Optimal Tax Policy

Matt Yglesias has made a mediocre post on optimal taxation. I'll try to hit some points that do a better job.

1. Taxes should not distort economic decisions that would have been made in their absence unless we are distorting those economic decisions on purpose in furtherance of intended policy goals. For example, the tax system: 

* should not prefer debt over equity financing (e.g. dividends and interest on loans should result in comparable combined taxation), 

* should not prefer subordinated debt over insurance mechanisms for protecting investors from risk (e.g. mortgage insurance as well as second mortgage interest should have similar tax treatment for home owners),

* should not prefer renting over owning (e.g. there should be a rent deduction comparable to the deduction for mortgage interest and property taxes)

* should not prefer tangible capital or financial capital over human capital (e.g. education expenses should be deductible), and

* should not prefer income from property over income from labor (e.g. capital gains and qualified dividends and "carried interests" should not received favorable tax treatment).

2. Intentional distortions of economic decisions to mitigate negative externalities with taxes should involve tax burdens comparable in magnitude to the harm caused by the externality. These taxes should also, ideally, be earmarked to mitigate the externalities caused. For example:

* Vehicle taxes should approximate the wear and tear on infrastructure that the vehicle creates (a per mile odometer tax adjusted for vehicle weight and owed when a car is registered may make sense).

*  Carbon taxes should approximate the harms caused by fossil fuel pollution.

3. Intentional distortions of economic decisions to encourage conduct with positive externalities with tax subsidies should involve subsidies comparable to the benefit the positive externality generates. These subsidies should be treat as expenditures in the budget process. Tax subsidies should be used only when direct spending is significantly less efficient and should regularly be reviewed for efficiency in generating the desired benefit. There are lots of dubious tax expenditures in the Internal Revenue Code that should be scrapped.

4. Taxes should be linked to means of determination that are transaction driven and hard to dispute, to the extent feasible, rather than based upon theoretical values.

* Cash flow based taxation for businesses (with what are now capital expenditures being deductible, loan proceeds being income, principal payments on loans being an expense, and no depreciation, amortization or depletion deductions) would be preferable to the current system of capital investments and loan proceeds that are not taxable and depreciation, amortization, and depletion deductions that are expenses without cash outlays. This eliminates the need to track capital gains tax basis and maintain depreciation and amortization schedules.

* C-corporation, trust and estate style taxation of distributions to beneficial owners when actually made is preferable in taxation of entity income to passthrough taxation. Pass through taxation should be limited to income allocable to unlimited liability owners of a company (treating a limited partnership as a partnership between a general partnership and a corporation made up of the limited partners).

* Taxes requiring property valuation should be disfavored in cases where there is not a well established market price for the thing valued, but can be attractive when a market price is easily established from many current and comparable transactions.

5. Taxes should be hard to defer with a preference for paying now rather than later. Indefinite tax deferral has a comparable economic impact to non-payment of taxes. For example:

* The deferral of gain in like-kind exchanges of investment real estate pursuant to IRC § 1031 should be eliminated.

* Multiple year carry forwards or carry backs of losses should be disfavored.

* A corporate entity level tax (or immediate passthrough taxation) is necessary to prevent taxation of income earned at the entity level from being indefinitely deferred.

6. Taxes should be paid to the geographic governmental subdivisions closest to where the underlying economic activity that gives rise to what is taxed occurs. In the case of intangible income, this should usually be the place the the transactions generating it occur and not the places where it is received. In a related point, taxes should be designed to address the fact that there are multiple levels of taxation in a federal system and that we have an open economy that includes interstate and international business. For example:

* Intellectual property royalties and sales taxes from the sale of intangible serviecs like streaming software should be subject to taxation when sales generating the royalties take place, or where the goods or services are delivered if this is not as "hot" and subject to manipulation.

* Retirement income should be taxed by the jurisdiction where the retirement funds were earned.

7. Taxation of non-profits should minimize the interactions between the tax collection system and non-profits. But this should not open up loopholes that undermine the taxation of the for profit tax sector. For example:

* Charitable deductions should be eliminated for income tax purposes, so that tax officials are not tracking who contributes charitably to whom and whether the charity is worthy. This is already the case for the tens of millions of taxpayers who do not itemized their deductions (especially homeowners in states with low taxes and renters).

