from Joel E. Bassett ofArentFox Kintner Plotkin & Kahn to Robert Kilinskis, Tax Specialist, Office of Tax Legislative Counsel, Department of Treasury, 9 3 Tax Notes Today 178-1 7 (August 9 , 1993) ; Comments of Tax Executives Institute on the Proper Income Tax Treatment of Environmental Remediation Expenditures, 93 Tax Notes Today 133-76 (June 15,1993) [hereinafte r the Executives Institute]. 34. See John W . Bagb y e t al. , How Green Was My Balance Sheet? Corporate Liability and Environmental Disclosure, 14 Va. Envtl. L.J. 225,229-30 (1995). 35. See Miscellaneous Revenue Proposals, supra note 4, at 1698 (testimony of John W. Lee, professor of law, College of William & Mary). 36. See id. 37. Teitelbaum v. Commissioner, 29 4 F.2d 541 (7th Cir . 1961 ) (conversio n fro m D.C . to A.C. current); Woolrich Woolen Mills v. United States, 289 F.2 d 44 4 (3r d Cir . 1961 ) (constructio n o f water filtration plant); Jones v. Commissioner, 242 F.2d 616 (5th Cir. 1959) (renovation o f historic building to avoid condemnation); Cerda v. United States, 84- 1 U.S. Tax Cas. (CCH) 5949 0 (N.D. 111. 1984 ) (repairs to rental apartment buildings); R.K.O. Theatres v. United States, 16 3 F. Supp. 598 (Ct. CI. 1958) (additio n o f exit s and fir e escapes) ; Bloomfield Steamship Co. v. Commissioner, 3 3 T.C. 75 (1959 ) (repair s t o mak e forme r warship s sea - an d cargoworthy) ; Hotel Sulgrave Inc. v. Commissioner, 2 1 T.C. 619 (1954 ) (installatio n o f sprinkle r system) ; Beaven v. Commissioner, 6 T.C.M. (CCH ) 134 4 (1947 ) (installatio n o f coa l burnin g centra l heatin g system) ; Home News Publishing Co. v. Commissioner, 1 8 B.T.A. 1008 (1930) (replacemen t o f wooden girder s with steel girders); I.M. Cowellv. Commissioner, 1 8 B.T.A. 997 (1930) (hotel building alterations). 38. See sources cited supra note 33. 39. See William W . Pyle & John A . White, Fundamenta l Accountin g Principle s 6 9 (7t h ed . 1975). 40. See generally Handelman, supra note 27 (demonstrating tha t worker health care expenses are "primarily directed to the activity of work" and criticizing the "false dichotomy between investment an d consumption" that rationalize s the treatment o f human capita l investments as nondeductible personal expenses). 41. See Miscellaneous Revenu e Proposals , supra note 4 , at 1626 , 162 8 (testimon y o f Wayne Robinson, director of taxes at Gencorp, testifying on behalf of the Coalition for the Fair Treatment of Environmental Cleanup Costs). 42. See id.

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43. See Marianne Lavell , Deductions Mulled for Environmental Cleanup Expenses, Nat' l L.J. , Dec. 20,1993, at 15,18. 44. See supra notes 4,33 and accompanying text. 45. Studds Release on Deductibility of Sewer and Water Services, 9 3 Tax Notes Toda y 131-1 8 (May 21,1993). 46. Friends of the Earth Release Backs Studds Bill to Eliminate Tax Breaks for Polluters, 93 Tax Notes Today 135-79 (June 25,1993). 47. See Bagby et al, supra note 34 passim. 48. See id. at 229; Robert L . Glicksman, Pollution on the Federal Lands III: Regulation of Solid and Hazardous Waste Management, 13 Stan. Envtl. L.J. 3, 3 (1994); Allison Rittenhous e Hayward , Common Law Remedies and the UST Regulations, 21 B.C. Envtl. Aff. L. Rev. 619,619-20 (1994). 49. S. Rep. No. 116,101st Cong., 1st Sess. 8 (1989) (citing Lou Harris polls). 50. Elizabeth Clar k Morin , Note , Americans with Disabilities Act of 1990: Social Integration through Employment, 40 Cath. U. L. Rev. 189,189 (1990). 51. Americans with Disabilities Act of 1990 , Pub. L. No. 101-336,104 Stat. 327 (codified a t 42 U.S.C.§§ 12111-213) . 52. See Nancy Chodorow, Mothering, Male Dominance, and Capitalism, in Capitalist Patriarch y and the Case for Socialist Feminism 83, passim (Zillah R. Eisenstein ed., 1979). 53. See id. at 90. 54. See, e.g., Welch v. Helvering, 290 U.S. 111,113 (1933) ("W e may assume that the payments to creditors of the Welch Company were necessary for th e development o f the petitioner's business, at least i n th e sens e that the y were appropriate an d helpful . . . . H e certainly though t the y were, and we should be slow to override his judgement."). 55. Tax Executives Institute, supra note 33. 56. See supra notes 3-4,33 and accompanying text. 57. See supra note 49 and accompanying text. 58. H.R. 2050,104th Cong., 1st Sess. (1995). 59. Id. at § 102(a). 60. Id. 6\.Id. 62. See id. 63. See id. at § 101(a). 64. S. 722,104th Cong., 1st Sess. (1995). 65. See Bradford & U.S. Treasury Tax Policy Staff, supra note 17 , at 101-28.

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8 BEVERLY I . MORA N

Economic Development Taxes, Sovereignty, and the Global Economy A New York state senator called on New York City ... to cancel a package of $234 million in tax breaks and subsidies awarded to Chase Manhattan Corp. that was intended to create new jobs. "Chase Manhattan Ban k has gone from th e largest recipient of tax breaks in the city's history to the city's biggest corporate welfare cheat," Leichter said in a statement. In addition to the $234 million retention program, Chase has received more than $200 million in tax exemptions from th e New York City Industrial Commercial Incentive Program, Leichter said. The city has given more than $300 million in tax breaks since 198 8 to four banks, including Chase. The tax breaks were given in return for assurances that new jobs would be created in the city and others would be kept. The senator ... noted Republican National Bank announced in May that it would cut 850 jobs, less than a year after receivin g a $6.4 million tax incentive agreement from th e city to create 1,10 0 new jobs. —Reuter s

This essay assesses the present state of the American us e of loca l governmen t ta x incentive s a s economic developmen t tools. I n particula r I focu s o n th e us e o f government-provide d ta x incentives t o relocatin g businesse s becaus e I believe tha t thes e incen tives portend seriou s future conflict s amon g sovereignty, taxation, and economic development. I have chosen to look at local, rather than federal or state, tax incentives for a number of reasons. First, I started my tax career in local government as a general counsel to a New York City board that granted tax exemptions. At the time tax incentives seemed the wave of the future . Yet, I fel t uncomfortabl e wit h th e massiv e giveaway s I administered . Second, I believe that tax policy analysts tend to ignore the significanc e of local government practice s i n economi c developmen t eve n thoug h local tax policy plays a critical role in business and tax planning. Finally, I 97

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a stud y o f loca l incentive s i s important becaus e loca l initiative s hav e national impact. This essay begins with a brief history of the use of tax incentives by local governments. It will demonstrate that the local incentive problem is not new. I then review social science literature on the effect o f incentives on business relocation decisions. These studies reveal a contradiction: on the one hand they claim that incentives are not a major facto r in business relocatio n decision s while a t th e sam e time the y sho w a n accelerating use of incentives by state and local governments. In subsequent sections I ask why localities continue to provide incentives, given the tremendou s economi c risk s involve d and , i n addition , I examin e the problem s create d b y the us e o f ta x incentive s t o encourag e loca l investment. Finally, I look at the alternatives and offer a possible solution to the dilemma of ever-accelerating tax incentives.

HISTORY O F TA X I N C E N T I V E S O F LOCAL G O V E R N M E N T S

As we will see below, the history of local government incentives is not a happ y one . In th e pas t loca l government s compete d fo r busines s by diverting publi c revenue s t o relocatin g companies . Thi s competitio n often le d t o crisi s a s companies enjoye d incentive s withou t providin g reciprocal benefits an d the n departe d t o othe r locale s for eve n greate r rewards. There are, however, two things that make today different fro m yesterday: the inability or unwillingness of state governments to restrict local governmen t giveaway s and th e expansio n o f th e world econom y with its shift in markets from the regional to the national and the global. American municipalitie s bega n usin g incentives to attrac t industr y at least as early as the railroad era. 1 In that era towns offered railroad s incentives i n orde r t o attrac t highl y covete d railwa y stations . Thes e incentives, which wer e mostl y i n th e for m o f loan s an d grant s rathe r than tax relief, often lef t localities bankrupt when railroads went under or otherwise failed to honor their obligations. 2 In respons e t o thes e bankruptcies , stat e legislature s sometime s passed constitutiona l amendment s prohibitin g localitie s from provid ing incentives. 3 A t time s stat e court s als o steppe d i n an d prohibite d

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incentives to specific businesses or business communities. 4 Apparently, these restrictions, combined wit h th e en d o f the railroa d era , led to a decline i n th e us e o f financial incentive s b y localitie s a s a mean s o f attracting business relocations. The next period o f wide use of government incentive s came on th e federal level as part of the New Deal.5 This use generated such project s as the Hoover Dam and the Tennessee Valley Authority. However, these federal incentive s wer e differen t fro m th e loca l incentive s discusse d here. Th e Ne w Dea l project s focuse d o n region s rathe r tha n o n a n industry o r a company. I n contrast , moder n loca l incentive s ar e customized for targeted companies and uses.6 Government incentive s bega n t o chang e afte r Worl d Wa r II . Although the federal government continued some of its major projects , under the Nixon administration the emphasis shifted to block grants to the states followed b y local administration o f those grant funds. These projects were often base d on the idea of rehabilitating a particular area rather than attractin g a particular business . The progeny of these programs ca n b e foun d i n suc h federa l program s a s enterprise zones . In enterprise zones , particular area s ar e targete d fo r economi c develop ment. Any business tha t move s int o thes e area s ca n expec t t o receiv e substantial ta x benefits. I n general , however, enterprise zone s ar e no t tailored to a particular business. Instead, they usually provide the same benefits to all businesses that relocate to the zone.7 As federal moneys began to dry up in the 1980s, localities were left to fend fo r themselves. With no state or federal financial assistance, there was a shift agai n to local incentives. With les s cash available for direc t grants, local government s bega n t o emphasiz e ta x benefits an d othe r incentives as a means of attracting business. Incentives in the 1990s As localities feel a greater and greater need to control their own economic destiny, the variety and size of incentives grow. This is true even though business relocation studie s assert that ta x and financial incentives pla y a small , eve n nonexistent , rol e i n attractin g industry . Th e increasing use of incentives is not eve n diminished b y well publicized fiascos i n which companies take advantage of incentives and then leave

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their benefactors t o garner additiona l fund s fro m ne w locations. Even in the face of this practice, local incentives continue to proliferate bot h in the United States and abroad. In th e 1990 s localitie s offe r a wide variet y o f incentive s t o attrac t businesses. Fo r example , Alabam a i s no w famou s fo r it s 199 3 "Mercedes" plan, which provided the Mercedes Benz Company with tax abatements, training expenses , and lan d wort h betwee n $25 0 millio n and $300 million, or about what the company expected to pay to build a plant in Tuscaloosa.8 In South Carolina Aiken stole Beaulieu of America from Augusta , Georgia , b y providin g Beaulie u wit h $1,220,00 0 fo r infrastructure improvements , $400,00 0 i n highwa y set-asid e funds , property purchased by the county for $650,000, and a $100,000 contribution from the state electrical cooperative for site preparation.9 These practice s ar e increasingl y common . Fo r example , al l o f th e southeastern state s have enacted or amended their economic development law s in the 1990s. 10 State and local jurisdictions no w offer low interest loans and grants for infrastructure improvements , utility lines, site clearing, landfills, road construction, grading, and water and sewerage lines. 11 Furthermore , a s competitio n accelerate s amon g th e states, loca l propert y ta x concession s ofte n las t fo r decades . Som e states even allow companies to share in the state sales taxes they collect as a means o f attractin g thes e companie s t o thei r communities . As a result of these varied benefits, Industry Week reports that incentives are a buyer's market. 12 Do Incentives Make a Difference? Beginnin g a t leas t a s early as th e 1940s, social scientist s bega n studyin g busines s relocatio n decisions . Almost uniformly , thes e studie s sho w tha t th e majo r attraction s i n a relocation sit e ar e transportation , acces s t o markets , labor costs , an d labor skill s rathe r tha n taxe s o r financia l incentives. 13 I n fact , som e studies have found tha t taxes and financial incentive s have no effect a t all o n th e relocatio n decision , whil e other s indicat e tha t taxe s an d financial incentive s hav e a low impact o n investmen t decision s whe n compared with other factors. For examples: In its survey of Fortune 500 companies, Deloitte and Touche foun d that taxes and financial incentive s ranked fourteenth ou t of a possible seventeen factors in the relocation decision. 14

ECONOMIC DEVELOPMEN T 2

In hi s stud y o f hig h technolog y firms' decision s t o relocat e thei r research an d developmen t facilities , Samue l Rabin o report s tha t political stability and the availability of skilled work forces is significantly more compelling than tax incentives or disincentives. 15 In a review of relocation studie s from th e 1960 s through th e 1980s , John Blai r and Rober t Premu s repor t tha t o f the seventee n survey s they reviewed, only one ranked ta x incentives a s "primarily signifi cant" i n th e relocatio n decision , an d n o surve y ranke d financial incentives as "primarily significant." 16 Neal Schmitt and company found i n their study that the actual location decisio n "seem s t o b e drive n primaril y b y labor an d distanc e considerations."17 Incentives Overseas. A s show n above , governmen t incentive s an d their accompanying problems are not new. At several points in our history, local governments have emptied thei r pockets to attract busines s and have suffered fo r their largesse. What makes incentives more problematic today is that we are no longer i n the post-World War II era in which production was centered in the United States because other locations wer e eithe r destroye d o r undeveloped . Today , American town s that onc e compete d onl y wit h eac h othe r no w compet e i n a worl d economy. In the early 1900s a company's relocation choices were often restrict ed by transportation cost s and acces s to skille d labo r markets . In fac t this restrictio n wa s so powerfu l tha t earl y relocatio n decisio n studie s limited locatio n variable s t o transportatio n cost s betwee n supplier s and markets. 18 Today, some industrie s ar e difficult i f no t impossibl e t o move . For example, farming an d minin g rel y on particula r attribute s o f specifi c lands, and accordingly , they are less likely to relocat e than a semiconductor productio n business . B y contrast , industrie s tha t seeme d immovable i n th e earl y part o f thi s century , such a s automobile pro duction and pharmaceuticals, now travel from country to country with regularity. For example, in the 1900 s the garment industr y was settled in New York City. Even as the trade move d fro m th e northeast t o th e southeast, Mexico , Hong Kong , and Ne w York City maintained som e shops that handled rush orders for designer samples. Now that the gar-

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ment trad e ha s move d farthe r int o Centra l Americ a an d int o China , even Ne w York City "sweatshops" have diminished , an d th e garmen t unions are disappearing. Given increasing global markets and decreasing transportatio n costs , garment productio n wil l continu e t o mov e from the United States to lower-cost labor sites. As industry becomes more mobile , countries rel y more o n ta x and financial incentive s t o attrac t an d retai n business . Th e resultin g los t revenues have prompted th e World Ban k to recommen d th e elimina tion o f tax incentives in developing countries' tax reform programs. 19 However, this appeal has not dampene d th e eagerness of many industrialized nations to provide these incentives.

EXPLAINING T H E C O N T R A D I C T I O N

How do w e reconcile th e studie s tha t asser t tha t incentive s d o no t affect relocatio n decision s with the accelerating pace of state and local tax incentives ? Wh y d o localities , states , an d countrie s al l continu e incentive program s whe n face d wit h businesse s tha t exploi t govern mental resource s fo r thei r sol e benefit? Wha t d o th e state s know tha t the studie s d o no t reveal ? Th e state s kno w tha t financia l incentive s work o n th e margin . Tha t is , they wor k a t th e end , rathe r tha n th e beginning, of the relocation process . In orde r t o understand thi s con cept, this section reviews the process of reaching a relocation decision. A company goes through severa l steps in making a relocation deci sion.20 Th e firs t ste p i s forecastin g futur e capacit y requirements . I f capacity is expected t o grow , the next ste p is to decid e how to handl e the projected increase . There are several alternatives, including the use of subcontractors , increasin g price s t o decreas e demand , an d expan sion at the present site. If these alternatives prove unsatisfactory, a company will begin to consider relocation. 21 The firs t ste p i n considerin g relocatio n i s th e formatio n o f a sit e selection team, which generally comes up with two lists, a "must have" list, listin g th e factor s tha t mus t b e provide d i n an y locatio n an d a "want" list, for each site.22 The next step is information gathering . What locations can satisfy the "must have" list? At this stage those companies most likel y t o receiv e relocatio n incentive s (i.e. , large firm s tha t ca n

ECONOMIC DEVELOPMEN T 2 0

promise significan t infusion s o f capita l an d jobs ) focu s o n labo r cli mate, proximity to markets, and to a lesser extent state and local taxes in making their choices. This focus narrow s the company's choice to a few localities.23 Next the compan y begins to investigat e thes e preselected localities . At this point th e compan y als o begins it s contact s with loca l govern ments. Thus, companies firs t ente r th e "buyer's market " of tax incen tives when their relocation choices are limited to a few locations.24 This is also the first tim e that localities try to influence th e relocation deci sion by offering incentives . Localities and states know that companies look to more than incen tives i n makin g thei r relocatio n decisions . Accordingly, loca l govern ments star t thei r economi c developmen t proces s b y evaluatin g thei r strong points an d packagin g those points int o promotiona l materials . As noted by Industry Week y "when it comes to economic development , not al l places ar e create d equal . And n o amoun t o f financia l induce ments ca n transfor m Gophe r Gulc h int o Camelot." 25 However , wha t localities an d state s als o know , an d wha t recen t literatur e shows , i s that—once the field is narrowed down—companies expect and receive massive relocation incentives. For example , whe n Stev e Bergsma n report s o n th e Deloitt e an d Touche surve y discusse d above , he find s that , althoug h th e surveye d companies did not consider tax and financial incentives in making their initial relocation decisions, 82 percent of them maintained that tax and financial incentives mad e a difference onc e thei r locatio n choic e wa s narrowed t o betwee n thre e an d five locations. 26 Furthermore , i n a review of fifty-seven studies o n th e effec t o f taxes on relocatio n deci sions, Timothy Barti k argue s tha t ta x incentive s influenc e relocatio n decisions especiall y when competin g location s offe r th e sam e level of government services. 27 That situation almost always arises once a company narrows its list to a few locations with similar attributes. Thus, we now know what the states know and what some later studies have shown: infrastructure an d labor pool may be what first attracts a company, but tax incentives often clos e the deal.28

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W H A T ' S WRON G WIT H I N C E N T I V E S

If incentives d o mak e a difference i n business relocatio n decisions , then why should localities employ strategies to limit incentives? There are at least three reasons. First, th e socia l scienc e researc h o n incentive s make s i t clea r tha t what really attracts business is a good business climate. Good business climate mean s differen t thing s t o differen t industries , but a t th e ver y least it means a local government that can deliver services such as good schools an d roads , trained workers , and acces s t o markets . Although some of these factors ar e a matter o f goo d fortune , mos t ar e paid fo r from ta x revenues . Thu s th e iron y o f ta x incentive s i s tha t th e ver y things that attrac t companie s to pick among three, four, o r five possibilities ar e the thing s tha t companie s avoi d payin g fo r b y negotiatin g special deals. The argument in favor of incentives, however, is that relocating companies do in fact pay their fair share, albeit indirectly, by providing jobs that in turn generate revenues in the form of taxes on salaries. However, this argument ignores at least two considerations. Initially, there is the question o f fairness. Is it fair tha t local citizens pay for thei r benefits directl y while relocating businesses pay for thei r benefits indirectl y throug h thi s typ e o f "trickl e down " approach ? Localities should face this question directly rather than simpl y assume that business tax benefits translat e into public benefits. After all , taxation i s not onl y about raisin g revenues . It i s also about ho w revenue s are raised. Second, eve n i f localitie s decid e tha t the y hav e n o mora l proble m allowing companies to pay for government service s indirectly through their employees ' payrol l taxe s rathe r tha n directl y throug h busines s taxes, it is not clear that these new jobs can generate sufficient revenue s to offset compan y benefits. According to one advocate of tax incentives for businesses , "[f]o r a stat e o r metropolita n are a t o permanentl y increase it s employmen t b y on e jo b compare d t o wha t i t otherwis e would be , the stat e o r metropolita n are a would hav e to enac t genera l business ta x rat e cut s tha t woul d reduc e busines s ta x revenues , fro m business activity that would have occurred even without the tax cut, by $1,906 to $10,800 per year, year after year." 29 Given that very few work-

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ers earn enough incom e to generate an additional $10,80 0 of local tax revenues eac h year , i t i s difficul t t o argu e tha t relocatin g companie s actually give back anythin g nea r wha t the y receive , especially i f othe r incentives are added to lost tax revenues. Furthermore, the literature shows that the amount o f tax incentives companies receiv e is increasing as competition become s more heated . As a result, if companie s continu e t o forc e localitie s an d state s int o a "race to the bottom" of tax incentives, the essential government services that once made these localities attractive will be lost. Thus, in the long run, tax incentives ma y actually work agains t economi c developmen t by making localities less attractive location choices. Third, even i f tax incentives ar e set s o that localitie s ge t back wha t they give, the payback can work only if the relocating companies stay in their ne w location. However, the unfortunat e realit y of th e incentive s game is that companies that receive attractive incentive packages sometimes prematurely leave the communities that gav e so much to attrac t them. Perhap s th e mos t wel l know n exampl e o f thi s phenomeno n occurred i n Ypsilanti, Michigan, where th e localit y attempte d t o pro hibit General Motor's relocation under a contract theory. The town and the state gave General Motors a series of incentives based on the company's projections tha t i t would creat e jobs by placing it s automobil e plant in Ypsilanti. When General Motors threatened to leave the town, thereby reducing the number o f promised jobs, a Michigan state court issued an injunction preventin g the move. 30 However, the decision was later reverse d b y a higher cour t an d th e plan t wa s allowed t o leave. 31 This essa y starte d wit h a quote d referenc e t o anothe r exampl e tha t recently attracte d pres s interest , th e cas e o f th e Chas e Manhatta n Bank/Chemical Bank Corporation merger . That merger will cost thousands of jobs even though Chas e received hundreds of millions of dollars from New York City to attract and retain those jobs.32 What makes these stories unique is not tha t the companies left, bu t that the localities publicly complained an d tried to extract some relief. After all, a city or town that loses a large employer is not always eager to broadcast th e news , particularl y whe n ther e ar e othe r businesse s t o entice and these businesses may not like litigious local governments.

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ATTEMPTS T O A D D R E S S T H E I N C E N T I V E S P R O B L E M

A numbe r o f institution s coul d ste p forwar d an d tr y t o contro l incentives. Yet, to date, there is no end in sight. In an attempt to understand why no one has stepped forward t o meet the challenge, this section looks briefly a t the role courts, government, and the markets play in controlling incentives. Can courts control incentives? As noted earlier , attempts to enforc e claimed contract rights have failed because courts have refused to find a contract eve n when a company mad e specifi c promise s abou t jobs o r capital investment. It is not surprising that American courts are unwilling to apply a contract theory in these situations, given that incentive s may not be in written agreements . Perhaps because courts are unwilling to construc t thes e contracts, few states or localities sue when the y get less than they expected in return for their lost tax dollars. Localities could better protect the interests of their communities by insisting o n writte n contracts . Unfortunately, loca l government s hav e not used this approach as much as they could. A recent example comes from th e many sports teams that received huge incentive packages but left fo r bette r locations . Furthermore , writte n contract s ma y no t impede corporate flight because localities may be reluctant to use such costly methods . Further , contract s canno t cur e ba d deals . Althoug h part o f th e proble m i s roun d robi n relocation , th e mor e prevalen t problem is that incentives are so generous that they can never be repaid even if companies fully comply. Localities coul d rel y on th e marke t t o control , o r limit , incentives . Reliance o n marke t force s woul d depen d o n a belief tha t th e marke t would resul t i n th e selectio n o f th e mos t efficien t sit e b y businesse s without regard to tax incentives. Unfortunately, a review of how relocation decision s ar e mad e indicate s tha t th e marke t doe s no t preven t incentive war s betwee n localities . Instead , companie s find th e fe w places that mee t their nonincentive requirement s an d the n hol d thos e localities hostage for the best incentive packages. So far the market has merely increased businesses' power. In other words, excessive tax incentives define the market, and so the market is not the cure. State governments coul d ste p in and prohibit th e use of incentives, as they di d i n th e nineteent h century . However , rathe r tha n takin g a

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neutral position , state s ar e a s eage r a s localitie s t o ente r th e incentiv e market. The federa l governmen t i s als o a potentia l playe r i n thi s area . On e recent proposa l i s that th e federa l governmen t shoul d strictl y prohibi t incentives. Arguments i n favor o f a federal limitatio n are : The federal government's greater political insulation allows for more objective economic development decisions; State legislatures have demonstrated limite d abilit y to control competitio n by failing to act; and Contract theory has failed to protect localities that have been misled in the relocation process. 33 The problem with looking to the federal governmen t i s that busines s relocation i s more tha n a national problem . Today, with transportatio n costs greatly reduced; with manufacturin g givin g way to high tech ; an d with th e Pacifi c Rim , th e India n subcontinent , th e res t o f Nort h America, South America, and Europ e al l providing skille d labor forces , business relocation i s no longer merel y a national concern . In fact ther e is a stron g argumen t tha t a federa l prohibitio n agains t relocatio n incentives would onl y increase th e transfe r o f capita l an d labo r oppor tunities overseas . Furthermore, ther e i s th e questio n o f sovereignty . Sovereignt y i s closely linked to the ability to tax. Thus states may be reluctant to trans fer thei r righ t t o ta x (or , mor e appropriately , no t t o tax ) t o th e federa l government.

F U T U R E P O S S I B I L I T I E S AN D P R E D I C T I O N S

Economic developmen t an d th e competitio n fo r busines s ar e mos t likely here to stay. As the global manufacturing bas e declines and trans portation cost s betwee n localities , states , countries , an d eve n conti nents decrease , localities will face a n econom y i n which ther e i s a limited suppl y of jobs and capita l investments . This is not merel y a nationa l trend. I t i s also a trend i n Asia, Europe, and Nort h America . The ques tion i s not whethe r o r no t state s an d nation s wil l compet e agains t on e

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another fo r economi c development. The question i s whether localitie s will compete o n businesses ' terms o r whethe r the y will find a way to regain contro l ove r thei r ow n economi c developmen t withou t relin quishing sovereignty to the federal government . The natur e o f th e relocatio n decisio n suggest s tha t cooperativ e action b y localitie s ma y foste r health y economi c development . A s discussed above , incentives d o no t hel p a company identif y it s initia l relocation choices , but the y have a potentially large effect o n th e fina l location decision. 34 The fact that incentives do not play a role in a company's first , second , or eve n third choic e means that localitie s ar e no t competing with every other place in the world. Each locality will compete with a few others based on a similarity of attributes such as infra structure, labor climate , an d transportatio n costs . Thes e competin g location sites may be scattered worldwide, but they are not global in the sense of every locality competing against every other. The fac t tha t a localit y ca n identif y it s competitio n i s significant , because the ability to identify competitors is a prerequisite to the ability to enter int o noncompetitio n agreements. 35 Furthermore, if competi tors can join, they can shif t powe r fro m a buyer's marke t t o a greater state of equilibrium by limiting the incentives market. By collaborating, regions coul d mor e fairl y se t incentiv e level s so as to limi t thei r ow n exploitation. The cartels I suggest have several advantages. First, by identifying th e competition an d formin g incentiv e cartels , localities retai n th e abilit y to compete. An inability to compete could very well result if the federal or state governments prohibited incentive s in this country while other nations continued to offer whatever they can to attract business. Second, localitie s maintain , an d eve n increase , thei r sovereignt y when they control their own tax systems without state or federal over sight. This is particularly important because location decisions are local decisions. They do not operate on a national, or even a statewide, level. When larger political bodies get involved in these local decisions, they are less likely to perceive or understand rapi d change s in business climate. As a result of a lack of current information , large r government s are also less likely to make adjustments for those changes. Local governments, on the other hand, are well versed in local business conditions. They are also well aware of actual and potential competitors. The more

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control localitie s have , the mor e likel y they ar e t o pu t thei r superio r information an d interest to good, swift use. Finally, the cartel s I envision coul d provid e th e tailore d incentive s that companies prefer. The only difference betwee n present-day incentives an d th e incentive s o f m y projected future , i s that, i n m y future , incentives ar e limite d i n conjunctio n wit h competitor s rathe r tha n increased in an attempt to beat the competition. This does not mean that my proposal is an easy or an obvious solution. Clearly, something has so far prevented localities from forming , or even conceptualizing, incentive cartels of this sort. For several reason s this failure seems odd because the basis for these cartels is well in place. First, there are no legal impediments t o governments' joining forces. 36 Second, the competition i s clearly identifiable, a major prerequisit e t o the creation o f a cartel. Third, there is little chance that ne w competitors will enter the market because the sorts of things that localities sell (quality of life, transportation, labor climate, etc.) are difficult t o replicate over short periods of time. Thus, once a cartel is formed, it would be difficult fo r an outsider to help destroy the agreement by undercutting th e cartel . Fourth , countries , states , and localitie s hav e a histor y of joinin g togethe r fo r othe r project s suc h a s join t transportatio n facilities. Accordingly , mechanism s exis t t o facilitat e communicatio n between thes e competitor s an d t o hel p the m reac h agreement . Yet , something keeps governments fro m joinin g together to protect them selves from this new and growing form o f corporate raiding. The classic explanation for the failure of governments to join together is the game theory story of the prisoners' dilemma. The classic prisoners' dilemma start s with a story. Two men hav e committed a crime, but there is not enough evidence to convict unless one of the two confesses. Logically, neither shoul d confes s because, without a confession , both will go free. However, the police have kept them separate from on e another, and each is offered a deal—confess an d go free while the other is convicted. In this situation the best solution for each individual is the worst solution for the group.37 Governments, however, are not in the same position as the prisoners in the game theory tale. The most dramatic difference betwee n the two situations i s that government s can , an d do , get informatio n o n wha t companies demand and what they receive. Governments are simply not

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in th e positio n o f havin g som e outside r kee p the m fro m gettin g th e information the y need to make good decisions. A better wa y t o understan d th e proble m o f incentiv e cartel s i s t o look a t th e OPE C oi l cartel , which too k almos t twent y years to for m and which still has compliance problems. OPEC is an example of how difficult i t i s to for m cartels . After all , there i s always the chanc e tha t someone will cheat. Experience shows that trust must be built up over time. Furthermore, everyone i n the carte l must b e sure that everyon e else is a repeat player because only repeat players have the incentive to collaborate toda y for benefit s tomorrow . Using OPEC as an example , we might conclud e tha t incentiv e cartel s will form i n th e futur e onc e governments have a chance to understand the buyer's market they have created and the time to build the relationships that they need to make the cartel work. Although it may seem unlikely, I think the "repeat player" problem is at the core of the failure o f governments to join into cartels. This may seem an odd claim at first because governments are classic repeat players. They are not goin g anywhere, and the y will always want a s much business as they can handle. However, I believe the problem lies in the fact tha t althoug h localitie s ar e repeat players , their representative s i n their economic development office s ar e not. Instead, what happens o n the economic development level is that localities employ young graduates of law, business, and public administration schools . These people make thei r reputation s base d o n th e bi g relocatio n deal s the y hel p negotiate, not on how these relocations work out. For these professionals, there is much more incentive to give away the store than there is to join with the competition. In thi s way governments ar e very different fro m businesses . Young people come to businesses to make their career, whereas young people come t o governmen t t o mak e their reputation s an d the n mov e o n t o business careers. The fact that local governments' interests conflict with their employees' interests undercuts the repeat player perspective that is so important for cartels. Governments may have to change the way that they staf f thei r economi c developmen t office s befor e the y ca n full y exploit their natural advantages. Greed, abandonment, frustration , an d th e demands o f the new global economy hav e all helped t o creat e a buyer's marke t i n ta x incentives .

ECONOMIC DEVELOPMEN T 2

Each day's newspaper brings more stories of growing business benefit s and diminishing government return. In this new world where businesses cross boundaries wit h ease , the traditiona l regulator s o f th e publi c good—federal an d state government, the market, and the courts—have failed t o right the imbalance between local governments and the businesses they try to attract. Fortunately fo r loca l governments , socia l scienc e researc h show s that, for busines s relocatio n decisions , each are a compete s with a few similar sites . The fact tha t eac h business require s particular amenitie s that, in turn, are found i n particular places may provide localities with some relief . Local government s kno w wha t make s the m attractiv e t o business, an d the y kno w whic h othe r region s offe r simila r benefits . Because they have this knowledge, local governments als o know thei r competition, tha t is , th e fe w place s wit h similarl y attractiv e nonta x attributes. Until now, businesses have forced these comparable districts to bid against one another in the tax incentive war. However, these governments could turn the tables by joining together with their competitors to cap benefits between them. Of course , formin g a n incentiv e carte l i s n o eas y thin g t o accom plish. One barrie r I identify t o a successful carte l i s the repea t playe r problem. Successful cartel s are based on a limitation o f present benefi t in contemplatio n o f greater futur e reward . Because expectation s con cerning th e futur e pla y suc h a n importan t rol e i n thei r formation , cartels are made up of repeat players. At first sight , governments see m the perfect repea t player s because the y ar e locked int o a site and int o the nee d t o attrac t busines s t o tha t site . However , wher e economi c development i s concerned, th e difference s betwee n government s an d their professiona l economi c developmen t team s ma y undercu t thei r repeat player status. Despite th e challenge s t o thei r formation , loca l government-spon sored incentiv e cartel s have some attractions ove r alternative s suc h as federal and state restrictions or reliance on the courts. The most significant benefit that I discuss is the strengthening of local government control and the concurrent increase in local sovereignty. Without incentiv e cartels, or some other form of intervention, I, along with others, predict an ever-increasin g amoun t o f loca l tax incentives tha t canno t pa y fo r themselves.

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NOTES 1. Mark Taylor, Note, A Proposal to Prohibit Industrial Relocation Subsidies, 72 Tex. L. Rev. 669 (1994). 2. Id. at 671-72. 3. Id. 4. Id. 5. M at 671-75 . 6. Joseph F . McKenna, Operator, Get Me Kansas City: Competition for Industrial Development, Mar. 6,1995, available in LEXIS, News Library, Indwk File. 7. For a description of federal enterprise zones, see Sidney Kess, Empowerment Zone Incentives, N.Y.LJ.,Feb.6,1995,at41. 8. James Krohe, Jr., Relocation Reconsidered: Do These Incentives Sound Too Good to Be True? Across the Board, Feb. 1995, at 41. 9. Stev e Bergsman , Incentives, Location, Quality of Life: All Figure into the Site Selection Equation, Nat'l Real Est. Investor, Oct. 1993, at 158. 10. Frank Schaefer & Milette Shanon, Size Up State, Local Tax Incentives before Making a Move, Nov. 1994, available in LEXIS, News Library, Crcash File. 11. McKenna, supra note 6 ; James Rayball , Ohio's Economic Development Strategy: Jobs and Taxes in a Global Economy, Feb. 1995, available in LEXIS, News Library, Asap File. 12. McKenna, supra note 6. 13. For a review of relocation studie s from th e 1960 s to the 1980s , see John P . Blair & Robert Premus, Major Factors in Industrial Location: A Review, 1 Econ . Dev. Q. 72,77 (1987). 14. Bergsman, supra note 9. 15. Samuel Rabino, High Technology Firms and Factors Influencing Transfer ofR & D Facilities, 18 J. Bus. Res. 195,204(1989). 16. Blair & Premus, supra note 13. 17. Neal Schmit t e t al. , Business Climate Attitudes and Company Relocation Decisions, 72 J. Applied Psychol. 622,625 (1987). 18. Blair & Premus, supra note 13 , at 72. 19. International Bank for Reconstruction and Development, Lessons of Tax Reform (1991) . 20. Blair & Premus, supra note 13 , at 74. 21. W. 22. Id. 23. Id. 24. Id. at 75. 25. McKenna, supra note 6. 26. Bergsman, supra note 9, at 158. 27. Timothy J. Bartik, The Effects of State and Local Taxes on Economic Development: A Review of Recent Research, 6 Econ. Dev. Q. 102,103-5 (1992). 28. Id.; Bergsman, supra note 9, at 158. 29. Bartik, supra note 27, at 106. 30. Charter Township of Ypsilanti v. General Motors Corp., 50 6 N.W. 2d 55 6 (Mich . Ct. App. 1993). 31. Id. 32. N. Y. Senator Urges Chase Tax Break Repeal, Reuters, Aug. 30,1989, available in LEXIS, News Library, Curnews File. 33. Taylor, supra note 1, at 694-701.

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34. Krohe, supra note 8, at 44. 35. Fo r a discussio n o f noncompetitio n agreements , se e Steve n D . Shadowe n & Kennet h Voytek, Economic and Critical Analyses of the Law of Covenants Not to Compete, 72 Geo. L.J. 1425 (1984). 36. Sherman Antitrust Act, 15 U.S.C. §§1,2 (1988) . 37. Lol a L . Lopes , Psychology and Economics: Perspectives on Risk, Cooperation, and the Marketplace, 45 Ann. Rev. Psychol. 197 (1994).

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9 KAREN B . B R O W N

Transforming the Unilateralist into the Internationalist New Tax Treaty Policy toward Developing Countries

The U.S. international tax system of the 1990 s is a relic 1 that largel y reflects polic y concern s o f th e earl y 1960 s durin g President John R Kennedy's tenure. The international tax rules generated during that period remain effective today. Those rules were designed to combat internationa l ta x avoidance o r evasio n a t a time when U.S. enterprises wer e th e primar y player s i n th e worl d economy . Interna tional tax policy at that time reflected seriou s concerns for the U.S. fisc. Given that U.S. businesses held a significant piec e of worldwide wealth, the governmen t mostl y aime d t o dete r cross-borde r transaction s tha t threatened to lower tax revenues and deplete the U.S treasury. The controlled foreig n corporatio n provision s tha t reduce d th e abilit y of U.S. business owners to escape U.S. tax on foreign operations typify international tax legislation o f the 1960s . The fear o f unbridled manipulatio n of U.S. tax liability by the conduct of business transactions abroad also motivated U.S. tax treaty policy. Increasingly, the United States insisted on exchange of information provision s in bilateral income tax treaties as a means of policing cross-border deals. To minimiz e interferenc e wit h th e busines s decision s o f it s con stituents an d t o protec t it s revenues , the Unite d State s continue d it s commitment to the principle of capital export neutrality in its interna2 14

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tional ta x system . Capital expor t neutralit y i s a subset o f th e broade r goal of economic neutrality. It is a tax doctrine premised on the notion that capital is allocated most efficiently when tax considerations do not distort the choice of location of investment by multinational enterprises.2 In the United States this meant that tax rules were designed to have no impact on the investment decisions of U.S. multinationals.3 U.S. tax liability wa s identica l whethe r operation s wer e locate d a t hom e o r abroad. As a consequence capita l coul d be invested where it was most efficiently employed , where it derived the greatest economic return. The principl e o f capita l expor t neutralit y prevail s i n th e Unite d States today . A key component i s elimination o r reductio n o f doubl e taxation tha t ma y resul t whe n mor e tha n on e countr y taxe s profit s resulting fro m cross-borde r transactions . Th e ta x credi t availabl e fo r income taxes paid to foreign countrie s insure s neutrality by offsettin g the U.S. tax otherwise imposed on the worldwide income of U.S. businesses. Some exceptions to the neutralit y principle , such a s the exclu sion fo r certai n incom e earne d fro m service s provide d abroad , offe r incentives to operate abroad in order to increase exports of U.S. goods and services. Others, like the limitation o n the tax credit when the for eign tax rate exceeds that of the United States, protect the U.S. treasury. The continue d relianc e o f th e Unite d State s upo n capita l expor t neutrality ha s impede d it s abilit y t o construc t effectiv e alliance s wit h developing countries. The traditional mechanism s use d by developing countries to attract investment, tax holidays (periods of no taxation fo r specified businesses) and low tax rates, do not interest the U.S. investor who will be taxed on all income, even income derived from outsid e the United States, at higher U.S. rates. If, for instance, a developing country taxed manufacturing profit s a t the rate of 5 percent, the rate reduction would not affect a U.S. corporation, which would owe additional tax at the rate of 30 percent to the U.S. government on those profits. 4 The following exampl e demonstrates this result. Assume a U.S. corporation derive s $1,000 in taxable income from manufacturin g opera tions in a developing country. That country imposes a tax of $50 (5 percent of $1,000). The United States imposes a 35 percent tax on the same profits, or $350 , but allow s a credit fo r th e $50 paid to the developin g country. The U.S. corporation pay s $50 to the developing country and $300 to the United States ($350 minus $50). The lower rate of tax in the developing country is of no consequence to the U.S. corporation.

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In contrast , capita l impor t neutrality , th e ta x doctrin e viewe d a s most compatible with the goal of encouraging investment i n developing countries , ha s bee n rejecte d b y th e Unite d States . That doctrin e maintains that capital should be taxed under the rules of the location in which i t i s employed , regardles s o f it s origin . Proponent s o f capita l import neutralit y would support an exemption from U.S . tax for prof its generate d abroad . Man y industrialize d countrie s othe r tha n th e United States , includin g Canada , France , Germany , an d th e Nether lands, hav e accepte d impor t neutralit y a s a mean s t o assis t develop ment.5 They believe that the stimulation o f investment resultin g fro m low taxes will increase worldwide competition and encourage economic activity that can only inure to the benefit o f all multinational enter prises. Th e los s o f revenu e t o a n individua l countr y i s offse t b y th e increment i n worldwid e growt h create d b y increase d production . As long a s investmen t i n a developin g countr y i s no t stimulate d b y exploitative mean s (fo r example , by payment o f subsistenc e wage s t o workers, b y constructio n o f environmentall y hazardou s productio n facilities, or by exporting unsafe products, such as cigarettes, to locales where produc t safet y regulation s d o no t reflec t moder n healt h con cerns), both the industrialized and the developing economies may benefit fro m expande d production. Projected benefit s includ e the spread ing of costs of production worldwide and the expansion of exports.6 Considering th e declin e sinc e the 1960 s of th e U.S. position i n th e world economy , devotion t o th e capita l expor t neutralit y principl e i s misplaced. From 196 0 to 199 0 the U.S. share of world gros s domesti c product droppe d fro m 4 3 percent to 24 percent.7 For the same period its share of high technology exports fell from 3 4 percent to 19 percent.8 From 197 5 to 198 9 foreign investmen t i n th e Unite d State s increase d from $22 0 billion to almost $2.1 trillion. At the same time U.S. investment abroa d faile d t o kee p pac e an d gre w fro m $29 5 billion t o onl y $1.4 trillion. As a result the U.S. net international investmen t positio n was negative $664 billio n i n 1989 . The Unite d State s becam e a ne t debtor natio n (foreig n investor s ha d mor e claim s o n U.S . assets tha n U.S. investors had abroad) for the first time in 1985.9 The trade position o f the U.S. has eroded seriously. By 1990 its current account balance was negative $100 billion. That balance reflected a huge trad e defici t (th e exces s o f import s o f good s an d service s ove r exports o f good s an d services ) create d primaril y b y a n imbalanc e i n

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merchandise exports . Th e U.S . trade defici t fo r 199 5 reache d $111. 5 billion.10 Despite th e declin e i n it s economi c prominence , th e Unite d State s continues t o asser t hegemon y i n internationa l ta x politics. In th e ta x policy debate, it behaves like a unilateralist.11 A unilateralist construct s international polic y alon e wit h regar d primaril y fo r it s ow n asserte d interests. Given th e growin g importanc e o f othe r actor s i n th e worl d economy, however , th e Unite d State s shoul d ac t i n ta x matter s a s a n internationalist. An internationalist form s alliances, and it acts in partnership with thos e allies. 12 I argue i n this essa y that th e Unite d State s should becom e a n internationalis t i n th e 1990s , becaus e concerte d action possesse s th e greates t potentia l t o advanc e th e interest s o f th e United States and its partners. The evolutio n o f U.S . relation s wit h developin g countrie s mus t begin to reflect internationalist strategies. Creative use of tax treaties by the Unite d State s an d developin g countr y partner s ma y advance economic goal s significantly . Tw o importan t ta x polic y goals , efficienc y and growth , ma y be achieve d b y the combine d effort s o f th e Unite d States an d emergin g partners , especiall y developin g countries . Th e mechanism for change is the development of tax treaties that represen t multilateral interests . Departin g fro m th e two-part y ta x agreement s generated by the current regime, treaties that strengthen th e economic position of a select group of trading partners could reform internation al tax strategy. If these agreements respect the interests of workers and local communities and the integrity of the environment, the enhanced business and investment opportunities in developing countries created by th e multilatera l treatie s woul d inur e t o th e Unite d State s an d it s partners. Accordingly, as discussed below, the transformative multilat eral treaty proposed i n this essay would withdraw treaty benefits fro m business arrangements that attempt to exploit the social and economi c resources of the developing country. 13 Developing countries are the preferred partner s fo r the multilatera l arrangement becaus e the y offe r th e greates t prospec t fo r economi c growth. The United State s has not take n ful l accoun t o f the economi c opportunities provide d b y partnership s wit h developin g countries . Fear that every developing country is a tax haven that hopes to siphon U.S. revenues an d careles s assessmen t o f developmen t potentia l hav e caused the United States to neglect possibilities for collaboration .

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Although th e multilateral approac h t o treat y negotiation (on e tha t values broa d coalitio n an d grou p interests ) i s ne w i n th e Unite d States,14 i t ha s bee n employe d successfull y abroad . Example s o f suc cessful multilatera l agreement s are the tax directives relating to mergers, parent-subsidiary transactions , and transfe r pricin g implemente d by th e fiftee n member s o f th e Europea n Unio n an d th e Europea n Economic Agreement , extendin g ta x an d trad e agreement s t o th e Economic Free Trade Agreement nations. 15 The movement supportin g establishment o f free trade zones also demonstrates the timeliness of a collaborative model in tax matters.16 Construction o f effectiv e ta x alliance s shoul d includ e provision s designed to assure fair working conditions and prevent environmenta l harm. Collaboration wit h a broad grou p o f countrie s ultimatel y ma y offer the greatest benefits, but this essay considers the prospect for multilateral agreements with developing countries with significant popula tions o f color . Development o f a blueprint fo r cooperatio n wit h thi s group will furnish valuabl e guidance fo r futur e treat y negotiations by the United States with a wider group.

