TAXING AUTHORITY AS INVESTMENT PARTNER
All of the interesting problems in tax planning arise because, from the standpoint
of taxpaying entities, the taxing authority is an uninvited party to all contracts. The
taxing authority brings to each of its “forced” ventures with taxpayers a set of
contractual terms (tax rules). Unlike other contracting parties, the taxing authority
generally does not negotiate these terms separately for each venture. Such a policy
would simply be too expensive. Instead, it announces a standard set of terms
taxpayers must accept. In addition, although the taxing authority claims an interest in
taxpayer profits, it exercises no voting rights. Moreover, being a partner in all firms
enables the taxing authority to determine when taxpayers are reporting results far out
of line with what other taxpayers are reporting in similar situations (information that is
used to select returns for audit). The specific contractual rules (the U.S. Tax Code) that
the taxing authority imposes on its joint venturers result from a variety of
socioeconomic forces. Among other things, taxes are designed (1) to finance public
projects (such as national defense and a legal system that enforces property rights),
(2) to redistribute wealth (high-income individuals pay tax at higher rates than do low-
income individuals), and (3) to encourage a variety of economic activities deemed by
Congress to be in the public interest (such as research and development and oil and
gas exploration). From a social policy standpoint, tax rules are most controversial
when they are designed to discriminate among different economic activities. Success
is achieved when the tax rules subsidize activities that benefit society as a whole more
than they benefit the individuals engaging directly in the activities. For example,
Congress subsidizes research and development (R&D) through a tax credit based on
R&D spending by the firm. Society benefits to the extent that the tax credit stimulates
additional R&D. But this desirable outcome is by no means guaranteed because it is
possible that special tax favors are bestowed undeservedly on taxpayers who mount
successful lobbying efforts.
For better or for worse, tax-favored treatment is granted to a variety of activities
by taxing authorities around the world. Common examples include the favorable
treatment accorded charitable organizations and educational institutions, energy-
related investments, research anddevelopment activities, agricultural production,
investments in productive equipment, foreign export activities, retirement-oriented
savings vehicles, and entrepreneurial risk-taking activities. Noble as the objectives
listed earlier might be (finance public projects, redistribute wealth, and encourage
economic activities), any tax system designed to achieve a variety of social goals
inevitably provides considerable private incentives to engage in tax planning. Any tax
system that seeks both to redistribute wealth as well as to subsidize certain economic
activities gives rise to explicit marginal tax rates that may vary widely from one
contracting party to the next, for a given contracting party over time, and for a given
contracting party over different economic activities. Most taxpayers around the world
pay no more tax than they believe they must, and they spend nontrivial resources to
arrange their affairs to keep the tax bite as painless as possible. It is precisely this
behavior that provides tax policy with so much potential as a means of achieving a
variety of social goals.
To illustrate, consider the case of low-income housing that U.S. citizens, through
their elected representatives, have chosen to subsidize for many years through
various tax benefits. If taxpayers were not responsive to these tax incentives (and
refused to build low-income housing to garner the tax benefits), subsidizing low-
income housing through tax policy would be ineffective. Instead, the government
would have to enter on the expenditure side, engaging directly in the construction and
management of the low-income housing itself. Both tax subsidies and direct
government expenditures to increase the supply of low-income housing generate
deadweight costs. This suggests that we must be careful in criticizing tax subsidies if
we desire to achieve our social objectives. The direct government expenditure
alternative might be far more costly than a tax system that favors private construction
of the properties. Another example is renewable energy credits, which are offered by
states and the federal government. Many of these credits are allowed to be “sold” to
other taxpaying entities that can use the credits, leading to tax-equity investment
structures. One form of this structure is where high-rate taxpayers finance projects in
exchange for partial ownership and access to the energy credits from low-tax-rate
energy developers, thus providing financing to the renewable-energy venture. Such
tax-credit transfers have led to a new line of work as well—“tax-credit brokers” to match
buyers and sellers (e.g., Tax Credits, LLC and Clocktower Tax Credits). One alternative
would be for the government to give grants directly to the low-tax-rate energy
developer instead of the tax credits that then need to be sold. Indeed, the American
Recovery and Reinvestment Act of 2009 allowed taxpayers eligible for the Federal
Renewable Electricity Production Tax Credit (PTC) to take the Federal Business
Energy Investment Tax Credit (ITC) or to receive a grant from the U.S. Treasury
Department instead of taking the PTC for new installations. The grant was only
available to systems where construction began prior to December 31, 2011.
Although the deadweight costs associated with time spent in tax planning may
seem socially wasteful, the relevant question is how much waste would exist using
alternative means to achieve the same social goals. In other words, how does the net
benefit of the altered economic activity brought about by the tax system compare with
the net benefits of the next best alternative? Obviously, if we could implement social
policy through a mechanism that would result in zero waste, we would do so, but this
is not always a realistic goal. Tax planning (or tax avoidance, as it is sometimes more
pejoratively labeled) has long earned the blessing of the U.S. courts. For example, in
a famous 1947 court opinion, Judge Learned Hand wrote (and similar statements
appear in official documents of other countries as well):
Over and over again courts have said that there is nothing sinister in so
arranging one’s affairs as to keep taxes as low as possible. Everybody does so,
rich or poor, and all do right, for nobody owes any public duty to pay more than
the law demands: taxes are enforced exactions, not voluntary contributions. To
demand more in the name of morals is mere cant.
(Commissioner v. Newman, 159 F.2d 848 [CA-2, 1947])