* The 501(c)(3) tax exemption should remain but investment income and payrolls should continue to be subject to taxation. This would protect non-profits from most kinds of audits intrusions.

* The exclusion of charitable gifts from gift and estate taxation should be retained since the gift and estate taxes are taxes in lieu of income taxation on the person receiving it and non-profits are not taxable on the income that they receive.

* The minister's housing exemption should be repealed.

* Sales tax exemptions particular to non-profits should be repealed. This way vendors don't have to treat non-profits differently from other customers.

*  Property tax exemptions for non-profits owning ordinary taxable property should be repealed although special valuation rules or taxes in lieu of property taxes may need to be established for property that has a very thin market in which the transactions that do take place are often not at arms-length like churches.

* The exclusion from income for municipal bond income should be repealed.

8. The overall tax system should not be regressive. It should be flat or progressive. High rates of marginal taxation of lower incomes should be avoided, and for this purpose, the phase out of means tested benefits should be considered. In a related point, taxes should not tend to push someone from not being in poverty to being in poverty. For example:

* Integrating a universal basis income into the tax system can avoid the complication of phase outs of means tested benefits.

9. The taxes used to pay for public spending should be commensurate with the characteristics of the tax. For example, these characteristics include the geographic equity, business cycle patterns, changes with economic growth, and magnitude of what they pay for, to the extent feasible.

10. Taxes should be imposed in a manner sensitive to tax related transaction costs so that the transaction costs are not unreasonable relative to the revenue generated by taxes. One important subset of transaction costs is tax planning for the purposes of reducing taxation in ways not in furtherance of intentional policy goals. Loopholes are undesirable in part because they encourage wasteful tax planning.

* One of the big offenders here is the Medicaid Cost Recovery System which is basically the poor man's estate tax, impose an immense planning and economic burden on the assets of people who die after having received state subsidized, means tested nursing home care.

11. Aggregate taxation levels from all types of taxes should be sufficient to pay for all long term average public spending, both on goods and services that are more desirable to purchase governmentally than privately and also on transfer payments as necessary for reasonable equity in society without eliminating incentives to earn income or be profitable in activities that are socially desirable on a net basis. We shouldn't run annual deficits in ordinary times but should use debts to buffer the economy in bad times, and should set aside rainy day funds in good times. 

On balance, in the U.S. we err on the side of underinvesting in public spending, resulting in less efficient private sector attempts to address the same issues that could be addressed with public funding, which means higher taxes to pay for that and to reduce the long term average annual budget deficit (not the national debt itself) would be a good thing.

12. Taxes should be designed and administered in a manner that keeps the "tax gap" between taxes imposed and taxes collected small. For example:

* Third-party information reporting should be established in areas where the tax gap is large.

* Excessively complex provisions like the "earned income tax credit" should be redesigned or eliminated to reduce the vast number of audits it creates. The Obamacare tax credit is similarly absurdly complex.

Criticism of Proposals From Matt Yglesias

1.  Yglesias is a proponent of a "Land Value Tax", which purports to be good because the supply of land is fixed so it is hard to evade and investments in its can't increase or decrease the supply of land. But, a Land Value Tax doesn't tax land, which is fixed in supply, it taxes "Land Value" which is not fixed in supply. Land value, in reality, is indirectly a product of the buildings built in the neighborhood of the land being valued. But it does puts arguably counterfactual theoretical analysis (since few sales actually involve land alone) between market comparable values and the quantity being taxed. 

It also arguably puts too much pressure on the owners of vacant land to develop it despite the fact that it doesn't generate any revenue, or in the alternative leads to tax sales, because the development value of vacant land doesn't generate income and hence doesn't generate an ability to pay this tax.

A better way to think about property taxes is as a tax in lieu of an income tax on the fair market rental value of use property that isn't taxed in an income tax since income taxes usually don't tax imputed income from property ownership. 

In this analysis, it isn't obvious that it makes sense to impose property taxes on real property that is a factor of production (like agricultural land) as opposed to use property, any more than it does to impose sales taxes on both the full amount of wholesale sales and the full amount of retail sales, effectively giving rise to double taxation.