TRADITIONAL I M P E D I M E N T S T O C O O P E R A T I O N BETWEEN T H E UNITE D STATE S AN D DEVELOPING COUNTRIE S

The United States is party to income taxation treaties with 57 countries.17 Excludin g Russi a an d Centra l an d Easter n Europea n nations , only eigh t treatie s ar e wit h developin g countries : Barbados , India , Indonesia, Jamaica, Mexico, Pakistan, People's Republic of China, and Trinidad an d Tobago . Although th e forme r treat y wit h Sout h Africa , revoked in protest of the former aparthei d regime , is under renegotia tion, there ar e no treatie s with African nations . Other tha n th e treat y with Mexico, there are no treaties with Latin American or South American nations. The United States has entered into exchange of tax infor mation agreement s wit h Barbados , Bermuda , Cost a Rica , Dominica , Dominican Republic , Grenada, Guyana , Honduras, Jamaica, Peru , St. Lucia, an d Trinida d an d Tobago . These agreement s d o no t offe r th e typical investment incentive s provided by tax treaties because they are limited t o informatio n sharing . Many developin g countrie s conclud e

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these agreements with th e United State s in orde r t o become attractiv e sites for U.S. owners of foreign sales corporations. Of the Asian nations, the United States has concluded treaties only with the People's Republic of China, India, and Indonesia. Most treaties with developing countries are of recent vintage. The treaty with Mexico did not become effectiv e until 1993 . The treaty with China was ratified i n 1986 , and the treaties with India and Indonesia were ratified i n 1990. The absence o f a mature treat y network wit h developin g countrie s results i n par t fro m th e xenophobi a tha t characterize s internationa l relations of the United States. 18 That xenophobia is particularly strong in the case of certain developing countries with substantial populations of color , as demonstrated b y restrictive immigratio n policie s fo r resi dents of Caribbean nations, especially Haiti and Cuba, Latin and South America, Mexico , and Africa. 19 Thi s ha s cause d th e Unite d State s t o ignore o r rejec t thes e countrie s a s viable partners fo r treat y strategie s that will support economic growth. Fear o f politica l incompatibilit y ha s als o impede d treat y partner ships wit h developin g countrie s tha t hav e significan t population s o f color. With fe w exceptions , th e Unite d State s ha s eschewe d alliance s with Marxist and other governments deemed faithful t o leftist politics . The huma n right s record s o f som e developin g countrie s hav e als o impeded coalitions. 20 Xenophobia, reaction to progressive politics, and human right s concern s hav e combined t o creat e a stereotype fo r U.S. businesses an d internationa l ta x policymaker s accordin g t o whic h developing nation s wit h significan t population s o f colo r becom e viewed a s inferior player s i n th e globa l marke t an d undesirabl e part ners for strategic development. For othe r developin g countries , however , xenophobia , politica l instability, an d huma n right s violation s hav e no t prevente d partner ships for economic development. Russia and many of the other forme r members of the Soviet Socialist Republic have entered into treaties with the United States . After th e USSR dissolved, Russia entered int o a new treaty wit h th e Unite d States , but th e othe r forme r member s o f th e USSR automatically remaine d partie s to the former USSR-U.S . treaty. Most ar e negotiatin g expande d treatie s wit h th e Unite d States . Fo r example, Kazakhstan anticipate s treat y ratificatio n i n th e nea r future , after i t solve s problem s wit h propose d informatio n exchang e provi sions.21 Treatie s wit h Poland , Romania , Hungary , an d th e Czec h an d

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Slovak Republics are in force. Much of the progress may be attribute d to the demands of U.S. businesses for expanded development opportu nities with central and eastern European countries. 22 China, a country with a significant populatio n of color, is an important example of a tax treaty partnership in which the stereotype of the developing country as an inferior business partner has not prevailed. In that cas e the United State s has not allowe d a communist governmen t and egregiou s violation s o f huma n right s t o imped e a ta x treat y alliance.23 For China factor s tha t hav e removed th e usual obstacle s t o conclusion o f a treaty with a developing country include its enormous population (nearl y one-fift h o f th e world's population ) an d th e willingness of U.S. industrialists and tax analysts to view China as a capable fiscal strategist. With th e exceptio n o f Mexico , India, an d Indonesia , however, the stereotyp e ha s held fo r othe r developin g countrie s wit h significant population s o f colo r an d ha s prevente d successfu l treat y negotiations with the United States. The slim U.S. network with developing countries witnesses the inadequacies in international and tax treaty policy. In addition to the xenophobic reluctance to enter into partnerships with developing countries, there are three major impediment s to successful treat y relations by the United State s with thes e countries : the acceptanc e o f th e principl e o f capital expor t neutrality , th e unilatera l us e o f ta x treatie s t o advanc e U.S. interests , an d th e underestimatio n o f th e capabilitie s o f th e economies of developing countries. Capital Export Neutrality Capital export neutrality is a primary obstacle to development o f a vibrant treaty network with developing countries. Acting in accordance with th e principle o f capita l expor t neutrality , the Unite d State s taxes the foreign income of its residents and citizens (U.S. taxpayers) in order to promot e worldwid e efficienc y i n th e allocatio n o f resources . U.S. taxpayers are taxed the same whether they derive income from domes tic or foreign sources. The system avoids the double taxation that could result fro m taxatio n o f worldwid e incom e b y allowin g a credi t (tha t decreases U.S . tax liability ) fo r foreig n taxe s pai d o n incom e derive d from operation s abroad. If the tax rate applied by a foreign jurisdictio n is less than tha t i n th e Unite d States , however, the U.S . taxpayer doe s

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not benefit fro m lowe r rates. Instead it pays the excess over the foreig n rate to the U.S. treasury. Thus, a U.S. business has no incentive to locate operations abroa d unles s th e economi c retur n (independen t o f ta x costs) is higher. The U.S. system of capital export neutrality is not perfect, however , because the United States does not extend the principle to a situation in which th e ta x rat e i n th e foreig n jurisdictio n i s higher tha n th e U.S. rate. If it carried the efficiency goa l underlying export neutralit y to its logical conclusion, the United States would refund th e taxes in excess of the U.S . rate t o multinationa l enterprises . Th e refund s woul d assur e that the issue of tax cost would be removed from the business judgment about th e appropriat e local e fo r investmen t o r productio n activities . Capital expor t neutralit y woul d deman d tha t a multinationa l enter prise conside r onl y th e economi c retur n fro m investment . If , fo r instance, a U.S. business were to conclude , based o n a comparison o f costs (other than taxes) and return on investment, that operations outside the United States were more profitable, then, under a neutral system, the United States would subsidize the higher tax rates of that for eign locale by refunding taxe s in excess of the U.S. rate. Out of concern for it s treasury, however, the United State s limits the amount o f cred itable taxes to those that would result from a tax at the U.S. rate, and no credit is allowed for any excess. This system provides an incentive to exploit the social and economic resources o f developin g countries . Becaus e capita l expor t neutralit y removes th e advantag e o f lo w ta x rates , th e developin g countr y i s forced t o provide U.S. investors other incentive s that lower barriers t o entry into the developing economy. These include low wages for workers, worker safet y an d chil d welfar e regulation s tha t ar e les s rigorou s than those in the United States, and environmental protection laws less restrictive than those in the United States. These incentives attract U.S. investment b y exacting sever e cost s o n worker s an d th e environmen t and b y underminin g constructio n o f a health y infrastructur e upo n which t o develo p th e economy . Although n o responsibl e governmen t would voluntarily support economi c policies that lead to the exploitation o f its worker populatio n (throug h paymen t o f below subsistenc e wages and inhumane working conditions) an d the depletion of natural resources, developin g countrie s ar e force d t o ente r int o exploitativ e partnerships in order to attract U.S. dollars.

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The Mexica n maquilador a demonstrate s th e socia l destructio n wreaked by actions designed to attract U.S. investment. A maquiladora is a company that assemble s component s o r conduct s labor-intensiv e manufacturing operation s o n behal f o f a foreigner t o produc e good s for export. 24 U.S . companies have found ownershi p o f a maquilador a attractive in part because it offers production of goods to be sold in the United States at lower cost. The cost advantages derive from th e ability to employ workers for wages far below that necessary for subsistence. In the clothin g manufacturin g industry , fo r example , worker s i n som e plants ear n n o mor e tha n th e equivalen t o f sevent y cent s fo r a lon g workday under conditions in which they are virtual prisoners with limited access to sanitary facilities and no possibility of exit before the end of th e shift. 25 A s demonstrate d b y th e exampl e o f th e maquiladora , capital expor t neutralit y support s a system i n whic h a U.S. investor's primary incentive for investmen t i n a developing country is the possibility o f exploitin g resource s t o maximiz e retur n o n investment . Th e consequence o f expor t neutralit y i s that i t foreclose s th e abilit y o f a developing country to attract investment by targeted tax incentives that would offer rat e reductions in exchange for commitments of resources designed to strengthen the social and fiscal infrastructure. Serious examination o f the U.S. international tax regime dispels the notion tha t th e disincentive to invest in developing countries, and th e exploitation of developing country resources that results from attempt s to counter the disincentive, may be justified by a neutrality or efficienc y norm. Th e U.S . system depart s fro m th e neutralit y goa l i n situation s that operat e to advantage targeted activities . In an effort t o encourag e export o f U.S. goods and services , the United State s exempts from ta x income derive d b y U.S . taxpayer s fro m performanc e o f service s abroad.26 T o the exten t tha t th e subpar t F provisions (requirin g U.S. taxation o f certain type s of income o f foreign affiliates ) d o not apply , the United States also exempts income derived from manufacturin g o r other sales operations conducted by U.S.-taxpayer-owned foreig n cor porations.27 The operation of the foreign tax credit itself allows circumvention of the neutralit y principle . B y manipulating th e geographica l sourc e o f income rule s upo n whic h th e foreig n ta x credi t depends , a taxpaye r may inflat e th e amoun t permitte d t o offse t U.S . tax liability . If , fo r instance, a U.S. seller of whiskey purchased abroa d contracts with U.S.

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purchasers to pass title to the goods abroad, the resulting sales income will be treated a s foreign sourc e incom e eve n i f the selle r has no economic connectio n t o th e foreign plac e of purchase. 28 If , a s a result of the lack of economic nexus , the foreig n local e fails t o tax the whiskey sales income, the U.S. seller may nonetheless include the whiskey sales income in computing its credit for taxes paid to other foreign countrie s on othe r foreig n sourc e income . By simply contracting fo r passag e of title i n a foreig n country , th e U.S . selle r ma y arbitraril y reduc e it s worldwide ta x liability . Th e sourc e rule s provid e tha t th e sourc e o f income from sale s of purchased inventory is where title passes. Passage of titl e ma y be provided b y contract. Th e agreemen t o f th e partie s i s sufficient t o determin e passag e o f titl e and , hence , th e sourc e o f income, unless there is a tax avoidance motive and the "substance of the sale" is not in a foreign country but rather is in the United States. 29 If, for example, the seller has other income of a foreign sourc e in the amount o f $1,000, which was taxed by a foreign countr y at the rate of 50 percent, and $1,000 of whiskey sales income of a U.S. source, a foreign ta x credi t o f onl y $35 0 (foreig n sourc e incom e [$1,000]/worid wide income [$2,000 ] x U.S. tax liability [$2,00 0 x 35 percent] o f $700) would b e allowe d t o offse t th e U.S . seller's U.S . tax liabilit y o f $70 0 ($2,000 of worldwide income x 35 percent). The foreign tax credit limitation o f sectio n 904(a ) effectivel y limit s the maximu m credi t agains t U.S. ta x liabilit y t o th e effectiv e U.S . rat e o f ta x o n foreig n sourc e income.30 The U.S. seller would pay $350 to the United States and $500 to the foreign country, for a total of $850 in tax liability. If, however, the whiskey sale s income wer e o f a foreign sourc e an d th e foreig n local e assesses no tax, a credit o f $700 would offse t U.S . tax liability of $70 0 (foreign sourc e income [$2,000]/worldwid e income [$2,000 ] x U.S. tax liability of $700 [$2,00 0 x 35 percent]. The U.S. seller would pay $500 to th e foreig n country , fo r a tota l o f $50 0 i n taxes . Thi s exampl e demonstrates tha t abilit y to manipulate th e sourc e of income rule s to minimize worldwide tax liability converts the capital export neutralit y principle supporting the current U.S. tax system into a myth. The foreig n ta x credi t rule s als o resul t i n th e marginalizatio n o f investment i n developing countries. As suggested by the whiskey seller example, the foreign tax credit encourages strategies to permit blending of high-rat e taxe s paid i n foreig n countries , for whic h th e maximu m credit allowabl e ma y not excee d th e 3 5 percent U.S . rate, with lower -

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taxed o r exemp t incom e derive d fro m othe r sale s transactions. If, fo r example, a U.S. taxpayer derives taxable income of $1,000 from opera tions in a foreign industrialize d countr y that impose s a 50 percent tax and $1,000 from U.S . operations, the maximum credi t against U.S. tax liability is $350 (foreign sourc e income of [$1,000] / worldwide income of [$2,000 ] x $700 [$2,00 0 x 35 percent]). The company pays $350 tax to th e Unite d State s (U.S . tax liabilit y o f $70 0 [$2,00 0 o f worldwid e income x 35 percent] minus the foreign tax credit of $350) and $500 to the foreign country for a total of $850. If the company can shift $30 0 of profits to a no-tax jurisdiction, such as a developing country that does not ta x sale s incom e fro m manufacturin g operations , o r i f i t ca n arrange passage of title in a developing country that does not tax such sales i f no t attributabl e t o permanen t operation s locate d withi n it s jurisdiction, it may reduce its overall tax liability to $700 (versus $850) with the same return on investment ($2,000). 31 Although th e 198 6 Tax Reform Ac t legislation establishe d separat e foreign ta x credit limitations for discret e categories of income (know n as foreign tax credit baskets) in an effort t o limit the ability of multinationals to circumven t th e foreign ta x credit limitations b y rate blend ing, thes e rule s generall y d o no t preven t th e possibilit y o f blendin g rates o n incom e derive d fro m manufacturin g an d sale s operations . Unless it fits within the special categories for shippin g or financial ser vices income, business incom e fro m operation s i n differen t countrie s will be placed in the same category, the residual basket.32 The U.S . system , whic h allow s manipulatio n o f th e geographica l source of income rules and provides an incentive to blend higher-rat e taxes with lower ones, encourages no meaningful investmen t i n developing countries. Instead it facilitates abus e of the tax systems of developing countrie s b y permitting U.S . companies t o obtai n ta x benefit s with no commitment of capital or other resources to support the economy. Under this system developing countries do not become magnet s for investmen t b y U.S . multinationals . Instea d eithe r the y becom e pawns use d primaril y t o subsidiz e operation s i n industrialize d coun tries to which U.S. businesses have committed substantia l resources or they become candidates for exploitative ventures that deplete the economy rather than build it. Another impedimen t t o fruitfu l relationship s ha s bee n th e refusa l by the United States to allow the "tax sparing" credit that has formed a

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cornerstone o f ta x policy in man y developin g countries . Many coun tries hav e cite d thi s refusa l a s a majo r impedimen t t o th e successfu l conclusion o f a treaty with the United States . U.S. rejection o f the tax sparing credi t wa s a majo r caus e o f th e dela y i n th e negotiatio n o f treaties with the People's Republic of China and India . It is the reaso n there is no treaty between the United State s and most African nation s or betwee n th e Unite d State s an d Singapore . Althoug h th e Unite d States rejected th e request of the People's Republic of China to include a tax sparing credit, it agreed to incorporate such a provision if adopted in any other U.S. treaty.33 The tax sparing credit would allow U.S. businesses the advantages of low tax rates imposed i n a developing country. In a tax sparing provision, the United States allows a credit in the amount of the U.S. tax rate on developin g countr y income , eve n i f th e developin g countr y taxe s paid were lower than the U.S. rate.34 The "tax spared" by the developing country benefit s th e U.S . business becaus e ther e i s n o additiona l ta x imposed b y th e Unite d State s o n developin g countr y incom e eve n though U.S. rates are higher.35 The failure of the United States to accept the ta x sparin g credi t ha s deraile d man y developin g countr y treat y negotiations.36 Motivate d b y a concer n fo r los t revenues , the Unite d States ha s no t incorporate d ta x sparin g agreement s int o it s treaties , even thoug h the y woul d encourag e U.S . investmen t i n developin g countries. Tax Treaties—A Tool for Pursuing U.S. Interests Traditionally, the United States has employed tax treaties to advance its short-ter m interest s bu t ha s neglecte d it s long-ter m interests . Notwithstanding tha t a treat y i s a for m o f contrac t an d th e treat y process reflects a give and tak e in which eac h party relinquishes som e rights i n exchang e fo r othe r privilege s an d benefits , th e Unite d State s maintains that the bargain struc k may be changed unilaterall y by subsequent legislation, by revocation o f the treaty, or by promulgation o f administrative regulations. 37 Industrialized countrie s have condemned the U.S. hegemonic stance but, nonetheless, feel compelled to conclude an agreemen t becaus e o f th e importanc e o f th e Unite d State s a s a source of relatively stable investment for their multinational enterpris es.38 I n thi s cas e th e decisio n t o negotiat e ta x agreement s wit h th e

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United State s results from a conclusion tha t th e benefits outweig h th e burdens. For developin g countries , however , th e conclusio n o f a ta x treat y with the United States is not motivated merely by a cost-benefit analy sis. The investmen t incentive s provide d b y a tax agreemen t wit h th e United States are key to their ability to attract significant investmen t by U.S. multinationals and to the stability of their economies. For a developing country, a tax treaty with the United States may provide an indirect sanctio n fo r investmen t b y constituent s o f othe r industrialize d countries. Consequently, if the United States is to become a responsible actor in the global economy, it must look beyond short-ter m interest s and i t mus t loo k forwar d t o an d creat e opportunitie s t o collaborat e with developin g countries . The status of the United State s as a superpower in foreign relation s matters (includin g the civil wars in Bosnia , Haiti, Northern Ireland , and parts of Africa) dictate s that i t become a leader in advancing effective ta x policy proposals that support the economic interests of developing countries. Underestimation of Developing Country Economies Since glasnos t an d th e fal l o f communism , th e Unite d State s ha s asserted a strong interest in constructing investment alliances with central and eastern European countries. 39 It has shown much less enthusiasm fo r economi c partnership s wit h othe r developin g countrie s i n Latin and South America or Africa eve n though many of these nations have operate d compatibl e politica l system s fo r a considerabl y longe r period. This neglect o f developin g countrie s with substantia l popula tions o f colo r seem s founde d i n th e mistake n belief , hel d unti l jus t recently, that such countries do not offer significan t investmen t oppor tunities.40 Careful study, however, demonstrates the enormous promise these countrie s hol d fo r substantia l contributio n t o worl d economi c growth. Recent congressiona l hearing s indicate , fo r example , tha t Africa n nations offer the prospect of important trade and investment growth. 41 Sub-Saharan Africa has a population of 560 million, an amount expected to double in thirty years.42 In the period from 198 6 to 1993 , African imports of U.S. goods grew by 50 percent, a growth rate faster than that of the European Union. 43 If demand fo r U.S . goods remains constant ,

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exports o f U.S . goods an d service s would amoun t t o $5 0 billion. 44 I n short, economi c an d politica l reform s i n Africa couple d wit h signifi cant investmen t promis e t o "transfor m th e regio n int o a leadin g growth marke t durin g th e firs t hal f o f th e [21s t century]." 45 Opportunities appea r mos t promisin g i n Ethiopia , Uganda, Tanzania, Kenya, Ghana, Senegal, Guinea Bissau, and South Africa.46 As noted by a representative o f AT&T, "[t]argeted investment s i n key technologie s can help move Africa fro m a n aid-based to a trade-based economy and into th e mainstrea m o f internationa l economi c prosperity— a benefi t for everyone." 47 This testimony demonstrates that the time is now right for a change by the Unite d State s in it s international ta x strategy tha t will maximize the social and economic advantages to be gained by collaboration amon g th e Unite d States , Africa , an d othe r developin g countries with significant populations of color.

P R O P O S A L FO R D E V E L O P I N G C O U N T R I E S

The propose d chang e i n strateg y i s that th e Unite d State s begin t o negotiate its future ta x treaties on behalf of a block of nations with significant population s o f color . Specifically, eac h ne w U.S. treaty woul d extend benefits t o businesses organized in the developing country. The United State s would implemen t thi s polic y by expanding th e "limita tions o f benefits " provision s o f eac h treat y t o encompas s busines s enterprises in the developing country. Limitations of benefits provisions typically restrict the availability of rate reductions on investment incom e or the availability of tax exemptions for business profits t o residents (whethe r individual s or business entities owne d i n significan t par t b y resident individuals ) o f the con tracting parties. 48 Nearl y al l U.S . treaties ar e bilateral (involvin g onl y two parties), and benefits ar e rarely accorded resident s o f third coun tries. The bilateral approach safeguard s th e U.S. interest in meting ou t treaty benefit s onl y i n exchang e fo r bargaine d concessions . Thi s approach harm s developin g countries , perceive d a s havin g littl e t o offer. Capita l expor t neutralit y an d stereotype s togethe r discourag e U.S. businesses fro m demandin g tha t th e U.S . government negotiat e the type of treaty (one featuring ta x sparing) acceptabl e to developin g countries. I n addition , developin g countrie s ar e exclude d fro m th e

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valuable benefit s offere d b y two-part y treaties . The sophisticate d two party treaty network i s constructed apar t fro m developin g countrie s i n a wa y tha t damage s thei r interests . Tha t har m ca n b e rectifie d onl y i f the Unite d State s become s a n internationalis t tha t construct s treatie s aimed a t offsettin g th e disadvantage s t o developin g countrie s alread y built into the U.S. international ta x system . The Unite d State s ca n counterac t th e distortion s create d b y its cur rent treat y strategie s b y adoptin g limitation s o f benefit s provision s i n treaties that encourag e appropriate investmen t practice s with business es i n developin g countrie s tha t hav e significan t population s o f color . The mos t importan t innovatio n woul d b e incorporatio n o f treat y lan guage tha t extend s treat y benefit s t o enterprise s owne d i n substantia l part b y resident s o f selecte d developin g countries . An exampl e o f th e type o f provisio n neede d i s foun d i n th e U.S.-Mexic o treaty , whic h automatically extend s it s benefits t o thir d partie s tha t becom e signato ries to NAFTA as follows: [A] company which is wholly owned, directly or indirectly, by residents of any Stat e tha t i s a part y t o th e Nort h America n Fre e Trad e Agreemen t ("NAFTA") i n whos e principa l clas s of share s there i s [ ] substantial an d regular trading on a recognized securities exchange;... and [ ] more than 50% owned, directly, or indirectly, by residents of either Contracting State [U.S. or Mexico] in whose principal class of shares there is such substantial and regula r tradin g o n a recognize d securitie s exchang e locate d i n suc h State..., 49 The suggested provisio n woul d exten d benefit s t o companie s owne d a t least in part by residents of the developing country . It would encourag e formation o f busines s venture s b y multinational s i n th e Unite d State s and the third countr y with partners from th e developing country. If th e United State s wer e t o incorporat e thi s typ e o f provisio n int o it s nex t treaty wit h Canada , fo r instance , join t venture s forme d wit h capita l from th e Unite d States , Canada , an d selecte d developin g countrie s would benefit fro m th e tax incentives offered b y the treaty. As additional treatie s ar e negotiated , a n economi c developmen t bloc k o f nations , sharing treat y benefit s wit h selecte d developin g countries , woul d emerge. Admittedly, this proposal contain s weaknesses. From th e perspectiv e of th e developin g country , i t i s only secon d best , because i t support s a

TRANSFORMING TH E UNILATERALIS T INT O TH E INTERNATIONALIS T 2 2

treaty tha t lack s a ta x sparin g provision . A s discusse d above , man y developing countrie s ar e no t willin g t o becom e signatorie s i n th e absence of such a provision.50 Given the reluctance of U.S. government policymakers t o approv e ta x sparin g agreement s becaus e o f revenu e concerns, it is not likely that a tax sparing arrangement will gain acceptance in the near future. 51 The prime advantage of the proposed new treaty policy is that it may benefit developin g countries, even if they are not willing to make concessions t o th e Unite d State s i n th e treat y negotiatio n proces s b y becoming signatories to an agreement that does not feature a tax sparing arrangement . Th e benefi t woul d resul t fro m th e incentiv e give n investors t o for m venture s wit h developin g countr y businesse s tha t would deriv e incom e eligibl e for preferentia l treatment . Without par ticipation of the developing country as a signatory to the treaty, however, treat y benefit s woul d g o onl y t o venture s reapin g profit s i n th e United States or the third country (for example , a joint venture owned by resident s o f th e Unite d States , Canada , an d Sout h Afric a woul d enjoy treaty benefits only for investment income or profits from U.S. or Canadian sources) , an d the y woul d no t exten d t o venture s derivin g profits o r incom e fro m th e developin g country . The advantag e t o th e developing countr y i s tha t it s businesse s ma y gai n withou t a corre sponding drai n o n th e nation' s ta x revenue s o r othe r resources . Although investor s fro m industrialize d countrie s hav e traditionall y sought treaty benefits for activities in a developing country, the proposal reverses this dynamic. Developing country businesses would share in substantial returns from venture s abroad, find market s for local goods or service s i n industrialize d markets , an d inves t profit s i n th e loca l economy. The resulting expansion in economic development may ultimately convince U.S. policymakers that enactment o f tax sparing provisions is affordable. New international ta x policy strategie s ar e neede d t o correc t th e cur rent U.S . international ta x syste m tha t disfavor s developin g countrie s with significant population s o f color. The proposal made by this essay is a first ste p toward developmen t o f a tax regime that doe s not har m developing countries. The goal is development o f a broad coalitio n o f countries tha t deriv e benefit s fro m ta x partnership . Investmen t an d business opportunitie s wil l increas e a s participation increases . A net-

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work o f countrie s connecte d throug h th e multilatera l ta x treat y ca n offer onl y greate r diversit y o f investmen t i n a variety o f locales . The partnership o f a broad grou p o f industrialized countrie s with a select group o f developin g countrie s woul d generat e economi c gai n fo r all . The selected group would exclude developing countries in which governments have not rigorously protected human rights (including rights of workers) o r the integrity of the environment. The most importan t aspect of the proposal is that it urges policy innovation that would provide growth opportunities for developing countries and avoid exploitation of their social and economic resources. NOTES The autho r wishe s t o acknowledg e th e suppor t o f th e Universit y o f Minnesot a La w School Faculty Summer Research Fund and the support, encouragement, and very helpful critiqu e of the other contributor s t o this antholog y wh o participate d i n Taxing America: A Conference o n th e Social and Economic Implications of Tax Reform, held November 3-5 , 1995 , at the University of Minnesota, especially Prof. Mary Louise Fellows, an incredible mentor (thoug h a contemporary) and friend wh o has freely shared her insightful analysis . 1. Department o f Treasury , Internationa l Ta x Reform: A n Interi m Repor t v (Jan . 15 , 1993) [hereinafter Interi m Report]. 2. Gar y Clyd e Hufbauer , U.S . Taxation o f Internationa l Income : Blueprin t fo r Refor m 4 9 (1992). 3. Interim Report, supra note 1, at 3. 4. SeeI.R.C.§§ 901,904(a). 5. Hufbauer, supra note 2, at 57. 6. Id. at 58. 7. Hufbauer, supra note 2, at 3 (table 1.1) . 8. Id. 9. See Staf f o f Join t Comm . o n Taxation , 102 d Cong. , 1s t Sess. , Factor s Affectin g th e International Competitiveness of the United States 79-81 (Comm. Print 1991). 10. Import Surge Drives Up Trade Deficit, L. A. Times, May 18,1996, at Dl. 11. See David Fromkin, We Can Go It Alone. We Shouldn't, N.Y. Times, Sept. 29,1995, at A17. 12. See id. 13. See John A. McLees et al., Mexico Moves toward Resolution of Maquiladora Transfer Pricing Issues, 11 Tax Notes Int'l 18 3 (1995). 14. See H. David Rosenbloom , Derivative Benefits: Emerging US Treaty Policy, Interta x (Feb . 1994), at 83. 15. See Dick G. Vliet et al., Tax and Legal Aspects of EC Harmonisation 147-9 5 (A. Peter Lier ed., 1993); John G. Goldsworth, Tax Aspects of the European Economic Area Agreement, 8 Tax Notes Int'l 131 0 (1994). 16. See James Brooke, U.S. and 33 Hemisphere Nations Agree to Create Free-Trade Zone, N.Y. Times, Dec. 11,1994, at 1.

TRANSFORMING TH E UNILATERALIS T INT O TH E INTERNATIONALIS T 2

17. Andre Fogaras i e t al. , Current Status of U.S. Tax Treaties, 2 4 Ta x Mgmt . Int' l J . 480-81 (1995). 18. See The Two Kinds of Immigration, S. F. Chron., Dec. 5,1995, at A22. \9.Seeid. 20. See Paul Beckett, Shell Boldly Defends Its Role in Nigeria, Wall St. J., Nov. 27, 1995, at A9; Nosa Igiebor, A Regime's Offense/Nigeria Scoffs at Worldwide Rebuke, Newsday, Nov. 25,1995, A8. 21. See Bank Secrecy Issue Holding Up US.-Kazak Treaty, Official Says, Daily Tax Rep. (BNA), July 17,1995, at G-5. 22. See The Russian Market Takes on New Luster, Wall St. J., July 11,1994, at Al. 23. See Ken Brown, Rights Issues Aside, Asia Deals Rise, N.Y. Times, Aug. 1, 1994, at CI; A. M. Rosenthal, History Is Today, N.Y. Times, Feb. 7,1995, at Al 1. 24. See Nicasio del Castillo & Manuel F . Solano, Business Operations in Mexico, 92 Tax Mgmt. Int'l Portfolios (BNA ) at A-5 (Dec. 1993). 25. Bob Herbert, Not a Living Wage, N.Y. Times, Oct. 9, 1995, at Al 1; Ray Sanchez, Taking on Guatemala Sweatshops, Organizers Risk Death by Trying to Launch Unions, Newsday, Sept. 4, 1995, atA6. 26. See I.R.C. § 911; Charles I. Kingson, A Somewhat Different View, 34 Tax Law. 737 (1981); see also I.R.C. § 921 (exempt income from certai n export activities of foreign sale s corporations). 27. See I.R.C. §§ 951-64. 28. See Liggett Group, Inc. v. Commr, 58 T.C.M. (CCH) 116 7 (1990) (basis for example in text); see also Intel Corp. v. Commr, 67 F.3d 144 5 (9th Cir. 1995 ) (interpretin g Treas . Reg. §1.863-3(b), which applies the source rule to transactions involving manufactured goods) . 29. I.R.C. §§ 861(a)(6), 862(a)(6); Treas. Reg. § 1.861-7 ; see also id. at § 1.863-3(b ) (sourc e rule for manufactured goods) . 30. See I.R.C. § 904(a) (establishin g th e followin g formula : foreig n sourc e taxabl e income / worldwide taxable income x U.S. tax liability). 31. See Linda Galler, An Historical and Policy Analysis of the Title Passage Rule in International Sales of Personal Property, 52 U. Pitt. L. Rev. 521 (1991). 32. I.R.C. §904(d)(l)(I). 33. See Joint Comm . on Taxation, Explanation o f Propose d Treat y between th e United State s and the People's Republic of China, in Tax Treaties (WGL) f 72,134 , at 72,128 (1995). 34. Charles I. Kingson, The Coherence of International Taxation, 81 Colum. L. Rev. 1151, 1262 (1981). 35. H. David Rosenbloom & Stanley I. Langbein, United States Tax Treaty Policy: An Overview, 19 Colum. J. Transnat'l L. 359,379 (1981). 36. Mary Bennett, Policy Perspective—Reflections on Current U.S. Policy for Developing Country Tax Treaties, 90 Tax Notes Int'l 698 (1990). 37. SeeH.R.Conf.Rep.No. 1104 , 100th Cong., lstSess.,pt. 1 (1988) ; Department of Treasury, Preamble to Conduit Arrangements Regulations, 59 C.F.R. 52,110 (1994). 38. See Richard Doernberg , Legislative Override of Income Tax Treaties: The Branch Profits Tax and Congressional Arrogation of Authority,42 Tax Law. 173 (1989). 39. Richard W. Stevenson, Russia's Arms Makers Try Change, N.Y. Times, May 2,1994, at CI. 40. See Ken Brown, Taking Stock in Third World, N.Y. Times, Nov. 11,1995, at 17 ; John F. Burns, India Now Winning U.S. Investment, N.Y. Times, Feb. 6,1995, at CI. 41. See Joint Hearin g on Investmen t an d Trade in Africa Befor e the Subcomm. on Africa an d International Economics Policy and Trade of the House Comm. on International Relations, 104th Cong., 1st Sess., available in WESTLAW, 1995 WL 93664 (Mar. 9,1995) [hereinafte r Join t Hearing]

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(testimony o f Joh n F . Hicks , Assistan t Administrator , Burea u fo r Africa , U.S . Agenc y fo r International Development). 42. Id. 43. Id. 44. Id. 45. Id. 46. See Joint Hearing, supra note 41, at 199 5 WL 93666 (testimony of General Motors Corp.); id. at 199 5 WL 93668 (testimony of the Coca-Cola Co.). 47. See Joint Hearing , supra note 41 , at 199 5 WL 9602 3 (testimon y o f Willia m B . Carter, President of AT&T Submarine Systems). 48. See William P . Streng, "Treaty Shopping": Tax Treaty "Limitation of Benefits" Issues, 1 5 Hous. J. Int'lL. 1(1992). 49. See U.S.-Mexico Incom e Ta x Treaty, art. 17(l)(d)(iii) , in Tax Treaties, supra note 33 , at 562,118, at 62,110 (1995); see also U.S.-Canada Income Tax Treaty, art. XXIX A, in id. at 522,075, at 22,100-Z.134 (1995 ) (extend s tax rate reductions o n investmen t incom e (royalties , interest, and dividends) to third party residents of countries having a comprehensive income tax treaty with the United States). 50. See Treasury Will Not Hold Tax Treaty Talks with Brazil until Assurances Are Met, Daily Tax Rep. (BNA), Oct. 16,1995, at G-2. 51. But cf. National Comm . o n Economi c Growt h an d Ta x Reform , Unleashin g America' s Potential: A Pro-Growth, Pro-Family Tax System for th e 21st Century, reprinted in 70 Tax Notes 449 (1996) (recommendin g tha t Congres s consider a territorial tax system imposing tax only on income generated within the borders of the United States, a change that would support tax sparing agreements).

IO L A B R E N D A GA R RETT" N E L S O N

The Future of Deferral Taxing the Income of U.S. Multinationals

The U.S . internationa l ta x regim e ca n b e ex plained by reference to four goals: efficiency, competitiveness, compatibility wit h internationa l ta x norms , an d preservatio n o f th e U.S . income tax base. Efficiency generally refers to the policy of minimizing tax considerations in investment decisions. In this regard U.S. tax rules tend to favor capital export neutrality ox the imposition of an equivalent U.S. tax burden on income wherever it is earned. The general U.S. policy of taxing citizens and domestic firms on their worldwide income is intended to promote capital export neutrality. Capital expor t neutralit y i s sometime s a t odd s wit h th e goa l o f preserving th e abilit y o f U.S . taxpayers t o compet e i n internationa l markets. If capital export neutralit y were the only policy at stake, U.S. policymakers migh t no t concer n themselve s wit h whethe r domesti c corporations earnin g income abroad ar e taxed on the same income by both the United States and a foreign country . Clearly, however, this sort of double taxation would disadvantage U.S. firms, relative to the many foreign firms organize d i n countrie s wit h territoria l (no t worldwide ) tax systems. The United States has sought to harmonize its tax laws with international ta x norms , includin g th e eliminatio n o f internationa l doubl e 233

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taxation. Consisten t wit h th e goa l o f avoidin g doubl e taxation , U.S . competitiveness i s furthered b y the deferral o f U.S. income tax on th e active busines s earning s o f controlle d foreig n corporation s (CFCs) . Deferral allow s U.S. multinational corporation s t o inves t i n a foreig n country, on an equal footing with foreign competitors , without attract ing current U.S. income tax. In recent years U.S. policymakers see m to have elevated the goal of preserving th e U.S . income ta x base ove r al l others . In principl e thi s goal call s fo r clearl y definin g th e ta x bas e an d limitin g th e exten t t o which U.S. rules operate to subsidize foreign governments . For example, the U.S. foreign ta x credit (FTC) is provided to relieve taxpayers of international doubl e taxation, but i t i s limited t o th e U.S. tax on for eign-source income. 1 Thus, no FTC is available to the extent that a foreign ta x rat e exceed s the U.S . tax o n incom e include d i n th e base. In addition t o enacting FTC limitations and income source rules, legislators, in th e interes t o f preservin g th e incom e ta x base, have adopte d antideferral rule s tha t impos e curren t U.S . ta x o n certai n incom e earned through CFCs. Obviously, the imposition of current U.S. income tax has the potential to increase the cost of doing business abroad through CFCs in contravention of the goals of advancing U.S. competitiveness and compatibility wit h internationa l ta x norms . O n th e othe r hand , bot h capita l export neutrality and the goal of preserving the U.S. tax base argue for antideferral measures. Indeed, a rule allowing unlimited deferral would create an incentive to locate income-producing activities in low- or notax jurisdictions, and th e unfettere d allowanc e o f FTC s would impai r the domestic tax base if foreign ta x payments could be used to shelter income fro m U.S . sources. Th e goa l o f preservin g th e U.S . tax bas e accounts fo r a plethora o f exception s t o deferra l an d th e awfu l com plexity of the current rules limiting the use of FTCs.2 The balance that has been struck between competing U.S. tax goals may be revisited a s a result o f the political chang e that occurre d afte r the 1994 midterm elections, giving Republicans control of both houses of the Congress for th e first tim e in forty years. Another harbinge r o f change is the growin g interes t i n fundamenta l ta x reform tha t woul d replace the current incom e tax system with som e form o f a consumption-based tax. 3 Many of the issues presented by deferral will be obviated if the U.S. income tax is replaced (or augmented) by a consumption

THE FUTURE OF DEFERRAL 23

tax. This essay explores the factors relevan t to (1 ) whether the Republican hegemon y will se t th e stag e for liberalization s tha t woul d lowe r the current U.S . tax on CFC operations, (2) the contravening implica tions of a fiscal environment i n which the need for new sources of revenue could result in further cutback s on deferral, and (3) selected issues relating t o th e significanc e o f deferra l i n th e even t th e Unite d State s adopts a consumption-based tax . At the least, the congressiona l focu s on competitiveness and tax reform shoul d facilitat e a serious reexamination o f the curren t U.S . tax policy that purport s t o advanc e capita l export neutralit y (an d preserv e the income tax base) by taxing a wide range of foreign investments. 4 D E F E R R A L— I N T H E O RY A N D PRACTIC E

Deferral o f ta x o n th e foreig n busines s operation s o f domesti c corporations result s from th e structure o f the U.S. system that treats a corporation and its shareholders as separate taxpayers. The general rule is that a U.S. corporate parent o f a CFC pays no U.S. tax on the CFC's foreign-source income , unless and until the CFCs earnings are repatriated (as dividends, gain on sale of the CFC, or otherwise). The internationa l ta x nor m o f avoidin g doubl e taxatio n coul d b e violated b y the U.S . rules tha t ta x the worldwide incom e o f domesti c corporations, includin g tha t derive d fro m a foreig n country . Th e United States bows to the international norm by allowing U.S. multinational corporation s t o reduc e U.S . tax liabilit y wit h FTCs , includin g credits for foreig n taxe s paid by a CFC but deemed paid by a U.S. parent corporatio n whe n incom e i s distributed b y the CFC . I.R.C. § 901 provides a dollar-for-dollar credi t for taxe s paid directly by a U.S. taxpayer, subject t o the limitations of I.R.C. § 904. Where a U.S. corporation operates in a foreign country through a CFC, I.R.C. § 902 provides an indirect credi t fo r taxe s paid by a foreign subsidiary . It deems payment by the U.S. parent o f foreign taxe s paid by the CFC in respect of income distribute d a s dividends . I.R.C . § 960 als o allow s a n indirec t FTC for taxe s paid by a CFC on incom e deeme d distribute d t o a U.S. parent under the subpart F rules.5 In addition , th e Unite d State s ha s entere d int o numerou s bilatera l income tax treaties that limit the taxation of U.S. multinational corpo -

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rations b y treat y partners . I n theory , t o th e exten t th e Unite d State s cedes taxing jurisdiction to a foreign country with a comparable corporate incom e ta x rate , no additiona l U.S . tax i s payable when a CFC' s earnings are taxed to a U.S. shareholder. Prior t o 196 2 antideferra l rule s wer e limite d t o foreig n persona l holding companies (FPHCs ) an d generally imposed a current tax only where at least half of a foreign corporation' s income was passive investment income. 6 Thus, before enactment of subpart F, U.S. multinational corporations enjoyed unlimited deferral of U.S. income tax on business profits earne d abroa d throug h CFCs . CFC statu s unde r subpar t F is based o n whether U.S . shareholders ow n mor e than 5 0 percent o f th e vote o r valu e o f a foreig n corporation' s stock , determine d wit h th e application o f constructiv e ownershi p rules. 7 A U.S . shareholde r i s defined a s one owning at least 1 0 percent by vote or value of the stock in a corporation. On e consequenc e i s that a U.S. shareholder i s taxed currently on the CFC's "subpart F income," which includes investmen t income and certain business income earned by related parties in transactions deemed to suggest a tax avoidance motive. Originally, subpar t F wa s aki n t o th e FPH C rules , focusin g o n income from passiv e investments. Indeed, subpart F trumps the FPHC rules where both could apply. Although certain active business income was subjected t o curren t taxation , this generall y occurre d onl y where U.S. taxpayers employed the device of organizing foreign bas e companies to isolate business profits in low-tax jurisdictions. In a typical case a domesti c firm woul d sel l it s export s t o a CF C fo r resal e abroad . The CFC would be organized in a foreign countr y in which little or no tax wa s impose d o n incom e derive d fro m resal e t o a thir d country . This enabled th e U.S. parent t o reduc e tax on a portion o f it s foreig n business profits . Ove r th e las t thre e decades , however , Congres s ha s increased th e numbe r an d expande d th e scop e o f antideferra l rule s applicable to CFCs, imposing current U.S. tax even in the case of active business incom e derive d throug h CFC s tha t wer e no t organize d t o avoid tax. The 198 6 Ta x Refor m Ac t adde d th e passiv e foreig n investmen t (PFIC) rules 8 and amended subpart F to eliminate deferral for shipping and most activities of the financial service s industry. Moreover, under legislation enacte d i n 1993 , current incom e inclusions ar e required t o the extent a CFC's passive assets exceed 25 percent of its gross assets.9

THE FUTURE OF DEFERRAL 23

Prior to enactment of the PFIC rules, taxpayers could shelter passive income from curren t U.S. taxation by organizing foreign mutua l fund s with widely dispersed ownership because subpart F has no applicatio n where no U.S. shareholder (define d t o mean at least a 10 percent shareholder) exists . The PFI C rule s were intende d t o hal t th e us e o f U.S.owned foreign mutua l funds t o defer U.S . tax on investments, 10 but i n operation the PFIC rules can apply to CFCs engaged in bona fide business activities. The enactmen t i n 199 3 of th e I.R.C . § 956A tax o n exces s passiv e assets was justified o n the ground that "deferral of U.S. tax on accumulated activ e business profits i s not necessar y to maintain th e competi tiveness of business activitie s conducte d b y [CFCs ] where . . . held i n the form o f excessive accumulations o f passive assets." 11 Treasury offi cials have defended this provision by reporting research results indicating that the average percentage of passive assets for all CFCs was just 13 percent a t th e tim e th e provisio n wa s enacte d an d onl y 7 percent i n non-tax have n countries. 12 Others , however, poin t t o wha t ha s bee n described a s a "perverse result" that encourage s CFCs to make foreig n (rather tha n domestic ) investment s i n busines s assets , i n orde r t o remain below the 2 5 percent threshold. 13 Moreover , it has a disparate impact on certain U.S. businesses because the current statute makes no allowance for CFCs that might accumulate profits in excess of the average fo r legitimat e busines s reason s (e.g. , fundin g planne d busines s expansions out of retained earnings).

T H E C A S E FO R C O M P E T I T I V E N E S S A S A TAX P O L I C Y GOA L

When subpar t F was enacted i n 1962 , the Congress recognized tha t there ar e nonta x busines s reason s fo r locatin g a U.S.-owne d facilit y outside th e Unite d State s (fo r example , reducin g distribution , trans portation, and customs costs). The validity of this premise is evidenced by th e numbe r o f CFC s organize d i n countrie s suc h a s th e Unite d Kingdom and France where corporate income tax rates are comparable to U.S. rates. The compromise reache d i n 196 2 was intended t o guar d against the potential for abuse while protecting the ability of U.S. businesses to compete abroad. 14 In the past congressional Republicans have

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expressed dissentin g view s wit h respec t t o th e breac h o f th e 196 2 compromise b y antideferra l legislation . Thus , on e woul d expec t a Republican-controlled Congres s t o reexamin e post-196 2 legislatio n that runs counter to the goal of promoting competitiveness. When the House Ways and Means Committee reported on the 1993 bill that ended deferral for CFCs with excessive passive assets, the (then minority) Republica n member s o f th e committe e opine d tha t "[t]h e area of U.S. taxation of international operations, already written off by most knowledgeable persons as a disaster, would be made significantl y worse."15 The Republicans further predicted , "U.S. corporations will be shackled with additiona l burdens , virtually assuring that the y will fal l behind i n internationa l competitiveness . Incom e o f foreig n sub sidiaries earned in prior years and not repatriated t o the United State s will, in many cases, be subject t o immediate taxation in what ca n only be called a retroactive tax change."16 The concern underlying the Republican dissen t from th e 199 3 Ways and Mean s Committe e bil l i s tha t th e Unite d State s taxe s outboun d investments mor e heavil y than othe r countries . Although th e 3 5 percent U.S. corporate income tax rate is in the same range as that o f our major tradin g partners, 17 countries such as Germany, the Netherlands, and France refrain fro m taxing foreign-source income . In contrast with a multinational organized under the laws of Germany or France, a CFC operation woul d resul t i n residua l U.S . income ta x payment s (afte r application o f the FT C limitations) i n additio n t o foreig n incom e tax liability. Even countries that have enacted provisions that are similar to subpart F (including Germany, the United Kingdom, and Japan) generally limit current taxation to passive income. F E D E R A L BUDGETAR Y C O N C E R N S

Republican contro l o f the Congress has spawned a concerted effor t to balance the federal budget . This fiscal exercise may tend t o restrai n any efforts to reduce current tax payments on CFC operations. The Revenue-Raising Potential of a Repeal of Deferral Notwithstanding the pronounced antideferral bias of past legislation in thi s area , deferral continue s t o b e the genera l rul e fo r man y CFC s

THE FUTURE OF DEFERRAL 23

(primarily, those engaged in manufacturing o r other activities confine d to a CFC's home country). Because the curtailment o f deferral contin ues to be viewed as a source of potential revenue, the subject continue s to surface in congressional debates. In 199 2 the former chairman of the House Ways and Means Committee, Dan Rostenkowski, cosponsored a bill to eliminate deferral fo r CF C operations, 18 and a s recently as May of 1995 , the Republica n chairma n o f th e Hous e Budge t Committee , John Kasich , included th e repeal of deferral o n a list of corporate rev enue raisers, estimating that the proposal would raise $26.4 billion over seven years. In July of 199 5 the former chairma n of the Senate Finance Committee, Robert Packwood , scheduled a hearing o n th e deferra l o f income tax of U.S. multinationals. Rostenkowski's bill provided for repeal in the context of comprehensive international tax reform, a proposition that might be viewed as too expensive i n today' s budgetar y environment . I t i s possible , however , that a stand-alone proposal to repeal deferral wil l arise, if at all, in the context o f a search fo r revenu e raisers . Thus, putting asid e th e man y debates abou t ta x polic y consideration s tha t suc h a proposa l woul d engender,19 th e legislativ e prognosi s fo r a simpl e repea l o f deferra l might turn , i n larg e part , o n estimate s o f th e revenu e effect . I n thi s regard it is far from clea r that a proposal to repeal deferral would generate the full amoun t o f potential revenue . Rather, the potential revenu e gain migh t wel l b e reduce d b y th e inclusio n o f transitio n o r othe r remedial provisions. Moreover, there is a basic question about the magnitude of the potential revenue gain, in light of the availability of FTCs. On a repeal o f deferral , equit y consideration s woul d certainl y suggest that U.S. parent corporations be allowed to include the results of a CFC's operations on their U.S. consolidated tax returns, particularly in light o f th e stron g politica l oppositio n tha t repea l woul d generate . Indeed, Rostenkowski' s 199 2 bil l couple d th e repea l o f deferra l wit h an irrevocable election to treat a CFC as a domestic corporation. Alternatively, a repeal of deferral coul d be accompanied by a rule that treats CFCs a s branch operations . I n eithe r cas e U.S . multinationals woul d then b e permitte d th e us e o f foreig n operatin g losse s o n thei r U.S . return, a resul t tha t woul d surel y reduc e an y hop e fo r revenu e gai n attributable to future taxabl e years. Given th e expecte d pressur e t o implemen t a repea l o f deferra l b y allowing U.S . taxpayers t o reflec t CF C operatin g result s o n thei r U.S. return, it may be that the only way to turn repeal of deferral into a sub-

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stantial revenu e raise r woul d b e to trigge r ta x o n previousl y untaxe d earnings (i.e. , earnings tha t hav e escape d taxatio n unde r antideferra l rules). The provision o f transitiona l relie f woul d no t onl y reduce th e revenue potential, but it would also increase the complexity of the law for those taxpayers who would then be required to account fo r result s under bot h th e ol d an d ne w regimes. Nevertheless, this i s exactly the way the Congress implemented th e I.R.C. § 956A tax on passive assets in 1993, 20 an d taxpayer s woul d b e sur e t o poin t t o thi s preceden t i f faced with a serious attempt to eliminate deferral completely . The Impact of FTC Limitations Some have argued that the repeal of deferral would have no signifi cant impac t o n th e ta x liability of CFCs , and thu s n o significan t rev enue effect , becaus e th e Unite d State s has on e o f th e lowes t ta x rate s among major industria l countries. 21 This view assumes that most CFC earnings would be fully sheltere d b y FTCs, ignoring th e realit y of th e FTC limitations that operate to deny full credit for income taxes paid to foreign governments . In additio n t o the overall FTC limitation, based o n th e U.S. tax on foreign-source income , there are nine (includin g the general) separat e limitations or "baskets." The FTC baskets isolate the tax effects o f particular types of income, including: passive income, income from financial services, income subject to high withholding tax, and dividends pai d b y each foreign corporatio n tha t fail s t o qualif y a s a CF C becaus e onl y 5 0 percen t o r les s i s owne d ("noncontrolle d foreign corporation basket"). 22 The higher rat e of tax on foreig n incom e of U.S. multinationals23 can be attributed to the FTC limitations. The stated purpose of the separate FTC limitations is to prevent cross-crediting or averaging of foreign tax rates.24 Consider a U.S. corporate taxpayer with $100 of foreign-sourc e business incom e (o n which foreig n ta x of $3 6 was paid) an d $10 0 of U.S.-source income . Th e U.S . tax o n th e $20 0 o f worldwid e incom e would be $70, before allowanc e of any FTC: $200 worldwide income x

THE FUTUR E O F DEFERRA L 2

35 percent U.S. Tax Rate = $70 U.S. tax liability. Under the overall FTC limitation, the taxpayer's FT C would be limited t o the U.S. tax on th e $100 o f foreign-sourc e income : $10 0 foreign-sourc e incom e / $20 0 worldwide income x $70 U.S. tax liability = $35 overall limitation. The taxpayer would have a $1 excess FTC (the $36 foreign tax payment, less the $3 5 overal l FT C limitation) , whic h coul d no t offse t U.S . tax . Suppose the taxpayer earned an additional $100 of foreign-source pas sive income, with respect to which no foreign ta x was imposed? In this case the overall FTC limitation would be $70 (the U.S. tax on the $200 of foreign-source income) : $200 foreign-source incom e / $30 0 worldwide incom e x $10 5 U.S . tax liabilit y = $7 0 overal l limitation . I n a world without separate limitations, the $1 excess FTC generated by the $36 payment on the $100 of foreign-source busines s income would be available to offset a dollar of U.S. tax on the $100 of foreign-source passive income. Here, however, the application of the separate FTC limitation fo r passiv e income would appl y to preven t th e cross-creditin g o f the $1 against U.S. tax on the foreign-source passive income. In operation , th e FT C baskets ca n resul t i n disparat e treatmen t o f income earne d b y a single CF C fro m th e sam e busines s activity . Fo r example, consider the case of a financial service s CFC engaged in leasing and other financin g transactions . Whether the CFCs income end s up in the general basket for business income or the passive basket will depend entirely on the mix of leasing income in any given year.25 Another basket that creates arbitrary results is the one for dividend s from noncontrolle d foreig n corporations . It s limitatio n hinder s th e ability of U.S. multinationals to enter into joint ventures with foreign owned enterprise s becaus e th e U.S . venturer wil l alway s nee d mor e than 50 percent ownership to avoid placing income from the venture in a separat e basket . I n man y cases , however, taxpayer s ar e abl e t o pla n around thi s rule , fo r example , b y enterin g int o comple x structure s involving the use of a hybrid foreign entity that will be treated as a partnership (and not a corporation) fo r U.S. tax purposes. P I E C E M E A L (AN D LES S COSTLY ) R E F O R M S

Against this backdrop 199 5 saw the introduction o f a bipartisan bill (H.R. 1690 ) b y th e Hous e Way s an d Mean s Committe e members ,

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which proposes simplification with a modest revenue impact and liberalization o f the CFC regime. 26 Many of the provisions in the 199 5 bill were adopted b y Congress i n 199 2 legislation tha t wa s vetoed.27 H.R . 1690 serves as a laundry list of some of the less defensible provisions of current law and may be a likely candidate for enactment. Its salient provisions are listed below. Simplification of the Separate FTC Basket for Noncontrolled Foreign Corporations. H.R . 169 0 would appl y th e "loo k through " rul e tha t now applies to dividends from controlle d foreig n corporation s an d to dividend s fro m noncontrolle d foreig n corporation s whe n th e information necessar y to trace the source (or content) of a dividend is available. Extending the Use of FTC Carrybacks and Carryforwards. The period during which excess FTCs could be carried back would be extended from tw o t o thre e years , an d th e carryforwar d perio d woul d b e changed fro m fiv e to fiftee n year s in conformit y wit h th e domesti c rules for net operating losses. Simplification of Antideferral Regimes. The Europea n Unio n (EU ) would b e treate d a s a single country , fo r purpose s o f subpar t F , a change tha t woul d reduc e th e instance s i n whic h us e o f E U sub sidiaries in cross-border transactions could trigger deemed applica tion of the antideferral rule. Restoration of Deferral for Financial Services. H.R. 1690 would restore the pre-1986 active business exception, as it applied to banks, insurance companies, and other financial services businesses. Elimination of the PFIC/CFC Overlap. CFC s would be exempt fro m the PFIC rules. Not surprisingl y (give n the Republica n positio n o n pas t legislatio n to curtail deferral), the 199 5 House Budget Reconciliation bill not only incorporates severa l o f th e simplification s previousl y passe d b y th e Congress, but it also proposes to repeal the I.R.C. § 956A tax on excess passive assets. 28 In additio n t o th e propose d repea l o f I.R.C . § 956A,

THE FUTURE OF DEFERRAL 24

the Hous e Budge t Reconciliatio n bil l woul d eliminat e th e overla p between subpart F and the PFIC rules. Whatever the fate of this bill, the content indicate s a retrea t fro m th e antideferra l bia s o f prio r years . Furthermore, the reality of budgetary constraints means that the scope of the House version of the 199 5 Budget Reconciliation bill may represent the outer limits of a tax treatment of CFCs viewed by multinational business as more favorable.

