QOZs Illustrate How Critical Tax Theory May Bolster Tax Policy Analysis

Islame Hosny (Pryor Cashman, New York), QOZs Illustrate How Critical Tax Theory May Bolster Tax Policy Analysis, Yale J. on Reg.: Notice & Comment (June 25, 2022):

June 30, 2022, is the last day on which certain taxpayers who had capital gains in 2021 can defer paying tax on those gains until 2026 by investing them in Qualified Opportunity Funds (QOFs)—investment vehicles used to invest in Qualified Opportunity Zones (QOZs). According to the IRS, the purpose of the QOZ program is to “spur economic development and job creation in distressed communities by providing tax benefits to investors.”

One such tax benefit is that an investor who holds a QOF investment for 10 years receives a 100% exclusion from federal tax on appreciation on the investment. That is a 0% effective tax rate on a potentially unlimited amount of gain. But how does the 0% tax rate compare to that of a QOZ resident?

Today, there are 8,764 QOZs in the United States. One of those QOZs is Central Harlem, where 29% of residents are below the federal poverty level, 77.2% of households do not include children, and the median household income is $57,720. The federal income tax liability for a single filer with no children, with income of $57,720, and who takes the standard deduction ($12,550) and, thus, has taxable income of $45,170, is $5,687. This results in an effective federal tax rate of 12.59% for a typical resident in Central Harlem. ...

It is undeniable that QOF investors risk their wealth by investing in QOZs, which are, by definition, economically distressed areas. It follows that if no tax incentive is provided to investors, they would be less likely to invest in QOZs. Proponents of the program argue that it causes significant investment in QOZs, spurring economic activity, and creating jobs in those communities. However, the Institute on Taxation and Economic Policy has warned that the QOZ tax rules do not have any mechanism to ensure that the benefits of the program are allocated to the members of QOZ communities.

According to Nancy J. Knauer, Director of the Law & Policy Program at Temple University Beasley School of Law, critics of critical tax theory argue that those who apply a critical tax lens have no reliable data supporting their claims. Knauer’s response is that such an argument assumes that the lack of data showing a disproportionate impact of the tax system on various demographic groups equates to proof that the tax system is equitable. This debate highlights the need for reliable taxpayer demographic data, which the IRS does not currently collect. ...

The capital gain requirement highlights one instance where traditional tax policy is insufficient to show whether the tax system disproportionately impacts groups of taxpayers. Traditional tax policy should not be discarded, but it can be enhanced by critical tax theory. By adding an additional dimension—taxpayer demographics—to traditional tax policy analysis, a critical tax lens could help us see what traditional tax policy does not.