Any kind of property tax or Land Value Tax is also a troublesome way to finance a good or service like public education that needs to be delivered to people statewide or nationwide, partially though local taxes, since there is so much variation in tax base of real estate in different areas. Only a couple of very low population rural states have statewide property taxes.

2. Yglesias makes a half-hearted case in support of consumption taxes while also favoring strongly progressive consumption taxation and arguing the the source of income should matter. His proposal looks a bit like a value added tax or sales tax analysis. But, mechanically, it is difficult to make that kind of consumption tax progressive or even flat, and the alternative to a VAT or sales tax is usually an exemption for income from property (sometimes in the form of a generalized IRA with no contribution or withdrawal limits whose gains aren't taxed until withdrawn, effectively deferring income taxation but not eliminating it).

Essentially all consumption taxes are regressive and are especially regressive with respect to the very rich, in whose case even basically consumptive purchases are easy to reclassify as investments. He admits himself that:

The economic case that consumption taxes increase economic growth in the case of real world consumption tax proposals are also based upon pretty feeble macroeconomic analysis that isn't rigorously and unequivocally supported empirically.

He and I agree that a carbon tax or greenhouse gas emissions tax makes sense, even if the right dollar amount per ton is not something that can be scientifically determined down to the last dollar (Biden is proposing $51 a ton, he points to studies that suggest something more like $258 per ton.) The best is the enemy of the good and I'd be glad to see anything done.

He thinks that:

With respect to alcohol taxes, the current amounts are so small that they barely justify the costs of collection and vastly higher alcohol taxes would have a pretty regressive effect (although less than one might expect because really poor people don't drink much alcohol).

With respect to Marijuana taxes, he's smoking something, because marijuana is already extremely heavily taxed at the federal, state, and local levels, for example, due to IRC § 280E.

With respect to sweeteners, the studies that have been done to date are a mixed bag and we don't really understand the causes of obesity well enough to be making tax policy based upon it. And, there is a basic cost-benefit issue since even a high sweetener tax would still generate not that much revenue for high collection costs.

He may have had better proposals in the gated portion of his post, but if so, he didn't put anything in his introductory discussion to suggest that they were coming.

Tax Deadbeats Caused The Greek Financial Crisis

One of the main reasons that the Greek government did not have enough money to pay its debts, which in turn produced a financial crisis that will had led to defaults on its national debt and is likely to cause Greece to leave the Euro-zone, is that 89.5% of Greek taxes are not collected.  By comparison, only 2.3% of taxes owed in Germany go uncollected.

The material linked also shows that the United States has a very small "shadow economy" (8.6% of GDP) compared to its European competitors (12.3%-26.3%), or even Japan (11%), let alone Greece (28.3%).

Low Profile Tax Reform

The President's Economic Recovery Advisory Board, led by former Fed Chair Paul Volcker has offered up a treasure trove of proposals for tax simplification, increasing tax compliance, corporate taxation and international taxation, all of which are revenue neutral or tax reducing for families making less than $250,000 a year, in a new 128 page report.

These are (mostly) moderate, sensible proposals, many of them old chestnuts that no one has seriously disagreed with but that have lacked political umph, that have a real chance of becoming law is the President and Congressional leaders decide to back them.

The table of contents (formatting added and some details omitted) tells the story:

II. SIMPLIFICATION OPTIONS

Option Group A: Simplification for Families
1: Consolidate Family Credits and Simplify Eligibility Rules
-1. Consolidate Family Benefits into a Work Credit and a Family Credit
-2. Combine the EITC, Child Tax Credit, and the Child Dependent Exemption
-3. Consolidate the Child Tax Credit and Dependent Exemption, and Repeal (or Reduce) Some Education Credits
2: Simplify and Consolidate Tax Incentives for Education
3: Simplify the “Kiddie Tax” (Taxation of Dependents)
4: Simplify Rules for Low-Income Credits, Filing Status, and Divorced Parents
-1. Harmonize the EITC and Additional Child Tax Credit
-2. Simplify Filing Status Determination
-3. Eliminate the “Household Maintenance Test” for “Estranged” Spouses
-4. Simplify the EITC for Childless Workers
-5. Clarify Child Waivers in the Event of Divorce or Separation