O V E R V I E W O F C O N S U M P T I O N - B A S E D TAXE S

The Republica n focu s o n internationa l competitivenes s dovetail s with th e growin g interes t i n consumption-base d taxes , particularl y because th e Unite d State s is the onl y major econom y o f th e G- 7 (th e group o f nations that include s Canada, France, Germany, Italy, Japan, and th e United Kingdom ) withou t a value added ta x (VAT). 29 A consumption tax can take the form of a retail sales tax, a consumed income tax, or a VAT, the common elemen t being the exclusion of savings and investments fro m th e tax base. Whatever th e form o f a consumption based tax, it is likely that politic s will dictate the allowance of exemptions or other mechanisms to introduce an element of progressivity. In Europe, fo r example , government s ten d t o us e thre e rates : standar d rates, which range from 1 2 percent in Luxembourg, Spain, and Turkey, to 2 5 percent i n Ireland ; lower rates , 0-17 percent , which ar e used t o combat regressivity and usually cover items such as food, medical care, books, electricity, and s o forth; an d highe r rates , usually over 3 0 percent, which typically apply to luxury items, such as automobiles, televisions, and VCRs.30 The rea l difference s amon g th e thre e basi c form s o f consumptio n taxes are the methods of collection. A retail sales tax is familiar t o most taxpayers because state and local governments impose sales taxes on a broad rang e of good s and services . The point o f collectio n o f a retail sales tax is by businesses on sale s to the ultimate consumers. 31 A consumed income tax may use a base identical to that of a retail sales tax, with the difference bein g that the tax would resemble (and be collected as) a personal income tax with savings excluded from th e tax base. An example of a consumed incom e tax that uses this structure is the individual tax component o f the Unlimited Saving s Allowance (USA ) tax,

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introduced b y Senator s Pet e Domenic i an d Sa m Nun n o n Apri l 25 , 1995.32 The USA tax, imposed at the rate of 11 percent on gross profits, defined a s taxable receipts reduced by business purchases, would apply to businesse s tha t sel l or leas e property o r sel l services i n th e Unite d States. Gross receipts would not include amounts attributable to property or services exported from the United States. A VAT is like a sales tax if it is collected along the production chain. A VAT is a consumption ta x if purchases o f capita l good s ar e deducte d immediately. Lik e a retai l sale s tax , a VAT is collecte d b y businesse s under on e of three models: the subtraction an d the addition method s (both o f whic h rel y o n accountin g records ) an d th e credi t invoic e method (base d on sales and purchase invoices). A consumption-based VAT may be structured as a broad-based tax on business activities, with businesses payin g ta x o n gros s receipt s ne t o f busines s purchase s o f goods and services , collected through th e subtraction method . This is the gist o f the 14. 5 percent Busines s Activities Tax introduced durin g the 103 d Congress by then senator s John Danfort h an d Davi d Bore n (referred t o herei n a s th e Danforth-Bore n Busines s Activities Tax). 33 The US A ta x o n businesse s discusse d abov e i s als o a subtraction method VAT. If the federal corporate income tax were replaced by a consumptionbased tax (as would occur under the USA tax), most of the issues relevant to deferral would be obviated because gross receipts from export s would b e ta x exempt . I n designin g th e consumptio n tax , however, i t would b e necessary to defin e th e jurisdictional border s o f th e Unite d States. In thi s regard , because U.S . multinationals woul d continu e t o have an incentive to structure CF C operations in a manner tha t mini mizes worldwide ta x liability, the concep t o f capita l expor t neutralit y would have continued relevance in defining jurisdictional borders. Generally, consumption taxes are thought of as being territorial, that is, imposed only on goods consumed in the country imposing the tax, as under th e USA tax. Indeed, as the staf f o f the Joint Committe e o n Taxation reporte d i n 1991 , "[virtually al l present-day VATs are based on th e destinatio n principle . I n orde r t o implemen t th e destinatio n principle, exports must be relieved of the domestic VAT and the domestic VAT must b e impose d o n imports." 34 I f th e genera l rul e unde r a consumption-based ta x exempt s expor t sales , one woul d no t expec t retention o f an y special rules to reac h th e foreign sale s of CFCs . This

THE FUTURE OF DEFERRAL ZA5

result would be consistent with the current U.S. tax policy of equalizing the treatmen t o f taxpayer s tha t operat e throug h CFC s and thos e tha t operate through branches. 35 There are proponents, however, of a consumption ta x based on origin. For example, both th e Hous e majorit y leader , Richard K . Armey, and Sen . Arle n Specte r propose d flat-rat e consumptio n taxe s tha t would ta x exports , not imports. 36 A tax based o n origi n migh t plac e U.S.-based companie s a t a competitiv e disadvantage , relativ e t o for eign-based companie s tha t coul d sel l thei r product s i n th e Unite d States a t a pric e tha t woul d no t includ e th e origin-base d consump tion tax . Thus, examinatio n o f anticompetitiv e consequence s shoul d accompany consideration of an origin-based VAT. The move to a consumption-based ta x might no t resolv e all of th e competition issue s identifie d unde r curren t law . Fo r example , com mentators hav e identified a concern abou t th e international competi tiveness o f U.S . financial servic e companie s unde r a VAT, if financia l services ar e exempte d (a s the y ar e unde r Europea n VA T regimes). 37 Generally, thi s concer n woul d b e presente d i f financial service s ar e exempt fro m ta x and the selle r i s denied credi t fo r (i.e. , the abilit y to recover) taxes paid on purchases related to the sale. A competitive disadvantage t o domesti c provider s (companie s i n th e securities , insur ance, banking , mutua l fund , an d leasin g industrie s tha t hav e bee n hardest hi t b y cutback s i n deferral ) ma y resul t i f offshor e financial service providers receive tax preference. Generally, because the United States is a party to GATT, it is obligated to refrain fro m subsidizin g exports . In practice, however, an "indirect tax" is excluded fro m thi s prohibition. 38 Thus , as is the case with the typical European-styl e VAT, an indirec t ta x can be adjusted a t th e border withou t runnin g afou l o f GATT . Proponent s o f movin g th e United States to a consumption tax often cite this "border adjustability " feature as one that would improve international competitiveness. With respect t o an y give n for m o f consumptio n tax , however , th e GAT T legality of border adjustment s wil l depend almos t entirely on whethe r U.S. trading partners agree that a levy qualifies as an indirect tax. A retail sale s tax would automaticall y exemp t import s becaus e th e tax would b e impose d onl y o n domesti c consumers . A VAT could b e structured t o reac h th e sam e resul t b y exemptin g expor t sale s an d allowing exporter s t o clai m a credi t fo r busines s purchase s o f good s

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and services , a s wa s propose d i n th e Danforth-Bore n Busines s Activities Tax and a s is the cas e in mos t countrie s tha t hav e a credit invoice VAT.39 In any case a border adjustmen t schem e would hav e to be structured to avoid challenge as a GATT-actionable (o r countervailable) expor t subsidy . Otherwise , U.S . exports benefitin g from borde r adjustments coul d face penalties equal to the export subsidy. Except in the case of a VAT, border adjustments generally are permitted only for taxe s imposed o n physically incorporated component s o f exported products . Expor t rebate s o f prio r stag e cumulativ e indirec t taxes are considered subsidies , unless the tax was levied on goods that were physically incorporate d int o th e exporte d product. 40 N o adjust ment woul d b e necessar y i f export s wer e simpl y exclude d fro m th e base. It i s no t know n whethe r U.S . trading partner s wil l agre e tha t th e GATT standards would be met by a consumption tax that resembles an income tax. For example, notwithstanding the economic similarity to a VAT, one might view the USA tax as an income tax (and not an indirect tax) because the tax is not computed on a transactional basis. Tax policymaker s wh o hav e considere d replacin g th e incom e ta x with a consumption-based ta x have loosely described a transition tha t would involv e grandfatherin g ol d investment s bu t requirin g futur e investments t o be made under th e new system. 41 This does not mea n that CFCs with earnings accumulated before the effective date of a consumption ta x woul d receiv e a windfall o n repea l o f th e incom e tax . Presumably, unles s specia l rule s ar e include d t o dea l wit h eventua l repatriation o f previously untaxed CF C profits, those earning s woul d be taxed as they are consumed in the United States. Alternatively, it has been suggested that transition could take the form of a final tax on capital an d consume r goods, 42 which woul d presen t th e issu e whether a multinational's investmen t i n stock of a CFC would be treated as subject to a final tax on capital. CFCS UNDE R A MIXE D TA X SYSTE M

The Unite d State s woul d stan d alon e amon g th e world' s majo r economies i f Congres s opte d fo r a wholesal e replacemen t o f th e income ta x with a consumption-based tax. 43 What i s far mor e likel y

THE FUTURE OF DEFERRAL 24

to occur , perhap s a s a transitiona l approach , i s th e enactmen t o f a consumption ta x tha t woul d supplemen t incom e ta x revenues . Fo r example, the Danforth-Boren Busines s Activities Tax would overlay the current federa l corporat e tax . I t i s fai r t o assum e tha t th e subpar t F regime an d othe r antideferra l rule s would surviv e a move to a mixed system tha t combine s incom e an d consumptio n taxes . On th e othe r hand, a new source of revenue, such as a consumption tax , would also loosen th e budgetar y constraint s tha t hav e prevente d policymaker s from rationalizin g some of the more severely criticized "glitches" under the current antideferra l rules . If the income tax ceases to be the prime source o f governmen t revenues , the cos t o f simplifyin g amendment s will also be less of an issue. It i s unlikel y tha t thi s o r an y othe r Congres s woul d withstan d th e onslaught o f lobbying tha t woul d ensu e i n th e even t o f a proposal t o repeal deferra l withou t othe r meaningfu l ta x refor m o f th e CF C regime. The fiscal movement t o balanc e th e federa l budge t wil l pro scribe extensive protaxpayer changes in this area, but we are likely to see limited reforms around the edges. Fundamental tax reform is a number of years away (and will certainly not happen unti l after th e 199 6 presidential elections); nevertheless, given the level of interest in moving in this direction, it would behoove multinationals an d thei r ta x advisor s t o begi n t o analyz e th e man y issues tha t woul d b e presente d shoul d a consumption-base d ta x become a reality. At the least, even if the Congress ends up adopting a mixed income/consumption ta x system, another new source of revenue will take some of the pressure off of the current statutory rules that are designed to preserve the income tax base, with the result that tax policymakers might gain breathing room (in terms of revenue) to rationalize the CFC regime. NOTES l.I.R.C.§904. 2. See Staff o f Joint Comm. on Taxation, 99th Cong., 2d Sess., General Explanation o f the Tax Reform Act of 1986,861,1023 (1987) [hereinafte r 198 6 Blue Book]. 3. See, e.g., Hearings on Flat Tax Proposals Before the Senate Comm. on Finance, 104th Cong., 1st Sess . (1995) ; Th e Nationa l Comm' n o n Economi c Growt h an d Ta x Reform , Unleashin g America's Potential : A Pro-Growth, Pro-Famil y Tax System fo r th e 21st Century , reprinted in 70

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Tax Notes 413 (1996) (commonly referred to as the Kemp Commission Report). 4. Fo r a detaile d discussio n o f th e principl e o f capita l expor t neutrality , se e Staf f o f Join t Comm. o n Taxation , Factor s Affecting th e Internationa l Competitivenes s o f th e Unite d States , 101st Cong., 1st Sess. (Comm. Print 1991). 5.1.R.C. §§ 951-64 (referred to as subpart F). 6. See id. at §§551-58. 7. See id. at §§957,958. 8. See id. at §§ 1291-97 (the PFIC rules). 9. For a consideration o f I.R.C . § 956A, see Melvin S . Adess e t al. , The Erosion of Deferral: Subpart F after the 1993 Act, 47 Tax Law. 933 (1994). 10. See 1986 Blue Book, supra note 2, at 1023. 11. Fisca l Year 199 4 Budge t Reconciliatio n Recommendation s o f th e Comm . o n Way s an d Means, House Comm. on Ways and Means , 103 d Cong., 1s t Sess. 250, 254 (Comm. Print 1993 ) [hereinafter 199 4 Budget Reconciliation Recommendations]. 12. See Hearings on U.S . Taxation o f Foreig n Incom e Befor e th e Senate Comm. on Finance , 104th Cong. , 1s t Sess . (Jul y 21 , 1995 ) (statemen t o f Josep h H . Guttentag , Internationa l Ta x Counsel, Department of the Treasury) (unpublished) . 13. See id. (statement o f Gar y Hufbauer , Reginal d Jone s Senio r Fellow , Institut e fo r Inter national Economics) (unpublished ) [hereinafte r Hufbauer] . 14. SeeS. Rep. No. 1881,87th Cong., 2d Sess. 78 (1962). 15.1994 Budget Reconciliation Recommendations, supra note 11 , at 383,388. 16. Id. 17. See Perry D. Quick & Thomas Neubig, Tax Burden Comparison: U.S. vs. the Rest of the G-7, 65 Tax Notes 1409 (1994). 18. H.R . 5270 , 102 d Cong. , 2 d Sess . (1992 ) (Foreig n Incom e Ta x Rationalizatio n an d Simplification Act of 1992). 19. Compare Hearings o n H.R . 527 0 Befor e th e Hous e Comm . o n Way s an d Means , 102 d Cong., 2d Sess . 358-76 (1992 ) (statemen t o f Michae l J . Mclntyre, professor o f law, Wayne State University Law School, on behalf o f Citizens for Tax Justice) [hereinafte r Mclntyre ] (supportin g the repea l o f deferral ) with Hufbauer , supra note 1 3 (encouragin g th e adoptio n o f territoria l taxation). 20. See H. R. Conf. Rep. No. 213,103d Cong. , 1st Sess. 633, 637 (1993) (th e conference agree ment followed the Senate bill that applied only to earnings accumulated after Sept. 30,1993). 21. See, e.g., Mclntyre, supra note 19. 22.1.R.C.§ 904(d). 23. U.S. Gen. Accounting Office, 198 8 and 198 9 Company Effective Ta x Rates Higher Than in Prior Years (1992). 24. See 1986 Blue Book, supra note 2, at 861. 25. SeeTreas. Reg. § 1.904-4(e)(3) (definition o f a financial services entity). 26. H.R. 1690 , 104t h Cong. , 1s t Sess. (1995) (introduce d b y Rep . Amo Houghto n an d Rep . Sander Levine). 27. The 199 2 legislation wa s derived from th e Tax Simplification Ac t of 1991 , H.R. 11 , 102d Cong., 1st Sess., which was not enacted. 28. See Language on Title XIII, Reconciliation Provisions Reported by the House Ways and Means Committee, Daily Rep. for Exec. (BNA), Sept. 27,1995, at Spec. Supp. 29. See Quick & Neubig, supra note 17 , at 1417. 30. See Ken Militzer, VAT: Evidence from the OECD, 47 Tax Notes 207,210 (1990).

THE FUTURE OF DEFERRAL 24 31. See Hearings on Tax Reform Befor e the House Comm. on Ways and Means, 104th Cong., 1st Sess. (June 8,1995) (prepared testimony of Sen. Richard Lugar) (unpublished) . 32. S. 722, 104t h Cong. , 1s t Sess. (1995). For a description o f this tax , see USA Tax System: Description and Explanation of the Unlimited Savings Allowance Income Tax System, 66 Tax Notes 1482(1995). 33. S. 2160,103d Cong., 2d Sess. (1994). 34. Staff of Joint Comm. on Taxation, supra note 4, at 310. 35. See 1986 Blue Book, supra note 2, at 869. 36. The Freedom and Restoration Act of 1995 , H.R. 2060,104th Cong., 1st Sess. (1995). 37. See Peter R. Merrill & Harold Adrion, Treatment of Financial Services under ConsumptionBased Tax Systems, reprinted in 68 Tax Notes 1496,1497 (1995) (presented at a Kemp Commission hearing on Sept. 6,1995). 38. General Agreement on Tariffs and Trade, opened for signature Oct. 30,1947,61 Stat. Pts. 5, 6,T.I.A.S.No. 1700,55U.N.T.S . 187 [hereinafter GATT] , Annex I, Note Ad Article XVI (providing " [t]he exemption of an exported product from duties or taxes borne by the like product when destined for domestic consumption, or the remission of such duties or taxes in amounts not in excess of those which have accrued, shall not be deemed to be a subsidy"). 39. Before Canada levied a VAT (effective Jan . 1, 1991) the twenty members of the Organiza tion o f Economi c Co-operatio n an d Developmen t wit h VAT s used th e consumptio n type . See James M. Bickley, Value Added Tax in Canada: Background, Evaluation, and Implications fo r th e United States, CRS Rep. No. 93-438 E, The Library of Congress 6 (Apr. 14,1993). 40. Guidelines on Physical Incorporation, GATT, Basic Instruments an d Selecte d Document s 32nd Supp. 156 (1985) ("Indirect rebat e scheme can allow for exemption, remission or deferral of prior stag e cumulativ e indirec t taxe s levie d o n good s tha t ar e physicall y incorporate d (makin g normal allowance for waste) in the exported product") . See also Agreement on the Interpretatio n and Application o f Articles VI, XVI, and XXII I o f the Genera l Agreement o n Tariff s an d Trade , Annex A, paragraph (h), n. 1 (1980 ) (the GATT Subsidies Code defines an "indirect tax" to include a sales, excise, or value added tax, whereas a "direct tax " would includ e taxes on wages and othe r forms of income). 41. See Gramm Promises End to Estate Tax, Calls for Balanced Budget and Flat Tax, Daily Rep. for Exec. (BNA), Oct. 18,1995, at G-3. 42. See Tax Reform: Gephardt Tells Kemp Commission He Expects Democratic Support for Tax Restructuring, Daily Rep. for Exec . (BNA), Sept. 7, 1995, at G-6 (indicatin g suggestion i n text was made by Wayne Angell, a former Federa l Reserve governor now with Bear, Stern & Co.). 43. See Hearings o n Ta x Refor m Befor e th e Senat e Budge t Comm. , 104t h Cong. , 1s t Sess . (1995) (statemen t o f Eri c Toder , deputy assistan t secretar y fo r ta x analysis , Department o f th e Treasury), available in 95 Tax Notes Today 36-29 (Feb . 23, 1995) (most o f ou r tradin g partner s now rely on a mixed tax system).

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The American Dream Savings Account Is It a Dream or a Nightmare?

The general rule of federal incom e taxation i s to tax all income a s it is earned. However, since the establishment o f th e income ta x i n 1913 , there hav e bee n exception s t o th e genera l rule . Accordingly, incom e derive d fro m certai n source s an d allocation s o f income to certain expenditures historically have received favorable ta x treatment.1 Typically , these exception s attemp t t o encourag e behavio r that is believed to benefit no t only individual taxpayers but also society as a whole.2 All taxpayers, including America's least wealthy taxpayers, subsidize the preferential ta x treatment o f these social programs. Everyone pays higher ta x rate s o n th e portion s o f thei r income s tha t d o no t enjo y special ta x treatmen t t o compensat e fo r revenue s los t becaus e o f th e social programs operated through the tax system. Although all taxpayers, rich and poor alike, subsidize the preferential tax treatment of these special programs, many critic s o f th e federa l incom e ta x syste m hav e observed that most preferential tax treatments disproportionately benefit wealth y Americans. 3 Thus , som e policymaker s conten d tha t i t i s grossly inequitabl e fo r th e federa l governmen t t o continu e providin g tax benefits to the wealthiest Americans without offering simila r incentives to those with modest or little wealth.4 253

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One o f th e country' s costlies t specia l ta x program s i s th e privat e pension system . The private pensio n syste m i s an employment-base d savings program in which both participating employers and employees receive tax benefits. One tax benefit i s that employer contributions ar e deductible b y the employe r whe n made , but the y ar e no t taxe d unti l distributed t o th e employee. 5 Thi s treatmen t i s a n exceptio n t o th e general rul e that a n employe r canno t tak e a tax deduction fo r salary related expenditure s a s a n ordinar y an d necessar y busines s expens e before th e employe e include s th e paymen t i n income. 6 Anothe r ta x benefit i s that income earned on the accumulated contribution s is not taxed until distributed. The nontaxability of investment incom e is the essence of the favorable tax treatment o f qualified pensio n plans. 7 The cost of the national retirement progra m i s estimated a t $64 billion fo r 1996.8 Notwithstanding the enormous cost of the private pension system, i t wa s not designe d t o b e a stand-alone progra m fo r individua l retirement savings. 9 Instead, the private pension syste m was designed to supplement personal savings and Social Security old-age benefits. 10 In addition to employment-based pension plans, the retirement system includes Individual Retirement Accounts (IRAs), which, on a more limited basis than employer-sponsored plans, provide individual workers wit h ta x incentive s t o sav e fo r retirement. 11 Althoug h i n man y respects IRA s resembl e define d contributio n plans , IRA s fal l outsid e the qualified plan regime.12 However, when defining the cost of the private pension system for the tax expenditure budget, estimates generally include the tax expenditure for IRAs.13 IRAs first were introduced in 197 4 to provide a tax-preferred retire ment saving s arrangemen t fo r worker s wh o wer e no t covere d b y employer-sponsored plans. 14 Sinc e tha t time , however , th e IR A pro gram has been expanded , so that i t now allows individuals covered by employer-sponsored plan s t o establis h an d maintai n IRAs. 15 An IR A can provide two distinct tax benefits to individuals. First, under certain conditions, individuals can deduct contributions made to an IRA from their gros s income. Second, the investment earning s on th e contribu tions made to an IRA are tax free until distribution.16 In general, under present law , all workers ar e entitled t o contribut e annuall y u p t o tw o thousand dollar s and t o have investment incom e o n th e contributio n accumulate tax free. However, taxpayers who are eligible to participate in employer-sponsore d pensio n plans , or wh o hav e spouse s wh o ar e

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eligible t o participat e i n employer-sponsore d plans , ar e subjec t t o phase-out rules for the deductibility of their contributions. 17 America's nationa l saving s rat e i s th e lowes t i n th e develope d world.18 This country's savings deficit contributes to a lack of domestic investment capital in the U.S. economy, and investment capital is essential for economi c growth and prosperity. More national savings means more mone y availabl e fo r bot h smal l an d larg e businesses a t a lower interest rate. In addition, increased personal savings benefits individua l savers by providing a cushion to prevent them from livin g on the edge of an "economic precipice." 19 Thus, assisting individuals i n savin g fo r retirement accomplishes two important social goals: (1) aggregate individual saving s increases , whic h create s greate r nationa l saving s an d investment capita l fo r America n economi c growth ; and (2 ) taxpayer s who ordinarily may not be able to save adequately for retirement mor e likely can do so. 20 The accomplishment o f both o f these goals is desirable and necessar y to ensur e the well-being o f both individua l mem bers of society and society as a whole. Notwithstanding substantia l federa l incom e tax incentives to foste r retirement savings, individual savings rates are declining in America. 21 Americans sav e only 4 percent o f their after-ta x income , as compare d to 1 2 percent in Germany and France and 1 5 percent in Japan. 22 While it may not b e surprising tha t th e savings rate among low-income tax payers is negligible, it is surprising that the savings rate among those in the middle class also is dangerously low.23 In fact, the accumulated savings of middle-incom e Americans i s so low that thei r saving s are no t expected t o keep up wit h thei r projecte d futur e needs. 24 Thus, unless individual savin g pattern s chang e significantly , th e bul k o f th e "bab y boom" generation could experience retirement living standards significantly lowe r tha n thei r curren t standards. 25 Base d o n a "worst case " model, there i s a risk tha t th e bab y boomers wil l no t enjo y th e sam e standard of living as their parents have during retirement. 26 In an effort t o raise the nation's dismal savings rate, and at the same time to respond to charges that too much is being done for the wealthiest taxpayers, the U.S. House of Representatives recently passed legislation tha t woul d reduc e taxe s substantiall y fo r middle-incom e Americans.27 The Tax Fairness and Deficit Reduction Act of 1995 (1995 Act) i s designed t o provid e $18 9 billion wort h o f ta x relie f mostl y t o middle-income taxpayers. 28 The figure of $189 billion is an estimate of

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the decrease in federal revenues that will occur over the five-year budget horizo n fro m 199 5 to 200 0 resulting from change s i n th e ta x law made b y the 199 5 Act. 29 However , budget watcher s hav e raise d con cerns abou t th e potential unde r th e 199 5 Act for substantia l losse s in revenues afte r th e initia l five-year budget period. 30 Th e 199 5 Act also has caused much debate about whether the tax provisions actually will benefit th e middl e class. 31 Most o f th e argumen t center s o n whethe r the benefits will go primarily to the wealthy or to the middle class, but few have bothered to define middle class. A general assumption appears to be tha t a household incom e leve l between $30,00 0 an d $75,00 0 is middle income.32 The 199 5 Act includes the American Drea m Restoratio n Act unde r the Contract with America. As one method for providing relief to middle-income taxpayers, the American Dream Restoration Act creates the American Drea m Saving s Accoun t (ADSA), 33 a mor e flexible retirement account than the traditional IRA. Investment earnings in ADSAs would accrue tax free subject to certain conditions, as they do in IRAs. A difference betwee n the two plans is that taxpayers could continue to make contributions to ADSAs after the age of 70V2.34 Under traditional IRA rules, deductible contributions ar e available and distributions ar e taxed upon receipt. 35 If the taxpayer or the taxpayer's spouse is covered by a n employer-sponsore d plan , the n th e maximu m deductio n o f $2,000 is phased out. The phase-out rang e is from $40,00 0 to $50,00 0 for joint returns and from $25,00 0 to $35,000 for single taxpayers.36 In contrast, all contributions to an ADSA would be nondeductible and all distributions fro m i t occurring afte r ag e 59 V2 would be tax exempt. 37 Distributions prior to age 59 V2 from a n ADSA that had been open fo r at leas t five years would b e als o ta x exempt , provide d tha t th e fund s were used for the purchase of a first-time home, educational expenses, or medical expenses.38 Distributions prior to age 59V2 for nonqualifie d purchases woul d b e subjec t t o a n earl y distributio n excis e tax. 39 I n addition, fo r a n interi m perio d ADSA s woul d accep t penalty-fre e rollovers from traditional IRAs.40 Thus, although there would be no immediate tax advantage when a taxpayer contributed money to an ADSA, that taxpayer ultimately could withdraw al l of th e investmen t buildu p o f th e contribution s ta x free. ADSAs are referre d t o a s back-loaded plans becaus e thei r ta x benefit s would be deferred unti l distribution. 41 Conversely , traditional IRAs are

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referred t o a s front-loaded plans, because contribution s ar e deductibl e when made, but all distributions are taxed upon withdrawal. 42 Because taxpayers coul d us e ADSA funds fo r qualifie d events , supporters of ADSAs contend that individuals ordinarily reluctant t o save in traditional retirement savings arrangements for fear of losing access to their funds ma y be encouraged to save. 43 However, directing savings toward the goals of purchasing a first home, educating children, or paying for medica l expenses raises numerous equit y and policy concerns. As passed by the House, an ADSA has less restrictive distribution rule s than a traditional IRA. Consequently, introducing ADSAs would redefine established pension policy substantially by shifting th e focus fro m retirement saving to saving in general. To the extent that ADSAs would encourage individual s t o contribut e mor e t o persona l savings , the y would b e consisten t wit h existin g pensio n policy. 44 However , t o th e extent tha t the y woul d caus e individual s t o sav e les s fo r retirement , ADSAs could prove problematic. Therefore, while it is important t o assess the effectiveness o f ADSAs in accomplishin g congressiona l goal s independentl y o f othe r socia l programs, it is also important to determine whether these goals can be accomplished withou t underminin g existin g pensio n policy . T o thi s end I describe and critique in this essay the objectives of ADSAs. I first place ADSAs into contex t b y exploring th e developmen t o f IRA s an d describing how ADSAs differ fro m traditiona l IRAs. Then I analyze the potential socia l an d economi c effect s o f ADSAs ' accomplishing thei r identified objectives . I conclude that th e shif t i n pension polic y mad e manifest by congressional enactment of ADSAs would have potentially dramatic implication s fo r futur e retiremen t saving s amon g middle and low-income Americans.

T H E D E V E L O P M E N T O F IRA S

Despite all of the attention recentl y given to numerous IRA proposals,45 expanding th e IR A is not a new concept. 46 Ove r th e last twent y years, IRAs have become less restrictive and then mor e restrictive 47 in efforts t o stimulat e retiremen t saving s equitably. 48 Whe n Congres s enacted th e Employe e Retiremen t Incom e Securit y Ac t o f 197 4 (ERISA), IRA s wer e limite d t o worker s no t covere d b y employer -

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sponsored plans. These individuals were permitted to contribute annually the lesser of fifteen hundred dollars or 1 5 percent of their compensation t o a n IRA . At that time , however, advocates fo r IR A expansion argued tha t becaus e al l workers neede d supplementa l retiremen t sav ings, all workers should have access to IRAs. 49 In response Congress in 1981 expande d th e us e o f IRA s an d allowe d al l worker s t o establis h these accounts.50 At the same time Congress raised the maximum con tribution amount to the lesser of two thousand dollars or 100 percent of compensation. These two changes caused the number of IRA contributors to more than triple and the amount o f IRA contributions to escalate fivefoldin the early 1980s.51 The popularit y o f IRA s abruptl y ended , however , whe n th e Ta x Reform Ac t o f 198 6 becam e law. 52 I n 198 6 15. 5 millio n taxpayer s claimed IR A deductions . I n 1987 , after th e Ta x Refor m Ac t o f 198 6 became effective, only 7.3 million taxpayers claimed IRA deductions.53 The 198 6 Ac t substantiall y decrease d individua l margina l ta x rates , which in part explains the sharp decline in IRA contributions. By lowering the marginal tax rates, Congress effectively reduce d th e benefit s of tax deferral derive d from IR A contributions.54 Additionally, to help offset th e revenu e los s fro m lowerin g margina l ta x rates , Congres s widened the income tax base by limiting the deductibility of IRA contributions t o workers an d thei r spouse s no t participatin g i n a n activ e plan o r worker s who me t certai n incom e tests. 55 However, under th e 1986 Act, just a s under curren t law , regardless o f a wage earner' s ta x deferral status, 56 sh e coul d mak e nondeductibl e contribution s o f u p to th e lesse r o f tw o thousan d dollar s o r 10 0 percen t o f he r curren t compensation an d thereby avoid taxation o n investment income unti l distribution.57 Congress mad e th e 198 6 change s becaus e i t determine d tha t th e expanded availabilit y of IRAs had n o discernibl e impact o n aggregat e personal saving s levels . Congres s als o believe d tha t th e widesprea d availability o f option s t o mak e electiv e contribution s i n cas h o r deferred arrangement s (CODAs), 58 more commonly known as 401 (k) plans, reduce d it s concer n tha t individual s i n employer-sponsore d plans neede d t o sav e additiona l amount s fo r retirement . Anothe r reason Congress made the 198 6 changes was the indication by statistical studies tha t significan t IR A participation wa s absen t amon g low income taxpayer s an d wa s presen t onl y amon g wealthie r taxpayers ,

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who presumabl y woul d hav e save d adequatel y fo r retiremen t eve n without the IRA incentives.59 Notwithstanding th e finding s an d conclusion s responsibl e fo r th e 1986 limitation s o n th e deductibilit y o f IR A contributions , recentl y there have been numerous proposals to restore the benefits taken away from IRA s by the Ta x Reform Ac t o f 1986. 60 These proposals hav e as their rationale the need to increase national savings by increasing personal savings among middle- and low-income Americans. The ADSA is one of those proposals. By establishing a new retirement saving s plan that does not incorporate the 1986 restrictions, enactment of the ADSA attempts t o recreat e th e leve l o f popularit y tha t IRA s enjoye d i n th e early 1980s. Moreover, the ADSA would extend the available uses of the traditional IR A to nonretirement savin g goals in it s effort t o improv e the nation' s savin g level . B y extendin g th e flexibilit y o f IR A usag e beyond that of the pre-1986 period, proponents of the ADSAs hope to increase nationa l saving s b y attractin g greate r number s o f low - an d middle-income savers.61

T H E ADS A

As passed by the House, contributions to an ADSA would not affec t a taxpayer's eligibility to make contributions to traditional IRAs. Thus, taxpayers woul d b e allowe d t o mak e contribution s bot h t o a n ADSA and to a traditional IRA. 62 ADSA provisions also would allow all wage earners t o contribut e t o a n ADSA regardless o f incom e o r employer sponsored plan participation status. Individuals could contribute up to $2,000 annuall y ($4,00 0 fo r marrie d couple s filin g jointly ) t o a n ADSA.63 The 1995 Act also proposes to increase the $250 IRA contribution limit for nonworking spouses to $2,000 for the ADSA.64 For an interim period, from Decembe r 31 , 1996, through January 1, 1998, ADSAs would accept penalty-free rollover s from existin g IRAs.65 However, the rolled-over amounts would be subject to an income tax at the tim e o f transfer. 66 Th e ta x would b e assesse d ratabl y ove r a four year perio d startin g wit h th e taxabl e yea r i n whic h th e rollove r wa s made.67 Future earnings on rolled-over amounts would accrue tax free, and distribution s fro m ADSA s resultin g fro m thes e rolled-ove r amounts would be subject to the ADSA distribution rules. 68

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Several policy arguments exist for eliminatin g the 198 6 restrictions on the tax deductibility of IRA contributions. One reason for lifting the restrictions is that denying tax-deferred statu s to employees covered by employer-sponsored plan s assumes that al l employer-sponsored plan s provide adequate retirement benefits. Many retirement plans, however, provide relatively small benefits.69 Another reason for lifting the 1986 restrictions on the deductibility of IRA contributions is that denying tax-deferred statu s to employees covered by employer-sponsored plan s assumes that al l covered employee s eventually will receive their accrued pension benefits. Some employees, however, will not receive their accrued pension benefits because of vesting rules. Employees who do not remain in their employer's service for the requisite time will not obtain vested rights in their accrued benefit s and therefore will forfeit thei r retirement benefits when they terminate employment.70 Thus, employees with short service histories are unlikely to receive sufficient retiremen t benefits. Finally, the fact that individuals with no pension coverage are denied deductions fo r thei r IR A contributions simpl y becaus e thei r spouse s are covered by employer-sponsored plans ignores the reality that many marriages ar e no t permanent. 71 Th e restrictio n o n deductibilit y als o fails t o acknowledg e tha t on e spouse' s retiremen t benefi t ma y not b e sufficient t o support two retirees adequately. 72 The ADSA legislation not only incorporates the expansive participation an d eligibilit y rule s tha t existe d i n th e earl y 1980 s whe n IRA s reached thei r greates t popularity , but i t als o introduces mor e flexibl e distribution rules. 73 Both the flexible distribution rule s for ADSAs and the ability to roll over IRA funds to ADSAs radically change the underlying policy of federal pension law, which has been aimed at encouraging individuals who ordinarily would not be able to save to provide for retirement. Although ther e ma y be goo d reason s fo r liftin g th e 198 6 restrictions, th e expansio n throug h ADSA s o f th e availabl e use s o f retirement savings would be potentially damaging to middle- and lowincome Americans. Allowing nonretirement distributions from ADSAs would hav e a substantia l impac t o n curren t pensio n polic y an d o n future retirees because the distribution rules create disincentives to save adequately fo r retirement . Furthermore , i t i s unlikel y tha t ADSA s would either benefit low- and middle-income taxpayers significantly or

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bring abou t th e intende d resul t o f increasin g aggregat e persona l sav ings among nonwealthy Americans. Shift in Pension Policy. National leaders rank crime, health care, and welfare reform a s the most pressing problems plaguing American society, but they identify inadequate savings as one of the leading problems of a second orde r o f societa l problems. 74 Lo w personal saving s rate s cross wealth and income lines. Interestingly enough, however, although overall nationa l saving s is down, more Americans sav e for retiremen t than for any other savings goal. 75 The relative popularity of retiremen t saving i n general , and IR A saving i n particular , ha s le d t o interes t i n increasing overal l persona l saving s b y usin g traditiona l retiremen t vehicles to direc t savin g toward othe r goals. 76 ADSA legislation relie s upon this theory. Historically, IRA s hav e bee n use d exclusivel y fo r th e purpos e o f retirement saving . Th e underlyin g purpos e fo r th e preferentia l ta x treatment o f retirement saving s plans, including IRAs, is to encourag e retirement saving , which i n tur n increase s economi c securit y i n ol d age. To ensure tha t retiremen t fund s actuall y ar e use d fo r retiremen t purposes, Congress imposed restriction s on the use of retirement sav ings. Nonretirement use of retirement funds is discouraged by a 10 percent excis e ta x o n th e taxabl e portio n o f al l earl y distribution s fro m tax-favored retiremen t saving s arrangements , unles s the distribution s are made on account of death or disability. 77 Generally, distribution s receive d befor e ag e 5 9 V2 ar e considere d early distributions. All early distributions fro m IRAs , as well a s fro m employer-sponsored retiremen t plans, are subject to the early distribution excis e tax. 78 Notwithstandin g th e penalt y fo r earl y withdrawal , many individuals continue to take early distributions from thei r retirement savings , makin g thos e distribution s availabl e fo r curren t con sumption. A s a resul t som e policymaker s hav e argue d tha t th e earl y withdrawal penalt y should b e higher t o ensure that individual s retai n their retirement asset s until retirement. 79 Therefore , to the extent tha t the ADSA distribution rule s would allo w fund s otherwis e earmarke d for retiremen t purpose s to be used fo r nonretiremen t purposes , existing pension policy would be undermined. Some hav e speculate d tha t th e reaso n man y wh o ar e eligibl e t o utilize a tax-deferred IR A choose not to is that they are hesitant to put

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savings in a vehicle that place s their asset s beyond thei r reac h for fea r that they will need the funds before retirement. 80 The withdrawal rules of th e ADSA addres s thi s concer n b y allowin g penalty-fre e acces s t o retirement fund s afte r five years for qualifie d expenditures. 81 Th e less restrictive distributio n rule s undoubtedl y woul d encourag e greate r contributions t o ADSAs . However, thes e rule s redirec t th e emphasi s placed o n savin g fo r retiremen t t o savin g i n general . This chang e o f focus not only expands the concept of the private pension system, but it also de-emphasizes th e importanc e o f retiremen t saving , which effec tively creates a new tax subsidy for current consumption . Regardless of the restrictions placed on the nonretirement uses of an ADSA,82 i f retiremen t fund s ar e spen t fo r curren t consumptio n the y will no t b e availabl e a t retirement. 83 I t wa s fo r thi s ver y reaso n tha t Congress introduced th e early distribution excis e tax in 1986. 84 At the time, Congress believed i t inappropriat e t o provid e ta x incentive s fo r retirement savin g if the savings were diverted to nonretirement uses. 85 Moreover, Congress generall y provided fo r n o exception s t o th e earl y distribution rules, regardless of an individual's compelling need for the funds.86 Th e ADSA therefore woul d violat e congressiona l inten t an d fundamental pensio n polic y by allowing individuals to use retiremen t funds fo r purposes other than retirement security. As a consequence, if the ADSA is established, million s o f Americans, who previousl y were encouraged to save for retirement through th e favorable ta x treatment of retiremen t arrangement s an d discourage d fro m usin g thos e fund s for curren t consumptio n b y the 1 0 percent excis e ta x o n earl y with drawals, could choos e to diver t thei r retiremen t saving s to nonretire ment use s withou t penalty . Th e brun t o f thi s polic y shif t woul d b e borne substantially by middle-and lower-income Americans. Dissavings for Retirement. ADSA s probabl y woul d b e popula r because they would allow taxpayers penalty-free acces s to their mone y before retirement for qualified purposes. 87 However, it is doubtful tha t contributions t o ADSA s woul d resul t i n a n overal l ne t increas e i n the saving s o f individua l taxpayer s becaus e an y projected increas e i n ADSA savings likely would b e accomplishe d a t th e expens e o f retire ment savings. For an interim period the ADSA, as passed by the House of Representatives , would permi t th e transfe r o f fund s fro m existin g IRAs t o ADSA s withou t penalty. 88 Accordingly , prio r contribution s made t o traditiona l IRAs , includin g lump-su m distribution s fro m

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employment-based pensio n plans 89 previousl y rolle d ove r int o tradi tional IRAs , would b e eligibl e fo r transfe r t o a n ADSA. 90 Rolled-ove r contributions currentl y represen t significan t amount s o f retiremen t savings.91 From 198 7 through 1990 , for example , taxpayers made 11. 2 million rollover contributions to traditional IRAs. 92 During that sam e period total IRA contributions reached $220 billion.93 Therefore, if the ADSA is established, as much as $220 billion of current IRA retirement funds, if rolled over into ADSAs, would be available penalty free in five years for nonretirement purposes. Thus, not only does the ADSA legislation redefin e presen t pensio n policy , but i t threaten s th e succes s o f the existing retirement savings program by allowing early, penalty-free withdrawals of current retirement funds for purposes other than retirement. This result could affect th e retirement securit y of future retiree s adversely by encouraging them t o use funds earmarke d fo r retiremen t savings for other purposes. 94 Proponents of the ADSA likely will argue that spending for the permitted purpose s i s consisten t wit h retiremen t polic y goal s an d tha t these purchases serv e to enhanc e futur e retiremen t incom e security. 95 In other words, they will maintain that purchasing a first home, educating children, and savin g for medica l expense s are all socially desirable goals consistent wit h pensio n polic y and publi c interest. However, fo r individuals who currently use different type s of savings vehicles for different saving s goals, the limitations place d o n th e use of ADSA fund s would prov e effectivel y meaningles s becaus e th e ADS A legislatio n allows taxpayers to shift thei r saving s from traditiona l retiremen t sav ings arrangements to the more flexible ADSAs. The following exampl e illustrates this point. A taxpayer, some years ago, desired to save for retirement, to pay for a child's college education, and to purchase a new sports car. However, the taxpayer was forced t o choose among these goals because of limited resources . The taxpayer , being a responsible parent, decided to forgo th e sports car and to save for th e paymen t o f colleg e tuitio n an d retiremen t throug h mutua l funds an d traditional IRAs respectively. With the enactment of ADSAs, the taxpaye r elect s t o rol l ove r th e entir e balanc e o f th e IR A into a n ADSA s o that , i f necessary , th e fund s wil l b e availabl e befor e retire ment. By the time the rollover occurs, the retirement fund has grown to a level that easily could appear to be a comfortable nes t egg. However, the appearance of saving adequacy may be misleading, given the uncer-

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tainty o f futur e inflation , anticipate d incom e increases , and expecte d investment performance. 96 Fiv e years later the child enters college and tuition become s due . Notwithstanding year s o f sacrificin g t o sav e fo r retirement security , because o f a lack o f awarenes s abou t th e insuffi ciency of th e retiremen t fund , th e taxpaye r decide s to tak e a tax-fre e distribution from th e ADSA to pay for the child's tuition. As a result of this decision, the funds i n th e mutual fun d ar e now available to pur chase the new sports car. Effectively, b y shiftin g saving s goal s an d saving s instruments , th e taxpayer is indirectly able to use the ADSA funds, which have enjoye d tax-free earning s ove r severa l years, 97 t o purchas e a ne w sport s car . Most people would agree that the purchase of the sports car would not be consistent with retirement income security or policy. Yet, the transfer o f traditiona l IR A fund s t o th e ADS A facilitate s th e purchase . Moreover, by shifting th e funds, th e taxpayer i n effec t i s able to enjo y preferential ta x treatmen t an d a penalty-fre e earl y distributio n fo r a nonqualified purchase . Absen t th e ADSA , th e sport s ca r purchas e would not have been possible for the taxpayer without either incurring a substantia l penalty 98 o r forgoin g th e child' s education . Absen t th e ADSA, th e ta x la w woul d hav e encourage d th e taxpaye r t o us e th e mutual funds fo r the child's education and the IRA for retirement pur poses a s originall y planned . Thus , as this exampl e illustrates , ADSAs not only would allow individuals to use money previously targeted fo r retirement fo r curren t consumption , but the y actually would encour age them to do so. Adverse Effects on 401 (k) Plans. In addition to its negative impact on retirement saving s i n general , ADSAs ultimately woul d hav e a n eve n more detrimental impact on employer-sponsored 401(k ) plans. Under these plans the employee is given an option to have the employer make contributions t o th e pla n fro m curren t wages. 99 Thus , the contribu tions are elective. Under existing law there is general consistency in the withdrawal rules for 401(k) plans and IRAs.100 However, the more flexible distribution rule s for th e ADSA would giv e the ADSA a competitive advantage , whic h ha s th e potentia l t o caus e contribution s t o employer-sponsored 401 (k) plans to decline.101 If the ADSA legislation i s enacted, some employees, especially lowpaid employees, would prefer to save in ADSAs, where they could have penalty-free acces s to their fund s earlie r than the y could i f they saved

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in a n employer-sponsore d plan . Most employer s alread y have troubl e persuading low-pai d employee s to contribut e t o electiv e contributio n plans.102 Participatio n amon g low-pai d employee s i s necessar y t o enable qualified plans 103 to meet ERISA' s minimum participatio n an d nondiscrimination standards. 104 Th e minimu m participatio n stan dards limit discriminatio n i n favo r o f highly compensated employee s by requiring an employer who establishes a plan covering highly compensated individuals also to cover some individuals who are not highly compensated. The nondiscrimination rule s ensure that the tax subsidy benefiting the highly compensated employees also provides some benefit to rank-and-file employees. Failure to meet these standards results in a plan's losing its preferential ta x status.105 If low-paid employees were to shift their retirement savings from 401 (k) plans to ADSAs because of the less restrictive distribution rules, the maximum 401(k) plan contribution level of higher-paid employee s would have to decrease in order for th e pla n t o retai n it s qualifie d status . The availabilit y o f ADSAs, therefore, would be likely to cause the retirement saving s among both lower-paid and higher-paid employees in 401 (k) plans to decline.106 Ultimately, difficulty meetin g the minimum participation standard s could have a negative impact on the establishment and maintenance of employer-sponsored 40 1 (k)s. Some employers may refrain fro m estab lishing or maintaining 401(k) plans on the assumption that employees would prefer to save in the more flexible ADSAs. This trend could prove problematic fo r futur e retiree s becaus e generall y i t i s believe d tha t 401(k) plan s ar e more generou s an d offe r greate r retiremen t securit y than IRAs. 107 For example, 401(k) plans often have employer matching features as a way of encouraging participation. Under these options the employer matches a given percentage of every dollar of pay contributed by the employee to the 401 (k) plan; 108 consequently, plan participant s receive a greater return from thei r investments than they would if they saved i n a n IRA-typ e vehicle . Employer-sponsored 401(k ) plan s als o offer th e convenience of payroll deduction, whereas ADSAs would not. Most importantly , however , th e typica l employer-sponsore d pla n i s professionally managed 109 an d is designed to ensure maximum invest ment performance. 110 I n contrast , the ADSA, like the traditional IRA, would requir e that investmen t decision s be made by individual ADSA holders, who may have little or no experience in financial management. In sum , th e ADS A coul d caus e retiremen t dissaving s amon g low -

