Cost-Benefit Analysis of Tax Regulations: A Case Study (with Jennifer Nou and David Weisbach)

by Daniel Hemel — Friday, July 27, 2018

[Note: This post is co-authored with University of Chicago Law School colleagues Jennifer Nou and David Weisbach.]

The Treasury Department and the Internal Revenue Service (IRS) have submitted a proposed rule regarding the new passthrough deduction to the Office of Information and Regulatory Affairs (OIRA) for review. This appears to be the first tax regulation labeled as “economically significant” that Treasury and IRS have submitted to OIRA since an April 2018 memorandum of agreement set forth a new process for the centralized review of tax regulations. That process requires Treasury and IRS to submit a regulatory impact analysis to OIRA before publishing any “economically significant” rule — one that is “likely” to “have an annual non-revenue effect on the economy of $100 million or more.” That analysis must include, “to the extent feasible,” a quantification of the proposal’s benefits and costs.

The proposed passthrough rule will likely require Treasury, the IRS, and OIRA to confront a question that has vexed tax scholars for some time: How should cost-benefit analysis be conducted for tax regulations? More precisely, how should it account for the revenue effects of tax-related changes? Guidance from the Office of Management and Budget (OMB, of which OIRA is a part) seems to instruct agencies to treat government revenue collections as “transfer payments” rather than as benefits or costs. The rationale is that “benefit and cost estimates should reflect real resource use,” while “transfer payments are monetary payments from one group to another that do not affect total resources available to society.” However, in the tax context, some increases in tax revenue do in fact reflect changes in real resource use. Under OMB’s own guidance, then, these revenue changes should be counted as a social benefit.

In a forthcoming article in Tax Notes, we propose a method for Treasury and IRS to calculate the social costs and benefits of tax regulations that affect revenue collections. This method, which we call the “marginal revenue rule,” builds upon recent work by economists Martin Feldstein, Raj Chetty, Michael Keen, and Joel Slemrod. We argue that revenues resulting from behavioral changes should be counted toward the social benefits of a tax regulation, whereas other revenues (what economists refer to as “mechanical transfers”) should not. For non-revenue costs and benefits, cost-benefit analysis of tax rules should proceed along the same lines as that for non-tax regulations.

We flesh out this argument in greater detail and address potential objections and complications in the paper, a draft of which is available upon request. For now, a simple example to illustrate the approach: Imagine two sectors of the economy—a taxed sector and an untaxed sector. Individuals can work in either. Let’s say that the tax rate in the taxed sector is 30%. Workers will seek to allocate their labor between the two sectors so that they are indifferent between working an additional hour in the taxed sector and an additional hour in the untaxed sector. At the margin, an individual will be indifferent between, say, working an additional hour in the taxed sector (and thereby earning a $100 pre-tax wage) or working an additional hour in the untaxed sector (and thereby earning $70 that goes untaxed).

Now imagine that a new tax rule makes working an additional hour in the taxed sector ever-so-slightly more attractive than it was before (e.g., by slightly lowering the rate, or by slightly reducing compliance costs). An individual who responds by reallocating an hour of labor from the untaxed sector to the taxed sector is, to a first approximation, no worse off than before, because she previously was indifferent between the two options. But the total resources available to society increase by $30, because the individual is now paying $30 more in taxes than she otherwise would have. Because real resources have increased, this additional revenue resulting from a behavioral change should count as a social benefit. Symmetrically, any loss in revenue resulting from a behavioral change should count in the social welfare calculus as a cost.

There is much more to say about the marginal revenue rule, its virtues, and its limits. For now, the passthrough deduction provides a nice potential case study of the marginal revenue rule in action. The deduction, added to the Internal Revenue Code by the December 2017 tax law as a new section 199A, allows taxpayers to write off up to 20% of their “qualified business income.” The term “qualified business income” refers to a taxpayer’s net income from a partnership, sole proprietorship, or S corporation, but not to the income that the taxpayer earns as an employee. There are a number of additional restrictions: for example, taxpayers earning more than $207,500 (double that for a married couple) cannot claim any deduction for income earned in the fields of health, law, accounting, consulting, and several others, and high-income taxpayers outside those fields face limits that depend upon the wages paid by and capital invested in their businesses. For now, we will focus on another restriction: the statute says that “[q]ualified business income shall not include . . . reasonable compensation paid to the taxpayer by any qualified trade or business of the taxpayer for services rendered with respect to the trade or business.”

