Paul L. Caron

Friday, August 9, 2019

Weekly SSRN Tax Article Review And Roundup: Eyal-Cohen Reviews McCaffery's A Better Hope For Campaign Finance Reform

This week, Mirit Eyal-Cohen (Alabama) reviews Edward J. McCaffery (USC), A Better Hope for Campaign Finance Reform.

Mirit-Cohen (2018)

McCaffrey begins this Article with a gloomy picture of American politics—”dark money” has made the identity of mega-givers and the degree of their political contributions opaque. Referring to 2016 presidential and congressional election biggest givers, he blames the social and political issues in the U.S. to the role of money in politics. Many wealthy donors are spending huge sums to influence democratic politics—to buy politicians or political offices or laws. McCaffery has little hope of changing these facts of human nature.  He demonstrates how legislative, judicial and regulatory actions have failed in solving this problem. But not to worry because he has a plan. McCaffery proposes to utilize the tax system to reduce campaign spending by raising the pre-tax costs of political expenditures. Similar to other Pigouvian models like the cigarettes tax, raising the costs of harmful political activities through taxation will reduce their occurrence. He claims that political contributions is another example where taxation is more efficient in reducing undesired behavior than other regulatory measures or public education campaigns. Yet, his proposal is not exclusive to political campaign contributions. Here, too, he advances his longtime proposal to switch from an income-based to consumption-based tax system, also known as a progressive spending tax. In fact, he admits that there would be no change in the tax treatment of campaign contrition—there will be no provision in the reformed consumption tax system that is specific to political expenditures, other than rules similar to today’s disallowing them as ordinary business deductions or as charitable contributions.

McCaffery assumes mega political donor that make out-sized contributions are rational and expect to benefit back from the transaction at least as much as their contribution in economic, or financial, benefits (admitting it might not be the case for smaller political donors). A progressive consumption tax system will increase the cost of political contributions for the mega-donor thereby deter them by placing marginally high levels of tax on consumption and treating their political contributions as non-deductible consumption. Political spending, thus, illustrates in a new light the problems of income-based system. Tax, he suggests, “brings hope to a cause that seems hopeless”.

Subsequently, McCaffery mathematically calculates the before-tax costs of political contributions (how much donors need to generate in order to give to candidates of their choice) under the current income tax system. He assumed before-tax cost of political expenditures on the wealthy with marginal rates of 0%, 20% capital gains tax, and 40% ordinary income tax. He claims that the top 40% ordinary income tax rate is not a viable assumption because the very richest rely on “unrealized appreciation,” which is not taxable under Eisner v Macomber.  The 20% capital gain rate is also inapplicable because the benefits of deferral and of the possibility of some basis offset, shelter the rich from the full 20% rate even if they sell assets to finance political spending. Accordingly, McCaffery suggests that the most plausible assumption is that rich donors pay 0% marginal income tax rate by borrowing and making debt the source of their consumption. Borrowing does not lead to a change in one’s net wealth, the borrowed funds being offset by the obligation to repay the loan. Accordingly, McCaffery concludes that the nontaxation of debt gives a way for billionaires to monetize their unrealized appreciation, tax-free.

The case of political contributions becomes more acute when introducing estate tax into the calculations.  Wealthy donors who have cash in hand or take a loan to make their political contributions receive a deduction on their taxable estate. The reason is that estate tax imposes 40% rate on net worth, i.e. assets minus liabilities post mortem. Accordingly, any expenses made by mega-donors prior to death reduce estate tax liability after death. McCaffery’s point here is that under a wealth tax like today’s estate tax, all present consumption has the structure of a tax expenditure because it allows a deduction (thereby saving) that is subtracted from a net sum subject to the 40% estate tax. Since donors that spend more during life pay less estate tax, it incentivizes them to spend more on political contributions, which McCaffery identifies as an important social harm that exacerbates wealth inequality.   

Hence, McCaffery’s proposal is for a progressive postpaid consumption tax, one that is levied as funds are put to use in financing personal spending.  Such a tax would have an annual form filed each year, that would add up all sources of Income, and then subtract all forms of Savings, to arrive at the residual category of Consumption, or personal spending. A progressive marginal rate structure would then be applied to each household’s spending for the year. Political expenditures would be included in Consumption, just as they are under the current income tax, because political expenditures would not qualify for any deduction as Savings. The most important practical policy change from today is including debt as income. Debt that is used to save will not be taxed because the inclusion of debt as income will be offset by the deduction for savings. Borrowing to consume will be taxable.

A progressive spending tax is also simpler. It needs no realization requirement, no tax-law concept of “basis” (since no savings has been taxed, savings do not need basis.). The difference is that savings accounts will be unlimited in potential amount. Taxpayers will pay tax when as they withdraw from the accounts to consume, when they consume out of current income, or when they borrow to consume. The source of that consumption, whether it be from labor, capital, or both combined, debt, gifts, bequests or anything else, is irrelevant.

Yet, even with progressive spending tax one is left to wonder whether McCaffery’s proposal will in fact help close the inequality gap. First, the mega wealthy own more assets and services; thus, they tend to overall consume less. They are also in a position to put more money aside and save more every year. Second, while tax on income creates a bias against labor and discourages people from going to work, the same can be said about consumption. Viewing consumption as “bad”  may create economic stagnation as people may avoid consumption or increase imputed income to provide their own services and self-consumption thus avoid the spending tax. McCaffery’s answer is that progressive spending tax only disincentives high-end spending, by applying proposed marginal tax rates of 50, 70, or even 90%. But then there is the problem of the feasibility of such a proposal to eradicate the current income tax system and impose a super-high consumption tax on the mega wealthy by the same system being governed by the super-rich. So we’re back to square one. Perhaps even gloomier.

Here’s the rest of this week’s SSRN Tax Roundup:

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