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and middle-income workers who would divert their retirement savings through ADSA s to curren t consumptio n uses . In addition , the ADSA could hav e a n advers e impac t o n retiremen t saving s amon g higher income taxpayers to the extent that their contribution level s would be forced t o decreas e a s low- an d middle-incom e employee s shif t thei r retirement saving s from employer-sponsored plan s to ADSAs. Finally, ADSAs also could caus e retirement dissaving s if employers, operating under th e assumptio n tha t employee s would prefe r th e mor e flexibl e distribution rules of the ADSA, decided not to offer 401 (k) plans. Disproportionate Benefit to the Wealthy, ADSAs have been promoted as part o f a middle-income America n ta x relief package. 111 However , most o f the benefits fro m ADSA s would g o to thos e who alread y ar e able to save. Therefore, although the proponents of ADSAs have targeted middle-class Americans as the primary beneficiaries o f this reform , in reality upper-income taxpayers would receive the greatest benefits. 112 The most obvious reason ADSAs would benefit wealthier Americans disproportionately as compared to middle- and low-income Americans is the tax system's progressive tax rate structure. The applicable tax rate increases as individuals earn more income. That means that the advantage o f ta x deferra l increase s a s a n individual' s margina l ta x rat e increases. Thus, the incentive to save in a tax-deferred accoun t and the amount of the tax subsidy creating that incentive is greater for higher income than for lower-income taxpayers.113 ADSAs raise other related questions of fairness concerning the merits o f a savings program base d solel y on ta x incentives . For example , giving preferential ta x treatment to first-home buyers adds to the large tax subsidies already available to homeowners, which includ e the fail ure t o ta x impute d incom e an d th e deductibilit y o f interes t pai d fo r qualified mortgages. 114 Pu t mor e succinctly , th e ADS A increase s th e disparity betwee n individual s wh o ca n affor d t o purchas e thei r ow n homes and those who are forced to rent. The inequity of this situation affects no t only low-income Americans but millions of middle-income Americans who, notwithstanding tax incentives, are unable to purchase their first home. Similarly, the offering o f a tax-advantaged metho d of funding educatio n and medical expenses must be balanced against the adequacy of public education and health funds fo r lower-income individuals.115 Another reason wealthy Americans will benefit more from the ADSA

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is that, unlike 401(k) plan contributions, which are made by a cross section o f the population, households that contribut e to IRAs tend to be wealthy.116 The primary reaso n give n by nonwealthy wage earners fo r not establishing IRAs is lack of money.117 More than 40 percent of lowincome, non-IR A owner s revea l tha t afte r meetin g th e cos t o f thei r necessities an d basi c expenses , nothin g i s lef t t o contribut e t o a n IRA.118 Approximatel y one-thir d o f American s ar e convince d that , notwithstanding th e need to save, they cannot save more because they do not have extra money. Seventy-four percen t o f households with an income les s than fort y thousan d dollar s d o no t sav e at al l because o f inadequate income. 119 Therefore , unles s American s ear n mor e i n wages, they will continu e t o lac k sufficien t disposabl e incom e t o tak e advantage of ADSAs or, for that matter, any other savings program. Contrary t o th e expectation s o f proponent s o f ADSAs , increase d savings limit s ar e no t likel y t o increas e tota l savin g amon g low - an d middle-income individuals . This prediction ca n be more full y under stood by looking at current IR A contribution patterns . Under existin g law IRA contributions ar e limited to $2,000. In 198 7 only 5 percent of households earning between $10,000 and $20,000 made IRA contributions. These households were eligible to make fully deductibl e contri butions o f $2,00 0 to their IRAs. 120 Presumably, low IRA participation is primaril y attributabl e t o lo w earnings. 121 Thus , t o th e exten t tha t low earnings are the reason for low participation, increasing the contribution level s for ADSA s for one-wage-earne r couple s fro m $2,25 0 t o $4,000 wil l hav e n o effect . Couple s wh o canno t affor d t o contribut e $2,250 unde r curren t la w t o a n IR A wil l no t b e abl e t o contribut e $4,000 to an ADSA. Similarly, allowing all wage earners to make contributions u p t o th e $2,00 0 limit (o r $4,00 0 fo r couples ) i s not likel y to motivate individual s wh o currentl y hav e littl e disposabl e incom e t o save. Thus, the principal beneficiaries of ADSAs will be those who already save and requir e n o additiona l incentiv e t o d o so—th e wealthy . They will benefit substantiall y fro m ADSA s because the y will receiv e addi tional ta x benefit s fo r first-hom e purchases , education , an d medica l care expenditures which currently enjoy preferential tax treatment. 122 Increase in Savings Unlikely. If the objective of enacting ADSAs is to increase savings in general , then a fair questio n t o as k is whether tax payers would be likely to use ADSAs for saving. 123 The Joint Committee

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on Taxatio n estimate d tha t 7 3 percen t o f al l taxpayer s wit h earne d income were eligible fo r ful l ta x deferral o f thei r 199 1 IRA contribu tions and 9 percent were eligible for partial deferrals. Yet, only 2 percent of th e eligibl e populatio n mad e contribution s t o IRA s i n 1991. 124 Furthermore, during the height of IRA participation in the early 1980s, IRA contributions never accounted for more than 1 percen t of disposable income. Therefore, the IRA's history of limited participatio n sug gests that it is unlikely that the ADSA would do much to bridge the personal savings gap between America and other countries. 125 One of the most controversial features o f the ADSA is that it is back loaded.126 Accordingly, taxpayers choosing an ADSA over a traditional IRA must be willing to pay current taxes on funds not available to them in relianc e o n a future ta x benefit. I f tax rates remai n constant , backloaded an d front-loade d saving s arrangement s provid e th e sam e ta x benefits.127 A n exampl e ca n illustrat e thi s point . A one-wage-earne r couple has $4,000 to invest in retiremen t savin g at a 5 percent rat e of return. The couple's margina l ta x rate i s 28 percent, an d the y plan t o retire in fifteen years . If the couple invests in a back-loaded ADSA, they would pay an initial tax of $1,120, which leaves $2,880 to invest. At the end of fifteen year s their accoun t balance would be $5,988 and woul d be free from tax. In contrast, if the couple invested $4,000 in a front-loaded IRA , they would pay no taxes initially, leaving the entire $4,000 to invest at 5 percent. At the end of fifteen years their account balance would be $8,316. A 28 percent tax would apply when the funds were distributed, leaving the coupl e agai n wit h $5,99 8 for thei r retirement. 128 I f tax rates were expected to increase, however, the back-loaded featur e woul d encour age increased ADSA savings.129 Conversely if tax rates were expected to decrease, taxpayers would find it more advantageous to invest in traditional IRAs. Thus, the back-loaded featur e o f ADSAs would presen t a calculated risk for prospective ADSA savers. The possibility of an income tax repeal presents a similar set of risks, especially fo r saver s wh o ma y expec t a futur e consumptio n tax. 130 Thus, th e anticipatio n o f incom e ta x refor m coul d discourag e o r encourage a taxpayer fro m payin g taxes initially in relianc e o n futur e tax benefits. Taxpayers should rely on future tax benefits only if they are convinced tha t th e curren t incom e ta x syste m wil l be i n plac e i n th e future, o r a t leas t tha t it s replacemen t wil l provid e equall y favorabl e

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future ta x benefits. It is therefore ironi c that ADSAs, which create a tax incentive base d o n th e presen t valu e o f futur e ta x benefits, ar e bein g introduced a t the same time that the chairman of the House Ways and Means Committe e i s urgin g a total repea l o f th e curren t incom e ta x system.131 Moreover , eve n i f th e federa l incom e ta x syste m i s no t repealed an d th e incom e ta x retain s it s curren t structure , years fro m now th e rule s fo r ADS A distribution s coul d b e amended . When on e considers th e increasin g budget deficit , i t i s not difficul t t o imagin e a taxpayer's reluctance to incur current tax liability in reliance on futur e tax benefits. Even in the absence of the possibility of marginal tax rate changes, a repeal of the federal income tax system, or distrust of continued prefer ential tax treatment, the back-loaded feature of ADSAs alone may make them ineffective a s a saving incentive. ADSAs may have less appeal than traditional IRA s simply because ADSAs do not reduc e a taxpayer's tax liability immediately . Durin g th e earl y 1980 s th e IR A progra m wa s much mor e popula r tha n i t i s today , particularl y amon g middle income taxpayers . Onc e IRA s wer e restricte d an d th e ta x deductibl e feature wa s eliminate d fo r mos t workers , however , man y taxpayer s discontinued thei r contributions. 132 Jus t a s th e eliminatio n o f th e immediate deductio n contribute d t o the sharp declin e in IRA participation i n 1986, 133 the absenc e o f a n immediat e deductio n fo r ADSAs may minimize thei r investmen t appea l today. 134 An additional reaso n ADSAs may no t hav e muc h appea l i s the currentl y lo w margina l ta x rates. IRA s wer e mos t popula r befor e th e Ta x Refor m Ac t o f 1986 , which lowered tax rates. Lower tax rates diminish the value of a tax-free buildup, making it less appealing to sacrifice spendin g flexibilit y fo r a future ta x benefit . O n th e othe r hand , relativel y lo w rate s migh t encourage some taxpayers to invest in ADSAs and incur current tax liability because the risk of higher tax rates in the future i s greater. Administrative Difficulties and Adverse Budgetary Implications. ADSAs introduce significan t administrativ e complexity . I f th e Hous e version of the ADSA is enacted, it will be necessary to educate taxpayers about th e difference s betwee n front-loade d an d back-loade d ta x programs. ADSAs also will be administrativel y burdensom e t o taxpayer s and th e IRS . Accounting fo r an d accuratel y measurin g th e five-yea r holding perio d necessar y fo r tax-fre e distribution s fo r qualifie d pur chases may become cumbersome. Many taxpayers will have both tradi-

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tional IRA s and ADSAs, which coul d caus e great confusio n abou t th e disparate distributio n rule s o f th e tw o type s o f accounts . As a result , taxpayers wil l incu r additiona l reportin g requirements , an d th e trea sury will incur additiona l cost s for th e administratio n o f ADSAs and the enforcement o f their regulations. A furthe r issu e i s th e cos t t o th e treasur y o f ADSAs . Budgetar y estimates indicat e tha t i f Congres s enact s th e ADSA as passed b y the House, net revenue losses will be substantial.135 For the interim period that taxpayer s ar e allowed t o rol l over funds fro m traditiona l IRA s to ADSAs, the ADSAs would produce revenue because these transactions would be subject t o an income tax. The income tax would be paid o n the rolled-ove r amount s ove r a four-year period , beginnin g wit h th e tax year in which the transfer was made. Thus, the conversion of traditional IRAs to ADSAs initially would increas e revenue. 136 However, as individuals became eligible for tax-free distribution s after th e first fiv e years, th e ADS A woul d produc e revenu e losse s tha t woul d increas e exponentially. A s a result , ove r time , rathe r tha n increasin g nationa l savings, ADSAs , b y increasin g th e federa l deficit , coul d actuall y decrease national savings.137 Various estimates project very different figure s about the amount of revenue ADSAs would generate in the short run a s well as the amoun t of revenu e they would los e in the long run. 138 Fo r example , the Join t Committee on Taxation estimates that ADSAs would raise $2.2 billion over th e firs t five years throug h taxatio n o f IR A rollovers bu t woul d lose $23.9 billion over the second five years.139 The treasury offers dif ferent figures. It estimate s tha t ove r th e first five years ADSAs would raise close to $5 billion but would lose $22.7 billion in revenue over the second five years.140 Budget expert s may not be in accor d o n th e revenue produced o r the cost incurred i n connection with the ADSA, but many experts do agree that the ADSA could be a fiscalnightmare rather than an American dream. 141 ADSAs represent a dramatic movement away from the existing tax policy of providing incentive s t o sav e for retiremen t securit y rather tha n for curren t consumption . This shift i n policy has potentially dramati c implications for future retirement saving. In particular, the shift in pension polic y woul d discourag e retiremen t savin g amon g middle-an d low-income individual s who previously have been encourage d t o save

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for retirement . Additionally, because the 199 5 Act establishing ADSAs allows taxpayers to roll over funds from traditional IRAs to ADSAs, taxpayers would be encouraged to shift their assets from on e savings vehicle to another. The ability to roll over funds tha t ca n be used onl y fo r retirement purposes to an arrangement tha t permits penalty-free non retirement usages , ma y caus e som e individual s t o shif t thei r savin g goals to accomplis h favorabl e ta x treatment o f nonqualifie d expendi tures. Furthermore, to the extent that ADSAs would adversely affect th e establishment of employer-sponsored pensio n plans, they could have a negative impact on overall retirement saving. Finally, because the ADSA is backloaded, taxpayers would be required to risk paying taxes today in anticipation o f future ta x benefits. Thus, the success of the ADSA program in increasing savings ultimately would depend on how risk averse taxpayers are. Therefore, despite its potentially disruptive effect o n current pensio n polic y and it s adverse budgetary implications , the establishment of ADSAs is unlikely to be successful i n accomplishing its goal of increasing aggregate personal savings among nonwealthy Americans. Even worse , th e establishmen t o f ADSA s coul d b e responsibl e fo r decreased retiremen t securit y amon g million s o f middle - an d low income future retiree s who currently are encouraged to save for retire ment by the existing retirement program . NOTES I a m gratefu l t o Prof . Danie l I . Halperi n fo r hi s comment s o n a n earlie r draft . I also wis h to than k Pete r Niko s Koufo s an d Elizabet h Dian e Sosci o fo r thei r extremel y valuabl e researc h assistance. 1. See, e.g., I.R.C . §§ 163(a) , (h)(1)—(3) (allowin g a deduction fo r "qualified residenc e inter est"), 170(a)(1) (generall y allowing "a deduction [for ] an y charitable contribution"). 2. See Joseph M . Dodg e e t al. , Federal Income Tax : Doctrine, Structur e an d Polic y 244-46 , 256-60(1995). 3. See, e.g., Camilla E. Watson, Machiavelli and the Politics of Welfare, National Health, and Old Age: A Comparative Perspective of the Policies of the United States and Canada, 193 Utah L . Rev. 1337,1356(1993). 4. See generally Regin a T . Jefferson, The Earned Income Tax Credit: Thou Goest Whither? A Critique of Existing Proposals to Reform the Earned Income Tax Credit, 68 Temp. L.Q. 143, 143-45 (1995) (notin g that the earned incom e tax credit (EITC ) i s designed t o lessen overall regressivit y within the federal tax system). 5. See I.R.C. §§ 402(a)(1), 404(a)(l)-(3); Regin a T . Jefferson, Defined Benefit Plan Funding: How Much Is TooMuch?44 Case W. Res. L. Rev. 1,2 (1993) . 6. See Jefferson, supra note 5, at 2.

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7. See I.R.C. § 72(t)(2) ; Danie l I . Halperin , Interest in Disguise: Taxing the "Time Value of Money" 95 Yale L.J. 506,519-22 (1986) ; Jefferson, supra note 5, at 2. 8. See Celia Silverman et al., EBRI Databook o n Employee Benefits 19-23 , table 2.5 (Caroly n Pemberton 8c Deborah Holmes eds., 3d ed. 1995). 9. See Jefferson, supra note 5, at 40-41. 10. See, e.g., Senat e Subcomm . o n Labo r o f th e Comm . o n Labo r an d Publi c Welfare, 94t h Cong., 2d Sess., Legislative History of the Employee Retirement Income Security Act of 1974,169 3 (Comm. Print 1976 ) [hereinafte r Histor y of ERISA] (noting that Social Security can only supplement pension and personal savings); 119 Cong. Rec. 16,824 (1973) (statement of Sen. Roth) (not ing that Social Security can only hope to supplement income derived from pension s and personal savings). 11. See History o f ERISA , supra note 10 , at 355 4 (statemen t o f Senato r Schneebeli ) (statin g that a n IRA "allows the fellow who . .. i s not covere d by a pension plan to contribute to a retirement account") , at 4809 (notin g that for th e first tim e the millions of employees not covere d by any pension pla n wil l "be allowed t o set u p thei r ow n tax-fre e retiremen t plans") ; Staff o f Join t Comm. on Taxation, 104th Cong., 1st Sess., Description and Analysis of Tax Proposals Relating to Individual Savings 2-6 (Comm . Print 1995 ) (describing and comparing the tax incentives associated with IRAs and qualified plans) . 12. See John H . Langbei n & Bruce A. Wolk, Pension an d Employe e Benefi t La w 51 (2 d ed . 1995); see also id. at 41-52 (discussing plan types). 13. See Silverman et al., supra note 8, at 19-23, tables 2.4,2.5. 14. The Employe e Retiremen t Income Security Act of 1974 , Pub. L. No. 93-406, 88 Stat. 829 (ERISA) (codified as amended in scattered sections of 29 U.S.C.). 15. Economic Recovery Tax Act of 1981 , Pub. L. No. 97-34, 95 Stat. 17 2 (ERTA) (codifie d a s amended in scattered sections of 26 U.S.C.). 16.5eeI.R.C.§219. 17. See id.§ 219(g). 18. See Bruce E. Thompson, Jr., Time to Tackle Our Savings Deficit, Wash. Times, Apr. 4, 1995, atA19. 19. See id. 20. See id. 21. See id; see also Joseph S. Coyle, How to Beat the Squeeze on the Middle Class, Money, May 1, 1995, at 106,109 (quoting DeeLee, a financial planner, as saying "[t]he middle class does not postpone its pleasures any more"). 22. See Coyle, supra note 21, at 109. 23. See id. 24. See Research Division , American Ass' n o f Retire d Persons , Aging Bab y Boomers : Ho w Secure Is Their Economic Future? 4 (1994) [hereinafte r AARP Report]. 25. See Douglas Bernheim , Adequacy of Savings for Retirement and the Role of Economic Literacy, in Retirement i n the 21st Century, Ready or Not 73 , 73-78 (Dalla s L. Salisbury & Nora Jones eds., 1994). But see AARP Report, supra note 24, at 20 (stating that baby boomers may not be able to maintain their working life standards in retirement but may be better off than their parents will be in retirement). 26. See AARP Report, supra note 24, at 20. 27. H.R. 1215 , 104th Cong., 1s t Sess. (1995) (Ta x Fairness and Defici t Reductio n Act ) [here inafter H.R.1215] ; see also Cheryl Wetzstein, House Approves GOP Tax-Cut Plan, 246-188: Passage of "Crown Jewel" Completes "Contract," Wash. Times, Apr. 6, 1995 , at Al (discussin g the House' s passage of the Act).

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28. See, e.g., Wetzstein, supra note 27, at Al. 29. See Joint Committee on Taxation Staff Preliminary Revenue Estimates of Tax Provisions in Republican Contrac t wit h America (H.R . 6, H.R. 8, H.R. 9, & H.R. 11 ) (1995) , reprinted in Daily Tax Rep. (BNA), Feb. 2,1995, at L-l. 30. See, e.g., Albert J. Davis, Budget Implications of the Contract with America Tax Cuts 67 Tax Notes 827,827 (1995) (notin g that in the following five-year period, 2000-2005, the U.S. Treasury Department estimate s the revenue losses will increase to $452 billion an d tha t thi s will seriously hurt efforts to balance the budget). 31. See, e.g., 14 1 Cong. Rec. H4213-02-73 (dail y ed. Apr. 5, 1995 ) (debatin g th e Tax Fairness and Deficit Reductio n Act of 1995). 32. See, e.g., 141 Cong . Rec . S9356-01 , S9363 (dail y ed . Jun e 29 , 1995 ) (debat e betwee n Senators Murray and Dodd on the Budget Conference Report) . 33. H.R. 1215, supra note 27, at §§ 6101-4. 34. Id. at §6103. 35.S«?I.R.C.§219(g)(l)-(3). 36. Id. 37. H.R . 1215 , supra note 27 , a t § 610 3 (propose d additio n t o I.R.C . § 408A , a t (c)(1) , (d)(2)(A)(I)). 38. Id. (proposed addition to I.R.C. § 408A, at (d)(2)(B), (e)). 39. Id. (proposed addition to I.R.C. § 408A, at (d)(1)(B)). 40. Id. (proposed addition to I.R.C. § 408A, at (c)(5)(B), (d)(3)). 41. See Clay Chandler, GOP Contractors' 'Dream' Bill Has Deficit Hawks Losing Sleep, Wash. Post, Dec. 9,1994, at A27. 42. See id. 43. See Office o f th e Hous e Majorit y Leader , H.R . 1215 : Th e Ta x Fairnes s an d Defici t Reduction Act : Facts , Figures , and Source s fo r th e Ta x Bil l Debate , H.R . Doc . No. 3572, 104t h Cong., 1st Sess. 14-17 (1995) [hereinafte r Ta x Bill Debated]. 44. See Gene Epstein , The Coming Changes in IRAs Will Be Popular, but They Won't Make Americans Save More, Barron's, Jan. 16,1995, at 51 (noting that the purpose of IRAs is to provide a saving incentive). 45. See, e.g., Vivian Marino, This Could Be the Year of the IRA, Assoc. Press, Feb. 28,1995, available in WESTLAW, 1995 WL 4364689. 46. See supra notes 14-1 5 and accompanying text. 47. See supra note 14. 48. See infra notes 56-57 and accompanying text. 49. See, e.g., H.R. Rep. No. 807, 93d Cong., 2d Sess. 521 (1974), 1974- 3 C.B. Supp. 236 (com paring origina l IR A proposa l submitte d b y th e Nixo n administratio n wit h th e IR A proposa l adopted b y ERISA; noting that the administration's proposa l was broader i n coverage, because it would have allowed employees covered by employer plans with low benefit levels to establish IRAs; quoting statement of Rep. Broy Hill). 50. See James R . Storey, CRS Issue Brief : Individual Retiremen t Accoun t Issue s an d Saving s Account Proposals 1 (1995) . 51. See id. at 2. 52. See id. at table. 1. 53. See id. 54. See Stephen B . Cohen , Federa l Income Taxation : A Conceptua l Approac h 1 0 (1989 ) (explaining progressive income tax structure). 55. See I.R.C. § 219(g).

3

2 7 4 REGIN

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56. See Storey, supra note 50, at 3. 57. See I.R.C. §408(o). 58. See infra notes 99-110 and accompanying text. 59. See Staff of Joint Comm. on Taxation, supra note 11 , at 16-17; Storey, supra note 50, at 5-6. 60. See Marino, supra note 45. 61. See Tax Bill Debated, supra note 43, at 13-15 ; see generally Hearings on the Contract wit h America Before the House Comm. on Ways and Means, 104th Cong., 1st Sess. (1995). 62. See Tax Bill Debated, supra note 43, at 13-15. 63. H.R. 1215, supra note 27, at § 6103 (proposed addition to I.R.C. § 408A, at (c)(2)). 64. Id. at § 6104 (proposed amendment to I.R.C. § 219(c)). 65. Id. at § 6103 (proposed addition to I.R.C. § 408A, at (c)(5)). 66. Id. (proposed addition to I.R.C. § 408A, at (d)(3)). 67. Id. 68. See supra notes 33-40 and accompanying text. 69. See Langbein & Wolk, supra note 12, at 137. 70.SeeI.R.C.§411. 71. See Storey, supra note 50, at 5. 72. See id. 73. See supra notes 33-41,62-68, and accompanying text. 74. Steve Farkas & Jean Johnson, Promises to Keep: How Leaders and th e Public Respond t o Saving an d Retiremen t 8 (1994) ( a repor t from Publi c Agenda i n collaboratio n wit h Employe e Benefit Research Inst.). 75. See id. at 9. 76. See Marino, supra note 45. 77. See I.R.C. § 72(t); Langbein 8c Wolk, supra note 12 , at 349. 78. See I.R.C. §72(t). 79. See Storey, supra note 50, at 6. 80. See Kathy Stokes Murray 8c Paul Yakoboski, Congress Considers IRA Expansion, EBRI Notes, Apr. 1995, at 1 [hereinafter EBRI]. 81. See id. 82. See supra note 43 and accompanying text. 83. See Langbein 8c Wolk, supra note 12 , at 342. 84. See Tax Reform Act of 1986, Pub. L. No. 99-514,100 Stat. 2085 (1986). 85. SeeH.R. Rep. No. 426,99th Cong., 1st Sess. 728-29 (1985). 86. I.R.C. §72(t). 87. See EBRI, supra note 80, at 3. 88. See supra notes 65-68 and accompanying text. 89. I.R.C. § 402(c). 90. EBRI, supra note 80, at 2. 91. See id. at 4 ; Hearings o n Proposa l t o Boos t Saving s an d Investment s Befor e th e Hous e Comm. on Ways and Means, 104th Cong., 1st Sess. (1995) (testimon y of Martin Jaffe, CFP president, International Association fo r Financia l Planning) , available in WESTLAW, 1995 WL 35220 [hereinafter Jaffe] . 92. See EBRI, supra note 80, at 4. 93. See id. 94. See Storey, supra note 50, at 8. 95. See EBRI, supra note 80, at 5.

THE AMERICA N DREA M SAVING S ACCOUN T 2 7

96. See Cohen, supra note 54, at 198-99. 97. See supra notes 5-7 and accompanying text. 98. See I.R.C. § 72(t); see also supra notes 77-81 and accompanying text (describing the 10 percent excise tax for early withdrawals). 99. See Langbein & Wolk, supra note 12 , at 251-52. 100. See I.R.C. §72(t). 101. See Christine Phili p 8 c Vineeta Anand , 401 (k)s Safe from New Competition, Pension 8c Investment, Mar. 20,1995, at 3. 102. See Gordon Williams, Pensions Piranhas, Fin. World, May 23,1995, at 82. 103. SeeI.R.C.§ 401(a)(4), (5). 104. See id. §411. 105. See id.§ 401(a). 106. See Williams, supra note 102 , at 82. 107. See Philip 8c Anand, supra note 101 , at 3. 108. See Langbein 8 c Wolk, supra note 12 , at 252 ; see also I.R.C. § 401(m) (explainin g th e nondiscrimination rules) ; Langbein 8 c Wolk, supra, at 253 (analyzing the section 401 (m) nondis crimination rule s for matching contributions). 109. See Philip 8 c Anand, supra note 101 , at 3 ; see also Regina T . Jefferson, Rethinking the Investment Risk of Defined Contribution Plans (on file with author) (explainin g the advantages of professional managemen t of pension assets). 110. See Philip 8c Anand, supra note 101 , at 3. 111. See Chandler, supra note 41, at A27. 112. See Gary Belsky, Why Most of the Rich Will Get Richer, Money, May 1995, at 134; see also Chandler, supra note 41, at A27 (noting that expande d IRA-typ e programs onl y encourage asse t shifting among those who are already high savers). 113. See Storey, supra note 50, at 2. 114. See id. at 8; see also I.R.C. § 163(h) (allowin g a deduction for the interest on a purchase of a qualified residence) . 115. See Storey, supra note 50, at 8. 116. See R . Glenn Hubbar d 8 c Jonathan S . Skinner, The Effectiveness of Saving Incentives: A Review of the Evidence 17 (July 12,1995) (unpublished manuscrip t on file with author). 117. See Research Dep't, Inv. Co. Inst., IRAs: The People's Choice 31 (1985). 118. See id. 119. Farkas 8c Johnson, supra note 74, at 14. 120. See Storey, supra note 50, at 5 (noting that 8 percent of those earning over $50,000 made contributions). 121. See Staff of Joint Comm. on Taxation, supra note 11 , at 52-55. 122. See, e.g., I.R.C. §§ 127(a ) (providin g a n exclusio n o f u p to $5,25 0 for educationa l assis tance provided by an employer), 163(h) (allowing deduction for interest on a qualified residence) , 213(a) (providin g a deductio n fo r medica l expense s exceedin g 7. 5 percen t o f adjuste d gros s income). 123. See EBRI, supra note 80, at 3. 124. See Storey, supra note 50, at 2-3. 125. See supra notes 21-22 and accompanying text. 126. See supra notes 41-42 and accompanying text. 127. See Hubbard 8c Skinner, supra note 116 , at 12-13 . 128. See id.

5

2 7 6 REGIN

A T . JEFFERSO N

129. See id. 130. See, e.g.-, Pete r Passell, Spending It: The Tax Code Heads into the Operating Room y N.Y . Times, Sept. 3,1995, at CI. 131. See David E . Rosenbaum, Chairman Proposes Redefining Tax Code, N.Y . Times, June 7, 1995,atA22. 132. See Jaffe, supra note 91. 133. See supra notes 52-57 and accompanying text. 134. See Staff of Joint Comm. on Taxation, supra note 11 , at 64; Robert D. Hershey, Jr., Toiling to Reduce Taxes in a Changing Environment, N.Y. Times, Feb. 26,1995, at CI 1. 135. See Chandler, supra note 41, at A27. 136. See id. 137. See Staff of Joint Comm. on Taxation, supra note 11 , at 70-80 (explaining the relationship of national savings and the federal deficit, defining nationa l savings as private savings plus public savings; public savings is positive when the government run s a surplus; public savings is negative when the government runs a deficit). 138. See H. Jane Lehman, IRA Proposals Could Aid First-Time Buyers: Congress Weighs Waiving Withdrawal Penalty, Wash. Post, Feb. 11,1995, at El. 139. See id. 140. See Alissa J. Rubin, Tax Cuts, 10 Years down the Road, Cong. Q. Wkly. Rep., Feb. 4, 1995, at 345. 141. See Chandler, supra note 41, at A27.

12 JONATHAN BARR Y FORMA N

Simplification fo r Low-Income Taxpayers Some Options

What ca n b e don e t o simplif y th e federa l ta x system for low-income individuals? Some of the more promising alternatives includ e statutor y an d regulator y change s tha t coul d bot h reduce th e numbe r o f low-incom e individual s require d t o fil e ta x returns an d simplif y th e return-filin g proces s fo r thos e low-incom e individuals who must file returns. According t o th e Censu s Bureau , mor e tha n thirty-si x millio n Americans liv e in poverty. 1 Th e principal federa l taxe s affecting thes e low-income individual s ar e th e individua l incom e ta x an d th e Socia l Security taxes. Once the earned income credit is taken into account, relatively few low-income individuals actually have a net federal tax liability at the end o f the year. Nevertheless, the curren t federa l ta x system requires virtually all low-income individuals to file income tax returns, if only to recover refunds o f their overwithheld taxes. Simplification o f the federa l ta x syste m ca n alleviat e th e heav y cost s an d burden s imposed b y the curren t syste m o n bot h low-incom e individual s an d the Internal Revenue Service (IRS) . Such changes hold the promise of achieving significant economi c and equitable gains. It may not be possible to simplify the federal tax system for all individuals, but it should be possible to simplify it for low-income individuals. 277

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N BARR Y FORMA N

C U R R E N T F E D E R A L TA X TREATMEN T O F L O W - I N C O M E INDIVIDUAL S

The Individual Income Tax. The federal incom e tax is imposed on a taxpayer's taxabl e income . I n general , th e taxabl e incom e o f a low income individua l i s equa l t o th e individual' s adjuste d gros s incom e less a standar d deductio n an d persona l exemptions . A low-incom e individual's preliminar y ta x liability (i f any ) i s equal to 1 5 percent o f taxable income . Th e amoun t tha t th e individua l mus t pa y wit h th e return or , alternatively, the amount o f the refund, i s equal to the individual's preliminar y ta x liabilit y minu s allowabl e credits . Other tha n the credit for withheld income taxes, the principal credits used by lowincome individual s ar e th e dependen t car e credi t an d th e earne d income credit. Each year , th e U.S . Department o f Treasur y adjust s th e standar d deduction amounts , th e persona l exemptio n amounts , th e earne d income credit, and the income tax rate tables to reflect the prior year's change i n th e Consume r Pric e Index. 2 Fo r 199 6 th e basi c standar d deduction amount s ar e $6,70 0 fo r marrie d couple s filin g jointl y an d surviving spouses , $5,900 for head s o f household, $4,00 0 fo r unmar ried individuals , and $3,35 0 fo r marrie d individual s filin g separately . Aged o r blin d individual s generall y ar e entitle d t o clai m additiona l standard deduction amounts of $800, except that aged or blind unmar ried individual s ca n clai m additiona l standar d deductio n amount s o f $1,000. The personal exemption amoun t fo r 199 6 is $2,550. The rate tables have also been modifie d s o that fo r 199 6 the 1 5 percent margina l ta x rate extends to all taxable incomes up to $40,10 0 for marrie d couple s filing jointly an d survivin g spouses , $32,150 for head s of households , $24,000 for unmarried individuals , and $20,050 for married individu als filing separately. For taxable incomes above those amounts, marginal tax rates of 28,31,36, and 39.6 percent are applicable. The maximum earned incom e credi t amount s fo r 199 6 hav e als o bee n increased . Individuals with one qualifying chil d are entitled to an earned incom e credit of up to $2,152. Individuals with two or more qualifying childre n are entitle d t o a n earne d incom e credi t o f u p t o $3,556 . Individual s without children are entitled to an earned income credit of up to $323;

SIMPLIFICATION FO R LOW-INCOM E TAXPAYER S 2

however, childless individuals unde r ag e twenty-five o r over age sixtyfour are not eligible for any earned income credit. Individuals fil e incom e ta x return s a s marrie d couple s filing join t returns, a s survivin g spouses , a s head s o f household , a s unmarrie d individuals, or a s married individual s filing separately. Some 11 5 million individual income tax returns were filed for the 199 4 tax year.3 Of these, about 6 8 million were on For m 1040 , 23 million wer e on For m 1040A, and 1 9 million were on Form 1040EZ. Typically, about 70 percent of individuals claim the standard deduction in lieu of itemizing their deductions. For example, for 199 3 roughly 8 1 millio n individual s claime d th e standar d deduction , an d th e remaining 33 million itemized their deductions. 4 An even greater per centage of low-income individuals claim the standard deduction: more than 9 0 percent of taxpayers with adjusted gros s income of $30,000 or less claimed the standard deduction in 1993. 5 Some low-income families also claim the dependent care credit. This is a credi t o f u p t o 3 0 percen t o f th e employment-relate d expense s incurred t o care for on e or more children unde r the age of thirteen o r for certai n disable d spouse s or dependents . Because the credit i s nonrefundable, however , it is generally of little or no value to low-incom e families. For 199 2 only about 1 5 percent o f the benefit fro m th e credit accrued to families with adjusted gros s income of less than $20,000. 6 Finally, many low-income workers claim th e earned incom e credit . Of particular importance, the credit is refundable; that is, if the amount of th e credi t exceed s th e taxpayer' s incom e ta x liability , th e exces s is payable t o th e taxpaye r a s a direc t transfe r payment . T o clai m th e earned income credit, an individual must file a tax return, and individ uals wit h childre n mus t attac h For m EIC . Almost ninetee n millio n families ar e expected t o clai m th e earne d incom e credi t fo r 1996 , and their claim s ar e expecte d t o tota l mor e tha n $2 5 billion. 7 O f tha t amount, $4 billion will offset preliminar y income tax liabilities, and the remaining $2 1 billion wil l be refunde d a s direct transfe r payment s t o these families. Virtually all of the benefits o f the earned incom e credi t go to families with adjusted gros s incomes of $30,000 or less. Social Security Taxes. Social Securit y taxe s ar e levie d o n earning s from employmen t an d self-employmen t covere d b y Socia l Security , with portion s o f the total tax allocated by law to eac h o f the Old-Ag e

79

280 JONATHA N BARRY FORMAN

and Survivor s Insuranc e trus t fun d (OASI) , the Disabilit y Insuranc e trust fund (DI) , and the Medicare Hospital Insurance trust fund (HI) . For 1996 employees pay Social Security taxes of 7.65 percent of the first $62,700 of wages and 1.4 5 percen t o f wages over $62,700. 8 Employers pay a matching Social Security tax of 7.65 percent o f up to $62,700 of wages o f eac h covere d employe e an d 1.4 5 percen t o f wage s ove r $62,700. Similarly , self-employe d worker s pa y a n equivalen t Socia l Security tax of 15. 3 percent of up to $62,700 of net earnings from cov ered self-employment an d 2.9 percent of net earnings over $62,700. In 1992 almost 11 8 million civilian workers were subject to Social Security taxes.9

T H E IMPAC T O F F E D E R A L TAXE S ON L O W - I N C O M E INDIVIDUAL S

Because o f standar d deductions , persona l exemptions , an d th e earned incom e credit , relativel y fe w low-incom e individual s pa y an y income taxes. On the other hand, because the Social Security tax system has no standard deductions or personal exemptions, many low-income individuals ar e require d t o pa y Social Securit y taxes . Fortunately, th e earned incom e credi t offset s th e Socia l Security tax liabilities o f mos t low-income individuals. Consequently, not many low-income workers owe any federal taxes at the end of the year. Table 12. 1 compares th e combine d incom e an d Socia l Security tax thresholds (i.e. , net federal tax thresholds) o f various family units with their povert y incom e guidelines . For example , consider th e ta x treat ment o f a typical famil y o f fou r i n 1995— a married coupl e with tw o children. Assuming that the couple's income consisted entirely of wages or salaries , the coupl e owe s no federa l taxe s unless the y earne d mor e than $18,370 . Basically , th e couple' s $6,55 0 standar d deductio n an d four $2,50 0 personal exemption s togethe r sheltere d $16,55 0 from th e income tax , an d th e couple' s earne d incom e credi t offse t th e res t o f their incom e an d Socia l Securit y ta x liability. By way of comparison , the poverty level for a family of four in 1995 was just $15,150.10 Table 12. 1 shows tha t man y (i f no t most ) low-incom e individual s had no net federal tax liability for 1995 . In particular, low-income married couples with one, two, or three children generally received welfare-

SIMPLIFICATION FO R LOW-INCOM E TAXPAYER S 2

Table 12.1. POVERT Y LEVELS AND NET FEDERAL TAX THRESHOLDS AFTER THE EARNED INCOME CREDIT IN 1995, BY FAMILY SIZE, IN DOLLARS FAMILY SIZ E 12 Poverty levels 7,47

0 10,03

3

4

5

6

0 12,59

0 15,15

0 17,71

0 20,27

0

Simple income tax threshold (befor e earned income credit)

6,400

11,550

14,050

16,550

19,050

21,550

Income tax threshold after earned incom e credit

7,357

11,550

19,386

22,360

23,425

24,490

0

0

0

0

0

0

Social Security tax threshold Combined income and Social Security tax threshold (i.e. , net federal tax threshold) 4,10

0 4,10

0 15,54

7 18,37

0 19,24

5 19,35

0

The table reflects assumptions that all family income consists of wages or salaries earned by a single worker, that families of two or more include a married couple (rather than an unmarried hea d of household wit h on e or mor e dependents) , that al l family member s ar e under ag e 65 and no t blind, and tha t al l famil y unit s ar e eligible fo r th e earne d incom e credi t (fo r example , childless workers are between th e ages of 25 and 65) . Also, only the employee's portion o f Socia l Securit y taxes is considered. Sources: U.S. Department of Health & Human Services , Office o f the Secretary, Annual Update of the Poverty Income Guidelines, 60 Federal Register 7772 (1995) and author's computations.

like subsidies from th e federal ta x system, through earne d incom e cred it refunds i n excess of any withheld incom e o r Social Security taxes. For example, a famil y o f fou r wit h a poverty-leve l incom e o f $15,15 0 received a net federa l transfe r o f $1,17 1 from th e federal government. 11 Many other low-income familie s were entitled t o refunds fo r 1995 . On th e other hand , som e low-incom e childles s individuals, childles s couples, an d larg e familie s ha d ne t federa l ta x liabilitie s fo r 1995 . Fo r example, a marrie d coupl e wit h fou r childre n (famil y o f six ) wh o earned mor e tha n $19,35 0 ha d a ne t federa l ta x liability . Similarly , a childless individua l wh o wa s eligible to clai m th e earne d incom e credi t had a net federal ta x liability if she earned mor e than $4,10 0 in 1995 . An analysi s o f famil y unit s heade d b y unmarrie d individual s (i.e. , heads o f household ) woul d sho w result s simila r t o thos e i n tabl e 12.1 .

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For example , consider a single paren t wit h tw o childre n an d incom e equal to the poverty level. She owed n o federa l taxe s until sh e earne d more than $17,216 in 1995. 12 Her $5,750 standard deduction and three $2,500 persona l exemption s togethe r sheltere d $13,25 0 fro m th e income tax, and her earned income credit offset th e rest of her income and Social Security tax liability. Moreover, a single parent with two children and a 1995 poverty-level income of $12,590 received a net federa l transfer of $1,884 for 1995. 13 In contrast, an analysis of low-income childless individuals and couples who are ineligible for the earned income credit (e.g. , because they are under ag e twenty-five o r ove r ag e sixty-four) woul d sho w slightly greater ta x liabilities . Fo r example , fo r 199 5 a twenty-one-year-ol d childless individual owed Social Security taxes from her very first dollar of earned income ; she owed income taxes once her earnings exceede d her $6,40 0 simple income tax threshold; and sh e has a net federa l ta x liability of $732 if she earned a poverty-level income of $7,470.14 Thus, i n larg e par t becaus e o f th e earne d incom e credit , relativel y few low-income families with children owed any federal taxes for 1995. The earned income credit is especially important to single parents, who are most likely to be women. In that regard almost 64 percent of earned income credi t beneficiarie s i n 199 3 were head s o f household. 15 Th e earned income credit also protects many childless workers and couples from regressiv e Social Security taxes. Unfortunately, eve n though relativel y few low-income workers owe federal taxes , most mus t file income ta x returns an d fill out Schedul e EIC t o recove r thei r overwithhel d taxe s an d thei r refundabl e earne d income credits. For example, for the tax year 199 3 almost 25 percent of the 114. 6 millio n individua l incom e ta x return s filed showe d n o income tax liability.16 That is roughly 28 million returns , and many of those were filed by low-income workers. Indeed, that year more than 12 million low-income workers received earned incom e credit refunds i n excess of their income tax liabilities.17 Moreover, millions of Americans need help preparing their incom e tax returns . Mor e tha n 5 6 millio n taxpayer s use d pai d preparer s fo r their 199 3 tax returns. 18 That i s about hal f o f all individual taxpayers. Even mor e astonishing , mor e tha n 1. 5 millio n taxpayer s pai d privat e preparers t o hel p the m fill ou t 1040E Z forms , an d mor e tha n 5. 8 million taxpayer s pai d preparer s t o hel p the m fill ou t 1040 A forms .

SIMPLIFICATION FO R LOW-INCOM E TAXPAYER S 2 8

Furthermore, half o f earned incom e credit recipient s use paid prepar ers.19 At twenty dollars or more per return fo r preparation , plus additional fee s fo r electroni c filing an d refun d anticipatio n loans , tha t amounts t o million s o f dollar s goin g fro m low-incom e worker s t o private preparers. All in all, filing returns is burdensome and expensive for low-income workers and for the IRS.

