The hidden costs of cliff effects in the Internal Revenue Code.

AuthorViswanathan, Manoj
PositionAbstract through II. Assessing the Burden of Cliff Effects C. The Uniqueness of Income-Based Cliff Effects, p. 931-955

Cliff effects in the Internal Revenue Code trigger a sudden increase of federal tax liability when some attribute of a taxpayer--most commonly income--exceeds a particular threshold value. As a result, two taxpayers in nearly identical economic situations can face considerably different tax liabilities depending on which side of the triggering criterion they fall. The magnitude of the equity and efficiency costs associated with cliff effects is significant: cliff effects are attached to tax provisions amounting to hundreds of billions of dollars, the majority of which are targeted at low- and moderate-income taxpayers.

Cliff effects have received little attention in legal academia. Prior scholarship has primarily discussed the relevant tax provisions in isolation, focusing on financial consequences on a single taxpayer or limiting analysis to taxpayers in one geographic area. This Article addresses the void in legal scholarship by first recognizing potential rationales for cliff effects and identifying situations where their definitional clarity might compensate for any equity and efficiency losses. Next, the individual and aggregate costs of cliff effects are quantified and plausible statutory alternatives are identified.

This Article argues that a cliff effect based on income is necessarily problematic on both equity and efficiency grounds because it improperly penalizes taxpayers and disincentivizes the economic empowerment the associated tax provision is intended to promote. A methodology is then provided by which these costs can be compared to the potential savings provided by the bright-line rule of the cliff effect. This empirical analysis is performed on the two cliff effects of the health premium subsidy of the Affordable Care Act and finds that the cliff effects will, if unchecked, represent a misallocation of over $8.5 billion by 2025.

This Article presents several options for replacing problematic cliff effects, including those in the health care subsidy. The most novel of these strategies awards a credit based on the severity of the cliff effect and ensures that no taxpayer is made worse off post-tax by virtue of earning more pre-tax income. The Article concludes by extending the analysis to cliff effects associated with state and local tax regimes and direct transfer programs.

INTRODUCTION I. CLIFF EFFECTS AS LEGISLATIVE TOOLS A. Examples of Cliff Effects in the Internal Revenue Code B. Justifications for Cliff Effects in the Internal Revenue Code 1. Cliff Effects Created by Bright-Line Rules 2. Cliff Effects Based on Income Used as a Proxy for Other Metrics 3. Cliff Effects as Cost Savings Measures 4. Cliff Effects Used in Politicking C. Cliff Effects in State and Local Tax Regimes and Direct Transfer Programs II. ASSESSING THE BURDEN OF CLIFF EFFECTS A. The Relationship Between Marginal Tax Rates and Cliff Effects B. Cliff Effects and Financial Planning C. The Uniqueness of Income-Based Cliff Effects D. Equity Concerns of Income-Based Cliff Effects E. Efficiency Concerns of Income-Based Cliff Effects F. Quantifying the Aggregate Cost of Income-Based Cliff Effects III. ASSESSING THE COSTS OF THE CLIFF EFFECTS ASSOCIATED WITH THE AFFORDABLE CARE ACT IV. PROPOSALS FOR CHANGE A. Identify Problematic Cliff Effects 1. Determine the Goals of the Tax Provision to Which the Cliff Effect Is Attached 2. Assess the Costs of the Cliff Effect B. Replace Problematic Cliff Effects with Alternate Provisions C. Ensure Taxpayers Are Not Worse Off Post-Tax for Any Increase in Pre-Tax Income V. CLIFF EFFECTS IN CONJUNCTION WITH STATE AND LOCAL TAX REGIMES AND DIRECT TRANSFER PROGRAMS CONCLUSION INTRODUCTION

