Paul L. Caron

Friday, January 22, 2021

Weekly SSRN Tax Article Review And Roundup: Layser Reviews Lederman's Valuation As A Challenge For Tax Administration

This week, Michelle Layser (Illinois) reviews Leandra Lederman (Indiana), Valuation as a Challenge for Tax Administration, 96 Notre Dame L. Rev. __ (2021).

Layser (2018)Property valuation lies at the center of many federal, state, and local tax policy debates. At the federal level, property valuation features prominently in problems related to gift and estate taxes, charitable contribution deductions, conservation easements, transfer pricing, and proposed wealth taxation. At the state and local levels, valuation problems arise most frequently in the context of property taxation. The goal of property valuation, of course, is to determine how an asset would be priced in an arms-length sale. In a forthcoming essay, Leandra Lederman argues that to achieve this goal, the tax law must overcome challenges presented by (i) opposing incentives that taxpayers have from the tax agency, and (ii) accurate measurement.

Lederman’s essay begins with an assumption: when taxpayers are permitted to self-report the value of their property, they are likely to do so in ways that are self-serving. In some cases, taxpayers may be inclined to undervalue their property to avoid taxes levied on the value. In other cases, taxpayers may be tempted to overvalue their property to maximize benefits associated with deductions or credits. In either case, the Treasury will lose revenue unless it has a strategy to encourage more accurate reporting by taxpayers.

To find such a strategy, Lederman looks beyond the valuation context to a structural feature of tax law that we know increases voluntary compliance: tax withholding. Tax withholding works, says Lederman, because “the presence of a third party information-reporter reduces the taxpayer’s opportunity to evade tax because the taxpayer knows that the government has been notified of the payment.” Lederman observes that, in some cases, it may be possible to use third-party reports to aid in property valuation as well.

However, the success of this approach depends on the reports of third parties acting at arm’s length—and Lederman argues that in the context of property valuation, some “third parties have an interest in helping the taxpayer lower the tax bill.” As examples, she points to charitable organizations like Goodwill and the Salvation Army, for-profit tax software companies like Intuit (the maker of TurboTax), and even expert appraisers who value art and conservation easements.

Having demonstrated that third-party reporting may be less successful than imagined, Lederman turns to another strategy to encourage taxpayers to value their property accurately. Here, too, Lederman looks for hints in the compliance literature, this time focusing on the role of penalties. In theory, taxpayer compliance can be increased “by raising the audit rate, the penalty rate, or both.” Since audits are costly to the government, the more common approach is to increase penalties—but it turns out that empirical “studies generally do not find substantial deterrent effects from increases in penalties.”

If neither third parties nor penalties are likely to increase the accuracy of voluntary reporting of property values, what tools remain to improve the accuracy of property valuation? Lederman considers two possibilities: a formulaic approach to valuation that draws on arm’s-length sales, and procedures that force a market transaction. For example, a formula may begin with a starting value based on an actual sale, update that value periodically using a formula, and reconcile the difference when the asset is eventually transferred in an arm’s length exchange.

But the most challenging valuation problems are presented by types of assets that don’t have much of a market, and information about recent arm’s length transactions may be unavailable. In these cases, Lederman argues that forced-sale approaches may prove more accurate. For example, the tax law may require taxpayers to publish the value at which it would be willing to sell the asset, as suggested by Professor Saul Levmore. Or, it may be required to pay a wealth tax in-kind by transferring shares in the company to the IRS, as suggested by Professors Emmanuel Saez and Gabriel Zucman. The latter approach would enable the IRS to sell the shares to the highest bidder in an amount that reflects their fair market value. However, Lederman notes that “the political viability of government-controlled piecemeal transfers of closely held businesses is questionable.”

In the end, Lederman concludes that valuation “approaches that rely primarily on arm’s-length transactions should face less noncompliance than ones that have important components of self-reporting,” but some of the most promising methods—in a theoretical sense—probably aren’t politically viable. In addition, Lederman urges policymakers to consider the distributional effects of tax evasion. These conclusions and recommendations make sense to me, given the compliance framework that Lederman has chosen. But I would also love to hear more from an equity perspective. Here’s why.

Overall, Lederman’s analysis seems to suggest that the most politically viable and theoretically promising approach is to use a formula that begins with a value from an actual arms-length purchase. However, in the case of property that was purchased many years ago, this starting value may be meaningless. It seems reasonable to assume that, at some point, assessment would be necessary to determine the starting figure, and in many cases, a comparable sales approach would be used for that purpose. But as Lederman acknowledges, there are problems with comparable sales—some of which disproportionately impact minorities. A particularly troublesome example is the devaluation of property in majority-African American neighborhoods where home values are consistently depressed, often leading to overvaluation by property assessment methods that rely on comparable sales. While this may well be an isolated example, I would love to see more research on property valuation methods from an equity lens.

This essay is a fun read and provides a thoughtful overview of the challenges of property valuation from a compliance perspective. I recommend this essay to anyone interested in tax compliance, gift and estate taxation, wealth taxation, charitable deductions, or property taxation.

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

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