O P T I O N S FO R S I M P L I F I C A T I O N

Complexity i s a major proble m fo r th e federa l incom e ta x system . Complexity erode s voluntar y complianc e wit h th e ta x laws , creates a perception of unfairness fo r the system, and results in high compliance costs for taxpayers and the IRS. 20 Simplification o f the tax system is in order. Simplify the Return-Filing Process Recently, th e IR S ha s implemente d a variet y o f alternativ e ta x methods tha t hav e helpe d reduc e burden s o n man y low-incom e individuals.21 Form s 1040 A an d 1040E Z wer e themselve s effort s t o reduce th e burde n o n individua l taxpayers . Also, volunteer program s such a s Volunteer Incom e Ta x Assistance (VITA ) an d Ta x Counseling for the Elderly have helped millions of taxpayers. More than three million taxpayers received volunteer assistance with their 199 3 returns.22 Newer alternative s includ e electroni c filing, telephon e filing (Telefile), 1040PC , an d 1040EZ-1 . Electroni c filing allow s IRS approved tax preparers to send tax returns over telephone lines directly to th e IR S servic e cente r computers . Telefil e allow s taxpayer s t o file 1040EZ returns using touch-tone phones. The 1040P C program allows taxpayers t o prepar e ta x return s o n thei r ow n persona l computers . Finally, Form 1040EZ- 1 is a simplified for m o f the 1040EZ . A taxpayer answers a few questions , attaches an y W-2s, and sign s th e form . Th e IRS then figures th e ta x liabilit y an d send s th e taxpaye r a refun d o r a notic e o f ta x due , together wit h a n explanatio n o f ho w the ta x was figured. So far, the mos t importan t o f thes e alternative s i s electronic filing. After a tax return i s sent directl y to the IR S service center's compute r

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system, the information i s automatically edited, processed, and stored . A refun d ca n eve n b e electronicall y deposite d i n a n individual' s account at a bank or other financial institution . Moreover, through socalled refun d anticipatio n loans , taxpayer s ca n usuall y ge t spendin g money eve n earlie r tha n the y ca n ge t thei r refunds . Th e IR S starte d accepting electronicall y file d incom e ta x return s i n 1986 , and b y th e year 2001 the IRS hopes to convert some 80 percent o f all taxpayers to electronic filing. 23 O f note, the IRS recently announced plan s to allow taxpayers to file electronically through the Internet. 24 Low-income taxpayer s especiall y benefi t fro m th e IRS' s effort s t o simplify the individual income tax system, and the IRS should continue with those efforts, including (1) working to simplify its forms and publications, (2 ) developin g an d expandin g it s taxpaye r assistanc e pro grams, and (3 ) exploring and expanding alternative filing methods. In particular, measure d expansio n o f th e electroni c filing progra m an d Telefile should result in significant simplificatio n fo r both low-incom e taxpayers and for the IRS. Another refor m woul d b e t o allo w th e IR S to prepar e return s fo r individual taxpayers. The IRS believes that it is barred fro m preparin g tax returns by Office o f Management an d Budge t (OMB ) Circula r A76.25 Promulgate d b y th e Reaga n Administration , tha t rulin g wa s designed t o preven t governmen t agencie s fro m competin g wit h pri vate-sector businesses . Modifyin g tha t circular , o r a t leas t th e IRS' s restrictive interpretation o f it, would enable the IRS to help individua l taxpayers prepare their returns. It would make sense especially to allow the IRS to prepare returns for those low-incom e taxpayer s wh o clai m th e earne d incom e credit . Virtually all welfare program s hel p individuals appl y for benefits , an d the earned income credit provides a welfare-like benefit. Why not allow the IRS to prepare returns so that eligibl e low-income individuals ca n get their earned income credit refunds ? Simplify Returns Increase the Standard Deduction and Personal Exemption Amounts and Repeal or Curtail Certain Itemized Deductions. Raising th e stan dard deductio n and/o r persona l exemptio n amount s woul d rais e th e income tax thresholds and would mean that fewer taxpayers would be

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required t o file income tax returns. Of course, this would greatl y simplify th e tax system fo r thos e individual s an d fo r th e IRS . Raising th e standard deductio n woul d also decrease the number o f taxpayers who itemize thei r deductions ; ther e woul d the n b e fewe r complicate d ta x returns for taxpayers to file and for the IRS to process. Repealing an y of th e man y itemize d deduction s woul d als o reduc e the numbe r o f individual s wh o itemiz e an d s o simplify thei r returns . Admittedly, relativel y fe w low-incom e taxpayer s itemiz e thei r deduc tions. Still, if the deductions for mortgage interest, state and local taxes, and charitabl e contribution s wer e repealed , virtuall y n o low-incom e taxpayers would end up itemizing their deductions. Moreover, because these itemized deduction s ar e used primarily to reduce the tax liabilities of middle- and high-income taxpayers , repeal of these deduction s would make the income tax more progressive. Simplify or Replace the Earned Income Credit. Over th e year s th e earned income credit has become both more generous and more complicated. For example, in 199 6 a qualifying taxpaye r with two children may claim an earned income credit of up to $3,556, but a low-income worker mus t fil e a tax retur n an d worker s wit h childre n mus t attac h Schedule EI C to receiv e the credit . Not surprisingly , taxpayer compli ance and participation in the program have become major concerns . In that regar d recen t studie s hav e show n tha t th e earne d incom e credi t reaches onl y 8 0 percent o f it s targe t population. 26 Moreover , ove r 2 0 percent of taxpayers who claim the credit mistakenly claim too large a credit or are completely ineligible for the credit. Consequently, it might make sense to simplify or replace the credit with an alternative program for distributing benefits to low-income workers. At the outse t i t shoul d b e noted , however , that th e earne d incom e credit i s a whoppingly successfu l progra m that , at least unti l recently , has enjoye d broa d bipartisa n support . Largel y because o f th e earne d income credit , million s o f America n worker s pa y n o federa l taxes . Furthermore, the credit provides important incom e assistance for millions o f low-incom e workers , especiall y single-parent , female-heade d households. An d th e earne d incom e credi t ha s lowe r administrativ e costs than an y other welfare program, just 1 percen t o f program costs, according to the General Accounting Office. 27 Simplify the Earned Income Credit. One refor m ide a woul d b e t o modify the 104 0 Forms so that workers with children would no longer

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have to fil e a Schedule EI C in orde r t o clai m the credit . It would als o make sens e t o simplif y som e o f th e earne d incom e credi t eligibilit y requirements. For example, it might be reasonable to simplify the definition of qualifying child and to better coordinate it with the definitio n of dependent. In order to claim another person as a dependent for pur poses of the personal exemption, the taxpayer must generally show (1) that the other is related to the taxpayer (relationshi p test), (2) that th e taxpayer has provided more than half of the support for the other (support test), (3) that the other's gross income does not exceed the amount of the exemption (gros s income test), and (4 ) that th e other doe s not file a joint return (join t retur n test). Different test s apply to claiming a person a s a qualifying chil d for purpose s o f the earned incom e credit : (1) the taxpayer must have a child (relationship test), (2) the child must be unde r th e ag e of ninetee n o r a full-time studen t unde r th e ag e of twenty-four (ag e test), and (3 ) the child must have the same principal place of abode as the taxpayer for more than one-half of the year (residence test). It is no wonder that so many low-income taxpayers pay to have their tax returns prepared, because it takes the Code, a dictionary, and a tax advisor to figure out conditions such as these. Obviously, significant simplificatio n coul d be achieved by conforming th e definitio n of qualifying child to that of dependent. Another reform would be to simplify the definition o f earned income that is used to determine the amount of an individual's earned incom e credit. The current definitio n o f earned income includes several items that are excluded from gros s income and that are not reporte d o n IRS W-2 or 109 9 forms. Most taxpayers eligible for the credit have none of these items, but both taxpayer s and th e IRS must tr y to keep track of them. Consequently , on e simplificatio n woul d b e t o bas e th e credi t directly on items actually appearing on W-2 and 1099 forms. For example, i t woul d mak e sens e i f a n employe e coul d comput e he r earne d income credit directly from the wages entry on her Form W-2. It migh t als o b e goo d t o limi t th e earne d incom e credi t fo r self employed worker s t o th e amoun t o f thei r self-employmen t taxes . Under current law the high level of earned income credit benefits available ca n actuall y provid e a n incentiv e fo r low-incom e individual s t o report fictitiou s amount s o f earnings. Such fraud i s relatively difficul t for wage earners because the IRS can match the employee and employer W- 2 forms . Becaus e onl y a portio n o f self-employmen t earning s

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shows up on 109 9 forms, however, it is easy for self-employed worker s to overstat e their earnings . Consequently, limiting th e credi t availabl e to self-employe d worker s ma y b e a n appropriat e wa y t o cur b abus e (although, admittedly , suc h a limit woul d creat e a n inequit y betwee n wage earners and self-employed workers). Another improvemen t migh t b e to simplif y o r repea l th e so-calle d advance paymen t option . Unde r curren t la w eligibl e individual s ca n claim a portion o f their earned income credit during the year throug h increases in their weekly paychecks. To receive these advance payments, individuals must provid e their employer s with a completed IR S Form W-5, Earned Income Credit Advance Payment Certificate, but less than 1 percen t o f eligibl e individual s bothe r t o file it. 28 Moreover , despit e extensive outreac h effort s b y the IR S and b y nonprofit organization s such as the Center on Budget and Policy Priorities, participation i n the advance payment optio n remain s dismal. Redoubling outreach effort s and incorporating For m W-5 into the standard For m W-4, Employer's Withholding Allowanc e Certificate , migh t increas e th e us e o f th e advance payment option. On the other hand, it might be better to eliminate the advance payment option altogether. 29 Replace the Earned Income Credit. Given th e complexit y o f th e earned incom e credit , i t i s wort h considering som e alternativ e approaches for distributing similar benefits to low-income individuals. One approach would be to replace the earned income credit with alternative tax provisions that could provide similar benefits directly to lowincome workers. 30 Muc h o f th e complexit y o f th e curren t syste m results fro m imposin g Socia l Securit y taxes on ever y dollar o f earne d income an d the n usin g the earne d incom e credi t t o offse t thos e taxe s for low-incom e workers. Because of that relationship , would i t not b e simpler i f th e federa l ta x syste m di d no t collec t Socia l Securit y taxe s from low-income workers in the first place? One alternative would b e to ad d a $5,000 or $10,00 0 exemption t o the Socia l Securit y ta x system. 31 Unlik e th e earne d incom e credit , a Social Security tax exemption would reach 10 0 percent o f low-income workers, and i t woul d b e les s complicate d tha n first collectin g Socia l Security taxes and then using the credit to refund them . Also, unlike the earned incom e credit , which mos t worker s collec t aroun d Apri l 1 5 of the year followin g thei r work , a Social Securit y tax exemptio n woul d result i n extra mone y every paycheck. This would be a powerful wor k

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incentive. For example, a $5,000-per-worker Social Security tax exemption for employees would leave $382.50 in the hands of every worker in America ($382.50 = $5,000 x 7.65 percent). Moreover, economic theory suggests that most of the benefit of a $5,000-per-worker Social Security tax exemptio n fo r employer s shoul d pas s throug h t o worker s i n th e form of relatively higher wages. Most importantly , neithe r low-incom e worker s no r th e IR S would have to bother with tax returns to get the Social Security tax exemption: millions o f low-incom e worker s woul d simpl y no longe r nee d t o fil e returns. According to the Joint Committe e o n Taxation , replacing th e earned income credit with a Social Security tax exemption could eliminate more than ten million tax returns annually and free IRS resources for other , more productive work. 32 Moreover , the paperwork burden s for many employers could also be reduced. Some migh t b e concerne d tha t a Socia l Securit y ta x exemptio n would requir e a concomitant reductio n i n Socia l Securit y benefits. 33 But ther e woul d b e n o reaso n t o reduc e Socia l Securit y benefits ; th e revenue lost from a Social Security tax exemption could easily be made up b y raising Socia l Securit y tax rate s o n earning s abov e th e exemp t amount o r b y raisin g incom e ta x rates. 34 I n an y event , th e earne d income credi t ha s alread y decouple d an y rea l lin k betwee n Socia l Security taxes and benefits. A Social Security tax exemption would just be a mor e efficien t wa y o f offsettin g Socia l Securit y taxe s fo r low income workers. Of course, much of the benefit o f the current earne d incom e credi t seems to be geared to providing income assistance to families with children. Bu t i t woul d b e simple r t o provid e tha t typ e o f famil y benefi t through a refundable chil d tax credit like the $l,000-per-child tax credit recentl y propose d b y th e bipartisa n Nationa l Commissio n o n Children.35 Congres s coul d star t b y makin g th e $500-per-chil d ta x credit in the House-passed tax bill refundable.36 A portion of the needed revenue could come from the current earned income credit. A second alternative would be to replace the current earned incom e credit wit h a ta x benefi t tha t reache s low-incom e worker s throug h their employers. 37 Fo r example, a tax credit coul d b e provided t o th e employers of low-wage workers. Again, economic theory suggests that the benefits o f such an employer tax credit would pass through t o th e low-wage workers in the form of relatively higher wages. Consequently,

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an employe r ta x credi t coul d en d u p helpin g mos t o f th e sam e low income workers targeted b y the curren t earne d incom e credit . Yet, an employer ta x credi t woul d b e significantl y easie r t o administe r tha n the curren t earne d incom e credit , i f onl y because ther e ar e fa r fewe r employers than low-income workers. Another approac h woul d b e t o combin e th e earne d incom e credi t with other welfare programs such as food stamps , Aid to Families with Dependent Childre n (AFDC) , an d Supplementa l Securit y Incom e (SSI).38 The multiplicity of these federal welfare programs has resulted in complexity , inequity , an d hig h administrativ e costs . Consequently , it migh t mak e sens e t o combin e th e earne d incom e credi t an d othe r federal welfar e program s int o a single , comprehensiv e progra m tha t could be administered by a single agency. That agency might even turn out t o b e th e IRS , although th e Departmen t o f Healt h an d Huma n Services o r th e Socia l Securit y Administration migh t b e mor e appro priate. Alternatively , th e revenue s no w use d fo r th e earne d incom e credit could be bundled together with the appropriations for other welfare programs and revenue-shared ou t to state welfare agencies. In any event the administrative savings that would result from combinin g the earned income credit with other welfare program s could be passed o n to beneficiaries in the form of higher benefits. Create a $500-per-year Exclusion for Interest, Dividends, Gains, and other Miscellaneous Items of Income. Another wa y to simplif y incom e tax return s fo r low-incom e individual s woul d b e to ad d a n exclusio n for some modest amount of noncompensation income . It just does not make sens e t o requir e million s o f individual s t o repor t negligibl e amounts of interest, dividends, gains, state tax refunds, and other miscellaneous items of income and then make the IRS dispute returns that miss a few dollars of such income. One option would be to let taxpayers exclude from gros s income u p t o $50 0 per year o f interest, dividends, gains, state tax refunds, and other miscellaneous items of income. The benefits of such an exclusion could result in a windfall to those middleand high-income taxpayers who are more likely to have such miscellaneous item s o f income , bu t mino r tinkerin g wit h th e rat e structur e could easily recapture the lost revenue. Classify More Workers as Employees Rather Than as Independent Contractors. Low-incom e workers face several problems because of the federal ta x distinction betwee n employees and independent contractors.

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At the outset, some low-income workers may have difficulty i n properly determining whether they are employees or independent contractor s for ta x purposes. Many analysts have offered recommendation s abou t how to clarif y IR S worker classificatio n rules ; such clarificatio n coul d help simplif y th e ta x syste m fo r low-incom e individuals , employers , and the IRS. But being classifie d a s an independen t contracto r cause s two far more significant problem s for low-income workers. First, lowincome independen t contractor s (e.g. , taxi drivers) ofte n fin d i t diffi cult to save enough mone y during th e year to mee t thei r incom e an d Social Security taxes the following April 15 . Second, the tax returns of low-income independent contractors are generally far more complicated than those of low-income employees (e.g. , they must file IRS Form 1040 and Schedules C and SE). One solution would be to change the IRS worker classification rule s so that virtually all low-income workers are classified as employees. That would make their compensation subject to the ordinary wage withholding rules . The y woul d the n avoi d th e financial hardshi p tha t ofte n results from th e absence of withholding, and they would be able to file relatively simpler ta x returns a s employees. Another alternativ e woul d be t o requir e tha t taxe s b e withhel d fro m payment s t o low-incom e workers wh o ac t a s independen t contractors. 39 Althoug h low-incom e independent contractor s woul d stil l have to file relatively complicate d returns, at least they would avoid the financial hardship that can result from underwithholding . Simplify Definitions. Low-income individuals can also have difficul ty determining the number of dependents they can claim and whether those dependents are qualifying individual s for head of household sta tus, surviving spouse status, the earned income credit, and the depen dent car e credit. Many analysts have therefore recommende d simple r definitions o f suc h term s a s child and dependent 40 Thes e individual s may find the filing status terms perplexing. A person must first determine her marital status. Only then can she determine which of five filing statuses is applicable: married filing jointly; married filing separately; survivin g spouse ; hea d o f household ; o r single . Muc h o f th e complexity i n th e individua l incom e ta x coul d b e eliminate d i f thes e determinations wer e simplified . Stil l mor e simplificatio n coul d b e achieved b y havin g eac h individual , marrie d o r unmarried , wit h o r without children, fileas an individual under a single tax rate schedule.41

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Fundamentally Revamp the Current System Integrate the Income and Social Security Taxes into a Comprehensive Income Tax, A more fundamenta l refor m woul d involv e bette r inte grating the income and Social Security taxes. As previously mentioned, one approach would be to allow each worker to exempt the first $5,00 0 or $10,000 of earnings from Socia l Security taxes. Another would be to add standard deductions and personal exemptions to the current Social Security tax system. An even more substantial reform woul d be to combine the individ ual incom e an d Socia l Securit y taxe s int o a single , comprehensiv e income tax. 42 Individuals with incomes below some poverty threshold would be exempt from tax , and tax rates could be increased in order to raise th e sam e amoun t o f revenue . In effec t ther e woul d b e a single, higher-yield incom e ta x instea d o f th e curren t bifurcate d ta x system , and million s o f low-incom e individual s woul d n o longe r hav e t o fil e returns. Fo r example , an integrate d ta x syste m migh t b e designe d t o impose no tax on income below some poverty threshold, a 25 percent tax rate on income from that threshold up to $100,000 of income, and a 40 percent tax rate on income over $100,000. Move to a Flat Tax. Another alternativ e woul d b e t o replac e th e current incom e ta x with som e for m o f fla t tax. 43 Th e underlyin g ta x base could be either incom e o r consumption . The key is that abov e a certain threshold, a single tax rate would apply . To keep the single rate low, mos t fla t ta x plan s woul d ge t ri d o f many , i f no t all , itemize d deductions. For example , Rep . Richard K . Armey (R-Texas ) recentl y propose d replacing the current income and Social Security taxes with a flat tax on earned income. 44 Under his proposal a taxpayer would total her earned income, subtract a large personal allowance, plus a deduction fo r eac h child, and then pay a flat 1 7 percent rate on the remainder. Proponents of flat taxe s are fond o f saying that mos t individual s would be able to file their tax returns on a postcard. Move to a Return-Free System. A return-free ta x syste m woul d b e another possibility. 45 Unde r th e return-fre e ta x syste m envisione d b y the IRS , most For m 1040E Z an d For m 1040 A filer s an d a few For m 1040 filers, some fifty-five millio n taxpayer s in all , could elec t to have the IRS compute their tax liabilities and prepare their returns. Starting

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in January of each year, a taxpayer would initiate the process by submitting a signe d postcar d containin g th e basi c informatio n neede d t o process a return (suc h as name, address, Social Security number, filin g status, and number o f dependents). The IRS would then prepare a tax return base d o n informatio n an d withholdin g report s receive d fro m employers and other taxpayer income sources. Starting in early March, the IRS would begin mailing returns to taxpayers, along with a refun d or a bill . I f th e taxpaye r disagree d wit h th e amount s show n o n th e return, h e coul d retur n i t t o th e IR S fo r adjustment . Al l taxpayer s would remain responsible for the validity of their returns. For a variety of reasons, the IRS concluded that it was not feasible to implement thi s return-free system . In truth th e IRS system would no t really b e return-free ; rather , a t a taxpayer' s election , th e burde n o f preparing th e retur n woul d shif t fro m th e taxpaye r t o th e IRS . Taxpayers would save some time filing their returns (te n minutes for a 1040EZ filer and thirty minutes for a 1040 filer), but many would have to wai t longe r t o ge t thei r refunds . Also, the progra m woul d increas e the burdens on the IRS and on employers and other filers of informa tion documents. To generate tax returns, the IRS would need to receive timely, verify, and post 970 million wage and information documents . The IRS estimated that it would cost over $1 billion and require about 17,000 additional staf f t o implement th e program. Moreover, the program woul d burde n employer s an d othe r payers ; they would hav e t o file their informatio n return s with th e IRS by January 31 , rather tha n February 28. With ever-expanding IRS computer capabilities, it may become fea sible for the IRS to move to a return-free syste m in the future, and fur ther consideration is merited. The return-free ta x system envisioned by the IRS, however, would increase the agency's work load just when the goal should be to reduce the number of tax returns processed. Move to a Final Withholding System. An eve n mor e fundamenta l change would b e to move to a so-called final withholding ta x system. Final withholding tax systems are similar to return-free systems , except that they rely more heavily on withholding. 46 Under a final withholding system , th e amoun t withhel d b y employer s an d othe r incom e sources is the tax, thus eliminating the need for man y taxpayers to file tax returns. More than thirty foreign countrie s use some form o f final withholding, including Great Britain, Japan, Germany, and Argentina.

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In Great Britain the income tax is withheld by employers under th e British Pa y a s You Ear n (PAYE ) final withholdin g system . Whe n a n individual firs t become s potentiall y subjec t t o tax , a n initia l retur n must b e filed s o tha t th e Inlan d Revenu e ca n determin e ho w muc h the employe r shoul d withhold . Thereafter , individual s wit h simpl e incomes an d modes t earning s ar e normall y require d t o file a retur n only abou t onc e ever y five years . I n 1991 , for example , mor e tha n twenty-three millio n o f th e twenty-si x millio n taxpayer s eligibl e fo r PAYE did not file tax returns. Would a final withholding system work in the United States? A final withholding system could significantly reduce burdens on both taxpayers an d th e IRS . In it s analysi s o f th e issue , the Genera l Accountin g Office conclude d tha t mos t taxpayer s wh o no w file 1040E Z return s (about ninetee n millio n i n 1994 ) an d man y o f thos e wh o no w file 1040A returns (about twenty-three million in 1994 ) could be served by a final withholdin g system. 47 Mos t o f thes e peopl e woul d n o longe r have to gather information , becom e familiar wit h ta x laws, or prepar e and file returns. The burden on the IRS would also be greatly reduced. Millions o f low-incom e American s hav e n o ne t federa l ta x liabilities , yet the y ar e require d t o file income ta x return s t o recove r refund s o f their overwithhel d taxes . Millions mor e hav e to kee p record s an d file unnecessarily complicated tax returns to pay relatively little federal tax. I have proposed a number of ways to restructure the federal tax system to help low-income taxpayers and the IRS. In many ways the federal ta x system is at a crossroads. Will it move toward having virtually every individual file a tax return, or will it move in th e opposite directio n an d reduc e th e numbe r o f individual s wh o must file returns ? O n th e on e hand , th e repeate d expansio n o f th e earned incom e credi t ha s oblige d mor e an d mor e individual s t o file returns, if onl y to collec t thei r earne d incom e credi t refunds . O n th e other hand , technological changes , such a s information reportin g an d electronic filing, could enable the federal tax system to move away from having so many individuals file returns. But whichever direction the tax system goes next, there will be opportunities to simplify the system fo r low-income taxpayer s an d fo r th e IRS . I t i s m y hop e tha t th e nex t round of tax reform will seize those opportunities.

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NOTES This essay is adapted from Jonatha n B. Forman, Simplification for Low Income Taxpayers: Some Options, 57 Ohio St. L. J. 145 (1996) and from Jonathan B. Forman, How to Reduce the Compliance Burden of the Earned Income Credit on Low-Income Workers and on the Internal Revenue Service, 48 Okla.L.Rev.63(1995). 1. U.S. Dep't of Commerce, Economics and Statistics Admin., Bureau of the Census, Statistical Abstract of the United States 1994: The National Data Book 475 (1994). 2. See, e.g., Rev. Proc. 95-53,1995-52 I.R.B. 22. 3. Internal Revenue Serv., Selected Historical and Other Data, 14 Stat. Inc. Bull. 139, 189 (Fall 1994). 4. Internal Revenue Serv., Selected Historical and Other Data, 15 Stat. Inc. Bull. 141, 202 (Fall 1995). 5. Author's computations are based on data found id. at 144. 6. Staf f o f th e Hous e Comm . o n Way s an d Means , 103 d Cong. , 2 d Sess. , Overvie w o f Entitlement Programs : 1994 Green Book: Background Material and Data on Programs within the Jurisdiction o f the Committe e o n Ways and Mean s 70 7 (Comm. Print 1994 ) [hereinafte r Gree n Book]. 7. Id. at 702-4. 8. U.S. Dep't of Health & Human Serv. , Social Sec. Admin., 199 6 Cost-of-Living Increas e and Other Determinations, 60 Fed. Reg. 54,751,54,753-54 (1995). 9. Green Book, supra note 6, at 80. 10. U.S. Dep't of Health & Human Serv., Office o f the Secretary, Annual Update of the Poverty Income Guidelines, 60 Fed. Reg. 7772 (1995). 11. See Jonathan B . Forman, Simplification for Low Income Taxpayers: Some Options, 57 Ohio St. L.J. 145,153(1996). 12. Cf. note 10. 13. Because her $12,590 poverty-level income is below her $13,250 simple income tax threshold, sh e has n o preliminar y federa l incom e ta x liability . She owes $96 3 in Socia l Securit y taxe s ($963 = 7.65 % x $12,590) , but he r $2,84 7 earne d incom e credi t mor e tha n offset s he r Socia l Security tax liability ($2,847 = $3,110 - .2022 [$12,590 - $11,290]). Consequently, she will get a net refund o f $1,884 (-$1,884 = $963 - $2,847). 14. See Forman, Simplification for Low Income Taxpayers, supra note 11 , at 157. 15. Hearings Before the Senate Comm. on Finance, 104t h Cong., 1s t Sess. 6-31 (1995 ) [here inafter 199 5 Finance Comm. Hearings] (statemen t of Margaret Milner Richardson, Commissioner of Internal Revenue) [hereinafte r Richardso n Statement]. 16. Internal Revenue Serv, supra note 4, at 197-98. 17. Mat 144 . 18. Mat 217 . 19. U.S. Gen. Accounting Office , Earne d Income Credit : Targetin g t o th e Working Poo r 3 1 (1995). 20. See Tax Div. of the Am. Inst, of Certifie d Pub . Accountants, Blueprint fo r Simplificatio n (1992); Federal Income Tax Simplification (Charle s H. Gustafson ed. , 1979). 21. U.S. Gen. Accounting Office, Internal Revenue Service: Opportunities to Reduce Taxpayer Burdens through Return-Free Filing 37 (1992). 22. Internal Revenue Serv, supra note 4, at 217.

SIMPLIFICATION FO R LOW-INCOM E TAXPAYER S 2 9

23. See Rita L. Zeidner, TSM: How the Service Plans to Move into the 21st Century, 63 Tax Notes 1239,1241 (1994). 24. Ryan J. Donmoyer, IRS Plans to Take Cyberplunge, Allow Returns Filing Via Internet, 68 Tax Notes 1534 (1995). 25. U.S . Office o f Managemen t & Budget, OM B Circula r No . A-76 (Rev.) , Performanc e o f Commercial Activities, 48 Fed. Reg. 37,110 (1983). 26. See Richardson Statement, supra note 15 ; John Karl Scholz, The Earned Income Tax Credit: Participation, Compliance, and Antipoverty Effectiveness, 47 Nat'l Tax J. 63 (1994); George K. Yin et al., Improving the Delivery of Benefits to the Working Poor: Proposals to Reform the Earned Income Credit Program, 11 Am. J. Tax Pol'y 225 (1994). 27. See 1995 Finance Comm. Hearings, supra note 15 , at 35-37 (statemen t of Lynda D. Willis, Associate Director, Tax Policy and Administration Issues , GAO). 28. U.S. Gen. Accounting Office, Earne d Income Tax Credit: Advance Payment Optio n i s Not Widely Known or Understood by the Public 3 (1992). 29. Yin, supra note 26, at 274-75. 30. See Regina T. Jefferson, The Earned Income Tax Credit: Thou Goest Whither? A Critique of Existing Proposals to Reform the Earned Income Credit, 6 8 Temple L . Rev. 143 (1995); Yin, supra note 26, at 279-94. 31. See Yin, supra note 26, at 280-86. 32. Staff of Joint Comm. on Taxation, 104th Cong., 1st Sess., Present Law Issues Relating to the Earned Income Credit 1 9 (Comm. Print 1995) . 33. See, e.g., Nanc y J . Altman, The Reconciliation of Retirement Security and Tax Policies: A Response to Professor Graetz, 136 U. Pa. L. Rev. 1419,1432-34 (1988). 34. Yin, supra note 26, at 280-82. 35. U.S. Nat'l Comm'n o n Children, Beyond Rhetoric: A New American Agenda for Children and Familie s 80-8 8 (1991) ; Jonatha n B . Forman , Beyond President Bush's Child Tax Credit Proposal: Towards a Comprehensive System of Tax Credits to Help Low-Income Families with Children, 38 Emory L.J. 661 (1989). 36. H.R. 1215 , 104th Cong. , 1s t Sess . § 10 1 (1995) (Ta x Fairnes s an d Defici t Reductio n Ac t of 1995). 37. See Yin, supra note 26, at 286-94. 38. See Forman, Simplification for Low Income Taxpayers, supra note 11 , at 186 ; Jonathan B . Forman, How to Reduce the Compliance Burden of the Earned Income Credit on Low-Income Workers and on the Internal Revenue Service, 48 Okla. L. Rev. 63,73 (1995). 39. See U.S . Gen . Accountin g Office , Ta x Administration : Approache s fo r Improvin g Independent Contractor Compliance 4-5 (1992). 40. See, e.g., Deborah H . Schenk , Simplification for Individual Taxpayers: Problems and Proposals, 45 Tax L. Rev. 121 (1989). 41. SeeMarjorie E . Kornhauser, Love, Money, and the IRS: Family, Income Sharing, and the Joint Return, 45 Hastings L.J. 63 (1993); Edward J. McCaffery, Taxation and the Family: A Fresh Look at Behavioral Gender Biases in the Code, 40 UCLA L. Rev. 983 (1993) ; Lawrence Zelenak, Marriage and the Income Tax, 67 S. Cal. L. Rev. 339,342 (1994). 42. See Jonathan B . Forman, Promoting Fairness in the Social Security Retirement Program: Partial Integration and a Credit for Dual-Earner Couples, 4 5 Ta x Law . 91 5 (1992) ; Josep h A . Pechman et al., Social Security: Perspectives for Reform passim (1968). 43. See Robert E. Hall & Alvin Rabushka, The Flat Tax (2d ed. 1995).

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44. H.R. 2060, 104th Cong., 1st Sess. (1995); see also The National Comm'n. on Econ. Growth and Ta x Reform, Unleashin g America's Potential: A Pro-Growth, Pro-Famil y Tax System fo r th e 21st Century (1996), reprinted in 70 Tax Notes 413 (1996). 45. See Internal Revenu e Serv., Current Feasibilit y of a Return-Free Ta x System (1987) ; U.S. Gen. Accounting Office, supra note 21. 46. See U.S. Gen. Accounting Office, supra note 21, at 22-23. 47. Id. at 25; Internal Revenue Serv., supra note 3, at 139,189.

13 G E O R G E K . YI N

The Uncertain Fate of the Earned Income Tax Credit Program

A largely unknown elemen t o f the federal safet y net for man y years, the earned incom e tax credit (EITC ) program ha s suddenly burs t ont o th e scen e a s a highl y controversia l par t o f th e nation's tax and transfer systems . Rarely a day goes by without the president, a leader in Congress, or some other important national figure or group voicing objection to or support for one or more possible changes to the program. The partisan divisio n regarding the program seem s as stark an d unyieldin g a s that concernin g Medicare , Medicaid, or othe r major aspect s of the federal budget. In this essay I discuss the evolution of the EITC program, how it came to be so controversial, and why current "reform" efforts, though perhaps well-intentioned, are largely misguided. Instead, I prescribe a major overhau l of the program i n which the bulk of its benefits ar e delivered through the transfer syste m rather than the tax system. O R I G I N S O F T H E EARNE D I N C O M E TA X CREDIT PROGRA M

The EITC program provide s cas h assistanc e t o certai n low-incom e workers.1 A s originall y enacte d i n 1975 , the progra m wa s primaril y 297

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designed to relieve eligible beneficiaries of their obligation to pay Social Security taxes.2 Congress decided that workers should not be taxed into poverty. But instead of simply exempting low-income workers from the payment o f Socia l Securit y taxes , which (unlik e th e incom e tax ) ar e imposed o n th e firs t dolla r earned , Congres s create d a small transfe r program, administere d b y the incom e ta x system , to reimburs e thos e workers fo r th e taxe s paid . Lik e a negativ e incom e tax , the progra m provided a cash benefit, equivalen t to a negative tax, to eligible recipients. Unlik e a negativ e incom e tax , however , bein g poo r wa s no t enough to entitle one to the benefit; the recipient also had to be working and have requisite family responsibilities. From th e beginnin g th e progra m enjoye d widespread , bipartisa n support.3 B y providing incom e assistanc e t o low-income families with children, but onl y i f heade d b y on e o r mor e workers, the progra m offered a strong appea l t o liberal s an d conservative s alike . Also, like a negative incom e tax , the progra m hel d ou t th e possibilit y o f bein g a highly efficien t transfe r mechanism . Governmen t benefit s coul d b e delivered to eligibl e recipients without th e administrative burde n an d cost o f a n elaborat e bureaucracy. 4 Th e incom e ta x system coul d pro vide "one-sto p shopping" : i n on e transaction , taxpayer s coul d bot h settle u p thei r ta x obligation s wit h th e governmen t an d receiv e fro m it any net benefits to which they might be entitled. 5 During its first ten years the program remained quite small and was not closel y scrutinized . Nevertheless , ther e wer e early , inconclusiv e indications of potential problems with it. For the most part the difficul ties were attributable to the incongruity of having a government transfer progra m fo r th e poo r administere d b y th e ta x system . Here , it i s important t o understan d ho w the tax system i s able to functio n wit h relatively lo w administrativ e cost s t o th e government : th e syste m achieves tha t outcom e b y shiftin g muc h o f th e burde n o f suc h cost s onto taxpayers and the private sector. The self-assessment system forces taxpayers to determine thei r ow n tax liabilities and t o file appropriate reports of their liabilities with the government in the form of annual tax returns. Taxpayers spend tens and hundreds of hours each year, as well as hundred s an d thousand s o f dollars , "voluntarily" complyin g wit h their self-assessmen t obligations . The governmen t the n spend s just a small fraction o f that cost overseeing and reviewing the efforts under -

THE FAT E O F TH E EARNE D INCOM E TA X CREDI T 2 9

taken b y taxpayer s t o insur e th e accurac y an d completenes s o f th e reports.6 For man y workin g Americans , ta x withholdin g an d informatio n reporting reliev e muc h o f th e burde n o f th e ta x system. Withholding insures that taxe s are paid i n a timely and relativel y effortless fashion , and informatio n reporting , typicall y supplie d b y th e taxpayer' s employer, facilitates muc h o f the res t o f the task. Thus, for man y taxpayers, the burden o f voluntary complianc e i s fairly modes t i n term s of bot h tim e an d money . O f course , for thos e taxpayer s wit h sizabl e amounts o f capital income and mor e complicated economi c lives, the burden is considerably heavier. Yet those same taxpayers, either because of their more favorable economic circumstances or their greater famil iarity wit h ta x arcana , ma y b e mor e abl e t o bea r tha t adde d cost . I n short, just as the income tax is a levy on one's "ability to pay," the voluntary compliance syste m migh t b e thought o f a s largely a tax on one' s "ability to comply." These broad generalization s ge t turned o n thei r hea d when th e tax system also tries to administer a government transfe r progra m fo r th e poor. To obtain a government benefit throug h the tax system, a beneficiary must likewis e incu r th e "voluntary compliance " expense o f tha t system: the beneficiary must first be aware of the existence of the benefit and his or her potential eligibility for it and then must maintain th e necessary records and understand and complete the necessary forms in order t o obtai n it . Furthermore, th e burden canno t easil y be reduce d through withholdin g o r informatio n reporting. 7 A s a consequence, a sizable portion of the administrative cost relating to the EITC program falls on the beneficiary o f the program, who may have neither the economic resource s nor th e educational backgroun d t o bear tha t burde n without considerabl e difficulty . Moreover , man y beneficiarie s woul d not need to deal with the tax system at all but for the EITC, thus mak ing a mockery o f th e notio n o f "one-stop shopping." 8 Finally , implementing a transfer program through the tax system produces one other quirky outcome: the concept of "self-assessment" becomes instead on e of "self-certification." Individual s certif y themselve s a s eligible fo r th e government benefit an d obtain it without having to encounter any person face to face. As might be expected from the foregoing description of the program,

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there were early indications (base d o n limited availabl e data) o f problems in making eligible beneficiaries awar e of the program an d gettin g them to participate i n it. 9 In addition, the rate of erroneous claim s on the part o f thos e who di d participat e seeme d unacceptabl y high. 10 As indicated below, these and other areas of concern became more prominent as the program experienced a dramatic increase in growth. GROWTH O F T H E PROGRA M ( 1 9 8 6 - 9 6 )

Congress approved three major expansion s of the EITC program i n 1986,1990, and 1993 , with the last expansion phased in over the period 1994 through 1996 . The change s increase d th e siz e an d scop e o f th e program i n five principal ways. First, Congress raised substantially the level of benefits availabl e from th e program—to a maximum amoun t of $3,556 expected in 1996 11 —so that for many beneficiaries th e EITC represents muc h mor e tha n mer e relie f fro m th e paymen t o f Socia l Security taxes. Second, Congress extended eligibility for the program to families with greater amounts of income. If the 199 3 changes are full y implemented, families with incomes of up to $11,610 will be eligible to receive full benefits , an d thos e with income s o f u p t o $28,49 5 will be eligible t o receiv e som e benefi t i n 1996. 12 Third , Congres s provide d increased benefit s t o EIT C claimant s wit h responsibilit y fo r tw o o r more qualifyin g children . Fourth , i t permitte d certai n childles s low income workers to receive a small EITC benefit calculate d t o equal an exact rebate of their Social Security taxes. Finally, it indexed all eligibility amounts to keep them up with inflation . Table 13. 1 provide s som e indicatio n o f th e overal l effec t o f thes e expansions by comparing the growth i n total federal expenditure s fo r the major means-tested , income-support program s between 198 6 and 1996, assuming th e 199 3 EITC changes ar e fully phase d in . The tabl e indicates that sinc e 198 6 the EITC program ha s grown fa r faste r tha n all o f th e othe r majo r means-tested , income-suppor t programs , with the nominal growth in the EITC program between 198 6 and 199 6 projected to be more than ly000percent Accordin g to these figures, by 1996 federal spending for the EITC program will be over $25 billion per year, or more than one and one-half times as much as the federal share of the AFDC program.13 There are a number o f reasons for thi s phenomenal rat e of growth.

THE FAT E O F TH E EARNE D INCOM E TA X CREDI T 3

Table 13.1 GROWT H IN FEDERAL EXPENDITURES FOR MEANSTESTED, INCOME-SUPPORT PROGRAMS, 1986-96 TOTAL FEDERAL EXPENDITURES AND GROWTH RATES Program

1986 spending

1993 spending

1986-93 increase

1996 spending (proj.)

1986-96 increase (proj.)

EITC

2.0

13.2

560%

25.1

1,155%

SSI

9.5

20.3

114%

27.0

184%

12.5

24.8

98%

n/a

n/a

9.2

13.8

50%

14.8

61%

food stamp s AFDC

Source: U.S. House Comm . on Ways and Means , 103 d Cong., 2d Sess., Overview of Entitlemen t Programs: 1994 Green Book: Background Materia l and Data on Programs within the Jurisdiction of the Committee on Ways and Means 262 (table 6-25), 389 (table 10-21) , 704 (table 16-13) , 782 (table 18-11) (Comm. Print 1994) . All spending figures are in billions of nominal dollars.

Certainly, th e cor e attribute s o f th e EIT C program—it s assistanc e directed towar d th e poo r wh o wor k an d wh o hav e youn g childre n living i n th e home—continue d t o b e extremel y appealin g t o a broad range of legislators. In addition Congress determined that other, related objectives coul d be served by the EITC program. For example, during the late 1980 s there was considerable interest in developing a new federal subsidy for child care expenses, including the costs of health insurance fo r children . Rathe r tha n creat e on e o r mor e ne w federa l pro grams, Congres s an d th e Bus h Administratio n eventuall y channele d this interest into an expansion of the EITC program.14 But th e growt h o f th e progra m durin g thi s perio d canno t b e explained merel y on the basis of its desirable programmatic elements . After all , the 1986-9 6 perio d wa s marke d b y continue d hug e federa l budget deficit s eac h year , with persisten t effort s t o curtai l th e rat e o f federal spendin g o n al l sort s o f potentiall y worthwhil e programs . Instead, tw o budge t polic y feature s o f th e EIT C progra m n o doub t enhanced its attractiveness to policymakers. One feature concern s how the cost of the EITC program is "scored" for budget accounting purposes. In both 198 6 and 199 0 the cost of the increases to the program were treated a s revenue reductions for budge t purposes.15 This characterization applied not only to the portion of the program that in fact reduced taxes otherwise owed by program benefi ciaries, but als o to that portio n representin g a n actual outlay of fund s by the government. In other words , increasing the size and scope of the

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EITC program was treated for budget purposes as a tax cut, not an increase in spending. Durin g a period when "no new taxes" was practically a mantra for certain of our nation's leaders, with tax cuts therefore being viewed i n a positive ligh t an d spendin g increase s i n a negativ e one, this characterization gave the EITC program a critical, competitive advantage over other direct spending programs for the poor. Of course , th e sam e characterizatio n ca n hav e th e opposit e effec t where the objective is to restrain the growth in the program instea d of continuing it s rapid expansion . Such an effor t coul d b e characterize d by its opponent s a s a tax increas e rathe r tha n a n attemp t t o contro l federal spending . Sadly , we hav e see n exactl y tha t leve l o f rhetorica l debate i n recen t times . Those seekin g to cur b growt h i n th e progra m have emphasize d ho w the y ar e "controlling spending, " whereas thos e opposed t o suc h move s hav e labele d the m a s "ta x increase s o n th e working poor." 16 Of greater importance than the budget scoring issue is the treatment of EITC program changes in estimating the distributional effect of government actions . Here, one needs to recall the importance policymak ers hav e place d o f lat e o n th e distributiona l impac t o f ta x changes : whether the y disproportionatel y benefi t o r disadvantag e certai n income classes. Proponents of the Tax Reform Act of 1986, for example, included a pledg e t o maintai n distributiona l neutrality : t o enac t changes tha t woul d continu e th e sam e relativ e ta x burden acros s th e entire incom e spectrum. 17 Th e same issue arose prominently i n 199 3 when the Clinton Administration offere d a s one of its tax proposals a broad-based consumptio n ta x on energy. At that time the Administration sought out progressive proposals to offset th e regressive impact of the proposed energy tax on lower- and middle-class Americans.18 In general , official distributiona l analyse s utilized b y lawmakers d o not tak e account o f th e distributiona l impac t o f governmen t transfe r programs.19 For example, enactment of a tax on the beneficiaries of the Head Star t progra m t o pa y fo r a n expansio n o f tha t progra m woul d have a neutral distributional impact because there would be no shift of the benefits an d burdens of government actio n from on e income class to another. Yet, under curren t policies the changes would be treated as regressive becaus e th e distributiona l effec t o f th e expansio n o f th e Head Star t progra m woul d b e disregarded . Rather , al l tha t woul d b e

THE FAT E O F TH E EARNE D INCOM E TA X CREDI T 3 0

counted for distributional purposes would be the tax on the Head Start beneficiaries, a regressive change if viewed in isolation. Although distributiona l analyse s generall y disregar d th e effect s o f government transfe r programs , th e EIT C progra m i s a n importan t exception. Changes to the EITC program, apparently because it is part of th e "tax " system, are taken int o accoun t i n makin g distributiona l estimates.20 In other words, if the tax on Head Start beneficiaries wer e used to pay for an expansion of the EITC program, the changes would be treated for budget purposes as distributionally neutral. Similarly, in contrast t o a n increas e in , say , th e foo d stam p progra m o r AFDC , expansion of the EITC program in 1993 served as a progressive offset to the Administration' s regressiv e energ y ta x proposal . Littl e wonder , then, tha t th e EIT C progra m ha s increase d s o muc h mor e tha n th e other two . Indeed, this budget polic y characteristi c o f th e EIT C pro gram was perhaps the single most important reason that federal spend ing patterns for the poor have tilted so far in its favor in recent years.

C O M P L E X I T Y , P A R T I C I P A T I O N , AN D C O M P L I A N C E

As the size and the scope of the EITC program have increased, so too have its problems. One problem is complexity, the bane of any program but particularl y a progra m lik e th e EIT C i n whic h th e burde n o f administration fall s on beneficiaries with relatively low levels of forma l education an d familiarit y wit h applicabl e rules . Complexit y i n tha t type of program tends to deter participation and invite errors. Compared with many aspects of the tax system, the EITC program is not that complicated . But surely that i s not th e right comparison . The fact that the EITC is implemented through a simplified Rub e Goldberg scheme is of no solac e to those who find an y such schem e a complete puzzle. A better indicatio n o f complexit y i s the lengt h o f instructio n booklets (thirty-tw o page s i n recen t years) , th e clarit y o f expressio n contained i n those booklets, and the number an d length of forms an d worksheets tha t mus t b e gathere d an d complete d i n orde r t o fil e a proper claim. Based on those factors, most observer s would agre e that the EITC program is unacceptably complex. 21 True, many beneficiarie s probably obtai n professiona l assistanc e i n preparin g an d filin g thei r

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claims, but the cost of that help reduces the net benefit provide d to the beneficiary by the program.22 It also interferes with the work incentive effect o f the program, as described shortly. There are many reasons why the program has become so complicated, but th e tw o mos t importan t ar e probably th e desir e fo r targetin g and the presence of the program i n the tax system. Targeting involve s the creatio n o f eligibilit y condition s t o insur e tha t onl y "deserving " claimants are entitled to the benefit. The more precise the definition o f who is deserving, the more complicated the rule structure for all participants. Implementation o f the EITC program throug h th e tax system means that the program's rules need to mesh to some extent with existing tax rules.23 Yet tax law is not the paradigm of simplicity. If one can imagine an irregular , multisided figur e needin g to fi t int o a hole with many highly irregular sides and crevices, one can get a little feel for the difficulty o f the task. To illustrat e th e problem , conside r first th e conditio n tha t EIT C recipients mus t hav e th e requisit e famil y responsibilities , generall y intended b y Congres s t o mea n responsibilit y fo r a mino r child . Bu t what do responsibility and minor child mean? For example, does responsibility refer t o daily care and nurturing , monetary support , o r some thing else altogether? Would a child over the age of majority qualif y if disabled or a student? Does the child have to have a certain relationshi p with the EITC claimant and if so, what relationship? Assuming appropriate definitions ca n be developed, who should be treated a s meetin g th e conditio n whe n tw o o r mor e person s hav e responsibility for the same child or children? Here, the tax laws help a bit by generally treating a married coupl e as one person. Thus, a married coupl e (actin g as a single EITC claimant) o r a single person wit h responsibility for a minor child both meet the condition.24 But suppose the person s wit h share d responsibilit y ar e no t married ? Example s o f such arrangements include an intergenerational household (fo r exam ple, a grandmother, a mother, an d a child livin g together), two adul t sisters with responsibility for the child of one of them, or an unmarried couple living with their children. If those with shared responsibility in each o f thes e example s ar e al l treated a s meeting th e condition , the n unless some type of formula i s mandated for splitting the EITC, two or more benefits might be awarded for the same child or children, a result not intended by Congress.

THE FAT E O F TH E EARNE D INCOM E TA X CREDI T 3 0

Early on, Congress defined th e EITC family responsibility condition in term s o f th e ta x filing status o f th e claimant : t o b e eligibl e fo r th e EITC, a claimant ha d to qualify eithe r as a "surviving spouse," a "head of household," or a married coupl e with a child wh o i s a tax "dependent" of the couple.25 These categories were chosen because they establish the meaning of family responsibility for other , related purposes in the ta x system . The y als o provid e "tiebreaker " rule s i n th e even t o f shared responsibility. Finally, the categories were selected because they were familia r one s i n th e ta x syste m an d therefor e wer e though t t o facilitate the filing task of the claimant and the review responsibility of the Internal Revenue Service (IRS). Problems with these categories soon became evident. For one thing, they meant that EITC claimants had to satisfy different family responsibility conditions depending upon th e nature of the family unit. A single-parent claimant, for example, was required to provide over half the costs of maintaining the household i n which the child resided (on e of the requirement s fo r "hea d o f household " status) , whereas a marrie d claimant ha d t o meet othe r criteria , including providing ove r half th e support o f the child (on e o f the tests for a tax dependent). 26 I n addi tion, th e condition s themselve s prove d t o b e quit e cumbersom e i n application. For example, "support" provided b y the claimant di d no t include welfare benefit s o r chil d support, 27 s o that a n EIT C claiman t caring fo r a child wit h to o muc h o f eithe r o f thos e source s o f fund s unwittingly becam e ineligibl e fo r th e credit . Fo r thes e an d othe r rea sons, erroneous claims were commonplace.28 Congress responded to these problems by adopting a uniform defin ition of family responsibility: a claimant must have a child of a certain age and relationship who resides with the claimant fo r mor e than half the year. 29 And Congres s the n specifie d additiona l tiebreake r rule s t o apply when two or more potential claimants meet that test for the same child.30 Bu t these requirement s represente d ne w ones fo r th e ta x system, adding some complexity to the claims process and making verification by the IRS more difficult. Furthermore , by focusing onl y on the presence of share d residence , they arguably mistargeted th e benefit i n favor of parents who do not provide the bulk of support for their children. In short, it is difficult t o implement a family responsibility condition, particularl y i f th e conditio n mus t confor m t o som e exten t t o existing tax rules and if the determination an d certification o f compli-

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ance with th e conditio n ar e to be undertake n b y the beneficiaries o n their own. As another example , consider th e condition tha t a n EIT C claiman t must be poor. This aspect of the EITC program would seem most easily administered by the income tax system because of that system's determination of a taxpayer's level of income. And indeed, the initial design of the EITC program calculate d benefit level s based on the amount o f income reported by the claimant for tax purposes.31 But matters di d no t sta y that simpl e for long . There ar e importan t differences betwee n th e concep t o f income use d for ta x purposes an d an economic concept of income, with many items of economic income, such as the value of certain fringe benefits, not being treated as taxable income. Congress decided early on to condition EIT C eligibility based on a broader notion o f income, not just taxable income, and therefor e required a whole host of nontaxable items to be included in the base for determining whethe r a claiman t i s poor. 32 Durin g th e pas t yea r Congress has gone even further b y implementing a form o f wealth test for EIT C eligibility 33 an d b y proposing t o ad d eve n mor e nontaxabl e items into the claimant's income base. The Balanced Budget Reconciliation Act of 199 5 expands the definition o f income for EITC purposes to includ e tax-exemp t interest , nontaxabl e Socia l Securit y benefits , nontaxable pensio n an d IR A distributions, an d certai n chil d suppor t payments, and to disregard certain losses.34 In theory, all of these modifications ma y be perfectly justified. Afte r all, poverty is an economic condition, not som e technical tax concept. The problem is that the tax system is not equipped to make those economic determinations . Mor e ofte n tha n not , i f a n ite m o f economi c income nee d no t b e include d i n taxabl e income , there i s little o r n o paper trai l o f th e ite m t o assis t th e claiman t i n filin g a proper EIT C claim an d t o help the IRS in verifying th e accuracy of the claim . As a result, th e claim s proces s become s extremel y burdensom e t o th e claimant, with resulting adverse effects on program participation levels, and there is no effective wa y to protect against errors and omissions of the claimants. 35 Th e assume d advantag e o f usin g th e ta x syste m t o administer the EITC program is lost if the program does not utilize the existing tax concepts at its disposal.36

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FRAUD

We hav e see n ho w complexit y i n th e EIT C progra m ma y b e a n important sourc e o f inadverten t claiman t error . O f course , claiman t error may also be intentional. Specifically, the self-certification featur e of the EITC program provides the opportunity fo r fraudulen t misrep resentations of one's family responsibilities, income level, and working status in order to maximize the size of benefit available. "Curbing frau d in the EITC program" is now one of the rallying cries of those in favo r of restrainin g growt h o f the program, 37 an d althoug h dat a i s limited, there does appear to be a significant frau d proble m in the program. 38 No one, of course, favors fraud , bu t shoul d frau d i n the EITC program b e an y more a concern tha n ta x fraud generally? 39 Some migh t argue i n th e affirmative , base d o n a moral an d philosophica l distinc tion between stealing someone else's money and stealing back what was originally one's own. A counter view, however, is that those who com mit fraud i n the EITC program ma y be less well off economically , and therefore somehow more sympathetic cases, than those who perpetrate tax frau d generally ; i t i s difficul t t o develo p muc h sympath y fo r th e Leona Helmsleys of the world. If the moral and philosophical element is set aside, there are still reasons for specia l concer n abou t EIT C fraud. Fo r on e thing, one sense s that the IRS may not be able to devote full effort t o tracking down erroneous $2,000 and $3,000 EITC claims, whether resulting from frau d o r not; surely the agency has bigger fish to fry tha n that . But if the EITC program is to be largely unmonitored, it would seem especially important t o design a program wel l insulated agains t possible fraud. I n tha t regard current proposals to add EITC eligibility conditions that are not part of the normal income tax system increase the program's susceptibility to frau d b y making it more likely that a fraudulent disregar d o f the law will go undetected. 40 Another reaso n t o be concerned abou t EIT C fraud involve s a relatively uniqu e featur e o f th e program : u p t o som e level , i t actuall y awards greater amounts of benefits to claimants who report higher levels of income . The program wa s designed i n thi s manne r t o enhanc e the work incentiv e fo r ver y low-income workers , a topic discusse d i n the next section . But from a fraud standpoint , i t means that ther e ar e incentives for claimants to overstate their income levels.

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The IRS is, and will be, hard pressed to deal with this type of fraud , should i t occur . Th e ta x law s an d administrativ e procedure s ar e al l designed to ferret out income understatement cases, not the reverse situation. Fo r example , informatio n reportin g create s a recor d t o hel p prevent taxpayers from fraudulentl y omittin g an item of income fro m their ta x return. But i f taxpayers voluntarily choos e t o repor t incom e amounts in excess of those reflected in their records, the IRS is ordinarily in no position to rebuff suc h assertions.41 What ca n be done to prevent EITC fraud? I f monitoring effort s ar e to b e minimal , th e answe r mus t li e i n reducin g opportunitie s an d incentives t o commi t fraud . T o reduce opportunities , th e ke y ste p i s tying eligibility conditions t o easily verifiable items . Thus, it might b e appropriate to consider only taxable wage and salary income provided by an employer a s evidence that th e claimant worked durin g the year and ma y therefor e b e eligibl e fo r th e EITC . Th e presenc e o f suc h income can be verified throug h information reportin g provided by the employer. To reduce incentives for fraud , on e coul d shrin k the size of the maximum benefit awarded . In the income overstatement situation , for example , the reportin g o f incom e carrie s with i t certai n liabilitie s such a s employment taxe s due. Hence, if the siz e of th e EIT C benefi t were tailored merel y to offset th e claimant's incom e an d employmen t tax liabilities , ther e woul d b e n o incentiv e t o overstat e incom e an d commit fraud i n the process.42

WORK I N C E N T I V E O R DISINCENTIVE ?