One question raised by the statutory language is whether a partner or sole proprietor who actively participates in a trade or business is required to pay herself some sort of wage. (S corporation shareholders already are required to do this.) To illustrate, let’s say that you are a barber who works as an independent contractor and nets $25 per hour, 40 hours per week, 50 weeks per year, for a total of $50,000. Can you claim a deduction of 20% x $50,000 = $10,000? Or are you required to calculate a “reasonable” wage—say, what you would earn if you worked at the federal minimum wage—and then subtract that from $50,000 before applying the 20% deduction? Since a larger deduction means less in taxes, you—the barber—would prefer the first approach.

Let’s say that Treasury and the IRS are trying to choose between two alternatives: (A) a rule that allows all partners and sole proprietors to claim the passthrough deduction without carving out “reasonable compensation,” and (B) a rule that requires partners and sole proprietors to calculate a “reasonable” wage that they subtract from their qualified business income before applying the 20% haircut. How should cost-benefit analysis approach this choice? (To be sure, while we know that Treasury and the IRS have submitted a proposed rule to OIRA regarding the computation of the passthrough deduction, we don’t yet know what’s in the proposal, other than that it apparently addresses “computational” issues rather than “definitions” or “anti-abuse” rules. Our interest here is simply illustrating how the marginal revenue rule could work in practice.)

It should be reasonably clear that government revenue will be higher under option B than under option A, because option B means a smaller deduction and therefore a larger tax bill for the barber. It also seems probable that administrative and compliance costs will be higher under option B than under option A, because option B will require millions of partners and sole proprietors to calculate an entirely hypothetical wage—which the IRS presumably will then review for “reasonableness,” with lots of litigation likely.

One approach might be to treat all of the additional revenues collected under option B as transfer payments rather than social benefits, and then weigh the benefits of option B (zero) against the administrative and compliance costs. In that case, option A would clearly dominate. The problem with that approach is that it ignores the change in the real resources available to society when individuals shift between lower-taxed and higher-taxed sectors, and the point of cost-benefit analysis is to estimate the chance in the real resources available to society.

Yet another possibility would be to assign some multiplier to the additional revenues raised under option B, on the theory that dollars in the government’s hands are worth more from a social welfare perspective than dollars in private pockets. Small-government advocates will argue that the multiplier should be negative (on the view that the federal government is too big already). Proponents of additional public spending will argue for a positive multiplier. Economic theory would suggest that $1 in the government’s hands should count the same as $1 in private pockets if tax rates are set optimally, in which case a mechanical transfer from the private sector to the public sector produces no net social benefit. Regardless, any effort to agree upon a multiplier is likely to be contested, and we thus think that this value should be set by OMB and Treasury with appropriate public input.

However OMB and Treasury resolve that question, we think that the agencies should adopt the marginal revenue rule, which counts additional revenues as social benefits to the extent that they reflect changes in the real resources available to society. (This approach could be applied with a multiplier that reflects the social benefits or costs of mechanical transfers, or it could operate under the assumption that $1 is worth the same whether in government or private hands.) To elaborate: Option A will result in lower effective and marginal tax rates on passthrough income than option B. We won’t go through all of the math here, but to summarize the results: Under option A, the barber would face an effective tax rate of 6.3% and a marginal tax rate of 9.6%. Under option B, the barber would face an effective tax rate of 7.0% and a marginal tax rate of 10.3%. If she were an employee earning $50,000 and claiming no passthrough deduction, she would pay an effective rate of 8.7% and a marginal rate of 12%. (We assume in all of these examples that she is a single filer claiming the standard deduction with other income or offsets.)