Option Group B: Simplifying Savings and Retirement Incentives
1: Consolidate Retirement Accounts and Harmonize Statutory Requirements
2: Integrate IRA and 401(k)-type Contribution Limits and Disallow Nondeductible Contributions
3: Consolidate and Segregate Non-Retirement Savings
4: Clarify and Improve Saving Incentives
-1. Make the Saver’s Credit a Match
-2. Expand Automatic Enrollment in Retirement Savings Plans
5: Reduce Retirement Account Leakage
6: Simplify Rules for Employers Sponsoring Plans
7: Simplify Disbursements
8: Simplify Taxation of Social Security Benefits

Option Group C: Simplify Taxation of Capital Gains
1: Harmonize Rules and Tax Rates for Long-Term Capital Gains
-1. Harmonize 25 and 28 Percent Rates on Capital Gains
-2. Simplify Capital Gains Taxes on Mutual Funds
-3. Small Business Stock
2: Simplify Capital Gains Tax Rate Structure
3: Limit or Repeal Section 1031 Like-Kind Exchanges
4: Capital Gains on Principal Residences

Option Group D: Simplifying Tax Filing
1: The Simple Return
2: Data Retrieval
3: Raise the Standard Deduction and Reduce the Benefit of Itemized Deductions

Option Group E: Simplification for Small Businesses
1: Expand Simplified Cash Accounting to More Businesses
2: Simplified Home Office Deduction
3: Simplify Recordkeeping for Cell Phones, PDAs, and Other Devices

Option Group F: The AMT
1: Eliminate the AMT
2: Modify and Simplify the AMT

III. COMPLIANCE OPTIONS

1: Dedicate More Resources to Enforcement and Enhance Enforcement Tools
2: Increase Information Reporting and Source Withholding
3: Small Business Bank Account Reporting
4: Clarifying the Definition of a Contractor
5: Clarify and Harmonize Employment Tax Rules for Businesses and the Self-Employed (SECA Conformity)
6: Voluntary Disclosure Programs
7: Examine Multiple Tax Years During Certain Audits
8: Extend Holding Period for Capital Gains Exclusion on Primary Residences

IV. CORPORATE TAX REFORM

Option Group A: Reducing Marginal Corporate Tax Rates
1: Reduce the Statutory Corporate Rate
2: Increase Incentives for New Investment/Direct Expensing

Option Group B: Broadening the Corporate Tax Base
1: Provide More Level Treatment of Debt and Equity Financing
2: Review the Boundary Between Corporate and Non-Corporate Taxation
3: Eliminate or Reduce Tax Expenditures
-1. Eliminating the Domestic Production Deduction
-2. Eliminate or Reduce Accelerated Depreciation
-3. Eliminate Other Tax Expenditures
--A. Special Employee Stock Ownership Plan (ESOP) Rules
--B. Exemption of Credit Union Income from Tax
--C. Low-Income Housing Credit

V. ADDRESSING INTERNATIONAL CORPORATE TAX ISSUES

Economic Effects of the Current U.S. Approach
i. Effects on the Location of the Economic Activities of U.S. Multinationals
ii. Effects on the Costs of U.S. Companies and their Foreign and Domestic Competitors
iii. Erosion of the Business Tax Base through Transfer Pricing and Expense Location
iv. The Costs of Administering and Complying with the Current U.S. System

1: Move to a Territorial System
2: Move to a Worldwide System with a Lower Corporate Tax Rate
3: Limit or End Deferral with the Current Corporate Tax Rate
4: Retain the Current System but Lower the Corporate Tax Rate

Limits of the EITC

The Earned Income Tax Credit (EITC) reduces the tax burden of working class people with earned income, a benefit which as phased out as taxpayers approach middle class incomes.

It has received considerable criticism, however, and rightly so.

The provision is a complex one targeted at people who rarely have access to professional tax advisors. Indeed, it is the single most complex part of the tax code that applies to working class and middle class taxpayers who are not self-employed. As a result, the EITC is the single largest source of audits in the tax code. EITC mistakes are so common that working class taxpayers are audited more often than wealthier taxpayers much more likely to be intentionally violating the law.