One major sourc e of controversy surrounding the EITC program is its labor suppl y effect. Proponent s argu e that by increasing the retur n from work , the program favor s work over leisure. Those who are currently not working, such as welfare recipients, would receive an unambiguously positive incentive from th e program to begin work.43 Others note tha t th e benefits provide d b y the progra m permi t a recipient t o achieve desired consumption levels with less work. This "income effect " of the program therefore discourage s work. Furthermore, once income levels of a beneficiary becom e high enoug h t o caus e a gradual loss of EITC benefits, additional work actually reduces the return from work. Thus, fo r thos e beneficiarie s i n th e incom e rang e wher e benefit s ar e

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level or being phased out, there is an unambiguously negative effect o n work.44 A few studie s hav e attempte d t o measur e th e impac t o f th e EIT C program on hours worked, but they have found a small, almost negligible, overall effect. 45 Needles s to say, many questions remain abou t th e program's net labor supply effect a s well as its impact o n categories of work and subpopulations. For example, what types of work are encouraged an d discourage d b y th e program : doe s i t resul t i n a n overal l increase in national product? Relatedly, how much of the work encouraged by the program i s already taking place "off the books" in order to avoid ta x an d othe r consequence s o f "on-the-books" activity? Who is being encouraged an d discourage d t o work mor e o r less? Are curren t welfare recipient s being encouraged t o work, are secondary earners of two-earner marrie d couple s bein g discourage d fro m doin g so , an d would those results be desirable from a policy standpoint? Lastly, what are the labor suppl y effects o n those who must finance the cost of the program through higher taxes?46 Some conten d tha t i t i s inappropriat e t o measur e th e valu e o f a n antipoverty progra m lik e th e EIT C o n a n efficienc y scale , suc h a s whether i t increases national product , because the program i s a redistributive one , which i s trying t o achiev e othe r goals . Under thi s view any program that shifts benefits fro m th e more to the less well-off ma y have a n advers e labor suppl y effect . Rather , th e appropriat e scop e o f comparison i s with othe r alternative s tha t attemp t t o accomplis h th e same wealth transfer. Applying that test, some argue that the EITC program has a more favorable effec t o n labor supply than d o pure welfar e or other programs for the poor. 47 But perhaps comparin g a program tie d t o work, such a s the EITC, with a program not tied to work, such as pure welfare, is also a false test. The prope r questio n i s whethe r a redistributiv e progra m linke d t o work effort shoul d be administered through the tax or transfer system . In that regard the existing program carried out by the tax system would seem to have two big strikes against it. First, despite considerable effort s to encourag e recipient s t o receiv e th e EIT C benefi t little-by-littl e i n each paycheck , a s i s permitte d unde r curren t law , almost al l curren t recipients obtai n th e benefi t jus t onc e a year, in th e for m o f a lumpsum chec k receive d a t ta x time. 48 Second , a s previousl y mentioned , many recipient s likel y utiliz e a pai d intermediary—a n incom e ta x

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return preparer—t o obtai n thei r EIT C benefit, an d th e intermediar y may wel l conve y littl e o r n o informatio n regardin g th e critica l lin k between work effort an d benefit obtained . Both of these aspects of the existing EIT C program—a once-a-yea r chec k an d th e presenc e o f a n uncommunicative intermediary—woul d see m to mute any significan t influence th e progra m migh t hav e o n th e wor k decision . Th e EIT C check from th e government migh t well be perceived a s an income tax refund, a product o f th e ta x retur n preparer' s ingenuity , o r simpl y a pure windfall, and not a reward for work and work effort. 49

IMPACT O N T H E MARRIAG E D E C I S I O N

Consider two individuals whose income levels and family responsi bilities entitle each of them to a maximum EITC benefit of over $3,000 apiece. Under curren t law , if the two individuals were to ge t married , they would not be entitled to aggregate their respective EITC awards to produce a total benefit of over $6,000. Rather, as a married couple, they would b e entitle d t o a tota l EIT C o f onl y approximatel y $1,000 . I n other words , by gettin g married , th e tw o individual s woul d suffe r a "marriage penalty" of approximately $5,000 , or mor e than 8 0 percent of their premarriage entitlement. Why woul d th e individual s suffe r suc h a los s o f benefit s i f the y decided t o ge t married ? Th e reaso n i s that a s a married couple , their pooled income s mak e the m appear les s needy , an d therefor e les s deserving of the EITC benefit. Hence , they would experienc e a reduction i n the size of their award. The existing benefit structur e could be, and perhaps should be, modified a bit to lessen the size of the marriage penalty, but a t som e poin t th e shif t i n benefit s fro m singl e head s o f households to married couple s would be unacceptable. To illustrate, if the marriag e penalt y wer e t o b e completel y eliminate d i n th e initia l example, a married couple earning twice the amount of a single head of household would have to receive not merely the same amount of EITC benefit bu t twice the size of the single person's benefit. I t is difficult t o see how a need-based progra m lik e the EITC could justify suc h a disparity in awards. The marriag e penalt y i n th e EIT C progra m i s thu s cause d b y th e choice o f househol d uni t utilize d t o determin e need. 50 Curren t la w

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treats a married couple and a single head of household exactly alike for that purpose . I f th e coupl e an d th e househol d hea d hav e th e sam e amount of income, they are treated as equally needy and entitled to the same size EITC benefit. Therefore , if two single household head s with equal amounts o f income get married, they appear fo r EIT C purposes to be twice as well off a s their individua l premarriag e situations , and therefore not entitled to receive a benefit eve n as large as either of their premarriage awards. One method for achieving marriage neutrality would be to disregard the existence of marital status in the award structure. The relevant unit for determinin g need would be the individual; the economic situatio n of th e claimant' s spouse, i f th e claiman t wer e married , woul d b e ignored. Although thi s approac h woul d eliminat e al l marriage penal ties, it would presumably not be a satisfactory solution. It would potentially allow , fo r example , a low-incom e spous e o f a millionair e t o receive the EITC.51 Most antipovert y program s mov e i n th e opposit e directio n an d broaden the definition o f the relevant unit beyond merely single heads of household an d married couples. 52 One might, for example , treat all of the members of the same household as the appropriate unit for pur poses o f determinin g need . Thus, if th e tw o individual s i n th e initia l example had been members of the same household eve n prior to their marriage to one another, their decisio n t o marry would no t affec t th e amount o f thei r EIT C award . Bot h prio r t o an d followin g marriage , they would be treated alike for EITC purposes. But this solution simply shifts th e penalty to some earlier stage in their relationship, when they were not yet sharing a household but were contemplating doing so. The decision to become members of the same household would trigger the penalty. In addition, defining "household" for this purpose would be a formidable tas k and coul d make the IRS's review function i n this area extremely intrusive.53 In summary, the EITC program creates fairly sizable marriage penalties, but they are largely unavoidable if the present general design of the program i s retained. Perhaps the one positive comment on e can make is that the decision to marry is very complex, and therefore mayb e not heavily influenced b y the existence of marriage penalties in the tax and transfer systems. 54

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T H E EIT C AN D C O N S U M P T I O N TAXE S

There seems to be greater and greater interest each day in adoptio n in this country of a broad-based consumptio n ta x to replace the existing income tax. We are told that the income tax (along with the IRS) is going to be torn out of the tax system by its roots and disposed of completely. Tha t scenari o raise s a n interestin g thought : ho w woul d th e EITC program fare in a pure consumption tax world? Not very well, one suspects. But not because the program wouldn' t be needed. Indeed, even proponents of broad-based consumption taxes advocate th e continuatio n an d expansio n o f EITC-typ e program s t o offset th e fact tha t a consumption ta x would be more regressiv e tha n the existing income tax. 55 Because the poor consume a greater proportion of their income than the wealthy, it is believed that a change fro m taxing income to taxing consumption would shift som e of the tax burden from the wealthy to the poor. The analysis is actually more complicated tha n that , but th e conclusio n i s reasonably accurat e a s a short term forecast. 56 Thus, an EITC-type program migh t be needed a s a policy tool in a consumption ta x world, but ho w would suc h a program b e designe d and implemented ? Here , we come up agains t a stark reality : although income for presen t ta x law purposes i s a number o f step s short o f th e concept of economic income, the amount o f one's consumption i s even further remove d from tha t concept. Yet, as discussed earlier, economic income is the appropriate measure for entitlemen t to a benefit suc h as the EITC ; it measure s nee d fo r th e need-base d benefit . Therefore , b y enacting a consumptio n ta x an d completel y repealin g th e existin g income tax, lawmakers would mak e it even more difficult t o ascertai n economic incom e level s an d entitlemen t t o need-base d benefits . Pu t more simply , the EIT C progra m i s designed t o hel p th e poor , but in a pure consumption tax world, one would not know who the poor would be.57 A person wh o consumes very little, and therefor e pay s very little consumption tax , ma y nevertheles s hav e ampl e amount s o f incom e and wealth and should not benefit fro m a need-based program like the EITC. But how would we know who should benefit?

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P R E S C R I P T I O N FO R C H A N G E

I hav e describe d ho w obscur e budge t accountin g policie s largel y explain the recent, phenomenal growt h of the EITC program an d why it i s now suc h a n importan t par t o f th e nation' s ta x and transfe r sys tems. With the growth and resulting increased public scrutiny, however, has come the realization tha t thi s program, trapped i n the tax system, faces ver y significan t problems . As the ETI C i s presently designed , i t will be difficult i f not impossibl e fo r th e program t o be as targeted a s Congress apparentl y desires , to maintai n hig h level s o f participatio n and compliance , to serv e as an effectiv e wor k incentive , to be neutra l toward the decision to marry, and to avoid unacceptable levels of fraud . Furthermore, th e outloo k fo r th e progra m i s no t brightene d b y th e possible switch to a broad-based consumption tax. Thus, there is ample cause for concer n o n the part o f policymaker s interested in improving the effectiveness o f the program. Unfortunate ly, though th e current leve l of rhetoric about th e program i s high, the degree o f seriou s debat e an d analysi s by lawmakers i s extremely low. This state of affairs i s reflected i n current 'reform' proposal s that see m certain a t thi s tim e t o mak e th e progra m onl y harde r t o administer . Among the ideas presently being considered are further effort s to target the benefit mor e precisely and t o create differential treatmen t o f various subgroups o f the EITC population. 58 Although man y of the ideas may be well-intentioned , th e ne t effec t wil l surel y increas e th e com plexity of the program, with resulting adverse impact on participation , compliance, and efforts t o curb fraud. 59 The problem s ar e extremel y difficul t bu t perhap s no t completel y intractable. The following fou r point s provide a blueprint fo r reform ing th e manne r i n whic h benefit s ar e provide d t o th e workin g poor . They assume a policy determination tha t a redistribution o f a certain amount of benefits in favor of low-income workers is desirable. 1. One straightforward suggestio n i s to retur n a t least a part o f th e EITC program to its roots and to exempt the first $5,000 or $10,000 of wages o f a worke r fro m th e paymen t o f Socia l Securit y taxes. 60 As described earlier , the EITC originated i n part a s an effor t t o rebat e t o low-income worker s th e Socia l Securit y taxe s collecte d fro m them . Instead o f collectin g suc h taxe s an d the n tryin g t o retur n thos e amounts t o worker s i n th e for m o f th e EITC , i t woul d mak e muc h

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more sens e simpl y t o refrai n fro m collectin g th e payrol l taxe s i n th e first place. The appeal of this idea is its simplicity: an exemption could be easily administered b y employer s throug h a n adjustmen t t o th e Socia l Security ta x withholdin g tables . Claimant s woul d no t nee d t o fil e claims t o ge t th e benefit—th e ultimat e simplificatio n fo r them—s o participation level s woul d b e extremel y high . Furthermore , th e lin k between work and rewar d would be more evident because the benefi t would appear in each paycheck rather than as a lump sum at the end of the year. Each individual could be treated separately , thereby eliminating marriage penalty problems. Finally, compliance could be expected to b e ver y hig h becaus e o f th e simplicit y o f th e syste m an d becaus e there would be no net cash benefit transferred b y the government back to the beneficiaries. Hence, the incentive to commit fraud t o obtain the benefit would not be nearly as strong as under the current program. In addition, taxpayers who try to qualify fraudulentl y fo r multipl e Social Security ta x exemption s b y reporting fictitiou s earning s fro m severa l different job s would quickly face adverse income tax consequences as a result. To be sure, many in Congress might be fearful o f tampering with the Social Security system. They might object to a proposal that decouple s the link between Social Security taxes and benefits. The reality, however, i s tha t fo r low-incom e worker s th e EIT C progra m ha s already decoupled the link between taxes and benefits. Such workers ostensibly pay Social Security taxes and thereby become entitled to Social Security benefits, even though th e EITC payment completel y reimburses the m for thei r Socia l Securit y contributions . I n effec t the y pa y no Socia l Security taxes yet ar e entitled t o receiv e Social Securit y benefits. Thi s proposal simpl y accomplishe s exactl y th e sam e resul t bu t i n a direc t fashion, by not collecting the Social Security taxes in the first instance . The proposal would make the exemption available to all workers, those with hig h an d lo w incomes, and the n woul d rais e Socia l Security ta x rates o n wage s above the exemp t leve l to hel p pa y for th e exemptio n and, in effect, t o "recapture" the value of the exemption fro m worker s with higher earnings. 2. If a Social Security tax exemption i s not viable, either because of political reluctance or because it is believed to be not sufficiently target ed to the poor, a small benefit pai d through th e tax system to reflect a

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rebate of Social Security taxes up to some level of income would be an adequate alternative . To be successful, however , this alternativ e woul d need to be much simpler than the existing EITC program. Specifically , there should be no attempt to implement a family responsibility condition: if the goal of this small program is to avoid having Social Security taxes push low-income workers into poverty, it should make no differ ence whethe r th e worke r ha s responsibilit y fo r youn g children . (A s described shortly, special benefits fo r children could be provided sepa rately.) In that regard current proposals to do away with the small EITC now availabl e t o childles s low-incom e worker s ar e ill-advised. 61 I t might also be appropriate to require that this small benefit b e paid out in each paycheck, rather than a s a lump sum a t the end of the year, in order to maximize the work incentive effect o f the benefit. 3. Either of the first two suggestions would accomplish a portion of what the EITC program is trying to do in a more effective manner . But what abou t th e res t o f th e program ? All remaining benefits should be delivered through the transfer system and not the tax system. One natural suggestion woul d b e t o utiliz e th e res t o f th e EIT C mone y t o hel p finance the work component o f welfare reform . The appropriate work programs coul d be administered b y the federa l governmen t o r by the states if the welfare system is converted into a block grant. If a principal objective of the EITC program is to provide work incentives for welfar e recipients, that goal should be addressed directly. Our twenty-yea r experimen t wit h th e EIT C ha s demonstrate d th e inability o f th e ta x syste m t o administe r a transfe r progra m fo r th e poor in an effective an d efficient manner . The tax system simply cannot target benefits precisel y enough fo r policymaker s without the creatio n of a rule structure that is impenetrable to claimants and unadministra ble by the IRS. Furthermore, so long as the EITC program resides in the tax system, there is an undesirable duplication o f bureaucratic expense in the tax and transfer systems , a division of budget responsibility with other related poverty programs, and a potential distortio n i n the budget accounting treatmen t o f the program, a s evidenced b y the budge t policies tha t triggere d th e growt h i n th e program . Finally , there i s a t least a credible case that a redistributive program linked to work effor t would hav e a more desirable effect o n work incentive s if the progra m were administered by the transfer rather than the tax system.62 Sad t o say , what i s needed t o administe r a program lik e the EIT C

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effectively i s a bureaucrat: a person who can explain rules and choices to potential beneficiaries, use discretion in difficult cases , and monito r the direction of the government's funds. The notion that the tax system somehow saves in bureaucratic cost s is misguided. For a program like the EITC, those costs are not avoide d but incurre d b y the beneficiary , probably the person least likely to bear such costs in an efficient man ner. There reall y is no fre e lunch ; if policymakers wan t t o maintai n a benefit program for the working poor, they must be willing to fund th e costs of administration. Some might contend that the EITC is in some way a structural par t of the tax system and therefore shoul d remain part of it. That position is based on a meaningless distinction. Rather, the tax and transfer sys tems constitute an integrated tool to effect public policy, and provisions in favor o f the poor may be implemented with either negative taxes or positive transfers. There is no structural barrier t o using either syste m to accomplis h th e polic y goals . Th e questio n i s whic h syste m i s designed to achieve in a more expedient fashion the desired objective of delivering the prescribed benefits. Finally, supporters o f th e EIT C program migh t b e concerne d tha t the current political climate will not likely permit adoption o f a major new spending initiativ e fo r th e benefit o f the poor. They would argu e that it is therefore better to retain the EITC program in the tax system, even if that system is a poor delivery mechanism. But that concern, in a sense, is exactly the reason for the proposed reform . Lawmakers ought to b e abl e t o evaluat e polic y initiative s side-by-sid e wit h othe r pro grams designed t o achieve similar objectives . Programs shoul d no t b e hidden i n th e ta x syste m an d therefor e b e subjec t t o a lower leve l of scrutiny. If a s a transfer progra m th e EIT C would no t garne r a suffi cient level of political support to remain viable, there is no reason that it shoul d continu e t o exis t i n th e ta x syste m an d i n th e proces s b e administered inefficiently . 4. If lawmakers are unwilling to shift th e bulk of the EITC program to the transfer syste m an d insis t upo n relyin g on the tax system, then there are two remaining options. One choice would be to use the balance of the EITC money to help fun d a refundable chil d credit . Both parties i n Congres s see m inten t upo n enactin g a credi t tha t woul d award families with $50 0 for eac h child in the family, and the Clinto n Administration appear s generally supportive of that effort. 63 Bu t there

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is disagreement over the refundable natur e of the credit. A nonrefund able credit means that low-income families without income tax liabilities would receiv e n o benefi t a t all . A better us e o f th e EIT C money , though no t as desirable as the earlier suggestions, would be to provide such familie s wit h a n equal-size d benefit . A refundabl e chil d credi t would be easier to administer than the EITC and would deliver benefits to the same general population. 64 The second option would be to provide the balance of the EITC benefit t o low-income workers through thei r employers. 65 For example, a tax credit could be awarded to the employer of certain qualifying work ers. The theor y i s that th e sam e genera l transaction—th e hirin g an d compensation o f a qualifying worker—ca n b e subsidized by providing a direct benefit to either the employer or the worker in the transaction if the benefit i s capitalized in the compensation arrangement . The extent of capitalization will depend upo n the competitive nature of the labor market. Once again, the advantage of this idea would be to simplify administration of the program. It would be easier to administer because of the far smaller number o f employers than workers. Further, employers are more used to dealing with the IRS than are low-income workers, so that at least noncompliance due to unintentional error s should be reduced. Finally, th e greate r dolla r amount s involve d pe r employe r tha n pe r worker woul d mak e IR S enforcemen t effort s mor e cos t effective . I n a sense , thi s ide a woul d conver t par t o f th e EIT C progra m int o a mini-block grant program to be administered by the business community rather than by the federal government . True, the experience with a similar employer tax credit, the targeted jobs tax credit (TJTC), 66 has not bee n ver y positive. But a number o f features uniqu e t o th e TJT C program—its star t an d sto p history , th e limited duratio n o f th e subsid y t o a portio n o f firs t yea r wages , th e highly targeted natur e o f th e subsid y directe d towar d individual s lik e ex-convicts who are undoubtedly the subject o f negative stereotyping, to name a few—may hel p to explain that program's ineffectiveness. I n contrast, a broadly applicable, employer-based subsid y program that is permanent has the potential for avoiding many of the TJTCs pitfalls. 67 Lawmakers interested i n real reform o f the EITC program shoul d give serious consideration to its major overhaul . Although there are no per-

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feet solutions , replacement o f th e progra m wit h a Social Securit y ta x exemption and delivery of remaining benefits through the transfer system would go far to effect a distinct improvement .

NOTES l.I.R.C.§32. 2. S. Rep. No. 94-36,94th Cong., 1st Sess. 32-33 (1975). 3. See Jeff Shear, The Credit Card, 27 Nat'l J. 2056,2057 (1995). 4. Cf. U.S. Gen. Accountin g Office , Earne d Income Credit : Noncomplianc e an d Potentia l Eligibility Revisions 7-8 (1995 ) [hereinafte r GA O Noncompliance Statement] (cos t to the government to administer the EITC program much less than for comparable welfare programs). 5. See Milton Friedman, Capitalism and Freedom 191-9 3 (1962). 6. See Marsha Blumenthal & Joel Slemrod, The Compliance Cost of the U.S. Individual Income Tax System: A Second Look after Tax Reform, 45 Nat'l Ta x J. 18 5 (1992) ; Joel Slemro d & Nikki Sorum, The Compliance Cost of the U.S. Individual Income Tax System, 37 Nat'l Tax J. 461 (1984). 7. See I.R.C. § 3507 (permitting advance payment o f the EITC, a form o f negative withholding); see also U.S. Gen. Accounting Office, Earned Income Tax Credit: Advance Payment Option Is Not Widely Known or Understood b y the Public (1992) (les s than one-half o f 1 percen t of those eligible an d claimin g th e EIT C i n 198 9 receive d a n advanc e payment) ; Georg e K . Yin e t al. , Improving the Delivery of Benefits to the Working Poor: Proposals to Reform the Earned Income Tax Credit Program, 11 Am. J. Tax Pol'y 225,247 n.75 (1994) (according to IRS data, by early 1993 only about 16,00 0 taxpayers had reported obtainin g an advance payment o f the EITC during tax year 1992, or less than one-thir d o f 1 percent o f the 5. 5 million taxpayer s who had receive d a lumpsum EITC benefit by that time). 8. SeeI.R.C. § 6012; Rev. Proc. 95-53,1995-52 I.R.B. 22,24-25 (Dec. 26,1995) (for 199 6 a married couple with two children and income of up to $16,900 will not need to file a federal incom e tax return). 9. See John Kar l Scholz , The Earned Income Tax Credit: Participation, Compliance, and Antipoverty Effectiveness, 47 Nat'l Tax J. 63 (1994); John Karl Scholz, The Participation Rate of the Earned Income Tax Credit (Institut e fo r Researc h o n Povert y Discussio n Pape r No . 928-90 , University o f Wisconsin, Madison ) (1990 ) (roughl y 3 0 percent o f eligibl e beneficiarie s di d no t participate in 1984) ; Yin et al., supra note 7, at 244-45 (estimated EITC participation rat e in 199 0 of between 7 5 percent and 86 percent, meaning that between 1. 4 million an d 2.5 million eligibl e families failed to participate). 10. See Yin et al., supra note 7, at 247-48,253 (reporting IRS TCMP data indicating 30 percent to 40 percent EITC error rates during 1982-8 8 period, compared with 6 percent to 7 percent error rates for AFDC and foo d stamps) . Noncompliance problem s see m to hav e persisted despit e (o r perhaps because of) a number o f changes to the program. See Hearing Before the Senate Comm. on Financ e on the Earned Income Tax Credit, 104t h Cong., 1s t Sess. 76-77 (1995 ) (statemen t of Margaret Milne r Richardson , commissioner o f interna l revenue ) (base d o n smal l study of electronically filed return s during first tw o weeks of 1994 , there was an excessive EITC claim rate of about 26 percent (b y dollars excessively claimed) and 38 percent (b y number of excessive claims), compared to an underclaim rate of about 1 percent (by dollars) and 6 percent (by claims)). 11. SeeI.R.C. § 32(a),(b); Rev. Proc. 95-53,1995-52 I.R.B. 22,24.

THE FAT E O F TH E EARNE D INCOM E TA X CREDI T 3

12.I.R.C.§32(a),(b). 13. Barring statutory change , the program i s projected t o cost over $30 billion by the end of the decade. See Janet Holtzblat t e t al., Promoting Work through the EITC, 47 Nat'l Tax J. 591, 591 (1994). 14. See Jane t Holtzblatt , Administering Refundable Tax Credits: Lessons from the EITC Experience, 199 1 Proceedings of the 84th Ann. Conf. on Tax'n of the Nat'l Tax Ass'n-Tax Inst , of Am. 180,180. 15. See H.R. Rep . No. 99-841 , 99t h Cong. , 2 d Sess . 11-866, table A. 2 (1986) ; Staf f o f Join t Comm. o n Taxation , 101s t Cong. , 2 d Sess. , Budge t Reconciliatio n (H.R . 5835)—Revenu e Provisions as Reported by the Conferees (Comm . Print 1990) . 16. Shear, supra note 3, at 2059. 17. See Office o f U.S . President, The President' s Proposal s to Congres s fo r Fairness , Growth, and Simplicity 8 (1985). 18. See Elizabeth Drew, On the Edge: The Clinton Presidency 71-72 (1994). 19. See Staff o f Join t Comm . on Taxation , 103 d Cong., 1s t Sess., Methodology an d Issue s in Measuring Change s i n th e Distributio n o f Ta x Burden s 2- 3 (Comm . Prin t 1993) ; Michae l J . Graetz, Paint-by-Numbers Tax Lawmaking, 95 Colum. L. Rev. 609,657 (1995). 20. Graetz, supra note 19 , at 660; see Staff o f Joint Comm. on Taxation, 101s t Cong., 2d Sess., Summary o f Distributiona l Effects , b y Incom e Category , Budge t Reconciliatio n (H.R . 5835) — Revenue Provisions as Reported by Conferees 46-90 n.l (Comm . Print 1990) . 21. See Lawrence S. Haas, Fear of Filing, 23 Nat'l J. 2415 (Oct. 5,1991); J.Andrew Hoerner, SOS on the EITC: Complex Rules Likely to Thwart Low-Income Filers, 52 Tax Notes 133 6 (1991); David Wessel, Paved with Good Intentions, Tax Writers' Road to Help the Working Poor Turns into a Maze, Wall St . J., June 11 , 1991, at A16 ; James E . Williamson 8 c Francine J . Lipman, The New Earned Income Tax Credit: Too Complex for the Targeted Taxpayers? 57 Tax Notes 789 (1992). 22. See Holtzblatt et al., supra note 13 , at 600-601 (ove r 50 percent of EITC claimants utilize a tax return preparer). 23. Se e Anne L . Alston, The Earned Income Tax Credit and the Oversimplified Case for TaxBased Welfare Reform, 108 Harv. L. Rev. 533,564-89 (1995). 24.1.R.C. § 32(d) (a married couple filing separate tax returns is not eligible for the EITC). 25. Id. at § 32(c)(1)(A) (prio r to 199 0 Amendment). 26. See Holtzblatt, supra note 14 , at 181-82. 27. See Deborah H. Schenk, Simplifying Dependency Exemptions: A Proposal for Reform, 35 Tax Law. 855,863-66 (1982). 28. See supra note 10 (estimates of EITC error rates). 29. LR.C.§ 32(c)(1)(A), (c)(3). 30. See id. at § 32(c)(1)(C) (i n general, claimant with higher adjusted gros s income is entitled to the credit). 31. See id. at § 43(c)(2)(B)(i), as enacted b y Tax Reduction Ac t of 1975 , Pub. L. No. 94-12, § 209(b), 89 Stat. 26,35; H.R. Rep. No. 19,94th Cong., 1st Sess. 30 (1975). 32. See Yin et al., supra note 7, at 255. 33. See I.R.C. § 32(i), as added b y Self-Employed Healt h Insuranc e Act, Pub. L. No. 104-7 , § 4(a), 10 9 Stat. 93 (1995) (denia l of EITC to any taxpayer with aggregate investment-type incom e for th e yea r o f ove r $2,350) ; H.R . Rep . No. 104-92 , 104t h Cong. , 1s t Sess . 1 8 (1995); Cherie J . O'Neil 8 c Linda B . Nelsestuen, The Earned Income Credit: The Need for a Wealth Restriction for Eligibility Determination, 63 Tax Notes 1189 (1994). 34. See Seven-Year Balance d Budge t Reconciliatio n Ac t of 1995 , H.R. 2491, 104th Cong. , 1st

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Sess. § 1320 5 (1995 ) (vetoe d b y Presiden t Clinton)[hereinafte r 199 5 Balance d Budge t Bill] ; Message Returnin g withou t Approva l t o th e Hous e o f Representative s Budge t Reconciliatio n Legislation, 31 Weekly Comp. Pres. Doc. 2140 (Dec. 6,1995). 35. See U.S. Gen. Accounting Office , Earne d Income Credit : Targeting t o th e Working Poo r 30-31 (1995) [hereinafte r GA O Targeting Report]. 36. See Alstott, supra note 23, at 570-76. 37. See Shear, supra note 3, at 2058. 38. See GAO Noncompliance Statement , supra note 4, at 6 (intentional error rate 1 3 percent); George K. Yin, Reforming the Earned Income Tax Credit Program, 67 Tax Notes 1828 , 1829 (1995) (intentional error rate as high as 25 percent of dollars claimed and 32 percent of total claims). 39. See GAO Noncompliance Statement, supra note 4, at 6 (self-employed a s a group underreport 64 percent of income). 40. See 1995 Balanced Budge t Bill , supra note 34 , at § 13205(b ) (inclusio n o f chil d suppor t payments to determine eligibility); GAO Targeting Report, supra note 35, at 32-33. 41. See C. Eugene Steuerle, The IRS Cannot Control the New Superterranean Economy, 59 Tax Notes 1839 (1993); Yin et al., supra note 7, at 259-60. 42. See Yin, supra note 38, at 1832-33. 43. See Jane G. Gravelle, CRS Report for Congress, The Earned Income Tax Credit (EITC): Effect on Work Effort, reprinted in 95 Tax Notes Today 181-39 (Aug. 30,1995). 44. See id.; Marvin H . Kosters , The Earned Income Tax Credit and the Working Poor, Am . Enterprise, May/June 1993 , at 64. 45. See U.S. Gen. Accounting Office , Earne d Incom e Tax Credit: Design an d Administratio n Could B e Improved (1993) ; Saul D . Hoffman & Laurence S . Seidman, The Earne d Incom e Tax Credit: Antipoverty Effectivenes s an d Labo r Marke t Effect s 37-5 1 (1990) ; Edga r K . Browning , Effects of the Earned Income Tax Credit on Income and Welfare, 4 8 Nat' l Ta x J. 23 (1995) ; Stacy Dickert et al., The Earned Income Tax Credit and Transfer Programs: A Study of Labor Market and Program Participation, in 9 Tax Policy and th e Econom y 1 (James M. Poterba ed. , 1995) ; Nada Eissa & Jeffrey B. Liebman, Labor Supply Response to the Earned Income Tax Credit (Nat'l Bureau of Econ. Res. Working Paper No. 5158) (June 1995). 46. See C. Eugene Steuerle, The Future of the Earned Income Tax Credit (Part 2), 67 Tax Notes 1819(1995). 47. Cf Hoffma n & Seidman, supra note 45, at 55 ; Eissa & Liebman, supra note 45; Steuerle, supra note 46; George K. Yin, Summary of EITC Conference Proceedings, 1 1 Am. J. Tax PoPy 299, 310-11 (1994) (statement of Gary Burtless). 48. See supra note 7. 49. Cf Hearin g on the Earned Income Tax Credit Before the Senate Comm. on Finance on the Earned Income Ta x Credit , 104t h Cong. , 1s t Sess . 55 (1995 ) (statemen t o f Rober t Greenstein ) (uncertain understandin g b y EITC claimants regardin g connectio n betwee n EIT C benefit level s and work effort); Staff of Joint Comm. on Taxation, 104th Cong., 1st Sess., Present Law and Issues Relating to the Earned Income Tax Credit 1 1 (Comm. Print 1995 ) (same); Eissa & Liebman, supra note 45 (same); Holtzblatt e t al. , supra note 1 3 (same); Lynn M. Olson, The Earned Income Tax Credit: Views from the Street Level (Working Paper Series, Center for Urb . Aff. an d Pol. Research, Northwestern University ) (Mar . 1994) (survey of thirty low-income working women making the transition from welfare to work found very little knowledge about relationship between EITC and work levels); Yin, supra note 38, at 1831. 50. See Lawrence Zelenak, Marriage and the Income Tax, 67 S. Cal. L. Rev. 339,398-401 (1994). 51. See Alstott, supra note 23, at 563-64. 52. Se e 7 U.S.C . § § 2012(i)(2) , 2014(a ) (1994 ) (foo d stamps) ; 4 2 U.S.C . §602(a)(38),(39 )

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(1994) (AFDC) ; U.S . House Comm . o n Way s an d Means , 103 d Cong. , 2 d Sess. , Overvie w o f Entitlement Programs : 1994 Green Book: Background Material and Data on Programs within the Jurisdiction of the Committee on Ways and Means 762-63 (Comm. Print 1994) . 53. See Boris I. Bittker, Federal Income Taxation and the Family, 27 Stan. L. Rev. 1389, 1398-99 (1975). 54. See James Aim & Leslie A. Whittington, Income Taxes and the Marriage Decision, 27 Applied Econ. 25 (1995); David L. Sjoquist 8c Mary Beth Walker, The Marriage Tax and the Rate and Timing of Marriage, 48 Nat'l Tax J. 547 (1995). 55. See USA Ta x Act o f 1995 , S. 722, 104t h Cong. , 1s t Sess . (1995) ; Congressiona l Budge t Office, Estimate s fo r a Prototype Saving-Exemp t Income Ta x 23 (1994); Sen. Pete V. Domenici, The Unamerican Spirit of the Federal Income Tax, 31 Harv. J. on Legis. 273,296-97 (1994). 56. See George K. Yin, Accommodating the "Low-Income" in a Cash-Flow or Consumed Income Tax World, 2 Fla. Tax Rev. 445,458-61 (1995). 57. Id. at 474. 58. See 1995 Balanced Budget Bill, supra note 34, at §§ 13201-5. 59. See GAO Targeting Report, supra note 35, at 30-31. 60. See George K . Yin & Jonathan Barr y Forman , Redesigning the Earned Income Tax Credit Program to Provide More Effective Assistance for the Working Poor, 59 Tax Notes 951,957-59 (1993); Yin et al., supra note 7, at 280-82,284-86. 61. See 1995 Balanced Budget Bill, supra note 34, at § 13202. 62. See Yin, supra note 38, at 1829-31 . 63. See 1995 Balanced Budge t Bill , supra note 34 , at § 11001(a ) (addin g ne w §23, a $500 per child tax credit). 64. See Yin 8c Forman, supra note 60, at 959-60; Yin et al., supra note 7, at 283. 65. See Yin et al., supra note 7, at 286-94. 66.I.R.C.§51. 67. See Yin et al., supra note 7, at 291-92.

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14 MARY L . H E E N

Welfare Reform , the Child Care Dilemma, and the Tax Code Family Values, the Wage Labor Market, and the Race- and Class-Based Double Standard

Although federa l wor k requirement s hav e bee n imposed o n welfar e recipient s fo r nearl y thirt y years , recen t welfar e reform proposal s emphasiz e mor e stringen t tim e limit s o n benefit s without work and impose such requirements on mothers with younger children.1 Th e shif t i n th e welfare paradig m towar d mandator y wag e work fo r mother s wit h youn g childre n ha s no t bee n accompanied , however, by universal child care. Historically, federal welfare an d labor policies hav e impede d women' s acces s t o th e wag e labo r marke t through the lack of affordable chil d care.2 Tax policies have contributed to the problem. 3 Effort s t o improve women's access to the wage labor market have clashed with policies aimed at reinforcing traditional fam ily values, and with race- and class-based double standards in the treatment o f chil d car e b y both th e incom e ta x an d th e incom e transfe r (welfare) systems. In requiring wage work of mothers with young children, policymakers assume that in-home car e welfare mother s provide their own children doe s not constitut e work at least equivalent i n value to the wage work available to welfare recipients (including child care they may provide t o othe r people' s children); 4 alternatively , the y assum e tha t th e wage work required of welfare recipients will produce long-term bene322

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fits greate r tha n th e intervenin g cos t o f providin g (o r no t providing ) substitute child care for their children. 5 At best those assumptions evidence an underestimation of the cost of quality substitute child care. At worst they reveal an entrenched race- or class-based devaluation of the care provided by welfare recipient s to their children. Without th e provision of adequate substitute chil d care, the work requirements repre sent an attempt t o shift welfar e mother s into poorly paid service positions while tacitly expecting that their child care responsibilities will be met by friends an d relatives , including th e aunts , siblings, and grand mothers of the children now receiving welfare. In any event the largely unstated assumptions suggest disturbing race, gender, and class stereotyping a t work , alon g wit h a retur n t o certai n preentitlemen t er a approaches to poor relief. 6 Tax policies have historically evidenced a tension between reinforc ing traditional family values and improving the access of women to the wage labor market. Congress has articulated various reasons for the tax allowance fo r work-relate d chil d care ; it ha s analogize d work-relate d child car e to othe r business-relate d cost s of producing incom e an d a t the sam e tim e ha s treated i t a s a hardship allowanc e fo r familie s dis rupted b y the death o r disabilit y of the primary breadwinner (usuall y the husband and father) o r the death or disability of the primary caregiver (usually the wife and mother). In the early 1970s Congress linked the child care deduction to welfare-related work programs and expanded th e deductio n t o encourag e th e employmen t o f welfar e recipient s in househol d servic e positions. 7 Policymaker s als o hav e periodicall y addressed chil d car e issue s b y providing additiona l o r alternativ e ta x allowances fo r familie s wit h childre n throug h increase d exemptio n amounts for dependents or by advocating refundable o r nonrefundabl e per chil d tax credits. 8 These tax adjustments ar e sometimes describe d as promoting traditional family values because they do not tie eligibility for the tax allowance to the parents' work outside of the home. Child tax credi t proposal s directe d a t th e middl e clas s ar e no w receivin g renewed political support. 9 The juxtapositio n o f curren t welfar e an d ta x policie s suggest s a n apparent race-an d class-base d doubl e standard . O n th e on e han d ta x policies favor th e in-home provisio n o f child car e and househol d ser vices b y mother s i n certai n "traditional " two-paren t household s an d facilitate the employment of child care providers if the single parent or

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secondary wage earner (usually the wife) can earn enough after taxes in the wage labor marke t t o pay for chil d car e and othe r househol d ser vices. On the other hand welfare policie s reject th e in-home provisio n of chil d car e fo r poo r mothers . Low-incom e familie s ar e generall y unable t o affor d adequat e chil d car e withou t additiona l governmen t subsidies or the modification o f current ta x provisions. The interrela tionship o f tax and welfar e policie s thus create s a classic double bin d for poor families. The implications of the double standard applied to the poor through the tax system are troubling and worthy of further examination . I begin here a preliminar y exploratio n o f th e interrelationshi p betwee n ta x and welfare double standards. In the welfare context a double standard historically ha s bee n applie d b y makin g race-base d distinction s between the "deserving" and the "undeserving" poor. Although the discriminatory denial of welfare benefits largely ended as a result of major reforms achieve d by the welfare right s movement i n the 1960s, 10 current welfare refor m proposal s would eliminat e th e structura l "entitlement" to benefits on which those reforms were built. In the tax context a famil y value s doubl e standar d ma y be identifie d throug h th e clos e correlation between an individual's race or gender and his or her family income o r wealth. 11 Traditiona l famil y value s ar e reinforce d throug h the ta x code ; nevertheless, acces s t o th e wag e labo r marke t ha s bee n improved fo r middle - an d upper-incom e wome n throug h offsettin g tax allowances fo r work-relate d chil d care . Those adjustments ar e not generally available, however, to low-income working families. The double standard may be eliminated only through offsetting adjustment s o r more comprehensive changes in the income tax system.

W E L F A R E , WOR K AN D T H E M O T H E R S O F YOUN G C H I L D R E N

The Historical Race-Based Double Standard Federal wor k requirement s fo r welfar e recipient s represen t a shif t away from the origins in 1935 of the Aid to Dependent Children (ADC) program, which developed from "mothers' pensions" or "mothers' aid" programs.12 Suc h program s wer e intende d b y socia l reformer s t o enable widow s an d certai n othe r "deserving " mother s wit h "suitabl e

WELFARE REFORM , TH E CHIL D CAR E DILEMMA , AN D TH E TA X COD E 3 2

homes" to car e fo r thei r youn g childre n withou t bein g compelle d t o work outside of the home. 13 Local welfare offices , particularly those in the South, used the "suitable home" and othe r rule s to deny assistance to Africa n America n childre n an d thei r families. 14 I n addition , lon g before th e federa l governmen t impose d wor k requirements , som e states use d "employabl e mother " rule s t o den y welfar e assistanc e t o women with children, especially nonwhite women, on the ground tha t they should work. 15 The first employabl e mother rul e was adopted by Louisiana i n 1943 , refusing AD C assistanc e t o familie s durin g time s when the mothers and their older children were needed to work in the cotton fields. 16 Georgi a adopte d a similar rul e i n 1952 , denying assistance to mothers with children over three years of age where "suitable" employment (a t an y wage) wa s deemed t o b e available. 17 Thus , local welfare policies coincided with local labor market demands by keeping nonwhite wome n i n seasona l agricultura l an d othe r labo r pools. 18 As late a s 196 6 Ne w Jerse y notifie d Ai d t o Familie s wit h Dependen t Children (AFDC) recipients that their grants would be cut because seasonal farm work was available.19 Federal work requirements were first imposed o n welfare recipient s by th e Wor k Incentiv e Progra m (WIN ) i n 1967 . WIN wa s no t ver y effective, however , due to weak funding an d enforcement. 20 Althoug h potentially subjec t t o th e origina l WI N wor k requirements , mother s with preschoo l childre n wer e determined b y many states to be "inappropriate" fo r jo b trainin g o r wor k an d thu s exemp t fro m th e wor k requirement.21 As amended i n 1971 , WIN I I required participation b y mothers with children six years of age or older. 22 The WIN progra m wa s replaced b y the Job Opportunity an d Basi c Skills Progra m (JOBS) , which wa s establishe d b y the Famil y Suppor t Act of 1988. 23 The Family Support Act mandated improved procedure s for chil d suppor t enforcemen t an d th e establishmen t o f paternity ; guaranteed federa l assistanc e fo r chil d car e durin g participatio n i n education, training, and employmen t (AFDC-relate d chil d care) ; and provided transitiona l eligibilit y fo r a year o f extende d chil d car e an d medical assistanc e for forme r AFD C recipients who become ineligibl e for AFDC because of increased income from employmen t (transitiona l child care). 24 All AFDC recipients , except thos e exempte d b y law, are required to participate in JOBS. 25 Mothers caring for a child under six years o f ag e ar e require d t o participat e i n JOB S onl y i f chil d car e i s

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guaranteed an d participatio n i s limite d t o twent y hour s pe r week. 26 Those caring for children under three years of age are exempt from par ticipation, unles s require d t o participat e unde r stat e option. 27 Mos t states, however, have exempted caretaker s of children under the age of three from the work requirements. 28 The shif t i n welfar e polic y towar d wor k requirement s occurre d a s the welfare populatio n expande d an d a s more African America n an d other women of color and their families were added to the rolls. 29 The shift als o coincided with the trend of increased labor market participation b y women with young children. 30 Although AFDC mothers hav e been reported as participating in the labor market at significantly lower levels than thei r nonwelfar e counterparts, 31 studie s conducte d b y th e Institute fo r Women' s Polic y Researc h sho w mor e comparabl e labor force participatio n levels : "[A]bou t fort y percen t o f poo r mother s receiving AFDC are also working in paid employment, and they work approximately half time, about a s much a s all mothers."32 On average, mothers "work in paid employment about half time, devoting the other half of the 'normal' work week as well as the 'second shift' to child and family care." 33 Lik e man y o f thei r counterpart s i n th e labor market , AFDC mother s d o no t ear n enoug h o n thei r ow n t o suppor t them selves an d thei r children ; man y nee d bot h thei r welfar e benefit s an d their earnings to survive. Because AFDC is not otherwise structured t o encourage work effort , th e paid wor k o f welfare recipient s ha s sometimes been driven underground. 34 The Current Work Programs and the Cost of Child Care As discussed above, the JOBS program was created in the last round of welfare refor m durin g the late 1980s . The JOBS program i s funde d through a cappe d entitlemen t unde r whic h state s ar e partiall y reim bursed (pursuan t t o a federal matchin g rate ) fo r eac h dollar spen t o n JOBS unti l the y reac h th e maximu m amoun t allocate d t o them. 35 Federal fund s fo r guarantee d JOBS-relate d chil d car e ar e separatel y provided as open-ended entitlement matching funds t o partially reimburse (at the Medicaid matching rate) state expenditures for AFDC and transitional chil d care. 36 As of th e en d o f fisca l yea r 1993 , states ha d claimed only about 70 percent of the allotted $1 billion in federal JOBS funds.37 Stat e budget constraints as well as the cost of guaranteed child

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care wer e amon g th e reason s identifie d fo r th e less-than-ful l imple mentation o f the JOBS program. In many states the same amount was spent on JOBS-related child care as on the JOBS program itself. 38 The At-Risk Chil d Car e Progra m provide s federa l matchin g fund s for states to provide child care services for low-income families who are "at risk " of becomin g welfar e recipient s i f the y d o no t receiv e work related chil d care. 39 Families ar e require d t o contribut e t o th e cos t o f care o n a slidin g fe e schedul e base d o n th e family' s abilit y t o pay. 40 Low-income families also receive child care assistance through variou s federal block grant programs. The Child Care and Development Bloc k Grant (CCDBG ) progra m currentl y provide s fundin g fo r chil d car e services t o low-incom e familie s a s well a s fo r effort s t o improv e th e quality and supply of child care in general. 41 Federal funds ar e distributed to states under a formula, and no matching funds ar e required. In addition t o the CCDBG program, some child care funds ar e currentl y available through the Social Services Block Grant Program o f Title XX of the Social Security Act.42 Title XX block grants operate as a capped entitlement, wit h n o stat e matchin g requirement , unde r whic h state s are allocated funds pursuant to a formula based on their relative population. Most state s spend som e portion o f their bloc k grant s o n chil d care services, and some, but not all, states determine eligibility for child care services based on income standards. 43 Under curren t federa l fundin g level s (totalin g approximatel y $ 2 billion pe r year), 44 th e state s hav e bee n unabl e t o mee t th e nee d fo r child care assistance for low-income families. 45 Between 5 percent an d 6 percent o f th e AFDC caseloa d receiv e AFDC chil d car e subsidies, 46 and only about one out of three JOBS participants receive JOBS-related child care. 47 Abou t 2 0 percen t o f thos e eligibl e receiv e transitiona l child car e assistance fo r th e first year afte r leavin g welfare fo r work. 48 Families tha t hav e use d u p thei r on e yea r o f guarantee d transitiona l assistance after leaving welfare have to compete with other low-income, non-AFDC familie s fo r chil d car e assistance . Survey s conducte d i n 1993 and 199 4 found tha t mos t state s either ha d length y waiting lists for chil d car e assistance o r ha d stoppe d acceptin g ne w applications. 49 In addition th e competitio n fo r slot s resulted i n the shiftin g o f scarc e state chil d car e fund s fro m low-incom e workin g familie s t o familie s receiving AFDC.50 Programs with low reimbursement rate s and retroactive reimburse-

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ment tend to steer families toward informal child care.51 A recent study concludes that childre n who are in the care of family and relative s are receiving substandard care from providers who are "taking care of children t o hel p ou t th e mother s an d no t becaus e the y wan t t o car e fo r children."52 The study's authors recommend tha t low-income familie s receive a child care subsidy sufficient t o pay for higher quality care.53 In addition the y d o no t recommen d requirin g welfar e recipient s t o become famil y chil d car e provider s an d the y urg e state s t o scree n al l welfare-to-work recipient s fo r interest , commitment , an d aptitud e before they become providers.54 The "devolution" approach to welfare reform recentl y considered by Congress woul d repea l entitlemen t program s suc h a s AFD C an d AFDC-related chil d car e an d woul d substitut e cappe d federa l bloc k grants to the states, giving the states the freedom t o impose their ow n requirements o r restriction s withou t th e necessit y o f applyin g fo r waivers of federal requirements. 55 Under the House version of welfar e reform som e of the federal budgetar y savings from th e elimination o f entitlement program s woul d hav e been reallocate d t o a revised Chil d Care and Development Block Grant Program (CCDBG) . Although the reallocation woul d hav e kep t chil d car e fundin g a t 199 4 levels , total funds available for child care would have been cut over a five-to sevenyear perio d throug h eliminatio n o f th e futur e growt h o f entitlemen t funding.56 The Senate and conference substitute proposals added limited amounts ove r curren t fundin g level s for work-relate d chil d care. 57 Each of the proposals would have cut overall welfare spending over the next five to seven years58 and would have increased the number of children i n poverty. 59 Whether Congres s and th e President will be able to reach a compromise that will result in the enactment o f major welfar e reform legislatio n remains t o be seen . Nevertheless, without substan tially increased federal or state support of work-related child care, new work requirements may be programmed for failure, or worse, they may result in the endangerment of children. If low-incom e familie s mus t pa y th e ful l cos t o f chil d car e them selves, they fac e a majo r obstacl e i n thei r transitio n fro m welfar e t o work. In general the type of child care purchased and the amount spent on car e varies by the family's economi c situation an d th e type of care used. Lower-incom e familie s spen d o n averag e abou t 2 3 percen t o f their income s o n chil d car e even though the y spend significantl y less,

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in absolut e terms , on chil d car e than familie s wit h highe r incomes. 60 Without subsidize d chil d care , low-income familie s wil l likely rely on lower-quality child care or informal arrangement s and relative-provid ed care. Those who pay for relative s to car e for thei r childre n pa y the lowest averag e weekl y costs , with increasingl y highe r weekl y averag e costs fo r famil y chil d care , cente r care , an d in-hom e car e b y a non relative. The family an d relativ e care received b y children fro m low-incom e families an d the center-based car e for very young children hav e raised developmental concerns. A recent study of children in family child care and relative care concluded that "regardless of maternal education, the lower the child's family income, the lower the quality of the child care home in which he or she is enrolled."61 That finding differed fro m find ings from researc h on center-based care, in which low-income children in subsidized care often were in better-quality arrangements than mid dle-income children. 62 I n center-base d care , the lowes t qualit y car e is received by toddlers and infants, with about 40 percent of those studied receiving below a minimally adequate level, although little difference i n fees was found fo r centers providing high- or low-quality care.63

TAXES AN D WORK : FAMIL Y VALUE S AN D A C C E S S T O T H E WAG E LABO R MARKE T

History of Congressional Approaches Congress has combined at least two or three notions in its approach to work-related chil d car e costs for incom e ta x purposes. Although i t has treated child care expenses as comparable to an employee business expense, it has also targeted th e deduction o r credit to hardship situa tions and used the allowance as part of an overall effort t o develop jobs for household workers, including former welfare recipients. 64 Congress firs t provide d a ta x adjustmen t fo r employment-relate d child care costs in 1954, 65 as a type of working expense deduction tar geted t o thos e i n hardshi p situation s suc h a s widows, widowers, an d low-income families. 66 Ove r the next two decades, Congress increase d the statutor y dolla r amount s an d expande d th e coverag e o f th e chil d care provision but retained the basic structure of a child care deduction. In the 1970 s the rationale for the deduction shifte d t o include a job

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development purpose in addition to its continued function a s a type of employee business expense in hardship situations. 67 When the deduction wa s significantly expande d i n 1971 , the Senat e committee repor t identified i t a s a "job developmen t deductio n fo r househol d service s and chil d care " and discusse d i t immediately following it s descriptio n of a proposed ta x credit fo r salarie s paid welfare recipient s unde r th e WIN program. 68 Whe n discussin g th e propose d WI N ta x credit , th e committee observed that the WIN program "has not been as successful as had been hoped, largely because persons have been placed in institutional rather than employment-base d training." 69 The expanded chil d care deduction wa s intended t o provid e a n incentiv e fo r th e employ ment o f household workers by giving large numbers of welfare recipi ents "the opportunity to perform sociall y desirable services in jobs that are vitally needed," while also helping "to remove these individuals from the welfare rolls and reduce the cost of providing public assistance."70 In 197 6 Congress changed the child care deduction to a nonrefund able tax credit by repealing the deduction provisio n an d adoptin g th e predecessor of the current I.R.C. § 21.71 The change to a tax credit was adopted a s a way to reac h taxpayer s who electe d th e standar d deduc tion an d a s a simplificatio n measure. 72 Althoug h th e famil y incom e limitation amount s were eliminated an d eligibilit y requirements were somewhat broadened, the credit otherwise retained the basic design of the earlier provisions with regard to determination of qualified expenses.73 Th e credi t wa s change d agai n i n 1981 , resulting i n th e curren t child car e ta x credi t structure. 74 Althoug h th e Senat e versio n o f th e credit include d refundability , th e conference agreemen t rejecte d mak ing the credit refundable.75 The credit was redesignated as I.R.C. § 21 in 1984,76 and Congress did some fine-tuning to curtail perceived abuse s or t o mak e technica l adjustment s i n 1987 77 and agai n i n 1988. 78 No major changes have been made to the credit since 1981. The Income Tax Work-Related Child Care Provisions The Internal Revenu e Code provisions specificall y addressin g chil d care expenses are I.R.C. § 21, the child and dependen t car e tax credit , and I.R.C . § 129 , the exclusio n fro m incom e fo r certai n employer provided child care benefits. The child care tax credit and the exclusion for employer-provide d chil d car e are estimated t o reduc e federa l rev -

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enues by about $2. 7 billion an d $. 7 billion , respectively, in fiscal year 1996.79 Although no t specificall y aime d a t th e chil d car e expense s o f working parents, the earned incom e tax credit, I.R.C. § 32, provides a refundable ta x credi t fo r certai n low-incom e workin g familie s wit h children. I n addition , th e persona l exemptio n deductio n fo r depen dents, I.R.C . § 151 , provide s a n adjustmen t i n computin g taxabl e income t o accoun t fo r th e adde d househol d cost s for thos e taxpayer s supporting children. 80 I.R.C . §§21 an d 12 9 provide tax benefits t o all working parents, but upper- and middle-income taxpayers utilize them the most , fo r th e reason s explaine d below . Th e followin g sectio n describes in greater detail how the child care credit and employer-pro vided child care exclusion provisions work and how the current desig n of these provisions makes it difficult fo r low-income taxpayers to benefit from them . How the Child Care Tax Credit Works. I.R.C. § 21 provides a nonrefundable ta x credit, the amount of which is equal to an "applicable percentage"81 o f th e eligibl e employment-relate d chil d car e expenses 82 paid b y th e taxpaye r durin g th e year. 83 Th e applicabl e percentage , which ranges on a sliding scale of 20 percent to 30 percent, varies with adjusted gros s income. The amount o f child care expenses that may be taken into account depends upon the number of children84 included in the household maintained by the taxpayer. Eligible expenses are limited to $2,40 0 per yea r fo r on e chil d an d $4,80 0 per year fo r tw o o r mor e children.85 A taxpayer wit h adjuste d gros s incom e o f $10,00 0 o r les s receives a credi t o f 3 0 percen t o f employment-relate d expenses . Th e credit percentage declines by one percentage point for eac h $2,000 (o r fraction thereof ) i n adjuste d gros s incom e abov e $10,000 , but i n n o case is the applicable percentage reduce d belo w 20 percent. 86 Fo r taxpayers with adjusted gros s incomes greater than $28,000, therefore, the applicable percentag e i s 20 percent. Fo r taxpayers with adjuste d gros s income o f $10,00 0 o r less , thus qualifyin g fo r th e highes t applicabl e percentage of 30 percent, the maximum credit is $720 for one child and $1,440 for two or more children. For taxpayers with incomes in excess of $28,000 , thus qualifyin g fo r th e lowes t applicabl e percentag e o f 2 0 percent, the maximum credi t is $480 for one child and $960 for two or more children. The amoun t o f th e dependen t car e credi t an d th e applicabl e per centage incom e phase-dow n schedul e hav e no t change d sinc e 1981 .

