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Friday, January 26, 2024

Weekly SSRN Tax Article Review And Roundup: Eyal-Cohen Reviews Hemel's Phaseouts

This week, Mirit Eyal-Cohen (Alabama; Google Scholar) reviews Daniel J. Hemel (NYU; Google Scholar), Phaseouts, 74 Tax L. Rev. __ (2024) (reviewed by Sloan Speck (Colorado; Google Scholar) here)

Eyal-CohenPhaseouts are federal tax benefits that decrease with income. They are used for health insurance, higher education, and retirement savings tax breaks. As income rises, tax breaks such as the child tax credit, earned income tax credit, deduction for traditional individual retirement plan contributions, and student loan interest deduction decrease. Individuals earning less than a certain income threshold receive the full benefit, while those earning more than that threshold are ineligible for benefits. Taxpayers with incomes in the range may claim partial benefits that decrease with income. Other federal income tax benefits, such as medical expenses and personal casualty loss deductions, have implicit phaseouts (though they appear as income-based "floors").

For example, the Code allows taxpayers to deduct medical expenses (including health insurance premiums) that exceed 7.5% of adjusted gross income. This represents a steady reduction of 7.5 cents for every dollar of adjusted gross income above zero. Thus, a taxpayer with $100,000 in adjusted gross income and $8000 in medical expenses will eventually lose $7500 of their deduction, leaving only $500. This reframe demonstrates how income-based floor literature can be applied to phaseouts, which is theoretically useful. Non-tax programs, such as the Supplemental Nutrition Assistance Program (Food Stamps) and Section 8 housing choice vouchers, like many federal tax breaks, gradually phase out as income increases. 

Some phaseouts have been justified by income-contingent externalities, internalities, and labor complementarities. However, other phaseouts have proven difficult to justify in terms of tax policy. Benefits such as child, adoption, and clean vehicle tax credits will also be phased out. Many prominent tax scholars, including Glenn Coven, Robert Peroni, and Lawrence Zelenak, have argued that phaseouts are bad policies that confuse the already complex Internal Revenue Code and mislead taxpayers about marginal rates. After evaluating these provisions, the ABA recommended avoiding phaseouts, and at least one Joint Committee on Taxation suggested eliminating them entirely. Regardless of these notions, we tend to see continuous use phaseouts in the Code each year. Why does Congress use phaseouts instead of a more straightforward universal benefit and a broadly applicable rate hike? 

This article takes a novice approach, explaining why tax statute phaseouts are desirable and why they are implemented—most notably for their unique distributional characteristics. The article highlights new justifications for policymakers to choose a phaseout over a universal benefit, as well as marginal rate changes for taxpayers within and above the phaseout range. It rejects some seemingly plausible justifications for phaseouts today, such as the notion that subsidies targeted solely at lower-income taxpayers (who can be influenced by such design) promote progressivity, reduce revenue loss, and improve the efficiency of the federal income tax system. The Article recognizes that phaseouts do not always improve vertical equity and may even reduce it when compared to the revenue-equivalent option of a universal benefit with a marginal rate increase for all taxpayers in and above the phaseout range. Such revenue and progressivity rationalizations are an illusion created by tax expenditure accounting's specific rules, and they fail to explain taxpayers in and above the phaseout range. A closer look reveals that the claim that phaseouts improve efficiency by eliminating subsidies for higher-income taxpayers is also false, as stated in the article. The fact that these taxpayers are unlikely to change their behavior in response to a subsidy undercuts the case for phaseouts. Thus, if progressivity, cost control, and efficiency are insufficient to justify the use of phaseouts

The article describes three distinct rationales for using phaseouts: "income-contingent externalities," "income-contingent internalities," and "income-contingent complementarities." It demonstrates that certain phaseouts can serve a legitimate and justifiable purpose of subsidizing low-income taxpayers while excluding high-income taxpayers.  First, when people with lower incomes participate in a particular activity, it benefits others more than those with higher incomes. As a result, income-contingent externalities may justify Congress's allocation of payments to taxpayers who generate such positive externalities. Second, according to the concept of income-contingent internalities, lower-income people, unlike higher-income people, frequently overlook long-term effects and prospective benefits that limit their well-being and impose externalities. When those with lower earnings engage in an activity that benefits them more than those with higher incomes, it may be justifiable (if paternalistic) to use phaseouts to help them internalize specific outcomes. Finally, research into income-contingent complementarities reveals that when a good or service benefits lower-income taxpayers but not higher-income taxpayers, Congress may opt for a phaseout over the revenue-equivalent alternative of direct subsidies to labor-friendly goods. For example, low-income people without health insurance face greater financial hardship, and they typically benefit more from such insurance. Health insurance tax credits benefit low-income individuals and address budgetary externalities. Furthermore, the benefit is intended to have the least impact on the consumption choices of higher-income consumers, who pose a lower risk of free riding. The article applies these novice justifications to phaseouts in healthcare, higher education, retirement savings, parenting (child tax credit, adoption credit), and clean energy vehicles.     