The lower rate under option A likely means that the barber will work slightly more than under option B. (This assumes, as is standard, that the substitution effect exceeds the income effect.) Imagine that the barber is deciding whether to work another hour, weighing the opportunity cost (lost leisure) against the additional after-tax income. The additional hours of work under option A have almost no effect on the barber’s own utility because—at the margin—she is essentially indifferent between labor and leisure. But there are more total resources available to society when the barber works the additional hour because for every additional hour she works, the government gets roughly two-and-a-half dollars in additional revenue (which it can use to provide additional public goods or tax rebates). So for purposes of cost-benefit analysis, we should estimate the additional hours of work under option A, multiply that by the amount of revenue raised for each additional hour, and count that as a social benefit of option A relative to option B. Again, these additional revenues make society better off without making the barber worse off.

But that is not the end of the story. The lower effective tax rate on passthrough income also will incentivize some barbers to switch from being barbershop employees (who cannot claim the deduction) to being independent contractors (who potentially can). The IRS has actually issued quite a bit of guidance as to when a barber who rents a booth in someone else’s shop can qualify as an independent contractor (see Rev. Rul. 57-110; Rev. Rul. 70-488; and Publication 4902). Factors that make it more likely that booth renters will qualify as independent contractors include: having keys to the establishment, setting their own hours, purchasing their own products, having their own phone number and business name, and setting their own prices. Whereas employees generally receive relatively stable wages, booth renters are more likely to experience income fluctuations. They also face additional tax compliance obligations. The tax benefits of switching from being an employee to an independent contractor are greater under option A than under option B, so if Treasury and the IRS go with A, more barbers will make the switch.

If Treasury and the IRS choose option A over option B, then some number of barbers who are on or near the edge between switching to independent contractor status and remaining employees will make the switch. Because those barbers were close to indifferent between the two alternatives, their decision to switch makes them only marginally better off but makes society materially worse off (as now the government has fewer resources to use for public goods or tax rebates). So for purposes of cost-benefit analysis, we should estimate the additional number of workers who will switch from being employees to independent contractors if we choose option A, multiply that by the revenue lost for each switch, and count that as a social cost of choosing option A instead of option B.

Summing up so far, and extending beyond barbers: The social benefits of choosing option A over option B include the additional revenues raised from taxpayers who work more when faced with a lower tax rate. The social costs of choosing option A over option B include the additional revenues lost from workers who make tax-motivated switches from employee status to independent contractor status. As noted above, option A also saves on administrative and compliance costs, and those savings should count as benefits of choosing option A. What we haven’t included in our calculation is any change in revenue from taxpayers whose behavior remains exactly the same under option A and option B. Transfers between those taxpayers and the government do not affect real resources available to society.

So which option ultimately fares better on cost-benefit analysis grounds: A or B? The marginal revenue rule instructs Treasury and the IRS to compare the additional revenues raised under A due to the additional hours worked versus the additional revenues raised under B due to workers choosing to remain as employees. If the latter term exceeds the former by more than the difference in administrative compliance costs, then B is the better option on cost-benefit grounds. Otherwise, it’s A. (In practice, the policy decision also may depend upon statutory language, legislative history, and distributional consequences; our focus here is on how to conduct the cost-benefit analysis that Treasury and the IRS now must produce.)

Do Treasury and the IRS actually have the capacity to run these numbers? It won’t be easy, but it won’t be impossible. The staff of the Joint Committee on Taxation estimated that the new passthrough deduction will result in revenue losses of $27.7 billion in 2018 and $229.5 billion over a five-year period. Implicit in those estimates are sub-estimates of (1) the revenue gain from an increase in the number of hours worked by taxpayers eligible for a deduction, (2) the revenue loss from employees who switch to independent contractor status, and (3) the mechanical transfer from the government to taxpayers who can now claim the deduction but whose behavior remains otherwise unchanged. Treasury can either rely on similar models developed by economists at its Office of Tax Analysis or consult with colleagues at the Joint Committee on Taxation to produce cost-benefit estimates of regulatory changes that include the first and second terms but exclude the third.

In sum, the extension of cost-benefit analysis to tax regulations under the April 2018 memorandum of agreement creates conceptual and technical challenges for Treasury, the IRS, and OIRA. The marginal revenue rule—which counts revenues resulting from behavioral changes but not mechanical transfers—points to a path forward. The new passthrough regulations provide the agencies with an initial opportunity to apply this approach. Some will still argue that cost-benefit analysis should not be applied to tax regulations, but hopefully all can agree that if it’s to be done, it should be done well.

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