Suitable for framing: business deductions in a net income tax system.

• Jurisdiction: United States
• Author: Walker, David I.
• Date: 01 March 2011

ABSTRACT

The federal tax code includes numerous provisions disallowing or curtailing income tax deductions related to such disparate activities as business lobbying and providing non-performance-based compensation to senior corporate executives. The primary claim of this Article is that a tendency to mentally frame business deductions as subsidies, often reinforced by rhetoric explicitly framing deductions as subsidies, helps explain these provisions. The traditional "public policy" disallowances directed at lobbying, fines and penalties paid by businesses, and antitrust treble damages respond to an appearance of a taxpayer subsidy that would follow from deduction, despite the fact that it is far from clear that these deductions, if allowed, would create an exception to taxation of net income. Disallowances directed at executive pay and other corporate governance matters also take advantage of an appearance of subsidy. In these cases, structuring an economic disincentive as a disallowed deduction (versus economically equivalent direct regulation) and explicitly framing the intervention as the elimination or curtailment of a subsidy create an illusion of lesser regulatory intervention that helps overcome opposition to the legislation. The normative implications of mental and rhetorical framing of deduction as subsidy are troubling. It is becoming increasing clear that disallowed deductions generally are a poor means of implementing economic policy, and the power of subsidy framing and rhetoric provides another reason to be skeptical of corporate governance and similar business regulation incorporated in the tax code.

TABLE OF CONTENTS INTRODUCTION I. OVERVIEW AND BACKGROUND ON DISALLOWED DEDUCTIONS A. Examples of Disallowances B. The Literature on Disallowances C. Tax-Like Disincentives Outside the Tax Code II. MENTAL AND RHETORICAL FRAMING OF DEDUCTION AS SUBSIDY A. Mental Framing 1. Choice of Baseline--In General 2. Inherent Ambiguity 3. Choice of Baseline--False Equality of Those Not Similarly Situated B. Rhetorical Framing C. Experimental Evidence on Mental and Rhetorical Framing III. THE CONSEQUENCES OF FRAMING DEDUCTION AS SUBSIDY A. Judicial Framing 1. Tank Truck and Common Law Disallowance of Deductions on Public Policy Grounds a. The (Missing)Analysis of Tank Truck i. Optimal Deterrence Model ii. Complete Deterrence Model b. The Impact of Baseline Selection in Tank Truck 2. Nonsubsidy Framing in Sullivan 3. Rhetorical Versus Mental Framing in Case Law B. Political Framing 1. Mental Framing and Codification of Public Policy Disallowances 2. Subsidy Appearance and Response to Public Outrage 3. Mental and Rhetorical Framing and the Choice To Structure Regulation as Tax Disallowance a. Regulatory Options and Considerations b. Overcoming Resistance to Interference with Private Contracting c. Regulatory Illusion of Deduction Disallowance Compared with Economically Equivalent Nontax Disincentives d. Does Framing Impact Structure? e. Regulatory Illusion Versus Fiscal Illusion IV. IMPLICATIONS OF MENTAL AND RHETORICAL FRAMING OF DEDUCTION AS SUBSIDY A. Mental Framing B. Rhetorical Framing C. Structural Choice or Framing CONCLUSION APPENDIX INTRODUCTION

The federal tax code includes numerous provisions that discourage particular nontax behaviors. "Sin taxes" and other excise taxes do so, of course, but often disincentives take the form of curtailed or disallowed business tax deductions. Consider Internal Revenue Code (Code) section 162(f), which disallows deductions for fines or penalties paid to the government for violations of law, (1) or section 162(m), which limits the corporate tax deduction for nonperformance-based compensation paid to certain senior executives. (2) The effect of both provisions is to raise the effective cost of--and to discourage--disfavored activity.

This Article asks why these disallowance provisions, which have been described as negative tax expenditures (3) or tax penalties, (4) appear in the Code. In the case of section 162(m) and other corporate governance-directed disallowances, the question is why tax instead of direct nontax regulation. In the case of section 162(f) and the other traditional "public policy" disallowances, the question is why there is any federal intervention at all. The primary claim of this Article is that a tendency to mentally frame business deductions as subsidies, often reinforced by rhetoric explicitly framing deductions as subsidies, helps to explain why one observes these disallowance provisions.