Equally problematic, the effective marginal tax rates that result from the phase out of the EITC are the highest faced by taxpayers of any income. Also, these same people often lose many means tested benefits at the same time that they are facing an EITC benefit. As a result, taxpayers in the EITC phaseout income range often face effective marginal tax rates approaching 100% when means tested benefit phase outs are considered. High marginal tax rates for working class people is hardly a good way to help them escape poverty.

A new law review article further explores the problems with the EITC:

[T]he EITC reduces poverty only modestly, and even the maximum credit falls short of closing the gap between low-wage earnings and poverty. At the same time, gaps in other social welfare programs leave low-income workers vulnerable to the job disruptions that characterize low-wage work - when the EITC provides no assistance at all.

Analysis

Getting The Working Poor Out Of The Tax System

Tax policy directed at the working poor needs to be minimally bureaucratic and provide good incentives for participants. As a general rule, those in poverty should owe no federal income or payroll taxes of any kind, and should not need to file a return to claim this benefit.

The resources of the IRS are not best spent chasing after working poor people who have trouble accurately calculating their entitlement to the EITC, waiters who don't fully report their tip income, and gray market part-time hairdressers and baby sitters. Its resources are better spent pursuing big businesses that take elaborate efforts to twist federal tax law to permit tax breaks not contemplated by the law, and affluent self-employed people and property owners who fail to report significant taxable income.

The jobs bill signed by President Obama today, which creates a payroll tax holiday for certain unemployed workers hired by businesses, is a step in the right direction.

Categorical Programs Are Often Preferrable To Means Testing

Social welfare programs, when possible, should have a categorical eligiblity test, like Medicare and public K-12 education, rather than a means test, like Medicaid and cash welfare programs.

Health Care

Once you are committed to the idea of universal health care, as our nation looks likely to be in a matter of weeks, the money spent administering means tested programs is no longer a matter of cost control; it simply a matter of shifting cost from one financing approach to another. This greatly reduces the value involved in high administrative costs.

School Breakfasts and Lunches

For example, the are many schools where the vast majority of students are poor. And, a large share of all poor students attend schools where the vast majority of students are poor, because neighorhoods tend to be made up of people with similar incomes. In schools where most students are poor, it may make more sense to make school breakfasts and lunch available for free to all students, than to try to keep track of free and reduced school nutrition program eligiblity and to collect lunch money from students who haven't applied to the program or are affluent enough not to qualify. The administrative cost savings involved in making entire schools eligible may offset the costs involved in providing benefits to more students. And, many of the new beneficiaries in these schools would have been eligible for a means tested program anyway, if they had applied, but have parents who never got their act together bureacratically well enough to receive those benefits.

Public Defenders and Bankruptcy

Programs that primarily benefit the working poor, even if they marginally benefit others, like the public defender system, and the bankruptcy system, should likewise be structured to avoid elaborate financial paperwork. Rather than basing access to these services on means, the nature of the benefit itself could be structured to favor the intended beneficiary.

For example, a universal public defender system, in which anyone can have a lawyer appointed for them in a criminal case regardless of means, is less likely to be abused if people who are convicted have a duty to reimburse the state for their defense if they have the means to do so. Perhaps 80% or more of people in the system already receive public defenders because they are indigent already, and many of those who don't are still far from affluent. Also, providing financial assistance to people who are charged with crimes and then acquitted would not be very expensive (since full acquittals at trial are quite rare as a percentage of all criminal cases filed, making about around 1% of the total) and have ample moral justification of a categorical benefit.

Similarly, a bankruptcy system that imposes a three year garnishment after the case is otherwise closed, for the benefit of creditors whose debts were discharged, would discourage high income people from filing for bankrputcy without using means as a gatekeeper to bankruptcy court relief.

Higher Education

Means tests may be unavoidable at times. But, they should be used sparingly and with an eye towards the incentives that they create.

For example, means testing may be a worthwhile part of the solution for higher education, where a large share of students are from affluent families, most of the rest of the students are from bureacratically competent middle class families (and most students are bureacratically competent), the benefit is relatively large in absolute dollar value, and the impact that financial assistance has on college attendance of students with low means is great. Yet, even in higher education, categorical screens based on factors like first generation college student status and academic merit are also very useful.

