Tax transitions, opportunistic retroactivity, and the benefits of government precommitment.

• Author: Logue, Kyle D.

"[T]he maximal exploitation of present possibilities may often be an obstacle to the maximal creation of new possibilities."(1) "Discretion is the enemy of optimality, commitment its ally."(2)

Introduction

What if the current federal income tax laws were repealed and replaced with a simple flat tax? What if the entire Internal Revenue Code (with its graduated rates and countless deductions, exclusions, and credits) were scuttled in favor of a broad-based consumption tax? Only a few years ago, such proposals would have seemed radical and extremely unlikely to be adopted. But times are changing. Calls for a drastic overhaul of the Internal Revenue Code have become commonplace, even at the highest levels in the tax-policy community.(3) In addition, proposals that would replace the income tax with a flat-rate broad-based consumption tax have received substantial bipartisan support in Congress.(4) And many commentators believe that Congress is likely to enact some version of these proposals in the not-too-distant future.(5)

One of the most important issues raised by the prospect of radical tax reform is that of transition effects.(6) Each of the tax-reform proposals currently under consideration would eliminate many of the deductions, exclusions, and credits that individuals and businesses have come to rely upon.(7) Therefore, unless Congress accompanies the repeal of those provisions with some form of transition relief (such as grandfathered, phased-in, or delayed effective dates) any taxpayer who made an investment in reliance on the prior rule will suffer substantial transition losses, losses in the value of investments.

As the tax-reform movement gathers momentum, however, so too will the pressure on lawmakers not to provide transition relief to those taxpayers who will be harmed by the reforms. This pressure comes from several sources. First, Congress may feel the need to keep tax reform at least revenue neutral, and transition relief may be the most obvious way of saving money.(8) Second, politicians may see tax reform as an opportunity actually to raise revenue. Given the political risk associated with being the congressperson who votes for a tax-rate increase, lawmakers may find the prospect of foregoing transition relief an attractive alternative source of revenue. Finally, lawmakers may be concerned about the perceptions of unfairness sometimes associated with the enactment of transition rules designed to protect particular taxpayers or groups of taxpayers.

In addition to the political forces pushing against the provision of transition relief in tax reform, the dominant view in the legal academy also opposes government-provided protection for losses arising from changes in the tax laws. Professor Michael Graetz, in a 1977 article,(9) and Professor Louis Kaplow, in a 1986 article,(10) present an elegant and compelling argument that Congress should adopt a policy of providing little or no transition relief to taxpayers who suffer losses owing to unanticipated tax-law changes. Put differently, under the Graetz-Kaplow theory, tax-law changes (indeed, all legal changes) should be made fully retroactive.(11) That argument has gone largely unchallenged in the legal academy.(12) Moreover, Professor Saul Levmore, taking the case for retroactive taxation one step further, has argued that the occasional, unexpected use of retroactive taxation may provide a potentially rich and nondistortionary source of revenue for the government.(13)

This article challenges the conventional academic wisdom that nominal retroactivity is presumptively efficient. In contrast to the Graetz-Kaplow view, I argue that, for certain types of tax transitions, the efficient transition policy entails full transition relief in the form of guaranteed grandfathering. The article is arranged as follows: Part I describes the issue of tax transitions more generally and details the Graetz-Kaplow efficiency argument for denying compensation to taxpayers who suffer tax-transition losses. Part II then defines a category of tax transitions for which the optimal transition policy probably is full transition relief in the form of grandfathered effective dates.(14) That category is composed of changes in incentive subsidies, that is, tax provisions designed by Congress to alter taxpayers' incentives or, more specifically, to induce taxpayers to increase their investment in some socially desirable activity. To make the case for guaranteed grandfathering, I exploit the analogy between incentive subsidies and government contracts. My argument is essentially this: We generally believe it is a good idea for the government to keep its contractual promises, those made to private parties and those made to other governments. Indeed, I argue that in most situations involving implicit or explicit government contracts our policy is that the government must keep its word. Next, I argue that, for the same reasons we follow such a policy in cases of government contracts, we should follow such a policy with respect to incentive-subsidy provisions, which are analogous to contracts in important ways. As I explain below, such a transition policy requires the government to guarantee grandfather treatment whenever an incentive subsidy is repealed or substantially reduced. Failure to make such a commitment can produce a number of problems, including an inefficient increase in the default premium that the government must pay taxpayers to compensate them for the risk of tax transitions. Failing to provide transition relief in such contexts, I argue, amounts to opportunistic behavior on the part of the government.