Public Policy Disallowances. This Article argues that the disallowance on "public policy" grounds of deductions for fines and penalties paid, (5) bribery, (6) a portion of antitrust treble damages, (7) and lobbying and political activities (8) is best understood as a response to an appearance of subsidy. Some legislators may honestly believe that the underlying deductions unfairly subsidize objectionable behavior and undermine public policy. (9) Others may favor disallowance as a means of mitigating public outrage that would follow from the appearance of subsidy if the deductions were allowed. (10) Still other legislators might harness, or even create, this outrage in order to advance their political prospects. (11)

But are the underlying deductions subsidies? That depends on one's baseline. In a tax system directed at net income, some deductions properly define net income and are not subsidies, whereas other deductions represent exceptions to the tax on net income and constitute subsidies. (12) In order to distinguish between the two groups, however, one would need a normative net income baseline, and Congress has provided no such baseline. (13) Moreover, even when theorists agree on a normative theory for defining the baseline, such as the Haig-Simons definition of income, (14) they do not always agree on the proper classification of particular deductions. (15)

The result of this ambiguity is not random classification of deductions as subsidy or nonsubsidy. There appears to be a tendency to equate deduction--at least business deduction--with subsidy. (16) There are several possible explanations for this phenomenon. First, the pre-deduction situation may be the instinctive mental baseline. In part, the use of the term "deduction" in other contexts to signify a discount may be imported into our thinking about tax. (17) Second, in some cases, observers may fail to consider the entire transaction, ignoring the fact that gains are taxable, which suggests that costs are appropriately deducted. (18) Third, and more perniciously, this Article will suggest that political rhetoric that frames deductions as subsidies may shape popular perception. (19)

As a policy matter, nothing should turn on uncertain "subsidy" labels, but the appearance of subsidy has long figured into public policy disallowances. Tax administrators initially sought these disallowances, and the courts sustained them. (20) Determining whether the allowance of a deduction for fines, penalties, or damages actually undermines public policy requires an inquiry into the processes by which the sanction was set. The courts were ill-equipped to conduct this inquiry, and disallowance seems to have followed from an intuitive but often questionable syllogism: (1) deduction equals subsidy; (2) subsidization of proscribed behavior undermines public policy; therefore, (3) deduction undermines public policy. (21)

As reactive responses to an appearance of subsidy that is inherent in a tax scheme directed at net income, these interventions likely would vanish if the corporate income tax were to vanish. Although section 162(f) increases the cost of violations of law and provides revenue for the United States Treasury, (22) it is unlikely that the provision would be replaced by a direct exaction levied on fines or penalties paid if the corporate income tax were repealed and not replaced with some other tax scheme levied on net corporate income.

Corporate Governance Disallowances. Section 162(m) and the other corporate governance disallowance provisions are different in this regard. (23) Section 162(m) was not a direct response to an appearance of subsidy but was a response to public outrage and a demand for action regarding executive pay generally. (24) This Article argues that the appearance of subsidy likely played a key role in the choice to structure the federal intervention as a disallowance instead of as direct regulation. But direct regulation was certainly a conceivable alternative and, absent a corporate income tax, direct regulation might have been enacted. (25)

Of course, there is no inherent economic difference between direct regulation and tax disincentive, but even where substantively identical, form matters. (26) Given the propensity to conceptualize business deductions as subsidies, structuring a disincentive as a tax disallowance creates an illusion that is similar to the fiscal illusion created by tax subsidies. (27) It is well understood that the difference between tax subsidies and direct spending is illusory. (28) The government can influence the allocation and distribution of societal resources through either avenue, but the use of a tax subsidy instead of direct spending creates an illusion of smaller government from a fiscal perspective because the tax subsidy appears to reduce taxes and spending. (29) Although an illusion, the appearance affects reception and helps to explain the popularity of various tax programs. (30)

Now consider tax disincentives and direct penalties that have the same allocational and distributional properties. Tax disincentives, such as section 162(m), suffer relative to direct penalties in terms of fiscal illusion because they appear to increase taxes and provide no direct revenue. (31) But to the extent that a tax disincentive taking the form of a disallowed deduction is viewed as simply eliminating a tax subsidy, it creates an illusion of lesser...