Rather than indiscriminantly funding all in state students, or all students who attend public institutions of higher education, it may make more sense to bring regular tuition more in line with the costs associated with providing higher education, and then to be more selective about who receives limited public assistance in getting a college education.

On one hand, the system does neither beneficiaries nor the public purse, few favors by providing financial assistance to students entering academic programs that they are likely to fail because they are ill prepared.

On the other hand, even a quite generous means test can end a subsidy for highly affluent upper middle class students, and in the process make more of the scarce funds available to fund higher education available to those who would likely forego higher education without financial assistance.

Unemployment

Our unemployment system is another major safety net that is deeply broken.

While not strictly speaking a means tested program, it devotes considerable resources to denying benefits to applicants, because they are unemployed for the wrong reasons, because they set their standards too high in their job hunt or don't devote enough effort to a job hunt, or because they get some marginal work that leaves them merely underemployed rather than unemployed.

For the long term umemployed, and the unemployed who didn't manage to build up a substantial emergency fund before losing work, credit cards are often a more meaningful form of unemployment and underemployment assistance than unemployment insurance.

The COBRA subsidies we've seen in response to the financial crisis are one sensible, catagorical response. Another policy option used in many countries is a system of severance payments that are due on termination of employment in the vast majority of cases that decouple the likely financial burden associated with a discharge from employment from the process of finding a new job.

Dayton Property Tax Collections Miserable

Dayton, Ohio has a struggling economy. A Dayton Daily News story on Sunday suggests that local governments (particularly schools) are paying for that with low property tax collections. About 13% of property taxes in Dayton proper were uncollected. The Dayton Public Schools are more than ten million dollars short on revenues as a result, even before accounting for a declining property tax base.

This is stunning because in Colorado, property tax revenue collection rates are extremely high (approaching perfect) even in bad times. This is because the right to receive unpaid taxes and the interest due on them are sold to private bidders who know that they have a nearly 100% chance of recovering their investment eventually because property taxes have a first priority lien on real estate, that generally can't be discharged in bankruptcy, and because the property that can be foreclosured upon in satisfaction of property tax liens is almost always worth more than the taxes due with interest. Investors eager to buy safe (if somewhat complicated) investments with an above market rate of return abound, and all the risks of non-collection quickly become private sector risks rather than burdens on property tax supported entities.

In contrast, predicting revenues from Colorado income and sales taxes is a dicey proposition requiring serious economic prognostication, because the tax base is less stable and the gap between taxes due and taxes collected is much greater and more variable.

While property values in Dayton are low, they aren't Detroit low. People in Dayton generally don't have houses worth less than their cars.

I don't know enough about the Dayton system to clearly discern why it can't collect its property taxes, but it seems like a problem that Ohio ought to be able to solve.

Rewards For Snitching?

Lots of the tax returns that a business has to file are "information returns" (such as forms W-2, 1099 and K-1). The returns report revenue or income that the filer is aware that someone else has received. No tax is due from the filer, although there is a penalty due if the return isn't filed on time (that can be abated in some circumstances).

Empirically, information return filing dramatically increases compliance by the person whose information is reported. But, this generates work for the party that files the return and is unlikely to be caught if there is non-compliance.

How could the IRS encourage filers to file returns? What if there was a reward assigned to every time that an information return identified taxable income that was not reported by the person identified in the return?

Alternately, should those who file information tax returns, at least, be entitled to some compensation for preparing them for the benefit of the IRS, much like vendors who collect sales taxes sometimes do?

The Rich Cheat More On Their Taxes

High income taxpayers are much more likely to pay less than what they are required by law to pay than lower income taxpayers. In the $500,000 to $1,000,000 per year income range, more than 20% of taxpayers cheat on their taxes, and "because of their higher noncompliance rates, those with true incomes of $200,000 or more received 25% of all income, but accounted for 40% of net underreported income and 42% of underreported tax in 2001[.]"

Palin Failed To Pay Taxes Due

As explained at greater length here, Vice Presidential candidate Sarah Palin understated her taxable income by at least $43,000, and quite possibly, by $52,000. Furthermore, the attorney who wrote an opinion letter backing up her tax return (which was prepared by H&R Block) probably violated the professional ethics obligations of tax attorneys in doing so.

