Paul L. Caron

Friday, June 10, 2022

Weekly SSRN Tax Article Review And Roundup: Layser Reviews Appleby's State Exit Taxes

This week, Michelle Layser (Illinois; moving to San Diego; Google Scholar) reviews Andrew Appleby (Stetson; Google Scholar), No Migration Without Taxation: State Exit Taxes, 60 Harv. J. on Legis. ___ (2023).

Layser (2018)In recent years, U.S. individuals and businesses have tended to move “from cold, high-tax northern states to warm, low-tax southern and southwestern states” (CNBC). These migration patterns have accelerated during the COVID-19 pandemic, as the work environment has shifted to remote settings, and “[m]ost experts expect more people and businesses will choose to locate where they can pay lower taxes.” (CNBC). When wealthy taxpayers and large businesses leave a state, they take income with them, eroding the state’s tax base. To fight these trends, states have traditionally engaged in tax competition to attract and retain wealthy taxpayers and businesses. A large body of research, including my ownforthcoming article (Overcoming Constitutional (And Political) Barriers to State Place-Based Tax Incentive Reform, 170 U. Pa. L. Rev. ___ (2022)), focuses on how states use tax incentives to discourage out-migration and encourage in-migration. In his forthcoming article, Professor Andrew Appleby focuses on another strategy states can use to fight out-migration: exit taxes.

Though exit taxes have rarely been used at the state and local level, Appleby argues that well-designed exit taxes may be an effective and constitutional way for jurisdictions to prevent wealthy individuals from eroding the tax base when they leave a state. His article begins with a discussion of the normative justifications for exit taxes. Appleby presents several possible justifications for exit taxes, including tax neutrality, progressivity, deterrence, and symbolism, but his argument relies most heavily on benefit theory. Benefit theory holds that when people and businesses enjoy the privileges of residence—and benefit from the protection of a jurisdiction’s laws—they have the responsibility to share in the costs of government. Appleby explains that when individuals leave a state and take unrealized income with them, they effectively shirk their responsibility to the state. 

Appleby provides several examples that illustrate the problem. First, an individual may own property that appreciated in value while the taxpayer was a resident. If that person leaves a state before a realization event, the taxable gains may be shifted to the destination state (which may not tax capital gains at all!). Second, taxpayers may invoke nonrecognition rules like I.R.C. § 1031 to exchange property in a high-tax state for new property in a lower-tax state. Third, taxpayers who have received deferred compensation or employee stock options may leave the state before the income is recognized. In such cases, the departure state may lose the ability to tax that income. Appleby cites Elon Musk’s recent move from California to Texas as a high-profile example of this scenario. In addition to these tax planning strategies used by individuals, Appleby describes how businesses may shift income from high-tax to low-tax states by exploiting corporate retained earnings and carried interest rules, or through business deductions and recapture.

Each of these scenarios deprives departure states of the ability to tax income that was created within their borders during the period when the taxpayer was a resident. Appleby argues that exit taxes are a viable solution to this problem. He explains that there are two ways that exit taxes may be structured. First, states could specify that change of residence triggers realization of income at the time of departure (a “realization-based exit tax”). Alternatively, states could adopt a continuation tax. Under a continuation tax regime, taxpayers are required to report information to the state at the time of departure, and then periodically for a number of years, so that the departure state can impose a tax whenever an actual realization event occurs in the future.

Before making any recommendations, Appleby analyzes a threshold question: Are exit taxes constitutional? Realization based exit taxes subject departing residents to different timing rules than continuing residents. Continuation taxes impose reporting obligations and, ultimately, a tax during a period when a taxpayer is not a resident at all and may lack nexus to the state. As a result, depending on their design, exit taxes may implicate questions under the privileges and immunities clause, the commerce clause, equal protection clause, and state uniformity clauses. Appleby analyzes exit taxes under each of these constitutional frameworks and ultimately concludes that, while constitutional uncertainly exists, exit taxes are arguably constitutional. Having concluded that exit taxes are probably constitutional, Appleby turns to design considerations. Broadly, Appleby recommends a combination approach, whereby states would implement a realization based exit tax with a continuation tax deferral option.

That said, the devil is in the details, and Appleby identifies a host of issues that states must address to implement an exit tax. These issues include threshold problems about how to determine when a change of residency has occurred (should the law include durational requirements that exempt short-term residents?) and how to value assets at the time of departure (Professor Leandra Lederman has written separately about the challenges of valuation for tax administration). They also include seemingly smaller—but nonetheless important—questions about what tax rate should apply, whether interest should be charged on deferred amounts, whether exemptions should apply for lower-income taxpayers, whether a continuation tax should sunset, and whether anti-abuse rules should be implemented. The upshot of Appleby’s research is that exit taxes may be justified, effective, and constitutionally permissible—but implementing a subnational exit tax regime would be no simple task. In addition to the technical issues, there may be political barriers. In fact, a proposed federal law would prohibit subnational exit taxes altogether.

As someone who has spent far more time thinking about incentives than exit taxes, I appreciated this article as a thorough primer on the theoretical, legal, and practical issues raised by exit taxes. I would love to learn more about Appleby’s take on a competing line of thought, which is that residential stagnation has traditionally presented a larger problem than mobility. Professor David Schleicher has set forth a compelling argument that state and local laws already create significant barriers to interstate mobility, with detrimental consequences for macroeconomic policy (see Stuck! The Law and Economics of Residential Stagnation). Since exit taxes may be understood as an additional barrier to interstate mobility, I think a great follow up project for Appleby would be to engage these broader economic arguments in the context of exit taxes. I recommend this article to anyone interested in state and local taxation, tax and geography, or tax competition.

Here’s the rest of this week’s roundup:

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