Thereafter, the article acknowledges potential criticisms of such justifications, including a lack of transparency (hidden taxes), complexity, and the importance of solidarity (via universal application). It confirms the notion of reduced transparency, noting that phaseouts can cause taxpayers who underestimate their marginal rates to internalize them, which can be beneficial to democratic legitimacy and economic efficiency. In terms of compliance complexity—i.e., costs associated with recordkeeping and return preparation—the article emphasizes that the consequences of phaseouts are much easier to understand. Finally, the equal application of benefits to all taxpayers highlights the positive social and political effects of universality. When everyone receives the same benefit, they share a common experience, which helps to avoid the social stigma that is often associated with means-tested benefits. However, at times, the perception that high-income taxpayers benefit from the program may be interpreted as evidence of inefficiency.

The article also relates the use of phaseouts to the concept of direct and indirect transfers, specifically when Congress chooses to use specific tax mechanisms to achieve social policy goals rather than other direct approaches by revealing how tax and non-tax programs allocate tasks.  It cites scarcity and decision-making research that suggests that people with low incomes who are experiencing the mental strain of poverty may be more likely to make poor decisions when allocating limited resources for necessities such as food, housing, healthcare, and other expenses. In this context, in-kind transfers such as SNAP, Section 8, and Medicaid can be viewed as government initiatives designed to help people dealing with cognitive stress manage their internal struggles. As a result, these welfare program phaseouts are justified because government intervention may be less necessary for high-income individuals, whose decision-making is unaffected by the cognitive strain of poverty. Society does not have to dictate how much of their budget high-income individuals should devote to necessities such as food, housing, and healthcare. Furthermore, from an organizational standpoint, implementing these programs under the Internal Revenue Code, specifically through the IRS, is advantageous because the IRS already has the necessary information. Changing from the current SNAP structure, in which people pay cash for food and are reimbursed on their tax returns, would raise recordkeeping costs and make it more difficult to manage consumption. 

Aside from normative reasons, from a positive perspective, the Article considers phaseout political economy by asking what are the facts that can motivate lawmakers to implement phaseouts instead of offering universal benefits. Lawmakers' true motivations may differ from normative arguments for or against phaseouts. It is possible that Congress has a vested interest in making high-income taxpayers' marginal tax rates appear higher than they are, in order to create the illusion of a more progressive tax system. It is especially clear when we consider that Congress tends to prioritize the needs of high-income individuals, who are frequently more financially savvy and understand the implications of phaseouts and phase-ins. Wealthier taxpayers will be able to recognize when the rate schedule is in their favor, whereas those with lower incomes may be unaware that they are bearing a greater burden. Based on this analysis, it appears that there may be a shift toward phaseouts at the bottom and phase-ins at the top. This is because phaseouts typically result in higher effective marginal rates than statutory rates, whereas phase-ins have the opposite effect. On the contrary, some adjustments affect individuals with higher incomes, while others benefit those with lower incomes, such as the gradual implementation of the EITC and the refundable child tax credit. In essence, political economy offers an explanation that is heavily reliant on specific circumstances to account for observed phaseouts and phase-ins. Further research in the field of political science has the potential to yield additional insights.

Ultimately, phaseouts have been increasingly prevalent in the last eight decades since the establishment of the income level for the medical expense deduction. This article offers a fresh perspective by arguing that phaseouts may not be as harmful as their critics claim. The use of phaseouts in the Internal Revenue Code is evidently suboptimal from a tax policy perspective. Nonetheless, an effectively structured tax system would almost certainly include gradual reductions for measures that promote income-related externalities, income-related internalities, and goods and services associated with income and labor participation. Further neutral evaluations of phaseouts, such as this Article, can help policymakers determine their efficacy in a variety of scenarios, including those in which phaseouts are not currently used but could be beneficial.

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

https://taxprof.typepad.com/taxprof_blog/2024/01/mirit-eyal-cohen-reviews-daniel-hemel-phaseouts.html

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