Landlords Are Crooks

At least an estimated 53% of individual taxpayers with rental real estate misreported their rental real estate activities for tax year 2001, resulting in an estimated $12.4 billion of net misreported income.

From here, citing a recent GAO report.

Also, keep in mind that in Colorado, where Colorado taxable income is a function of federal taxable income, that gaps in federal income tax enforcement cost Colorado money as well.

Undocumented Americans Emigrate

The legal immigration system admits about 1.1 million people a year. Immigration quota backlogs keep this number constant and close to that number every year.

As recently as 2006, about 700,000 undocumented immigrants added to that flow. But, in 2007, there was a dramatic reversal of this trend. According to the census bureau, only about 500,000 people documented and undocumented immigrated to the United States in 2007, compared to 1.8 million in 2006. This means that a net of about 600,000 undocumented Americans left the U.S. in 2007. In Colorado, the total estimated foreign born population declined by 0.9%, which means that more undocumented immigrants left the U.S. than there were legal immigrants who entered the state.

Presumably, this is driven by the decline in the U.S. economy generally, and the undocumented immigrant intensive construction sector in particular. Given the state of the economy so far in 2008 and the prospects for the U.S. economy in 2009, we are likely to see two more years of emigration by undocumented Americans.

This may rob the immigration issue of the pressure that it has seen in recent years. Immigration hasn't been the number one issue for many years. But, an important and vocal minority of voters, who are often disaffected from either major political party, care a great deal about the issue. A talked with one likely Obama voter while canvasing explain his concerns about this issue (and related ones) for about fifteen minutes. I have a politically active neighbor who feels the same way. And, no issue more frequently garners fierce reactions to otherwise routine stories on comment pages of the online Denver Post and Rocky Mountain News.

State and local governments have tried to address the issue. Colorado recently had a special session of the legislature addressing these issues, and Denver voters cast votes on a ballot issue this summer targeted at illegal immigration. But, the President and Congress are the dominant players on this issue.

How will this play out politically?

Tax collection changes are one likely place this could have an impact.

Cheap labor conservatives will lose clout, because their industries, particularly construction, are weak. In these industries, most undocumented immigrants operate as independent contractors, often through corporations, which don't have to be issued a 1099 when they provide services. If these corporations were 1099'd, they would have to report the income on federal tax returns, drying up a big hunk of the small business tax gap, while at the same time reducing the economic incentive to hire undocumented immigrants in these industries.

Also, given that Democrats will control Congress, facially neutral tax gap measures that have an incidental, even if significant impact on immigration, is likely to be more popular than an immigration specific measure.

We also may expect to see legislation requiring subcontractors to certify in detail immigration compliance for the general contractors that hire them.

Private Tax Collection A Bust

Using private collection firms to collect unpaid taxes isn't working. Contract oversight is poor and the approach isn't increasing tax collections as intended.

Perhaps there is some manner in which the federal government bureacracy is regulated, but the private sector is not, which makes tax collection less effective. For example, perhaps private debt collectors have more compensation package flexibility allowing them to give their employees greater incentives to increase collections. If that is the problem, it is within the power of Congress to change to offending rules while keeping tax collectors within the I.R.S.

On the other hand, if private debt collectors are no more effective at collecting taxes than government employees, which appears to be the case in real life, there is no reason to use private debt collectors or their methods.

Tax Law Sinks Car Donations

Some donations are more tax driven than others. In hindsight, it is clear that one form of charity which was very tax motivated was an in-kind donation of car. They plummetted when tax rules changed in 2004. An analysis cited at the Tax Profs Blog explains:

Before 2005, taxpayers who donated a vehicle were allowed to deduct its fair market value. Tax legislation enacted in 2004 changed the rules to generally limit vehicle donation deductions of over $500 to either the actual proceeds from a vehicle’s sale or the vehicle’s fair market value -- whichever is less. . . .

