TAX PLANNING FUNDAMENTALS
These differential tax rates, in turn, provide strong incentives for taxpayers to
engage in tax planning. These incentives are the key ingredients that allow the tax
system to be used to implement desired social policy.1 A problem with this approach,
however, is that tax rules adopted for the purpose of achieving certain social goals are
generally too broad, which encourages some taxpayers to exploit their ambiguity and,
as a result, leads to some socially undesirable economic activity. Socially undesirable
economic activities are those undertaken with the major (or sole) purpose of reducing
the taxpayer’s tax bill without any real nontax benefits to society; often these are
unintended and unanticipated by lawmakers. The response is often to fine-tune the
tax system. In particular, when taxpayers have gone “too far” in their efforts to avoid
taxes, the Congress or the Treasury (or both) fight back by establishing legislative
restrictions (tax bills), judicial restrictions (court cases), or administrative guidelines on
what taxpayers can do. Of course, legislative changes are designed to do much more
than simply plug tax loopholes. Congress also uses them in attempts to change the
distribution of wealth in the economy, to raise revenue, and/or to change the degree
to which certain economic activities are subsidized in light of changes in the economy.
To combat socially undesirable tax planning, Congress imposes two classes of
restrictions. These include (1) very broad restrictions that apply to a great variety of
transactions, and (2) very specific restrictions that respond to particular abuses of the
tax system. Of course, Congress must be careful not to impose too many restrictions
or to make enforcement of the rules too uncertain. Tax rule and enforcement
uncertainty may discourage precisely the transactions that Congress wishes to
encourage. In other words, restrictions can be too broad as well. Moreover, the costs
associated with imposing many specific restrictions can be quite high. These include
(1) legislative costs, such as the cost of elected representatives and their research
and administrative staffs, and the cost of lobbyists; (2) the cost to the general public
of becoming informed so that they can participate in the legislative process; and (3)
compliance costs, which increase with the complexity of the tax system and the
number of restrictions. Life would be simple, indeed, if tax rules were unambiguous.
But tax rules, like all other areas of the law, are far from clear. Tax-law ambiguity
implies that even if you could claim to have committed to memory the entire Internal
Revenue Code, you would be able to resolve only a small degree of ambiguity in how
a tax return should be prepared. As technically detailed as the U.S. Tax Code may
seem to be, it still contains rules that are far too general to indicate clearly how
particular transactions are to be taxed. The inherent ambiguity in the tax law gives rise
to numerous disputes between taxpayers and the taxing authority, as these parties
have opposing interests regarding the assessment of tax liabilities. In turn, the judicial
branch of government (the court system) must resolve disputes. And as disputes are
resolved by the courts, the tax rules take on greater and greater detail—that is, the
courts help to interpret the rules.
We can make the tax system simpler if we abandon using it as a means of
achieving desired social policies. In fact, the Tax Reform Act of 1986 (TRA 86) was a
clear move in this direction. Many tax-rule changes brought about by this major piece
of legislation were designed to “level the playing field,” so to speak—that is, the
changes removed or reduced tax subsidies for many economic activities. It is not
obvious that governments should or should not use tax policy to influence behavior;
there are mixed views on the topic. One question to consider is what alternative means
the government would use to promote or discourage certain behaviors, and whether
such alternatives would be better or worse (in terms of efficiency, effectiveness,
fairness, etc.). In addition, we know that in the years following the TRA 86, Congress
reintroduced substantial complexity into the tax code via complex phase-out rules,2
special capital gains rates, and a myriad of tax credits, among other items. Thus, any
simplicity achieved by TRA 86 was, for the most part, short lived. In this chapter, we
consider some of the difficulties associated with using the tax system to achieve social
goals. In particular, we identify a few classes of tax-planning games that aggressive
taxpayers might naturally be inclined to play, and we provide examples of the broad
restrictions that are imposed when such tax-planning games lead to socially
undesirable outcomes. In later chapters we elaborate on the importance of more
specific tax-rule restrictions. We also consider how transaction and information costs
affect taxpayers’ abilities to engage in socially unacceptable tax planning, and we will
see that Congress need not impose as many tax-rule restrictions where transaction
costs are high.
Types of Income Tax Planning
Over the years, taxpayers have displayed considerable ingenuity in their
attempts to have their income (1) converted from one type to another, (2) shifted from
one pocket to another, and (3) shifted from one time period to another. Briefly, we
consider each of these types of tax-planning activities.
Converting Income from One Type to Another
“Capital gains” are typically realized on the sale of capital assets such as
common stock. Wages, interest on bonds, and royalties are items that are typically
considered “ordinary income.” In most countries, capital gains are taxed favorably
relative to ordinary income. The attempt to convert ordinary income into capital gains
is a common tax-planning strategy, at times abused, among individual taxpayers.
Besides the capital gains/ordinary income distinction, tax liabilities are often
affected by whether income is classified as:
1. Interest, dividend, or operating income
2. Earned domestically or abroad
3. Derived from a profit-seeking business or from an activity engaged in as a
hobby
For example, whether income is classified as interest or operating income may
determine the amount of deductible interest expense. Whether income is deemed to
be U.S.-sourced or foreign sourced income may affect not only the tax rate that applies
to the income but also the foreign taxes paid that the United States will permit as a
credit against U.S. income tax liability. Whether income is judged to come from an
actively managed business, or a passive investment may affect whether losses from
such activities are currently tax deductible. Whether income is considered to come
from an activity engaged in for profit or an activity that is a hobby may affect whether
losses from such activities will ever be deductible. These examples are by no means
exhaustive (and some of these are discussed in more detail in later chapters). Many
other labeling distinctions are important to taxpayers, particularly in the international
tax area.