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Income ta x thresholds , however , hav e substantiall y increase d sinc e then.87 Thus , although I.R.C . § 21 appears t o targe t low-incom e tax payers, the relationshi p betwee n th e credi t percentag e incom e phase down an d curren t incom e ta x thresholds make s i t unlikel y that poo r taxpayers receiv e an y benefit fro m th e credit . The Ta x Reform Ac t of 198688 remove d abou t si x millio n povert y leve l familie s fro m th e income ta x rolls 89 b y increasin g standar d deduction 90 an d persona l exemption amounts, 91 an d adjustin g thos e amount s o n a yearly basis for inflation. 92 I n 1996 , for example, a family of four (tw o parents and two children) woul d ow e no taxe s on u p to $16,90 0 of adjusted gros s income,93 which i s above the federal povert y threshold fo r a family of four.94 A single head of household with on e child would ow e no taxes up to $ 11,000 of income,95 which is above the poverty level for a family of two. 96 Although bot h familie s coul d b e entitle d t o a child car e tax credit, they would have no income tax liability to offset throug h use of the credit. The current thresholds for tax liability,97 combined with the nonrefundability o f the credit, thus make it unlikely for poo r familie s to benefit from the child and dependent care tax credit.98 The Exclusion for Employer-Provided Dependent Care Assistance Programs. I.R.C. § 129 provides an exclusion from th e gross income of employees o f amount s u p t o $5,00 0 pai d b y th e employe r unde r a dependent car e assistanc e program. 99 Th e dependen t car e assistanc e program must be a separate written plan of the employer for the exclusive benefi t o f employees 100 an d mus t mee t certai n othe r require ments.101 The amount of the exclusion may not exceed the lesser of the earned income of the employee or the earned income of the employee's spouse.102 Payment s fo r chil d car e mad e t o th e employee' s spous e o r certain othe r relate d individual s (anothe r chil d o f th e employee , fo r example) are ineligible for exclusion. 103 Employers mos t frequentl y provid e th e dependen t car e assistanc e benefit throug h reimbursemen t accounts , sometime s referre d t o a s flexible spendin g accounts , whic h ma y als o cove r othe r type s o f expenses, such a s out-of-pocket healt h car e expenses. 104 Up to $5,00 0 may be paid into a dependent care assistance account (throug h a salary reduction plan ) fro m whic h chil d car e expense s o f th e employe e ar e reimbursed. The effect o f such a program is that the employee may pay child care expenses (or out-of-pocket healt h care expenses) with pretax dollars. Thus, the I.R.C. § 129 exclusion operates as a complete adjust -

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ment, offsettin g th e ta x cost s o f u p t o $5,00 0 o f chil d car e expenses , regardless of the taxpayer's marginal tax rate. About one-thir d o f full time employees a t large and medium-size d privat e firms wer e eligible for such accounts in 1991 , compared to nearly one-tenth of such workers who were eligible for chil d car e benefits provide d by the employe r in the form o f child care facilities provided at or near the workplace or through direct reimbursement of employee expenses.105 Generally, taxpayers choose whether eligibl e child care expenses will be claime d unde r th e I.R.C . § 21 credit o r th e I.R.C . § 12 9 exclusion. Double dipping is not permitted. 106 For most middle- or upper-income taxpayers, the I.R.C . § 12 9 exclusion wil l provid e th e mos t benefit. 107 For example , for taxpayer s subjec t t o th e highes t margina l ta x rat e o f 39.6 percent , th e I.R.C . § 12 9 exclusio n i s wort h $1,98 0 (maximu m amount allowe d of $5,000 x 39.6 percent), compared to the maximu m I.R.C. § 21 credit of $480 for one child or $960 for two or more children. Tax Theory: The Implications of Viewing a Child Care Allowance as a Subsidy or as a Cost of Producing Income As discussed above , Congres s ha s neve r reall y decide d whethe r t o conceptualize th e chil d car e credi t a s a cos t o f earnin g income , a s a hardship allowance for child care, or as a job development program fo r household workers. Tax theorists have also disagreed about the proper treatment o f such expenses. If child care expenses are a legitimate cost of producin g income , the y shoul d b e deductibl e regardles s of the amount o r the taxpayer's income level. 108 But if child care costs are personal consumption expenditures , they should not be deductible —just a s expenditure s fo r th e cost s o f foo d o r shelte r ar e nonde ductible.109 An y specia l ta x allowanc e fo r persona l consumptio n expenditures may be viewed as a tax expenditure110 and thus equivalent to a direc t subsid y fo r chil d care . Th e conclusio n on e reache s wit h regard t o thes e theoretica l issue s ma y hav e a s much t o d o wit h one' s view o f th e family , an d th e rol e o f wome n withi n th e family , a s with one's understanding of tax policy.111 The following sections consider whether an adjustment t o income to reflect child care costs can be justified unde r the tax norms of ability to pay and neutrality. I conclude that an income tax adjustment fo r chil d care costs should not be viewed as a subsidy because it reflects a taxpay-

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er's ability to pay taxes. Even if it were viewed as a subsidy or equivalent to a direct expenditure, however, there are arguments in favor of retaining o r expandin g a n incom e ta x adjustmen t fo r chil d car e expenses . Such a n adjustmen t shoul d b e tolerated a s a "second best " solutio n because i t offset s othe r ta x nonneutralitie s betwee n wag e wor k an d household labor . Eliminatin g th e "subsidy " would exacerbat e alread y serious allocativ e inefficiencie s involvin g participatio n b y wome n i n the labor market. The Ability-to-Pay Norm. Th e ability-to-pay norm derive s from th e idea that taxpayer s should contribut e t o the government accordin g t o the relativ e amoun t o f materia l resource s the y contro l abov e subsis tence amounts . Ability to pa y may be understoo d i n bot h horizonta l and vertical equity terms. Questions concerning the normative under pinnings of the traditional tax policy equity analysis have recently provoked much commentary, and several theorists have emphasized that if two taxpayers pay different amount s in tax, the difference mus t be consistent wit h a n appropriat e theor y o f distributiv e justice. 112 Analysi s under the traditional tax norm of horizontal equity, under which similarly situated taxpayers should be similarly taxed, tends to be conclusory because of the lack of a tax-determined metho d of identifying simi larly situate d taxpayers . Fo r example , th e conclusio n reache d wit h regard to horizontal equity may depend upon whether one begins with a worker with or without childre n and how one views one-earner versus two-earne r workin g families. 113 Thus , the prio r questio n o f ho w taxpayers with equal incomes are identified determine s the outcome of the horizontal equity analysis. The application o f the ability-to-pay norm generall y does not favo r deductions unles s the y relat e t o minimu m subsistenc e amounts , cer tain nondiscretionary expenditures, 114 or legitimate costs of producing income. Child care costs reduce the taxpayer's ability to pay taxes only if one conclude s tha t chil d car e fits within suc h a category o f expendi tures. If so, a deduction or a credit would be justified base d on the taxpayer's reduced capacity to pay taxes. Debate about the tax treatment o f child care costs generally centers on whethe r suc h expense s ar e persona l o r busines s expenses , that is , whether t o trea t suc h expense s a s a cost o f producing incom e o r a s a personal consumptio n expenditure . Althoug h th e business/persona l boundary is difficult t o delineate when the expenses involve additional

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costs o f bein g employed , chil d car e ha s bee n analogize d t o nonde ductible personal expenses, such as commuting costs and higher clothing expens e wher e th e perso n "alread y a t work " marks th e boundar y between busines s an d persona l expenses. 115 Som e hav e argue d tha t child car e cost s ma y contai n element s o f eithe r persona l o r busines s expenditures or a mixture of both,116 and at least one commentator has suggested tha t a limit i n th e amoun t o f deductibl e expense s ma y b e appropriate a s a mean s o f restrictin g th e persona l consumptio n ele ment for middle- or upper-income taxpayers. 117 Arguably, however, child care costs (up to some generally recognized standard amoun t fo r qualit y care ) ar e legitimat e cost s o f producin g income, and a child care deduction properly reflects a working parent's ability t o pa y taxes . A caretake r i s require d i f singl e o r dua l parent s work outside of the home, and the tax code should recognize child care as a deductible work-relate d expense . But thos e wh o vie w chil d car e costs as a personal expense would conclude that an income tax adjust ment constitute s a subsidy . Unde r suc h a vie w th e neutralit y nor m becomes more important because an adjustment t o income cannot be justified on the basis of a working parent's relative ability to pay taxes. The Neutrality Norm. Th e neutrality norm derive s from th e notio n that taxe s should influenc e allocatio n o f resource s i n th e econom y as little as possible; otherwise, economic inefficiencies ma y result. Under the neutralit y nor m subsidie s ar e suspect an d shoul d b e discouraged . For those who view child care costs as a personal consumption expense, an income adjustment fo r suc h costs would constitute an income subsidy violating th e neutralit y norm . Th e neutralit y norm , however , i s tempered by several other theories. First, under th e theory o f optimal taxation , nonneutrality doe s no t result i n economi c distortion s whe n taxe s do no t affec t consume r o r other allocative choices (that is, where there is a low degree of elasticity or substitutabilit y o f behaviors). 118 Accordingly , becaus e economi c distortions ar e a functio n o f elasticity , highe r taxe s ma y b e impose d on inelasti c commoditie s withou t creatin g allocativ e inefficiencies . Second, unde r th e Pigouvia n theor y o f taxation , departure s fro m th e neutrality nor m ma y b e justifie d t o correc t marke t failures ; whe n free market s d o no t work , throug h th e presenc e o f externalitie s o r information failures , taxatio n ma y legitimatel y correc t th e failure. 119 For example, an observed market failure o f parents or society to invest

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adequately i n children' s huma n capital 120 coul d provid e theoretica l justification fo r a tax incentive to correct such market failure. Third, the theory of the "second best" suggests that tax nonneutralities should not necessarily be corrected if allocative inefficiencies woul d be aggravated because of the existence of other nonneutralities. 121 The theor y o f th e secon d bes t provide s a justificatio n fo r a ta x allowance for work-related child care because of the existence of the tax nonneutrality between wage work and household labor. 122 The tax system generall y favors nonmarke t productio n b y failing t o tax impute d income from service s taxpayers perform fo r themselves or their households.123 For example, no incom e ta x is imposed o n th e value of ser vices suc h a s vegetable gardening , mea l preparation , o r hai r cuttin g provided by taxpayers to members of their own households. However, for those taxpayers who hire others to perform such services, no deductions fro m incom e ar e generall y allowe d fo r th e cos t o f th e services . Unless eac h taxpaye r earn s mor e tha n th e valu e o f th e service s plu s taxes, the tax system encourages taxpayers to provide the services on an in-kind basis (assuming that they have or can develop the skill to perform th e services) . A deduction fo r market-purchase d service s would eliminate th e ta x incentiv e fo r hom e production . Alternatively , non neutrality could be eliminated by including the imputed incom e fro m the in-kin d family-provide d service s i n gros s income . Inclusio n o f imputed incom e woul d b e quit e problematic , however , du e t o th e administrative difficulties o f valuation and enforcement . Child car e expense s arguabl y shoul d b e treate d differentl y fro m other types of nondeductible household expenses because of the necessary relationship between child care and access to the labor market. 124 The need for a child car e deduction o r credit to offset th e current ta x incentive fo r a paren t t o provid e chil d car e a t hom e i s typicall y advanced in the context of a constellation of other social and economic factors discouragin g wome n fro m ful l labo r forc e participation. 125 Studies sugges t tha t labor forc e participatio n o f secondar y worker s responds to changes in tax rates,126 and thus tax nonneutrality between wage work and household labor may result in allocative inefficiencies . The secon d bes t solutio n o f a tax adjustmen t fo r work-relate d chil d care achieves special force i n a setting otherwise discouragin g wome n from entering or staying in the labor market.

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The Double Standard Applied to Low-Income Taxpayers As argued above, the tax treatment o f child care expenses cannot be evaluated in isolation from th e Code's taxation of the family in general. Even i f on e conclude s tha t th e chil d car e credi t canno t b e justifie d under the ability-to-pay norm, analysis under the neutrality norm suggests that a tax allowance for child care costs could be justified a s a second bes t solutio n t o currentl y existin g nonneutralitie s betwee n wag e work and household labor. I.R.C. §§21 and 12 9 offset, at least partially, the effects of certain policy trade-offs mad e in connection with taxation of the family. Thus, the child care allowances should be understood a s serving important structural functions withi n the tax system. As I have argued elsewhere , because of the structural rol e played by these provisions as an offset to other nonneutralities involving taxation of the family, the child care tax credit shoul d no t be phased ou t fo r middle - an d upper-income taxpayer s a s a mean s o f redirectin g benefit s t o low income families . Instead , revenue s shoul d b e reallocate d fro m othe r sources to extend the benefits of such offsets to low-income families. 127 The Policy Trade-Offs Creating Nonneutralities in Taxation of the Family. Conflicts amon g th e competin g ta x polic y goal s o f marriag e neutrality, progressivity, and the policy of taxing equal-income married couples equally 128 have forced inescapabl e trade-offs i n the taxation of the family . A s man y analyst s hav e pointe d out , i t i s mathematicall y impossible to accomplish al l three goals at the same time, and give n a progressive rate structure, nonneutralities may result.129 The tax system has shifte d th e balanc e amon g thes e goal s ove r tim e a s Congress ha s responded to changes in social patterns, distributive goals, and prevailing perceptions of the role of the family in society. The I.R.C. § 21 child car e tax credit an d th e I.R.C. § 12 9 exclusion for employer-provide d chil d car e serv e a n importan t functio n a s a n offset to current nonneutralities between married and unmarried earners give n th e followin g feature s o f th e curren t ta x structure : (1 ) th e phase-out percentages of the earned income tax credit for low-incom e workers,130 (2) a progressive rate structure, and (3) a joint filing regime for marrie d taxpayers . Unles s thes e feature s o f th e ta x structur e ar e altered, the child care tax provisions should be retained or expanded as a second best solution.

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How the Nonneutralities Affect Low-Income Taxpayers. A t lo w income levels, tax costs make working to cover child care expenses an inherently losin g proposition . Althoug h ta x cost s o f workin g i n the wage labor marke t ar e somewhat offse t b y I.R.C. §§2 1 and 12 9 for middle- and upper-income taxpayers, low-income taxpayers receive little or no benefit fro m thos e provisions. Thus, the low-income mothe r generally is better off staying at home to care for the children unless she earns more than it costs to purchase adequate child care or can rely on unpaid relatives or low-cost providers for child care. As has been pointe d ou t by Prof. Edward McCaffery , th e tax costs result from a combination o f the 1 5 percent margina l income tax rate on earne d incom e abov e the tax threshold amounts , the 7.65 percent employee portion of social security taxes, and the phase-out percentage of th e earne d incom e ta x credit. 131 Th e earned incom e ta x credit i s structured to benefit low-incom e working families. The amount of the credit initially increases with earnings , then remain s constant a s earnings increase, and then decrease s with earning s until it is fully phase d out. In 1996 , unles s schedule d increase s ar e repealed b y Congress, 132 the maximum benefit for a family with two or more qualifying childre n will be $3,556 (equa l t o 40 percent o f the earned incom e amoun t o f $8,890). The maximum benefit applie s to incomes between $8,890 and $11,610 an d decline s thereafter . A phase-out percentag e (21.0 6 per cent) applie s t o adjuste d gros s incom e (or , i f greater , th e earne d income) i n excess of $11,610. Thus, the benefit i s fully phase d ou t at $28,495 of adjusted gross income for a taxpayer with two or more qualifying children. 133 In 1996 , for example, the marginal incom e tax rate (15 percent) , th e employe e portio n o f socia l securit y ta x rates (7.65 percent), and the earned income credit phase-out rat e (21.0 6 percent) equal a combined tax rate of 43.71 percent, without taking into account state taxes and the incidence of the employer portion of social security taxes. The earned income tax credit phase-out percentages have the effec t of increasing the marriage penalty for families at low-income levels; in addition, the y mak e th e marginal ta x rate ver y hig h fo r low-incom e families earning at levels within the phase-out range. 134 A possible off setting adjustment t o these nonneutralities would be to make the child care tax credit refundable an d to increase the applicable percentage to at least 50 percent of an increased level of eligible child care expenses.

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Alternatively, I.R.C . § 12 9 program s coul d b e mad e availabl e t o al l employees. The tax double standard a s applied to low-income families operate s at cross purposes to current welfare refor m proposal s and create s a double bind for welfare mothers. The problem could be partially addressed by deliverin g increase d chil d car e benefits throug h th e ta x syste m o r through direc t assistanc e programs, or som e combination o f the two. More comprehensiv e ta x polic y reform s woul d requir e revisitin g th e policy trade-offs regardin g the use of the joint return, the goal of taxing equal earning families equally, and the nontaxation of imputed incom e from househol d labor . I n th e absenc e o f mor e comprehensiv e ta x reforms, the policy clash between welfare reform goal s and the tax code will requir e increase d attentio n b y policymakers t o th e effect s o f th e family values double standard as applied to low-income families.

NOTES As this volume was going to press, President Clinton signed into law a modified version of welfare refor m legislatio n tha t h e had vetoe d earlie r i n 1996 . See Personal Responsibilit y an d Work Opportunity Act of 1996 , Pub. L. 104-193,110 Stat. 2105. Some related portions of this essay were published b y The Yale Law and Polic y Review , Inc. , Mary L . Heen, Welfare Reform, Child Care Costs, and Taxes: Delivering Increased Work-Related Child Care Benefits to Low-Income Families, 1 3 Yale L. 8c Pol'y Rev. 173 (1995) (examining the current federal child care programs, describing the need fo r increase d assistance , and addressin g th e issu e o f whethe r additiona l federa l chil d car e assistance to low-income families should be provided through a transfer payment system, through the tax system, or through som e combination o f the two systems). Lisa Barnett, Dax Olsher, and John M . Ramey III provided researc h assistance, and th e University of Richmond Schoo l of Law summer research fund provide d financial support for this project. 1. Personal Responsibilit y an d Work Opportunity Act of 1995 , H.R. 4, 104th Cong., 1s t Sess. (1995) (vetoe d by President Clinto n o n Jan . 9, 1996) ; H.R. Conf. Rep. No. 430, 104th Cong. , 1st Sess. (1995) (describin g the House welfare refor m bill , the Senate amendment, and the substitute agreed to in conference). The conference report was agreed to by a vote of 245 to 178 in the House, 141 Cong. Rec. HI5533 (daily ed. Dec. 21,1995), and by a vote of 52 to 47 in the Senate, 141 Cong. Rec.S19181 (daily ed. Dec. 22,1995). See a/so Work Opportunity Act of 1995, H.R. 4,104th Cong., 1st Sess. (1995), 141 Cong. Rec. S13802 (dail y ed. Sept. 19 , 1995) (passe d by a Senate vote of 8712); Personal Responsibilit y Ac t o f 1995 , H.R. 4 , 104t h Cong. , 1s t Sess . (1995), 14 1 Cong. Rec. H3790 (daily ed. Mar. 24,1995) (passe d by a House vote of 234-199). 2. See Sylvia A. Law, Women, Work, Welfare, and the Preservation of Patriarchy,131 U. Pa. L. Rev. 1249(1983). 3. See Edward J. McCaffery, Taxation and the Family: A Fresh Look at Behavioral Gender Biases in the Code, 40 UCLA L. Rev. 983 (1993).

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4. See Gwendolyn Mink, Welfare Reform in Historical Perspective, 26 Conn. L. Rev. 879, 881-83 (1994); Doroth y E . Roberts , The Value of Black Mothers' Work, 2 6 Conn . L . Rev. 871 , 873-75 (1994). 5. See Lance Liebman , Evaluating Child Care Legislation: Program Structures and Political Consequences, 26 Harv. J. on Legis. 357, 360-61 (1989 ) (questionin g whether i t is important tha t single mothers work even if child care costs more than their short-term earnings); see also Martha L. Fineman, Images of Mothers in Poverty Discourses, 199 1 Duke L. J. 274 (observing that the primary objective of welfare reform legislation is to link poverty with the lack of a work ethic and critiquing mandator y wor k requirements , the substitutio n o f governmenta l suppor t wit h suppor t from fathers , and the stigmatizing of single mothers). 6. See Mimi Abramovitz, Regulating the Lives of Women: Social Welfare Policy from Colonia l Times to the Present 34 1 (1988); Linda Gordon, Pitied but No t Entitled: Single Mothers and th e History of Welfare 1890-1935 , 289-99 (1994); see generally Theodore R. Marmor et al, Americas Misunderstood Welfar e State : Persistent Myths, Enduring Realitie s 23-24 (1990 ) (describin g th e behaviorist visio n o f socia l welfar e polic y i n whic h th e poo r ar e induce d t o behave "in a mor e socially acceptable manner"). 7. See infra discussion in section titled History of Congressional Approaches. 8. See C. Eugen e Steuerl e & Jason Juffras , A $1,000 Ta x Credi t fo r Ever y Child : A Basis of Reform fo r th e Nation's Tax, Welfare, and Healt h System s 3-4 (Urba n Inst . Changing Domesti c Priorities Serie s 1991) ; see also Jonathan B . Forman, Beyond President Bush's Child Tax Credit Proposal: Towards a Comprehensive System of Tax Credits to Help Low-Income Families with Children, 38 Emory L.J. 661, 693-96 (1989 ) (proposin g a $1,000 refundable children' s allowanc e tax credit). 9.H.R.2491,104th Cong. , 1st Sess. Title XI, Subtitle A, §11001 (1995) (House and Senate conferees agreein g t o a $50 0 per chil d ta x credit , phasin g ou t th e credi t a t adjuste d gros s income s above $110,000 for joint return s and $75,00 0 for unmarrie d individuals) ; see generally Lawrence Zelenak, Children and the Income Tax, 49 Tax L. Rev. 349 (1994) (discussin g various proposals for change). 10. See Frances Fox Piven & Richard A. Cloward, Regulating the Poor: The Functions of Public Welfare 248-340 (1971). 11. For a discussion of this correlation, see Dorothy A. Brown, The Marriage Bonus/Penalty in Black and White, this volume ; John a . powell, How Government Tax and Housing Policies Have Racially Segregated America, this volume. 12. See Abramovitz, supra note 6 , a t 181-206 , 315-19 ; Winifre d Bell , Ai d t o Dependen t Children 3-75 (1965); Gordon, supra note 6, at 37-64,253-85. 13. See Alice Kessler-Harris, Out to Work: A History of Wage-Earning Women i n the Unite d States viii, 16-19,119-27 (1982) ; Piven & Cloward, supra note 10 , at 3-41,123-45. 14. See Bell, supra note 12 , at 174-94. 15. See Piven & Cloward, supra note 10 , at 138. 16. See id. at 134; Bell, supra note 12 , at 46 (noting that "[i]n one parish, the policy extended to children as young as 7 years of age). 17. See Piven & Cloward, supra note 10 , at 134-35. 18. See Bell, supra note 12 , at 46,107,141. 19. See Abramovitz, supra note 6, at 333. 20. Se e Joel F . Handler & Yeheskel Hasenfeld , Th e Mora l Constructio n o f Poverty : Welfar e Reform in America 141-4 2 (WIN I), 156-58 (WIN II) (1991). 21. See Abramovitz, supra note 6, at 341 (attributing the exemption t o limited funding, a lack of child care, and an excess of welfare recipients over WIN slots).

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22. See Handler & Hasenfeld, supra note 20, at 154. 23. Pub . L . No. 100-485 , Title III, 10 2 Stat . 234 3 (codifie d a s amende d a t 4 2 U.S.C . § 602 (1988)). 24.SeeH.R.Conf.Rep.No.998,100th Cong. , 2d Sess. 1 (1988) . 25.42 U.S.C § 602(a)(19)(B)(I) (1986) . 26. Id. at § 602(a)(19)(C)(iii)(II). 27.Jd.at§602(a)(19)(C)(iii)(I). 28. See Staff o f Hous e Comm . o n Way s an d Means , 103 d Cong. , 2 d Sess. , Overvie w o f Entitlement Programs , 199 4 Green Book , table 10-4 , at 344-48 (Comm . Print 1994 ) [hereinafte r 1994 Green Book ] (listin g eight state s exempting onl y those caretaker s with childre n unde r ag e one, and four states and the Virgin Islands exempting those with children under age two). 29. See Piven 8c Cloward, supra note 10 , at 341, App. Source, table 1,4 . 30. See generally Martha Minow, The Welfare of Single Mothers and Their Children, 26 Conn. L. Rev. 817, 826-31 (1994) (rejectin g the argument tha t "work requirements for mothers on welfar e simply reflect the changing social expectations of all women"). 31. Se e 1994 Green Book , supra note 28 , at 40 4 n. 2 (reporting tha t i n 199 2 16. 1 percent o f AFDC mothers or other caretakers were at school or training, 2.2 percent worked more than thirty hours per week, and 4.2 percent worked fewer than thirty hours per week); see also Ann L. Alstott, The Earned Income Tax Credit and the Limitations of Tax-Based Welfare Reform, 108 Harv. L. Rev. 533, 546-47 n. 52 (1995) (statin g that data typically show that few AFDC recipients work and citing other studies indicating that a majority of women work at some point while receiving welfare). In comparison, about 56. 8 percent o f married women whos e youngest child i s under si x participate in the labor force. See Minow, supra note 30, at 827 n. 53 (citing figures based on census data from 1987) ; see also Lucy A. Williams, The Ideology of Division: Behavior Modification Welfare Reform Proposals, 10 2 Yale L.J. 719, 745 n. 173 (1992) ("O f wome n with children under the age of six, 64 percent worke d a t some time during the year, although onl y 25 percent worke d full-tim e year-round"). 32. Heidi Hartman n & Roberta Spalter-Roth , Reducing Welfare's Stigma: Policies That Build upon Commonalities among Women, 26 Conn. L. Rev. 901,908 (1994). 33. Id. 34. See id. 35. 1994 Green Book, supra note 28, at 342, 789. 36.42 U.S.C. § 602(g)(3). See 1994 Greenbook, supra note 28, at 342. 37. See 1994 Green Book, supra note 28, table 10-5 , at 349. 38. See Hearing on the Job Opportunities an d Basi c Skills Programs: Views from Participant s and Stat e Administrators Befor e th e Subcomm . o n Huma n Resource s o f th e Hous e Comm . o n Educ. and Labor, 103d Cong., 2d Sess. 80 (1994) (statemen t of Raymond C. Scheppach, Executive Director, National Governor's Association); see also 1994 Green Book, supra note 28, table 10-5 , at 349 ($646.6 million total federal fund s expende d o n JOBS in 199 3 compared to $582.5 million in JOBS-related chil d care) ; id. at 553 , table 12-1 1 (estimate d tha t abou t $66 8 millio n woul d be expended on AFDC child care and transitional child care in fiscal year 1994). 39. See 42 U.S.C. § 603(n)(2)(B) (Supp . IV 1992) (the program is authorized a s a capped entitlement at $300 million annually). 40.42 U.S.C. § 602(i)(3)(A) (1986) . 41.42 U.S.C. §§ 9858,9858a-q (Supp . V 1993). 42. 4 2 U.S.C . § § 139 7 (1992) , 1397a- f (199 2 & Supp. 1995 ) (Socia l Service s Bloc k Gran t Program of Title XX of the Social Security Act). 43. For a discussion o f these programs, see Mary L . Heen, Welfare Reform, Child Care Costs,

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and Taxes: Delivering Increased Work-Related Child Care Benefits to Low-Income Families, 1 3 Yale L. &Pol'y Rev. 173(1995). 44. Id. (excluding amounts expended on programs such as Head Start and the Child and Adult Care Food Program). 45. See Ann Collins & Barbara Reisman, Child Care under the Family Support Act: Guarantee, Quasi-Entitlement, or Paper Promise? 11 Yale L. & Pol'y Rev. 203 (1993). 46. U.S . Gen . Accountin g Office , Chil d Care : Workin g Poo r an d Welfar e Recipient s Fac e Service Gap s 4- 5 (Ma y 1994 ) (base d o n preliminar y fisca l yea r 199 2 dat a reporte d t o th e Department of Health and Human Services by the states). 47. See The Impac t o f Welfare Refor m o n Childre n an d Thei r Families : Hearings Befor e th e Senate Comm. on Labo r and Huma n Resources , 104th Cong., 1s t Sess. 211 (1995) (statemen t of Sandra L. Hofferth, Universit y of Michigan Institute for Social Research) (citin g reports published in 1991 and 1992). 48. See id. (based on transitional care data from twent y states). 49. Children's Defense Fund, The State of America's Children Yearbook 42 (1995) [hereinafte r 1995 Yearbook] (findin g that eight states had at least ten thousand children on the child care assistance waiting lists); Children's Defense Fund, The State of America's Children Yearbook 32 (1994) [hereinafter 199 4 Yearbook] (findin g that thirty-one states and the District of Columbia had waiting lists). 50. See U.S. Gen. Accounting Office , supra note 46 , at 15 ; 1995 Yearbook, supra note 49 , at 41-42; 1994 Yearbook, supra note 49, at 34. 51. See 1994 Yearbook, supra note 49, at 35. 52. Elle n Galinsk y e t al. , Th e Stud y o f Childre n i n Famil y Chil d Car e an d Relativ e Care : Highlights of Findings 5,97 (1994). 53. Id. at 97. 54. Id. 55. See supra note 1 ; Daniel Patrick Moynihan, The Devolution Revolution, N.Y. Times, Aug. 6, 1995,atD15. 56. See H.R. Conf. Rep. No. 430, supra note 1 (describing the House version of H. R. 4, which authorized states to use up to 30 percent of their family assistance block grants for other purposes, including fo r Titl e XX and Chil d Car e an d Developmen t Bloc k Gran t programs , and provide d $2.09 billion per year for child care block grants). 57. See id. (describing the Senate version o f H . R. 4, which authorize d state s to us e up to 30 percent o f their famil y assistanc e grants for Chil d Car e and Developmen t Bloc k grant activities , required th e states to maintain 8 0 percent o f historic state expenditures fo r fiv e years, including child care expenditures, set aside funds to improve the quality of child care, and provided slightly increased federal funds for child care over a five-year period; and describing the conference substitute, later vetoed, which provide d modes t increase s in federal chil d car e funds ove r a seven-year period). 58. See GOP Agrees on Cutting Welfare by $80 Billion, L.A. Times, Nov. 11,1995, at A21. 59. See Alison Mitchell, Greater Poverty Toll Is Seen in Welfare Bill, but White House Says It May Be Forced to Accept Senate Measure, N.Y. Times, Nov. 10,1995, at A27. 60. See 1994 Green Book, supra note 28, at 540-41; Sandra L . Hofferth, e t al., National Chil d Care Survey, 1990 119-96,198-99 (1991) (defining child care as care provided while the mother is at work , an d includin g car e provide d b y fathers , mothers , an d childre n themselves) ; Hearings , supra note 47, at 202 (in 1990, only 27 percent of the working poor paid for child care; the working poor who paid for child care spent about 33 percent of their incomes on child care, compared with 13 percent for working-class and 6 percent for middle-class families).

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61. Galinsky et al., supra note 52, at 90. 62. See id. at 91. 63. See Cost, Qualit y & Child Outcome s Stud y Team , Economic s Dept. , U . of Colorad o a t Denver, et al., Cost, Quality, and Child Outcomes in Child Care Centers: Executive Summary 2, 5 (Apr. 1995) (finding also that the average center in the study expended $95 per week, per child fo r full-time care). 64. For a more detailed discussion o f the legislative history of the child care tax credit and its predecessors, see Alan L. Feld, Deductibility of Expenses for Child Care and Household Services: New Section 214, 27 Tax L . Rev. 415 (1972) ; Heen, supra note 43 , at 211-14 ; John B . Keane, Federal Income Tax Treatment of Child Care Expenses, 10 Harv. J. Legis. 1,2-7 (1972) ; William A. Klein, Tax Deductions for Family Care Expenses, 14 B.C. Int'l & Comp. L. Rev. 917,919-32,936-37 (1973) ; see also Wendy Gerzog Shaller, Limit Deductions for Mixed Personal/Business Expenses: Curb Current Abuses and Restore Some Progressivity into the Tax Code, 41 Cath . L . Rev . 581 , 606-9 (1992 ) (describing the § 129 exclusion for dependent care assistance). 65. Internal Revenue Code of 1954 , Pub. L. No. 591-736, 68A Stat. 70 (codified a t I.R.C. §214, repealed in 1976). 66. See H.R. Rep. No. 1337, 83d Cong., 2d Sess. (1954), reprinted in 1954 U.S.C.C.A.N. 4019, 4055; Detailed Discussio n o f the Technical Provisions of the Bill , reprinted in 1954 U.S.C.C.A.N. 4137,4197-98. 67. See S . Rep . No . 437 , 92 d Cong. , 1s t Sess . 13-14 , 59-6 2 (1971) , reprinted in 197 1 U.S.C.C.A.N. 1918,1929,1966-68 . 68. Id. at 1928-29. 69. Mat 1928 . 70. Mat 1929 . 71. Pub . L. No. 94-455, Title V, § 504(a)(1), 90 Stat . 156 3 (1976 ) (codifie d a t I.R.C . § 44A) (amended in 197 8 and 198 1 and redesignated in 198 4 as I.R.C. § 21). 72. See H.R. Rep. No. 658, 94th Cong., 2d Sess. 147-48 (1976), reprinted in 1976 U.S.C.C.A.N. 2897, 3040-41 ; S . Rep. No . 938 , 94t h Cong. , 2 d Sess. , pt . I , 132-3 3 (1976) , reprinted in 197 6 U.S.C.C.A.N. 3439,3565-66. 73. Pub. L. No. 94-455, supra note 71 (codified a t I.R.C. § 44A(c)). 74. Economic Recovery Tax Act of 1981 , Pub. L. No. 97-34, § 124,95 Stat. 172,197-201 (codi fied at I.R.C. §§ 44A, 129). 75. See H.R. Conf. Rep. No. 215, 97th Cong. , 1s t Sess. 195, 200-201 (1981) , reprinted in 1981 U.S.C.C.A.N. 285,290-91. 76. Deficit Reductio n Act of 1984 , Pub. L. No. 98-369, § 471(c)(1), 98 Stat. 494,826. 77. Omnibus Reconciliation Act of 1987, Pub. L. No. 100-203, § 10101,101 Stat. 1330-84 (codified at I.R.C. § 21(b)(2)(A)). 78. Family Support Act of 1988 , Pub. L. No. 100-485, § 703,102 Stat. 2343, 2426-27; Technical and Miscellaneous Revenue Act of 1988 , Pub. L. No. 100-647, § 2004,102 Stat. 3342,3598. 79. Staf f o f Join t Comm . o n Taxation , 104t h Cong. , 1s t Sess. , Estimate s o f Federa l Ta x Expenditures for Fiscal Years 1996-2000 (Comm . Print 1995) , reprinted in Daily Tax Rep. (BNA), Sept. 6,1995, at L-l, L-9, L-12 [hereinafter 199 5 JCT Tax Expenditure Estimates]. 80. See I.R.C. § 151(d)(3) (1986 ) (providin g for the phaseout of personal exemptions for taxpayers wit h adjuste d gros s income s abov e certai n threshol d amounts) ; Debora h H . Schenk , Simplification for Individual Taxpayers: Problems and Proposals, 45 Tax L. Rev. 121, 127-49 (1989); Zelenak, supra note 9. 81.1.R.C.§ 21(a)(2). 82. Id. at § 21(b)(2).

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83. Id. at § 21(a)(1). 84. Id. at §§ 21(a) (refer s t o "qualifying individuals " rather tha n children) , 21(b)(1) (define s "qualifying individuals" as including three categories of individuals: (1) a dependent under the age of thirteen, (2) a dependent who is physically or mentally incapable of self-care, or (3) the spouse of the taxpayer, if physically or mentally incapable of self-care). 85. Id. at § 21(c); see also id. at § 21(d)(1), (2) (the amount of the employment-related expenses may not excee d th e lower o f earne d incom e of the taxpayer o r tha t o f the taxpayer's spouse ; however, if the taxpayer's spouse is a full-time studen t or incapable of self-care, a monthly amount of income is deemed to be earned by the spouse in the amount of $200 (if the $2,400 limit applies) or $400 (if the $4,800 limit applies)). 86. Id. at § 21(a)(2). 87. See Forman, supra note 8, at 686. 88. Pub. L. No. 99-514,100 Stat. 2085 (1986). 89. See Michael J . Graet z 8 c Deborah H . Schenk , Federa l Incom e Taxatio n Principle s an d Policies 428 (3d ed. 1995). 90.1.R.C.§ 63(c)(2). 91. Id. at § 151(b), (c). 92. Id. at § § 63(c)(4 ) (requirin g inflatio n adjustment s t o th e standar d deductio n amount s beginning after 1988) , 151(d)(4) (requirin g inflation adjustment s t o the $2,000 personal exemption amount for tax years beginning after 1989) . 93. See Rev. Proc. 95-53,1995-52 I.R.B. 22 (for 199 6 the inflation-adjusted standar d deduction amount fo r a marrie d taxpaye r filing a joint retur n i s $6,700 ; the inflatio n adjuste d persona l exemption amoun t i s $2,550; thus, a family of four claimin g a standard deductio n ($6,700 ) an d four exemptions (4 x $2,550 = $10,200) would pay no tax on up to $16,900 of income). 94. See Notice, Annual Update of the HHS Poverty Guidelines, 61 Fed. Reg. 8286 (1996) (th e federal poverty guideline for a family of four is $15,600 for 1996). 95. Rev. Proc. 95-53, supra note 93, at §§ 3.04, 3.08 (fo r 199 6 the inflation-adjusted standar d deduction fo r a single hea d o f househol d i s $5,900; the inflatio n adjuste d persona l exemptio n amount is $2,550; the standard deduction ($5,900 ) plus two personal exemptions ($5,100) equals $11,000). 96. See Notice, supra note 9 4 (fo r 1996 , the federa l povert y incom e fo r a famil y o f tw o i s $10,360). 97. See Jonathan Barry Forman, Simplification for Low-Income Taxpayers: Some Options, Table 12.1, this volume. 98. See 1995 JCT Tax Expenditure Estimates, supra note 79, at 23, table 3, at L-12 (the staff prepares estimates by income class for the child and dependent care credit; the estimates illustrate the concentration of benefits in the middle and upper income ranges). 99.1.R.C.§ 129(a). 100. Id. at § 129(d)(1). 101. Id. at § 129(d)(l)-(8 ) (includin g requirement s tha t contribution s t o th e pla n no t dis criminate in favor of highly compensated employees, id. at (d)(2), and that employees be notifie d of the terms and availability of the program, id. at (d)(6)). 102. Id. at § 129(b)(1); see also id. at § 129(b)(2) (incorporatin g by reference the provisions of §21 (d)(2), the statute applies the same rules that are applicable to the child and dependent care tax credit for determining a deemed amount of earned income for a student spouse or a spouse incapable of self-care). 103. Id. at § 129(c).

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104. See 1994 Green Book , supra note 28, at 708 (citing U.S. Department o f Labor, Bureau of Labor Statistics, Employee Benefits in Medium and Large Firms, 1991 (May 1993)). 105. See id. 106. See I.R.C. § 21(c) (providin g that th e amount o f employment-relate d expense s claime d for purposes of the credit shall be reduced by the amount excludabl e from gros s income under § 129 for the taxable year). 107. See generally 1994 Green Book, supra note 28, at 708 ("... th e credit generally is less valuable than the exclusion for taxpayers who are above the 15-percen t tax bracket"). 108. See Grace Blumberg , Sexism in the Code: A Comparative Study of Income Taxation of Working Wives and Mothers, 21 Buff. L. Rev. 49,64-66 (1971). 109. See Smith v. Commissioner, 40 B.T.A. 1038 (1939), aff'd without opinion, 113 F.2d 11 4 (2d Cir. 1940) (denyin g a business expense deduction fo r chil d care costs on the basis that child care was one of the basic functions o f family living and thus was a "personal" concern). 110. See Stanley S . Surrey & Paul R . McDaniel, Tax Expenditures 3 (1985 ) (explainin g tha t departures fro m th e norma l ta x structur e ar e ta x expenditure s o r specia l preference s an d ar e viewed as equivalent to direct government outlays). 111. See Boris I. Bittker, Federal Income Taxation and the Family, 27 Stan. L. Rev. 1389, 1463 (1975). 112. See Thomas D . Griffith, Personal Deductions in the Income Tcuc, 4 0 Hasting s L.J . 343, 385-94 (1989) ; Pau l R . McDanie l & Jame s R . Repetti , Horizontal and Vertical Equity: The Musgrave/Kaplow Exchange, 1 Fla . Tax Rev. 607 (1993). 113. See Klein, supra note 64 , at 937-40 ; Brian Wolfman , Child Care, Work, and the Federal Income Tax, 3 Am. J. Tax Poly 153,167-7 4 (1984). 114. See Klein, supra note 64 , a t 941 ; see generally Bori s I . Bittker , Income Tax Reform in Canada: The Report of the Royal Commission on Taxation, 3 5 U. Chi. L. Rev. 637, 638-45 (1968 ) (discussing the commission's conclusion that a taxpaying unit's ability to pay taxes is measured by its discretionary economic power). 115. See Marvin A . Chirelstein, Federa l Incom e Taxation : Th e Leadin g Case s an d Concept s 56.01(a) (7t h ed. 1994); Keane, supra note 64, at 30-35. 116. See Feld, supra note 64, at 429; McCaffery, supra note 3, at 1005-10 ; Daniel C. Shaffer & Donald A. Berman, Two Cheers for the Child Care Deduction, 28 Tax L. Rev. 535,535-36 (1973). 117. Wolfman, supra note 113 , at 190-93. 118. Fo r a mor e detaile d discussio n o f optima l incom e taxation , se e Josep h Bankma n & Thomas Griffith, Social Welfare and the Rate Structure: A New Look at Progressive Taxation, 75 Cal. L. Rev. 1905,1919-29 (1987); McCaffery, supra note 3, at 1035-46. 119. A. C. Pigou , A Study i n Publi c Financ e (3 d ed . 1947) ; see McCaffery, supra note 3 , at 1046-53. 120. For the view that in economic terms, child care costs are an investment by parents in their children's human capital, see Lynn A. Stout, Some Thoughts on Poverty and Failure in the Market for Children's Human Capital, 8 1 Geo. L.J. 194 5 (1993). But see Bittker, supra note 111 , at 1447-4 8 (noting that th e concept o f children a s the "poor man' s capital," or as an informal socia l security system, has made little headway in the analysis of American society); accord Klein, supra note 64, at 940 n . 1189 ; see generally Joseph M . Dodge , Taxing Human Capital Acquisition Costs—or Why Costs of Higher Education Should Not Be Deducted or Amortized, 54 Ohi o St . L . J. 927, 948-6 1 (1993). 121. See R. G. Lipsey & Kelvin Lancaster, The General Theory of the Second Best, 24 Rev. Econ. Stud. 11 (1956). For more general use of the term second best solution to refer to solutions to prob-

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lems that take into accoun t existin g imperfections an d tolerat e compensating imperfections , see Boris I. Bittker, A "Comprehensive Tax Base" as a Goal of Income Tax Reform, 80 Harv. L. Rev. 925, 983-84 (1967); Dodge, supra note 120, at 941-43. 122. See generally Schaffer 8 c Berman, supra note 116 , at 537-43 (discussing the nonneutralit y between wage work and house work). 123. See Wolfman, supra note 113 , at 175-81 . 124. See Schaffer 8 c Berman, supra note 116 , at 543-4 5 (distinguishin g chil d care from othe r self-provided service s because of the necessary, although no t sufficient , relationshi p between th e expense and the income earned). 125. See Rachel Connelly , The Effect of Child Care Costs on Married Women's Labor Force Participation, 74 Rev. Econ. 8c Stat. 83,90 (1992). 126. See Bankman 8c Griffith, supra note 118 , at 1925-27 (discussing studies). 127. SeeHeen, supra note 43, at 210-17. 128. For a discussion o f th e "fiction" o f marita l unit y underlyin g th e polic y of taxin g equa l earning families equally, see Lily Kahng, Fiction in Tax, this volume. 129. See Bittker, supra note 111 , at 1395-97. 130. See infra. 131. McCaffery, supra note 3, at 1015-16. 132. Omnibus Budget Reconciliation Act of 1993 , Pub. L. No. 103-66, § 13131 , 107 Stat. 312, 433 (increasing benefits through 1996) . 133. See I.R.C. § 32(b); Rev. Proc. 95-53, supra note 93 , at § 3.03; Alstott, supra note 31 , at 541-44; Regin a T . Jefferson, The Earned Income Tax Credit: Thou Goest Whither? A Critique of Existing Proposals to Reform the Earned Income Tax Credit, 68 Temp. L. Rev. 143, 145-52 (1995) ; George K. Yin et al., Improving the Delivery of Benefits to the Working Poor: Proposals to Reform the Earned Income Tax Credit Program, 11 Am. J. Tax Pol'y 225,230-60 (1994). 134. See Alstott, supra not e 31 , a t 549-50 , 559-64 ; Doroth y A . Brown , The Marriage Bonus/Penalty in Black and White, this volume.