[B]etween tax year 2004 and 2005, car donations of over $500 dropped by two-thirds. Over 900,000 tax returns claimed deductions for donated automobiles in 2004. In 2005, the last year for which the IRS has detailed data, less than 300,000 tax returns included such claims.. The total amount deducted for all car donations declined from $2.4 billion in 2004 to just a half a billion dollars the following year, a decrease of over 80%.... the total number of car donations fell by 67%, and the amount of deductions claimed as a result of such donations fell by over 80%, the deduction claimed per car donated . . . declined by 41%....

The total amount of deductions claimed for charitable deductions increased from $156 billion in 2004 to $172 billion in 2005. In 2006, the number increased again to $173 billion.

Needless to say, optimism concerning the fair market value of used cars abounded prior to the change in the tax law, something that serves as fair warning to policy makers considering any tax code provision dependent upon individualized estimates of fair market value (grants of conservation easements are another area of charitable giving that poses similar concerns).

The Case For Two Track Tax Enforcement

Alex Raskolnikov, a tax professor, has an exceedingly clever idea for improving compliance with tax laws described in a pre-print draft article.

His idea: Give taxpayers two choices regarding how questions about their returns will be handled that give them an incentive to choose the regime most likely to cause them to comply.

One regime, which would apply by default, would be similar to the current regime, but with civil penalties five times as high.

The other regime, with penalties the same as those under current law, which could be elected by return filing taxpayers, would included features such as:

1. The IRS is right unless clearly wrong in interpreting tax laws and facts
2. Binding arbitration with the IRS
3. Waiver of tax preparer privileges
4. Voluntary waiver of foreign law privacy protections
5. Higher standards for tax preparers (re disclosing aggressive positions)
6. Higher penalties for tax preparers
7. Reimbursement of costs for prevailing taxpayers
8. Separate enforcement staffs (elective taxpayer staff would be nicer)

The notion is that existing civil penalties are too weak to deter people who try to game the current system, but that stiff penalties are harsh for people who fail to comply despite not trying to game the system, and that high penalties discourage cooperation with tax authorities by people who aren't trying to take aggresive positions on purpose.

The elective regime would impose make it much more likely for taxpayers and their advisors intentionally relying on aggressive interpretations of tax laws to lose upon an audit, while imposing minimal costs upon taxpayers who simply made mistakes in applying sometimes unclear tax laws. Thus, the election would be designed to give taxpayers most responsive to high penalties an incentive to choose the traditional regime with high penalties, and would give taxpayers more responsive to a less adversarial approach an incentive to choose the elective regime.

Also, taxpayers found to have gamed the system in an audit under the elective approach could be barred from using it in future years.

He argues for some complex reasons, that the best strategy to accompanying this change would be to make decisions to audit at all without considering whether or not a taxpayer has made the election.

Also, the approach avoids constitutional challenge because taxpayers are free to elect the traditional regime that preserves all traditional legal rights, and will not be penalized for doing so unless they are found upon an audit to have failed to comply with the tax laws. Nothing in the constitution imposes limits on how high civil penalties for tax law violations may be, so long as they are reasonably proportional to the violation (the vast majority of tax penalties are a multiple or percentage of the amount of tax not paid).

The proposal isn't a comprehensive approach to closing the tax gap, nor is it intended to be.

But, one of the issues the proposal does not address, non-reporting of domestic income, is well suited to an entirely different solution: expanded information reporting. Another approach within the plan would be to apply greatly increased penalties under both regimes in the narrow area of intentionally not reporting gross income not subject to information reporting.

Others unaddressed issues, like non-reporting of foreign income, may not have any good solutions through a taxpayer level audit process. One recent breakthrough on that front was to audit credit card companies that facilitated access to non-reported foreign funds. Another may be tough multi-national diplomatic action against tax havens. A third approach could involve aggressive federal criminal enforcement directed towards taxpayers who fail to report tax haven income, a strategy that may have benefits in curbing money laundering and bankruptcy fraud as well.

Closing The International Tax Gap

Every politician wants easy ways to raise revenues. Few are more beautiful than getting money from people who are already cheating on their taxes, or are abusing tax laws to artificially reduce their taxes in unintended ways.

This international tax gap isn't part of the official tax gap measures by the I.R.S. because it is hard to measure. But, changes in international taxation could raise $50 billion or more a year, with almost no pain to legitimate taxpayers. A detailed analysis of what can be done to address the problem is set forth here.