Part III responds to a number of specific objections that might be raised in response to my argument. Part IV then begins to draw a distinction between incentive-subsidy transitions and other types of tax transitions for which efficiency may require some degree of retroactivity. This latter class of tax transitions includes legislative corrections of obvious drafting errors and broad-based tax transitions such as an increase in tax rates or a shift from an income-based to a consumption-based tax. Therefore, Part IV agrees with Levmore that some nominally retroactive tax changes can have efficiency benefits, but it suggests that those benefits are easily overstated. Finally, Part V concludes with a discussion of some of the practical problems associated with designing an efficient grandfathering policy, and it provides a brief examination of some ways in which the government could precommit to the transition policy described in Part II.

1. Tax Transitions: The Debate

   1. Defining Transition Losses and Transition Relief

      Any time Congress changes the federal income tax laws and any time the Treasury Department or a court alters its interpretation of those laws, there typically will be a class of taxpayers who will suffer transition losses. Likewise, tax-law changes also give rise to transition gains; those taxpayers who are holding investments that happen to benefit from a tax change suddenly experience a windfall increase in the value of those investments.(15)

      The classic illustration of these concepts involves the repeal of the exemption for interest on state and local bonds. Suppose a taxpayer were to purchase a long-term bond that paid interest in annual installments with the principal returned at the date of maturity. Assuming for simplicity that this investment is risk-free, the price of the bond would be equal to the discounted present value of the after-tax cash flow that the taxpayer expects to receive on the bond. Assume that, at the time of purchase, the interest on the bond is exempt from federal income taxation and therefore the price of the bond would equal the discounted value of the pretax cash flow. Now suppose that, in the following year, Congress repeals the interest exemption and provides no transition relief to taxpayers who made investments in reliance on the old exemption. The value of the taxpayer's formerly exempt bond would fall, and the taxpayer would suffer a transition loss. Likewise, when the tax exemption was first enacted, the lucky or clever taxpayers who happened to have purchased their bonds prior to the passage of the exemption would enjoy transition gains.

      Transition losses can occur whether the new tax law or new interpretation applies nominally retroactively or nominally prospectively.(16) Under a nominally retroactive tax-law change, the change applies not only to income that is earned after the date of enactment but also to income earned before the date of enactment.(17) Under a nominally prospective income tax change, however, the new law applies only to income earned after the date of enactment and, often, only to income earned after the end of the year of enactment. Under either type of transition, if the change applies to income earned on pre-enactment investments and is not anticipated by taxpayers, transition losses will occur.(18) Returning to the tax-exempt-bond example, as long as the repeal of the tax exemption applies to future income on bonds that were purchased before the repeal was enacted, there will be transition losses.(19)

      When enacting changes in the federal tax laws, Congress often provides some type of transition relief. For example, Congress frequently uses nominally prospective effective dates for new tax laws. In some circumstances, however, Congress instead uses phased-in, delayed, or grandfathered effective dates. Under a phased-in effective date, the change is made effective gradually, and the transition effects are mitigated (spread over time) but not eliminated. Under a delayed effective date, the change is announced upon enactment but made effective at some later date. This, too, provides only partial transition relief. Under a grandfathered effective date, however, the new tax provision applies only to income earned on investments that are made after the date on which the change is enacted...