The Internal Revenue Code contains many credits, deductions, exclusions, and other benefits that apply when a taxpayer satisfies a certain numerical criterion, but that immediately vanish once this triggering criterion is no longer met. As a result, two taxpayers in nearly identical economic situations can face considerably different federal tax liabilities depending on which side of the triggering criterion they happen to fall. The "cliff effects" attached to these tax provisions can drastically affect taxpayer behavior and undermine what these provisions are intended to accomplish. The magnitude of this issue is significant: cliff effects, in one form or another, are attached to various federal tax expenditures totaling hundreds of billions of dollars. (1)

Cliff effects in the Internal Revenue Code have received little discussion in legal academia. Prior scholarship has mentioned cliff effects only in passing or focused solely on the financial consequences of specific tax provisions on individual taxpayers. (2) Scant effort has been expended on quantifying the aggregate cost imposed by cliff effects in the Internal Revenue Code on the public and on identifying plausible statutory alternatives. This Article addresses this void by examining the extent to which cliff effects in the Internal Revenue Code create problematic results for taxpayers and frustrate the intended goals of the tax provisions to which they are attached. The consequences of cliff effects at the state and local level, in both tax legislation and direct transfer programs, are also explored. The extent to which cliff effects are problematic is identified and quantified on both individual and aggregate microeconomic levels. Through this analysis, this Article proposes alternatives to the use of cliff effects in the Internal Revenue Code that still limit the reach of the relevant subsidies but do so in a more equitable and efficient manner.

This Article proceeds as follows: Part I provides background information on cliff effects and discusses their use in the Internal Revenue Code. Part II assesses the burdens of cliff effects on equity and efficiency grounds, and provides a methodology by which the aggregate cost of cliff effects can be calculated. Part III applies the cost methodology to the particular cliff effects contained in the Patient Protection and Affordable Care Act (the "Affordable Care Act"). (3) Part IV proposes alternatives to cliff effects that reduce both inefficiencies and equity burdens and lessen their impact on low- to moderate-income taxpayers. Part V extends the analysis to include direct transfer programs administered by state and local governments.

  1. CLIFF EFFECTS AS LEGISLATIVE TOOLS

    Cliff effects in the Internal Revenue Code represent a subset of the line drawing that occurs with respect to all governmental regulation. In order to measure, assess, proscribe, or tax behavior, that behavior must first be identified. This identification occurs by categorizing behavior into either regulated or unregulated conduct, which in turn occurs by line drawing at both state and federal levels. For example, a motorist in Connecticut is permitted to travel at sixty-five miles per hour on specified highways but sixty-six miles per hour is forbidden. (4) Federal law permits a mercury level in drinking water of two parts per billion, but any greater level is prohibited. (5) Whereas line drawing in other regulatory contexts may result in a ticket or revocation of some preferred status, line drawing in the Internal Revenue Code causes nearly identical taxpayers close to the threshold, on either side of the line, to incur varying amounts of tax liability. When the difference in tax liability is significant, the result is known as a cliff effect. (6)

    The term "cliff effect" is not a technical term and, as such, has no common definition. Qualitatively, a cliff effect exists when a differential change to some characteristic of an individual has significant economic consequences to that individual. In practice, the reference metric to which the cliff effect is attached is often, but not always, (7) an income or asset level. (8) For example, the cliff effects associated with the health premium credits of the Affordable Care Act reference "modified adjusted gross income" (9) and the cliff effects associated with the Earned Income Tax Credit reference "investment income." (10) The consequence associated with a cliff effect is generally the sudden loss of some economic benefit. (11) A cliff effect in the Internal Revenue Code occurs when a change in some characteristic of a taxpayer (or a third-party) results in a substantial increase in that taxpayer's tax liability. A subset of cliff effects in the Internal Revenue Code are those based on the taxpayer's income, where an additional amount of some category of a taxpayer's income results in an increase in tax liability greater than the increase in income. (12) These cliff effects, which leave some taxpayers economically worse off post-tax by earning income beyond the cliff effect threshold, are the central focus of this Article. Inherent in this definition of an income-based cliff effect is the existence of, for at least some portion of the additional...

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