CONTRIBUTORS

Jennifer J. S. Brooks earned he r undergraduat e degree fro m Wak e Fores t Universit y an d he r J.D . fro m Catholi c University. After graduatio n sh e practiced ta x law at th e Washington , D.C., law firm o f Covington and Burling, where she was strongly influenced b y Joh n B . Jones, Jr. In 198 3 Brooks joine d th e facult y o f th e William Mitchel l Colleg e of La w in St . Paul, Minnesota. She obtaine d her LL.M . from Harvar d La w School, writing a thesis under th e guid ance o f Willia m D . Andrews . A membe r o f th e America n Ba r Association's Tax Section, from 198 9 to 199 0 Brooks served as chair of the Corporat e Ta x Committee , fro m 199 1 t o 199 5 a s secretary , an d from 199 5 to 1996 as a member of the council. She is currently co-chair of th e Committe e o n Integratio n o f th e Corporat e an d Individua l Taxes and a sponsor of the Tax and Social Policy Forum. Dorothy A. Brown is associate professor o f law at the University of Cincinnati College of Law. She received her J.D. from the Georgetown University Law Center and her LL.M. in tax from Ne w York University . Befor e enterin g th e lega l academy , Brow n practice d law and worked a s an investment banke r o n Wall Street. She regularly publishes in the state and local and tax areas. Her most recent publication, Invisibility Factor: The Limits of Public Choice Theory and Public Institutions, will appear in the Washington University Law Quarterly in 1996. She i s currentl y completin g a n article , The Invisibility of Black Women in Tax Jurisprudence, that examine s the tax treatment o f black women. Karen B. Brown is professor o f law and associat e dean fo r academi c affair s a t th e Universit y o f Minnesota . Sh e wa s appointed Juliu s E . Davi s Professo r o f La w fo r 1995-96 . I n keepin g with her interest in the impact o f the changing world econom y on th e U.S. syste m o f taxatio n o f incom e fro m internationa l transactions , Brown ha s written numerou s article s o n corporat e an d internationa l taxation an d ha s coauthore d a treatise o n internationa l transactions . 347

3 4 8 CONTRIBUTOR

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Before joining the Minnesota faculty , sh e was a professor a t Brookly n Law School. A graduate of Princeton University, she earned her J.D. and LL.M. in taxation from the New York University School of Law. Charlotte Crane teaches ta x an d loca l govern ment la w a t Northwester n Universit y Schoo l o f Law . She clerke d fo r Judge Wade H. McCree on th e Cour t o f Appeals for th e Sixt h Circui t and for Justice Harry A. Blackmun on the Supreme Court of the United States. Before joining the academy, Crane practiced primarily in tax for four year s in Chicago . Her recen t researc h interest s includ e question s not onl y regarding the appropriate ta x base but als o about the role of legal institutions in the design and implementation of such bases. Jonathan Barry Forman has been a faculty mem ber at the University of Oklahoma College of Law since 1985, where he teaches ta x an d socia l welfar e courses . Previously , h e serve d a s ta x counsel to U.S. senator Danie l Patrick Moynihan (1983-84) , as a trial attorney fo r th e U.S . Department o f Justice , Tax Division , Norther n Civil Trial Region (1979-83), and as a law clerk for Judge Robert J. Yock of the U.S. Claims Court (1978-79) . Forman received his J.D. from th e University of Michigan School of Law in 197 8 and has M.A. degrees in economics fro m Georg e Washingto n Universit y an d i n psycholog y from the University of Iowa. He is admitted to practice in the District of Columbia an d i s active i n th e American Ba r Association's Sectio n o f Taxation and in the Association of American Law Schools' Sections on Taxation an d o n Povert y Law . Forman' s recen t article s includ e Reconsidering the Tax Treatment of the Elderly and The Income Tax Treatment of Social Welfare Benefits. LaBrenda Garrett-Nelson bega n th e practic e o f tax law in 197 8 as an associate at a major Ne w York law firm. Later she joined the staff o f the Joint Committee on Taxation, serving as counsel during th e five-year perio d tha t sa w enactmen t o f th e Defici t Reduction Act of 1984. Garrett-Nelson also had significant responsibil ity for majo r portion s o f the 198 6 Tax Reform Act . For four year s she taught corporat e an d foreig n ta x course s a s adjunc t professo r i n th e graduate divisio n o f th e Georgetow n Universit y La w Center. Garrett Nelson ha s serve d o n severa l committee s o f th e America n Ba r

CONTRIBUTORS 3 4

Association's Tax Section an d o n the Board o f Advisors of the Journa l of Internationa l Taxation . She has lectured extensivel y fo r continuin g legal educational programs and before professional and trade organizations. Garrett-Nelso n joine d Washingto n Counsel , Inc. , in 1996 . She holds a n undergraduat e degre e fro m Joh n Ja y Colleg e o f Crimina l Justice, City University of New York, and a J.D. and an LL.M. in taxation from New York University School of Law. Gwen Thayer Handelman receive d a B.A . and a J.D., magna cum laude, from th e University of Michigan. In law school she was an editor o f The Michigan Law Review. Followin g graduation , she served as a law clerk to Patricia M. Wald of the United States Court of Appeals for the District of Columbia Circuit and as special assistant to Josep h A. Califano i n hi s capacity a s special counse l fo r th e Hous e Committee on Standards of Official Conduct . She was also an associate with th e la w fir m o f Covingto n an d Burlin g i n Washington , D.C . In 1986 she joined th e la w faculty o f Washington an d Le e University i n Lexington, Virginia. Handelman teaches courses in federal income taxation, employe e benefit s law , and professiona l responsibility . Sh e ha s authored a number of articles and has lectured widely on ethical issues and tax-relate d subjects . Activ e i n th e America n Ba r Association , Handelman co-chairs the Ethics Subcommittee of the Section of Labor and Employmen t La w Employee Benefit s Committe e an d i s chai r o f the Section of Taxation Committee on Standards of Tax Practice. Mary L. Heen is associate professo r a t th e Uni versity of Richmond Schoo l of Law. She previously taught a t the New York University School of Law as acting assistant professor i n the graduate tax program, where sh e also served a s assistant edito r o f th e Tax Law Review. Sh e receive d a n LL.M . i n Taxatio n fro m Ne w Yor k University Schoo l o f Law , a J.D. from th e Universit y o f Californi a a t Berkeley ( Boalt Hall), and a B.A. from Yal e University. Before joinin g the faculty at Richmond, Heen practiced as a tax attorney at Patterson, Belknap, Webb and Tyler in New York City and as a national staff coun sel fo r th e Women' s Right s Projec t o f th e America n Civi l Libertie s Union. Sh e has published a book chapte r an d article s o n gende r dis crimination i n addition t o law review articles on tax and socia l policy issues.

9

3 5 0 CONTRIBUTOR

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Regina T Jefferson is assistant professor o f law at the Catholic University of America Columbus School of Law, where she teaches courses on federa l incom e taxation, partnership taxation , an d ERISA. Jefferson i s an exper t i n the are a o f ERISA . She was a tax law specialist a t the nationa l offic e o f th e Interna l Revenu e Servic e in th e Employee Plan s Divisio n fro m 198 7 through 1990 . Her publication s include Defined Benefit Plan Funding: How Much Is Too Much? published in the Case Western Reserve Law Review, and The Earned Income Tax Credit: Thou Goest Whither? which appeare d i n th e Templ e La w Review. Sh e wa s a speake r a t th e Teachin g Taxatio n Sectio n o f th e annual May meeting of the ABA Taxation Section, May 1994. Jefferson was a graduat e Teachin g Taxatio n Fello w i n th e Graduat e Teachin g Program fo r Futur e Law Professors a t the Georgetown Universit y Law Center. She has a B.S. in mathematics from Howar d University (1981), a J.D. from Georg e Washington Universit y (1987) , and a n LL.M. from Georgetown University (1992). Lily Kahng is associate professo r a t Cornel l Law School. Sh e previousl y taugh t a t th e Ne w York Universit y Schoo l o f Law. She teaches and writes in the fields of federal income taxation and federal estat e an d gif t taxation . Befor e enterin g la w teaching i n 1991, Kahng practiced tax law at the New York City firm of Simpson Thacher and Bartlet t an d wa s a vic e presiden t a t Salomo n Brothers . Kahn g received her B.A. in philosophy from Princeto n University in 1980 , her J.D. fro m th e Columbi a Universit y Schoo l o f La w i n 1984 , an d he r LL.M in taxation from the New York University School of Law in 1991. Beverly I. Moran is professor o f la w at th e Uni versity of Wisconsin La w School. She has dedicated a large part o f her career to increasing the number o f minority professors i n legal education. In addition to creating and coordinating a number of conference s for minority law professors, Moran has been instrumental in changing the direction of tax scholarship through her various speeches and publications emphasizing the social, race, and class aspects of taxation. She is a graduat e o f Vassa r College , th e Universit y o f Pennsylvani a La w School, and th e New York University La w School. She lectures widely on variou s ta x issue s i n th e Unite d States , Canada , Hon g Kong , th e People's Republic of China, Ethiopia, and Eritrea.

CONTRIBUTORS 3

john a. powell is professor of law at the University of Minnesota Law School and executive director of the Institute of Race and Poverty. He received his B.A. from Stanfor d Universit y and his J.D. from th e University of California, Berkele y (Boalt Hall). Before joining the facult y a t Minnesota , Professo r powel l serve d a s nationa l lega l director o f th e America n Civi l Libertie s Unio n (ACLU) . He ha s als o taught at the Columbia University School of Law, Harvard Law School, the Universit y o f Miam i Schoo l o f Law , an d th e Universit y o f Sa n Francisco Schoo l o f Law . He i s widely published i n both th e popula r and th e scholarl y press . Professor powel l als o serve s o n th e boar d o f directors o f th e Povert y an d Rac e Researc h Actio n Counci l an d i s a member of the ABA Commission on Homelessness and Poverty. Denise D. J. Roy is associate professor a t William Mitchell Colleg e o f La w in St . Paul, Minnesota. Sh e teache s feminis t jurisprudence an d a variet y o f J.D . an d LL. M ta x courses . Befor e becoming a law teacher, Ro y served a s tax counse l t o th e U.S . Senate Finance Committe e unde r Chairma n Lloy d Bentsen , practiced la w at Long, Aldridge and Norman i n Atlanta, Georgia, and clerked for Judge Thomas A. Clark on the U.S. Court of Appeals for the eleventh Circuit. Roy receive d he r J.D . degree fro m Yal e La w School . Sh e i s currentl y writing a book on tax law for family lawyers. George K. Yin is Harrison Foundatio n Researc h Professor of Law at the University of Virginia, where he teaches primarily in the tax area. He previously taught law at the University of Florida and ha s bee n a visitin g professo r a t th e Universit y o f Pennsylvania , Brigham Youn g University , th e Universit y o f Virginia , an d th e Join t Committee o n Taxatio n i n Washington , D.C . Before becomin g a law professor, h e serve d a s tax counse l t o th e Senat e Financ e Committe e and practiced law in Washington, D.C. He has written a number of articles in the tax field and i s presently the reporter t o the ALI tax projec t on the taxation o f pass-through entities . He is a member o f the board of trustees of the American Tax Policy Institute.

5I

INDEX

Ability, as aspect of human capital income, 66-67 Ability-to-pay norm: and child care expenditures, 334-35,337 ADSA. See American Dream Savings Account (ADSA) Aid to Dependent Children program, 324 Aid to Families with Dependent Children, and child care, 325-28 American Dream: tax law and, 1- 2 American Dream Savings Account (ADSA), 253-71; administrative complexity of , 269-70; back-loaded feature of, 256-57, 268-69; benefit to wealthy, 266-67; budgetary implications of, 269-70; class bias of, 266-67; compared with Individua l Retirement Account, 256-57,265; and consumption, 262; cost to U.S. Treasury of , 270; distributions from, 256,260; effect o n 401 (k) plans, 264—65; effect o n retiremen t savings, 257,262-64,265-66,270-71; fairness of, 266-67; and low-income taxpayers, 260,266-67; as part of Tax Fairness and Deficit Reductio n Act of 1995,256 ; provisions of, 259,260,262; regressivity of , 3; and retirement savings disincentives, 257,260,262-66; rollovers from Individua l Retirement Account, 259,262-63; social and economic impact of, 260-70; and U.S. savings rate, 259,261-62,267-68,271. See also Individual Retirement Account (IRA); Private pension system Americans with Disabilities Act of 1990,18 6 Andrews, William, 121 Armey-Shelby flat-tax proposal, 125-26, 245; as alternative to income tax, 291; and consumption, 190 At-Risk Child Care Program, 327 Back-loaded feature, of American Dream Savings Account, 256-57,268-69. See also American Dream Savings Account (ADSA) Balanced budget, U.S., 238 Bankman, Joseph: on nondiscrimination rules , 139 Benefits, employee. See Employee benefits

Bentham, Jeremy: on legal fiction, 25 Bittker, Boris, 38,121 Blair, John, and Rover Premus: business relocation studies by, 201 Border tax adjustments, 245-46 Bradford, David, 121; and consumed-incom e tax proposal, 128; on consumption tax and human capital, 165 Business: and government tax incentives, 197; privileged in personal/business dichotomy , 187,189,190 Business expenses: child care expenditures as, 334-35; and consumption, 177,182; employee benefits as, 129-30; and entrepreneurial expenditures, 135; and environmental cleanup costs' nondeductibility, 173,183; health expenditures as, 130; personal aspects of, 177 ; and personal expenses, 171; and productivity, 171-73,177; tax deductibility of, 171,172,183,189 ; worker training costs as, 135. See also Personal/business dichotom y Business relocation, 197-211; from citie s to suburbs, 95; Deloitte and Touche survey on, 200; John Blair and Rover Premus studies on, 201; Neal Schmitt study on, 201; problems with, 204-5; and property tax incentives, 200; reasons for, 200-201; Samuel Rabino study on, 201; tax incentives for, 200-203 Capital export neutrality: defined, 215; and developing countries, 215-16,220; as economic neutrality goal, 215; and efficiency , 233; and maquiladora, 222; as myth, 223; and preservation of U.S. tax base, 234; and U.S. international tax policy, 214-16, 220-25,227,233,234; as treaty obstacle, 220-25,227. See also International tax policy, U.S.; Treaties, U.S. international tax Capital gains preferences: as tax benefit of home ownership, 93 Car ownership: and racialization, 96 Cartels, government: for tax incentives, 208-10 Cash or deferred arrangements . See 401 (k) plans 353

3 5 4 INDE

X

Child care: and Aid to Families with Dependent Children, 325-28; and earned income tax credit, 331; federal expenditures for, 327; and Job Opportunity and Basic Skills Program (JOBS), 326-27; and labor market participation, 322-26,336; and low-income taxpayers, 327-28; as subsidy, 333-34; and tax double standard, 322-24; and tax law, 322-39; and tax policy goals, 337; and tax theory, 333; tax treatment of, 322-39; and welfare policies, 322-39; and welfare reform, 328; and Work Incentive Program, 330. See also Child care expenditures Child Care and Development Block Grant (CCDBG) program, 327,328 Child care expenditures: and ability-to-pa y norm, 334-35,337; as business cost, 334-35; consumption tax and, 162; and economic neutrality norm, 335-36, 337; as income production cost, 333-35; Internal Revenue Code on, 330-33; and lowincome taxpayers, 324, 328-29, 338-39; and reimbursement accounts, 332-33; taxation of, 70; tax deduction for, 329-30; and tax double standard, 323-24,337; tax law and, 50; work-related, 323, 329-33, 336 Child care tax credit: explained, 331-32; and low-income taxpayers, 337 Child-rearing costs: accounting for, in tax reform, 141 Child tax credit: as alternative to earned income tax credit, 317-18; proposals for, 323; as proposed by National Commission on Children, 288 Choice: as aspect of human capital, 66-67,71; and housing patterns, 103; and income definition, 72; and metropolitan racializa tion, 103-7; and social privilege, 9; and tax law claim to objectivity, 8 Class: bias in American Dream Savings Account, 266-67; bias in U.S. income tax law, 253; and choice, 9; and home ownership, 92-93,94-95; and tax law, 2,10, 323-24; and welfare policies, 323 Class-based double standard, 322-24 Coff, Russell: on human capital investment, 138 Compatibility with tax norms, as goal of U.S. international tax policy, 233 Competition: and consumption tax, 245-46; and value-added tax, 245-46

Competitiveness: and consumption tax, 243; as a goal of international tax policy, 233, 237 Comprehensive Environmental Response, Compensation and Liability Act of 1980, 184 Consumed-income tax: David Bradford proposal, 128; defined, 127-2 8 Consumption: and American Dream Savings Account, 262; and business expenses, 177; education as, 155-57; and Haig-Simons model, 133-34; health care expenditures as, 121; and human capital, 155; and income tax, 151,158; and investment, 158-60,162,170,174,176-90; and investment, dichotomy between, 152; and investment, false dichotomy between, 134; and living expenditures, 119; masked by personal/business dichotomy, 188; and NunnDominici USA Tax, 190; and personal expenses, 183; problem of defining, 189-90; and workers' expenditures, 120. See also Consumption tax Consumption/investment dichotomy , 175; and personal/business distinction, 182-8 4 Consumption tax , 146,158; as alternative to income tax, 146-67; arguments for, 158-59; combined with income tax, 74, 247; and competition, 245-46; and competitiveness, 243; David Bradford on, 165; and deferral, 28; and earned income tax credit, 313; and economic neutrality, 158-59; and educational expenditures, 146-67; effect o n taxpayers, 162; flat tax as, 126; and Haig-Simons ideal tax base model, 12; and human capital development, 160-67; and human capital income, 59-60; and income definition benefit , 313; and international tax policy, 243-47; investment and, 146-147; Louis Kaplow on, 75,160-61; as part of Nunn-Domenici USA Tax, 128; proposals for, 126,127-28; rationale for, 5; regressivity of, 127 ; and savings, 160; and tax deferral, 234; treatment of U.S.-owned multinationals under, 244-45; types of, 243-44. See also Consumed-income tax, Value-added tax Contract with America, 2; and American Dream Savings Account, 256; tax reform proposals under, 120; Tax Relief Act of 1995,45 Controlled foreign corporations (CFCs): and passive assets, 237,238; and tax deferral,

INDEX 3 5

234-43; and U.S. international tax policy, 214 Courts: and tax incentives, 206 Crime: effects of segregation on, 88 Danforth-Boren Busines s Activities Tax: as overlay to current U.S. corporate tax, 247; and value-added tax, 246 Deferral. See Tax deferral Deloitte and Touche: business relocation survey by, 200 Dependent care assistance tax exclusion, 332-33 Dependent care credit: and low-income taxpayers, 278-79 Developing countries: and capital export neutrality, 215-16; and international investment, 226-27; and limitations-of-benefit s provisions, 228-29; and people of color, 226; and tax sparing, 229; and tax sparing credit, 224-25; and U.S. international tax policy, 215-17,219-30 Disability access expenditures: and environmental expenditures, compared, 170-90; and income production, 181-82 ; as investment, 177-78; tax deduction of, 170, 174-75,187; and tax law, 171; value of, 178-81 Disability discrimination: and tax law, 2 Discrimination: and tax law, 2,3; in zoning practices, 98-103 Distributional analyses: and earned incom e tax credit, 303-4; limitations of, 303- 4 Double standards. See Tax double standards Double taxation avoidance: and tax deferral, 234,235 Early distribution excise tax, 262 Earned income definition: for earned incom e tax credit, 286 Earned income tax credit, 279; alternatives to, 287-89; amounts for 1996,278 ; budget treatment of, 302-3; and child care, 331; child tax credit as alternative to, 317-18; complexity of program, 304-7; and consumption tax, 313; and distributional neu trality, 303; and efficiency, 310-11 ; employer credit as alternative to, 318; and filing status, 306; growth of program, 300-304; history of, 297-307; and income definition, 313 ; and low-income taxpayers, 278-79,280-83,287; and marriage penalty, 47, 311-12,338; program compliance,

304-7; proposed combination with federa l welfare programs, 289; reform of , 285-89, 297-319; reform proposals, 314-18; Social Security tax exemption as alternative to, 287-88,314-15; Social Security tax rebate as alternative to, 315-16; and tax fraud, 308-9; as transfer instea d of tax credit, 316; U.S. expenditures on, 300-302; and welfare reform, 316; and work incentive, 309-10 Economic development: tax incentives as tools for, 197 ; tax law and, 197-21 1 Economic exploitation: and tax law, 2 Economic factors: in marriage decision, 46 Economic Free Trade Agreement, 218 Economic growth: and low U.S. savings rate, 255 Economic neutrality: and capital export neutrality, 215; and child care expenditures, 335-36; and consumption tax, 158-59; fiction of, 5,76; fiction of , and racial inequality, 83; as goal of traditional tax analysis, 5; and income tax, 146,147,148,149-53; marketplace limitations to, 149-53; and marriage penalty, 46; and tax law, 14; and U.S. international tax policy, 222 Economic Recovery Tax Act of 1981 : and estate tax, 36-37 Economic theory: Jean-Baptiste Say on, 124-25; workers in, 125 Education: as consumption, 155-57 ; and human capital, 153-57; as investment, 153; tax deductions for, 135 ; and tax law, 155 Educational expenditures: and consumptio n tax: 146-67; income-related componen t of, 163 ; tax law treatment of, 155-57 ; and workers, 135 Efficiency: an d earned income tax credit, 310-11; as goal of U.S. international tax policy, 233 Electronic filing of U.S. income tax, 283-84 Employee benefits, 128,129-32 ; Arthur Goldberg on, 129; as business production costs, 129; Edward Zelinsky on, 136; effect of tax reform on , 130-32; employer-paid, 128-32; and nondiscrimination rules , 121-22,130,140,265; and part-time workers, 140; as tax expenditures, 119-22,124, 136; tax treatment of, 129-30 ; and temporary workers, 140. See also Health benefit s Employee Retirement Income Security Act of 1974 (ERISA): and Individual Retiremen t Account, 257 Employee status (versus independent con -

5

3 5 6 INDE

X

Employee status (Continued) tractor status): benefits to low-income workers, 289-90 Employers: and tax deductions, 135 Employer tax credit: as alternative to earned income tax credit, 288,318 Employment as social welfare basis, 129-31 Entrepreneurs: taxation of, 119 ; and tax deductions, 134-35; and tax reform, 133, 141 Environmental cleanup costs. See Environmental expenditure s Environmental expenditures: as consumption, 179-81; and disability access expenditures, compared, 170-90; as investment, 177; Internal Revenue Service on, 170; tax deduction of, 170,174-75,184,187 ; and tax law, 170-90; value of, 178-8 1 Environmental policy: and tax law, 184-86 Environmental protection: and international tax treaties, 218 Equal taxation of equal-income married couples: conflicts with other tax policy goals, 337 Estate tax: and marital deduction, 33-34; and marital unity fiction, 27-28,32-3 8 Exclusion of income. See Income exclusion Fair Housing Act (FHA): and exclusionary zoning, 101-3; and housing discrimination, 101 Fair Housing Act of New Jersey, 108 Family Support Act of 1988,325-2 6 Family values. See Values Federal Housing Administration (FHA) : and segregation, 90-92 Fiction in tax. See Legal fictions, 25 Filing status: and earned income tax credit, 306 Final withholding tax system, 292-93; British PAYE system, 293 Fisher, Irving, 61 Flamholtz, Eric: on human capital investment, 138 Flat-rate income tax. See Flat tax Flat tax: as alternative to income tax, 291; compared with USA Tax, 128; as consumption tax, 126; as proposed by Steven Forbes, 1; regressivity of, 126 ; as remedy for marriage penalty, 54; and workers, 125-26 Flexible spending accounts. See Reimbursement account s Forbes, Steven: flat tax proposal of, 1

Foreign income: taxation of, 220-21 Foreign investment: and Tax Reform Act of 1986,236 Foreign personal holding companies, 236 Foreign tax credit (FTC): limitations of , 240-41; and Tax Reform Act of 1986,224; in U.S. international tax policy, 222,234 401 (k) plans, 258; effect o f American Dream Savings Account on, 264-65 Fourteenth Amendment: and property rights, 99 Freedom and Fairness Restoration Act of 1995, 125 Free trade zones, 218 Fuller, Lon: legal fictions criticized by, 26 Gender: and head-of-household status , 53,54; and income tax law, 12; and marriage penalty, 50-52; and marriage penalty tax, 12; and tax law, 2; and wage rates, 52-53 Gender essentialism: in tax law, 50 General Agreement on Tariffs and Trade (GATT): and international tax policy, 245 Gifts: tax treatment of, 27,123 Global economy: and tax incentives, 210 Goldberg, Arthur: on employee benefits, 129 Goode, Richard: and human capital, 73 Government policies: and highway construction, 95-96; role in perpetuating poverty, 89; role in perpetuating segregation, 89; and tax incentives, 206. See also Race; Racialization; Redlining; Tax incentives Government tax incentives. See Tax incentives Government tax policy: racial bias of, 94; suburban bias of, 94,95,96,97,103. See also Race; Racialization; Tax incentives Gray, John Chipman: legal fictions criticized by, 26 Haig, Robert: and ideal income tax base, 6. See also Haig-Simons model; Simons, Henry Haig-Simons model, 6-7,61; and consumption, 133-34; and health care expenditures, 135-36; ideal income definition, 12,75,59 , 133,175-76; and personal/busines s dichotomy, 175 Hall, Robert E., flat tax proposed by, 125 Head-of-household status : and gender, 53,54; and race, 53,54 Health benefits: as tax expenditures, 119-22, 124,136 Health care: effects of segregation on, 88 Health care expenditures: as consumption,

INDEX 3 5

121; and Haig-Simons model, 135-36; and Medical Savings Accounts, 131; and tax law, 130,132,135-36,139,183; and workers, 119-41 Heterosexism: and tax law, 2 Higgins, Allan H. W.: on marital deduction in estate tax law, 35,36 Highway construction: and business abandonment of cities, 95; effect o n metropolita n racialization, 95-96; effect o n white flight, 95; and neighborhood destruction, 96-97 Home ownership: as access to wealth, 80,83, 92; and capital gains preferences, 93; and class, 92-93,94-95; effect o f redlining on, 92; government subsidization of, 94,95; and imputed income, 93-94; and mortgage interest deduction, 93-94; and property tax deduction, 94; and race, 80-81,83,90, 92-93; racialization of, 80; and segregation, 80-81; tax benefits of, 92-95; and Tax Reform Act of 1986,9 5 Home Owners' Loan Corporation: redlining by, 90-91; and segregation, 89 Horizontal equity, 122,334 Housing Act of 1949 : as start of urban renewal, 97 Housing discrimination, 101-3 ; and choice, 103; and Fair Housing Act, 101; National Fair Share Act as remedy for, 108 ; perpetuation of, by tax law, 13. See also Racialization; Segregation Housing market: effects of segregation on, 87 Housing policy, U.S.: and Fair Housing Act of New Jersey, 108; and public housing, 97-98; and race, 12-13; and segregation, 89-92; and tax law, 80-109 Howe, Irving: on "dominant American myth," 124; on the working class, 141 Human capital: accurate depiction of, 71 ; aspects of, 66-69; and choice, 66-67,71; and consumption, 155 ; definition of , 58, 75; development, and consumption tax, 160-67; and education, 153-57; and expenditures, 134; Henry Simons and, 134; and income tax, 153-57,160-61; investment in, 138-39; and leisure, 66-67, 69-76; and opportunity, 66-68,71; relation to material capital, 60,65-66,72,134; Richard Goode on, 73; taxation of, 160-67 ; and tax law, 58-77,153-57; value of, 134; wage-measured, 65-66; and work-related deductions, 73 Human capital income: and ability, 66-67; and

consumption tax, 59-60; and leisure, 69; Louis Kaplow on, 58; tax treatment of, 58 Human capital investment: Eric Flamholtz on, 138; Russell Coff on, 138 Human rights: and U.S. international tax policy, 219 Imputed income: and home ownership, 93-94; and income tax, 150 Incentive cartels. See Cartels, government Income definition, 59,133-34; bias in, 120; and choice; and consumption tax, 313; and earned income tax credit, 313; and HaigSimons model, 59,61,62-63,75,175-76; limitations of models, 151; Louis Kaplow on, 59,71-73; new models for, 72; and opportunity, 72; and personal/busines s dichotomy, 173; Stanley Surrey on, 122 Income exclusion: for low-income taxpayers, 289 Income, imputed. See Imputed incom e Income production: child care expenditures as, 333-35; and personal expenses, 176-77 Income redistribution: income tax and, 147 Income splitting: effect o n married women, 30; and marital unity fiction, 28-32 Income tax: combined with consumption tax, 74,247; and consumption, 151,158 ; consumption tax as alternative to, 146-67; and economic neutrality, 146,148,149-53; flat tax as alternative to, 291; and Henry Simons model, 148; and human capital, 153-57,160-61; and income redistribution, 147; integration with Social Security tax, 291; and investment, 152,158; logic of, 147-49,158; and the marketplace, 149-53; perceived progressivity of, 152-53 ; principles of, 133 ; and production, 153 ; and savings, 159; and wage earners, 119-41. See also Income tax, U.S. Income tax, U.S., 146-67; class bias of, 253; complexity of, 282-83; compliance with, 283,299; cost of, 282-83; electronic filing of returns for, 283-84; and filing status, 290; forms elimination, 291-92; and Internal Revenue Code, 148; and lowincome taxpayers, 278-79; purposes of , 63-65; redistributive principle of, 64; reform of , 73,283-93; regressivity of, 9-10; and return-free system , 291-92; simplification of, 277-93. See also Income tax Income taxation: general rule of, 253 Independent contractors: and low-income

7

3 5 8 INDE

X

Independent contractors (Continued) workers, 289-90; and nondiscriminatio n rules, 139; reclassification a s employees, 289-90 Individual Retirement Account (IRA), 254-55; compared with American Dream Savings Account, 256-57,265; distribution restrictions of, 261-62; effect o f Tax Reform Act of 1986 on, 258-59; and Employee Retirement Income Security Act of 1974 (ERISA), 257; history of, 257-59; and lowincome taxpayers, 258; rationale for, 261; rollovers to American Dream Savings Account, 259,262-63; tax benefits of, 254, 258,260. See also American Dream Savings Account (ADSA); Private pension system Institute for Women's Policy Research study of welfare recipients' work patterns, 326 Internal Revenue Code: bias in favor of marriage, 46; on child care expenditures, 330-33; on environmental expenditures, 170; personal/business dichotomy in, 171-72; on tax deferral, 237; and U.S. income tax, 148 Internationalism: defined, 217 International tax policy, U.S., 214-30; and capital export neutrality, 214,215-16,220-25, 233; competitiveness as a goal of, 233,237; and consumption tax, 243-47; and developing countries, 215-17,219-30; and economic neutrality, 222; and foreign tax credit, 222-24,234; and General Agreement on Tariffs and Trade (GATT), 245; goals of, 233-47; and human rights, 219; and investment, 224; and limitationsof-benefits provisions , 227-29; multilateral treaties, 217-18; and race, 219,227; reform of, 241-43; and tax sparing credit, 224-25, 229; treaties and, 217-20; unilateralism of , 217,225-26; and value-added tax, 243. See also Treaties, U.S. international tax International tax treaties. See Treaties, U.S. international tax International trade deficit, U.S., 216-17 Inverse tax: defined, 74; and material capital, 74 Investment: and consumption, 158-60,162 , 170,176-81,190; and consumption expenditures, 174; and consumption tax, 146-47; and developing countries, 226-27; disability access expenditures as, 177-78; environmental expenditures as, 177; foreign, and Tax Reform Act of 1986,236; and

income tax, 152,158; and international tax policy, 224; and tax reform, 120 ; and value, 177-80; and workers, 120 Investment and consumption: dichotomy between, 134,152,17 5 Job Opportunity and Basic Skills Program (JOBS), 325-27; and child care, 326-27 Joint Committee on Taxation: personal/business dichotomy and, 173; on Social Security tax exemption as alternative to earned income credit, 288 Kalleberg, Arne: on part-time workers, 139 Kaplow, Louis: on consumption tax, 75, 160-61; definition o f wealth, 59; on HaigSimons ideal tax base model, 59-60; on human capital income, 58; on leisure, 66, 69; on wage-measured human capital, 65 Kasich, John: and tax deferral repeal, 239 Klein, William, and Joseph Bankman: on personal/business dichotomy, 172 Labor participation. See Work force participation Legal fictions: criticism of, 25-26; defined, 25-26; Henry Maine on, 26; Jeremy Bentham on, 25; John Chipman Gray on, 26; Lon Fuller on, 26; in tax, 26. See also Economic neutrality; Marital unity fiction; Tax objectivity Leisure: as aspect of human capital, 66-67, 69-76; defined, 59; and human capita l income, 69; Louis Kaplow on, 66,69 Lendors, and redlining, 91 Levittown, N.Y.: racial segregation in, 91 Limitations-of-benefits provisions : defined, 227; and developing countries, 228-29; of tax treaties, 227-29 Low-income taxpayers: and American Dream Savings Account, 260,266-67; and child care, 323,327-28; and child care costs, 338; and child care tax credit, 337; and dependent care credit, 278-79; and earned income credit, 278-79; and earned income tax credit, 287; effect o f earned income tax credit on, 280-83; effect of Social Security taxes on, 280-82; income exclusion for, 289; and income tax forms, 284; and marriage penalty, 47; net federal tax on, 280-83; and private pension system, 259; and retirement savings, 265,267; and Social Security taxes, 280-82,287,314-15;

INDEX 3 5

and tax double standard for child care costs, 337; and U.S. tax law, 277 Maine, Henry: on legal fictions, 26 Maquiladora: and capital export neutrality, 222 Marital deduction in estate tax, 33-34; Allan H. W. Higgins on, 35, 36; John W. Snyder on, 34; Stanley Surrey on, 34 Marital unity fiction, 11-12,26-41 ; effect o n women, 38-39; and estate tax policy, 27-28,32-38; as first principle of taxation, 38; and income splitting, 28-32; and qualified terminable interest in property (QTIP) deduction, 36-38; racial and gender implications of, 11 Markets: and tax incentives, 206 Marriage: Internal Revenue Code bias in favor of, 46; tax implications of, 48; and women's work-force participation, 53 Marriage bonus: defined, 45 Marriage decision: and earned income tax credit, 311-12; economic factors in, 46 Marriage neutrality: conflicts with other tax policy goals, 337 Marriage penalty, 45-54; changes proposed by Contract with America Tax Relief Act of 1995,45; defined, 45; and earned incom e tax credit, 47,311-12, 338; and gender, 50, 52; and household income, 46-47; and Internal Revenue Code, 45; and lowincome taxpayers, 47; and progressivity, 54; and race, 45,48-50; racial and gender implications of, 12 ; remedies for, 54; tax credit to offset, 47-48; and wage discrimination, 52 Material capital: and inverse tax, 74; relation to human capital, 65,134; and tax shelters, 73-74 Medical Savings Accounts, 131 Metropolitan history, U.S., 83-86 Minority migration to U.S. cities, 83-84 Mortgage interest deduction: as tax benefit of home ownership, 93-94 Multilateral treaties, 217-18; capital export neutrality as obstacle to, 220-25. See also Treaties, U.S. international; International tax policy, U.S. National Commission on Children: child tax credit proposed by, 288 National Fair Share Act: as proposed remed y for housing discrimination, 108

Neutrality. See Economic Neutrality New Deal projects: tax incentives of, 19 9 New Jersey Fair Housing Act, 108 Nondiscrimination rules , for employee benefits, 121-22,130,140,165 ; Joseph Bankmanon, 139 North American Free Trade Agreement, 228 Nunn-Domenici USA Tax, 127-28,243; and consumption, 190 ; as value-added tax, 244 Objectivity, as goal of traditional tax analysis, 5 Opportunity, as aspect of human capital, 66 Packwood, Robert: and tax deferral repeal, 239 Passive assets: and controlled foreign corpora tions, 237,238 Passive foreign investmen t rules, of Tax Reform Act of 1986,236-3 7 Pechman, Joseph, 121; on class gap, 64 Pensions. See Private pension system, 254 People of color: and developing countries, 226 Personal/business dichotomy: business bias of, 187; and business expenses, 173; and child care costs, 334; and consumption, 188 ; and consumption/investment distinction , 182; function i n tax analysis, 187-89; and HaigSimons model, 175; inadequacies of, 170, 171,173; and income definition, 173 ; in Internal Revenue Code, 171-72; and Joint Committee on Taxation, 173; justification for, 172 ; and personal expenses, 173-74; William Klein and Joseph Bankman on, 172; and workers, 188 Personal exemption amount (fo r 1996) , 278 Personal expenses, and business expenses. See Personal/business dichotom y Piguovian theory of taxation: and economic neutrality norm, 335 Political values, U.S., relation to tax law, 3-4 Poverty, U.S., 277; government's role in perpetuating, 89; and public housing, 97-98; and race, 87; and racialization of space, 85; and urban renewal, 97; U.S. income guidelines, 280 Preservation of U.S. tax base, as goal of U.S. international tax policy, 233 Price: relation to consumer value, 69 Private pension system: and Individua l Retirement Account, 254—55; and lowincome taxpayers, 258,259,265,267; tax law and, 254. See also American Drea m Savings Account (ADSA); Individual Retirement Account (IRA)

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3 6 0 INDE

X

Production: of income, 171,176-77; and income tax theory, 153; and wage labor, 124-25; and workers, 134,141 Productivity: and business expenses, 171-73 Progressivity: conflicts with other tax policy goals, 337; fiction of , 9-10; as goal of traditional tax analysis, 5; and income tax, 152-53; and marriage penalty, 54 Property: tax treatment of, 123 Property rights: and Fourteenth Amendment, 99; of married women, 31-32 Property tax: and business relocation incentives, 200; deduction for, 94; reform, 109 Psychic income, 58; defined, 59; difficulty i n taxing, 69 Public housing: and metropolitan racializa tion, 97; and poverty, 97; and segregation, 98 Public transportation: government funding of , 95; and racialization, 96 Qualified terminable interest in property (QTIP): deduction in estate tax, 36,37; effect o f rules on women, 39; and fiction of marital unity, 36-38 Rabino, Samuel: business relocation study by, 201 Rabushka, Alvin, flat tax proposed by, 125 Race: and choice, 9; and developing countries, 225-27; and head-of-household status , 53-54; and home ownership, 80-81,83,90, 92-93; and housing policies, 12-13; and income tax law, 12; and the inner city, 83; and marriage penalty, 12,45,48-50; and poverty, 85,87; and tax law, 2,323; and urban space, 81; and U.S. international tax policy, 219,225-27; and wage rates, 52-53; and welfare policies, 323,324-26; and work force participation, 51. See also Racialization; Segregation Race-based double standard, 322; and welfare policies, 324-26 Racial inequality: and taxation, 83 Racialization: and car ownership, 96; and choice, 103-7; effect o f highway construction on, 95-96; federal government's role in creating, 83; of metropolitan areas, 80-92,95,109; and poverty, 85; prospects for change, 107; and public housing, 97-98; and public transportation, 96; of U.S. cities, 84-89; and zoning, 98-103. See also Housing discrimination, Segregation

Redistribution of income: and income tax, 147 Redlining: effect on home ownership, 92; by Federal Housing Administration, 90-91; government, 90-92; by Home Owners' Loan Corporation, 90-91; in private lending industry, 91 Regressivity: of Social Security taxes, 282 Reimbursement accounts: and child care expenses, 332 Retirement savings: and American Dream Savings Account, 257; American Dream Savings Account disincentives for, 260, 262-66,271; and low-income taxpayers, 267; and private pension system, 254-55; and tax expenditure analysis, 123-24; and U.S. savings rate, 261. See also American Dream Savings Account (ADSA); Individual Retirement Account (IRA); Private pension system; Savings rate, U.S. Return-free tax system, 291 Revenue Act of 1948,28,3 2 Rostenkowski, Dan: and tax deferral repeal, 239 Sales tax: compared to value-added tax, 244 Savings: and consumption tax, 160; and income tax, 159; and tax reform, 120,130 . See also Retirement savings; Savings rate, U.S. Savings rate, U.S., 255,261; and American Dream Savings Account, 261-62,267-68, 271; and retirement savings, 261. See also Retirement savings Say, Jean-Baptiste: economic theory of, 124-2 5 Schmitt, Neal: business relocation study by, 201 Segregation, 81,104; as cause of tax-base erosion, 86; consequences of, 86-89; effects o n crime, 88; effects on health care, 88; effects on housing market, 87; and Federal Housing Administration, 90-92; government's role in perpetuating, 83,89; and home ownership, 80-81; and Home Owners' Loan Corporation, 90-91; and housing policy, 89; and public housing, 97-98. See also Race; Racialization Simons, Henry: and human capital, 134; and ideal tax base model, 6,148; income definition, 151. See also Haig-Simons model Snyder, John W.: on marital deduction in estate tax law, 34 Social justice: and tax law, 2-21

INDEX 3

Social Security tax, 279-80; integration with income taxes, 291; and low-income taxpayers, 280-82,314-15; and private pension system, 254; regressivity of, 282; tax exemption, as alternative to earned incom e tax credit, 287-88,314-15; tax rebate, as alternative to earned income tax credit, 315-16; tax rate (for 1996) , 280 Social Services Block Grant Program of Title XX of the Social Security Act, 327 Social welfare: employment as basis of, 129-3 1 Standard deduction amount (fo r 1996) , 278 Supply-side economic policy, 125 Surrey, Stanley: income defined by, 122; on marital deduction in estate tax, 34; on tax expenditures, 7 Targeted jobs tax credit, 318 Tax analysis: function o f personal/business dichotomy in, 187-89; social justice approach, 3-21; traditional, 4 Taxation: and racial inequality, 83 Tax-base erosion: as effect o f segregation, 86 Tax deferral, 233-47; and consumption tax, 234; and Controlled Foreign Corporations, 234-43; and double taxation avoidance, 234,235; and federal budgetary goals, 239; Internal Revenue Code on, 237; and repeal proposals, 238-39,240 Tax double standard, race- and class-based, 322 Tax expenditure analysis, 121; defined, 122; and retirement savings, 123; Stanley Surrey on, 122; and workers, 123,128 Tax expenditure budget, U.S.: and personal/business dichotomy, 173 Tax expenditures: defined, 122 ; ethical proposition of, 122 ; health benefits as, 119-22, 124,136; as concepts of Stanley Surrey, 7 Tax Fairness and Deficit Reductio n Act of 1995: and middle-income taxpayers, 255-56 Tax fiction. See Economic neutrality; Marital unity fiction; Tax objectivity Tax fraud: and earned income tax credit, 308-9 Tax incentives: for business relocation, 200-203; courts' role in controlling, 206; drawbacks of, 204-5; and economic development, 197-211 ; government cartels for, 208-10; governments' role in controlling, 206-7; in the 1990s, 199-202; local govern-

ment, 197-98; local government, history of, 198-202 ; markets' role in controlling, 206; property tax, 200; and sovereignty, 197; types of, 200 Tax law: bias against workers of, 135 ; and child care, 50,322-39; and child care deductions, 323; and class, 10,323-24; and disability access expenditures, 171; and discrimination, 2,3; and economic development, 197-211 ; and educational expenditures, 155,157; and entrepreneurs, 119; and environmental expenditures, 170-90; and environmental policy, 184-86; estate, 27,28,32-38; gift, 27; goals of, 3, 4-5; and health care expenditures, 135-36, 139; and housing policy, 80-109; and human capital, 58-77,153-57; and lowincome taxpayers, 277-93; and marriage penalty, 45-54; and private pension system, 254; and race, 323; relation to U.S. political values, 3-4; and social hierarchies, 3; and workers, 13-14,119,124-4 1 Tax logic, 158; and U.S. income tax, 147-49 Tax neutrality. See Economic neutrality Tax objectivity: and choice, 8; fiction of , 6- 9 Tax policies: and business relocation, 95; double standards of, 324; and home ownership, 94-95; and racialization of space, 81; and values, 323; and wage labor, 322. See also International tax policy, U.S. Tax policy goals: conflicts among, 337; and tax treatment of child care costs, 337 Tax reform: and child-rearing costs, 141; combination of income and Social Security taxes, 291; of earned income tax credit, 285-89,297-319; effect o n employee benefits, 130-32 ; and entrepreneurs, 133,141; final withholding tax system, 292-93; and flat tax, 125,291; of income and Social Security taxes, 291; and international tax policy, 241-43; and investment, 120 ; outlook for, 247; relation to government subsidies, 7; return-free incom e tax system, 291-92; and savings, 120; and savings bias, 5; scapegoating of workers in, 128; Stanley Surrey on, 7; workers and, 120,128, 130-31,133-41 Tax Reform Act of 1986 : and distributiona l neutrality, 303; effect o n Child Care Tax Credit, 332; effect o n Individua l Retirement Account, 258; and foreig n investment, 236; and foreign ta x credit,

61

3 6 2 INDE

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Tax Reform Act of 198 6 (Continued) 224; and home ownership inequities, 95 Tax Relief Act of 1995,4 5 Tax shelters: and material capital, 73-74 Tax sparing credit: and developing countries, 229; in international tax policy, 224,225 Tax theory: and child care, 333 Tax treaties, U.S. See Treaties, U.S. international tax Theory of the "second best," as rationale for child care allowance, 336 Traditional tax analysis: income definition in , 133; weaknesses of, 182 Treaties, U.S. international tax, 217-20; and capital export neutrality, 220-25; and environmental protections, 218; and limitations-of-benefits provisions , 227-29; multilateral, 217-18; policy, 214-30; policy weaknesses of, 220-27; and tax sparing credit, 224-25; as tool for U.S. interests, 225; of United States, 218-19; and working conditions, 218. See also International tax policy, U.S. Unilateralism: defined, 217; of U.S. international tax policy, 217,225-26 Unlimited Savings Allowance Tax Act (USA Tax), 127-28; compared with flat tax, 128; and workers, 128. See also Nunn-Domenici USA Tax United States: budget, balancing of, 238; foreign tax credit of, 222-24; government, tax and housing policy of, 9; international relations of, as xenophobic, 219; international tax policy, goals of, 233-47; metropolitan history of, 83-86; political values, relation to tax law, 3-4; poverty in, 277; rejection of "tax sparing" credit, 224; savings rate of, 255,261; unilateralism of international tax policy, 217; in world economy, 216. See also Government policies; Income tax, U.S.; International tax policy, U.S.; Tax law; Treaties, U.S. international tax Urban history, U.S. See Metropolitan history, U.S. Urban renewal: and Housing Act of 1949,97; and poverty, 97; and racialization, 97-98 U.S. income tax. See Income tax, U.S. U.S. savings rate. See Savings rate, U.S. Value: and investment, 177-80

Value-added tax: compared to sales tax, 244; and competition, 245-46; as consumption tax, 244; and Danforth-Boren Busines s Activities Tax, 246; defined, 127 ; international tax policy and, 243 Values: and tax policies, 323-24; and welfare policies, 324-26; and welfare reform, 322 Vertical equity, 122,334; as U.S. income tax principle, 64 Wage discrimination: benefit of, to white families, 52; and marriage penalty, 52 Wage earners: and income tax, 119-41 Wage income: tax treatment of, 123 Wage labor: and production, 124-25; and welfare reform, 322-39 Wage-measured human capital. See Human capital, wage-measured Wage rates: and gender, 52-53; and race, 52-53 Wealth: and Haig-Simons model, 176; home ownership as access to, 83,92; Louis Kaplow definition of , 59; as wage-measured human capital, 65; and women, 39-40 Welfare policies: and child care, 322-39; double standard of, 324-26; and Job Opportunity and Basic Skills Program (JOBS), 325-27; and race, 324-26; race and class bias of, 323; and values, 324-26; and Work Incentive Program (WIN), 325; and work requirements, 325-26 Welfare programs: proposed combinatio n with earned income tax credit, 289 Welfare recipients and work, Institute for Women's Policy Research study of, 326 Welfare reform, 322-39; and child care, 328; and earned income tax credit, 316; and values, 322; and wage labor, 322-39; welfare rights movement (1960s) , 324 White flight from U.S. cities, 84; effect o f highway construction on, 95 Women: effect o f marital unity fiction on, 38-39; effect of QTIP rules on, 39; and wealth, 39. See also Gender Work: and welfare recipients, Institute for Women's Policy Research study of, 326 Workers: and consumption, 120 ; and earned income tax credit, 309-10; in economic theory, 125; and educational expenditures, 135; effect o f Medical Savings Accounts on, 131; and flat tax, 125-26; health care costs of, 121 ; and health care expenditures,

INDEX 3 6

119-41; and Individual Retiremen t Account, 257; and investment, 120; parttime, 140; part-time, Arne Kalleberg on, 139; and personal/business dichotomy, 188; and private pension system, 254; and production, 124-25,134,141; as scapegoats in tax reform, 128 ; tax bias against, 120-21,129; and tax deductions, 135,156; and tax expenditure analysis, 123,128; and tax law, 13,119-41; and tax reform, 130-31,133-41; and USA Tax, 128 Work force participation: gender and, 49,53; race and, 49,51

Work Incentive Program, 325; and child care, 330 Working class: Irving Howe on, 141 Work requirements: and welfare policies, 325-26 Xenophobia: of U.S. international relations, 219 Zelinsky, Edward: on employee benefits, 136 Zoning: court decisions on, 99-103,107; exclusionary, 98-103; and Fair Housing Act, 101-3; and Fourteenth Amendment, 99; and racialization, 98-103

3