R9941 Tax Complexity, Reform In George Mason 1994

User Manual: R9941

Open the PDF directly: View PDF .
Page Count: 42

319

r9941

TAX COMPLEXITY, REFORM,

AND THE ILLUSIONS

TAX SIMPLIFICATION

Sheldon

D. Pollack*

OF

..[N]o one

understands

the Income

Tax Law [the

Revenue

Act of 1913]

ex.

cept

persons who have

not sufficient

intelligence

to understand

the

questions

that arise

under

it."

Senator

Elihu

Root

of New York (1913)

"simplicity in modern

taxation

is a problem of basic architectural

design.

Present

legislation

is

insufferably

complicated

and

nearly

unintelligible.

If it is

not simplified,

half of the population

may have

to become

tax lawyers

and

tax

accountants."

Henry C. Simons,

Federal

Tax Reform (1950)

..The

complexity

of our code

in the main is not there because

of some

mis-

chief.

Most of it is there

in the effort

to do more

perfect

justice'"

Senator Russell Long, Former Chairman, Senate Finance

Committee

lNrRooucuoN

Inasmuch

as only the rudimentary

Structure

of a taxing scheme

was laid out

in the

first

income

tax

law,

the

Revenue

Act of 1913,r

the

many

details

required

to give

concrete

meaning

to the statute

were left

to be filled

in over

subsequent

decades.

Accordingly,

the

newly

imposed

federal

income

tax progressively became

more

complicated

during its

first decades

as

it evolved

through

a process of gradual

and

incremental

adjustments

to the original

tax laws.

The development

of the tax laws

entered

a second

phase

when the

income

tax was radically

transformed

into a "mass

tax" during

World War II' In the post-War

era'

espe-

* Assistant

Professor,

College

of Busincss

and

Economics,

University

of Delaware;

Univer-

sitV

of Rochester,

B.A., 19?4;

Cornell University,

Ph.D.,

1980;

University

of Pennsylvania,

l9E6'

J.D. The author

wishes to thank Professor

Dcborah

H. Schenk

of New York University

School

of

Law for her helpful

comments

on an earlier

draft of this article

and

the Gowen

Fellowship

Fund

of the Law School

of the University

of Pennsylvania

for its generous financial

support'

' Pub.

L. No.63'16,

ch. l6' 38

Stat.

l14' 166-81

320 Gro. MnsoN

lNnrp. L. Rrv. lYol.2:2

cially during the 1970s

and 1980s,

the level

of complexity of the in-

come tax

increased dramatically.'

As reflected by the sheer number

of

provisions

of the federal income tax, there

was

a virtual explosion in

the complexity of the tax code in the post-War period.s

In light of this dramatic

increase

in complexity of the federal

in-

come

tax, there is a tendency

to equate

tax reform

with tax "simplifica-

tion."a

Indeed,

tax simplification

has emerged

as

one

of the perennial

themes in the academic

tax literature.6

Some

reform

efforts have been

directed at specific

provisions

of the tax code and

regulations.

Other

proposals

amount

to little more

than broad

pleas

for general

simplifica.

tion and appear to be

politically

motivated. For instance,

House

Ways

and Means Chairman Rostenkowski

and then Finance

Committee

Chairman Bentsen

picked

up on the theme of tax simplification

and

introduced

a package

of proposals

in 1991.6 These

proposed provisions

were

mostly window

dressing

and

focused

on simplification

of reporting

2 In a recent interview,

Professor Martin Ginsburg recounts that even under the Internal

Revenue Code of 1954 there were

only a few statutory

and

regulatory "monsters"

for tax lawyers

to struggle

to master.

Under the 1986 tax code, the monsters now

seem

to dominate

the

playing

field. ,See Martin D. Ginsburg, Interview With Professor

Martin D. Ginsburg, l2 ABA SrcrroN

Or TrxrrroN NEwslnrrEn, Fall 1992, at 6-12.

" The Internal Revenue Code

and

Treasury

regulations

were

first

published

in l9l3 by Com-

merce Clearing House, Inc. (CCH) in a single

volume

consisting of little more

than

400

pages.

This remained

the case

through World War II. Presently,

the tax code and

regulations

take up a

total of eight

volumes

and over 36,000

pages.

There has been

a comparable explosion of "law" in

other

policy

areas as

well. For

instance, Title II of the Social Security Act of 1935

was

only

four

pages

long

when

enacted,

grew

to 50

pages

by 1950, and exploded to 200

pages

in the 1970s. This

did not even include new

sections of the statute,

such as medicare. Mlnrun Dnnrurcr, Acrxcy

UNoEn Srnrss: Tur Soctlr Srcunrrv AoMrNrsrnerroN

rN AMERTcAN GovrnNlrrNr 201

(1990).

' See,

e.g., David

Brockway, The Process Behind

Successful

Tax Reform,3l Vrll. L. Rrv.

1803,

1803

(1986) ("True

tax

reform will not be

achieved unless there

is significant

simplification

of code

provisions.").

o See,

e.g.,

HrNny C. Srrr,roNs, Frnrul T,lx Rnnonu 28-30

(

1950); Paul McDaniel

, Federal

Income Tax Simplifcation: The Political Process,

34 Tlx L. Rrv. 27 (1978);

Federal

Income

Tax Simplifcarfon

(Charles

H. Gustafson

ed.,

1979);

U.S. Department of Treasury, Office of Tax

Analysis, Tax Reform

for Fairness, Simplicity, and Economic Growth: The Treasury Depart-

ment Report

to the

President,25Tt'x NorEs

873

(1984);

Joint Comm.

on

Tax'n,95th Cong., lst

Sess., Issues in Simplification

of the Income Tax Laws

(Comm.

Print 1977);

Sidney L Roberts,

Simplifcation Symposium,

34 Tlx L. Rnv. 5 (1978);

Boris I. Bittker, Iar Reform and Tax

Simplification,29

U. Mlrrrlt L. Rnv. I (1974);

Deborah H. Schenk, Simplifcationfor Individual

Taxpayers: Problems

and Proposals,45

Tu L. REv.

l2l (1989);

Charles A. Mclure, Jt., The

Budget Process and Tax Simplifcation/Complication,45

Tex L. REv. 25 (1989).

6 Trx Srrrlpr-rrrcArroN

Acr Or 1991,

S.

Doc. No. 1394, H.R. Doc. No.2777,102d Cong.,

lst Sess.

(1991).

r

e94l IrlusroNs or T,c,x StvtpLIrIclttoN

on tax returns.

Even

former

IRS Commissioner

Goldberg

promoted

tax

simplification,

but he left unstated

precisely

what that meant.T

These and many other

proposals

for simplification

make

for good

press,

but do not address

the fundamental

causes

behind the

rise in tax

complexity.

Few of the

reformers

posturing

for simplification

of the tax

laws recognize the inherent difficulties

in any attempt

to simplify the

code.

Some

of the excess

complexity is attributable to efforts by policy-

makers to accomplish too much through the tax laws. In other in-

stances,

the

great

complexities

of the tax laws

are attributable

to prior

reforms enacted

in the

pursuit

of ever

greater purity

in the

tax laws. As

Senator

Russell

Long

once

quipped: "The complexity of our

code in the

main is not there because

of some

mischief. Most of it is there

in the

effort to do

more

perfect

justice."s

Long's

proposition

is worth consider-

ing, even if it lacks a certain critical

perspective

as evidenced

by Long's

own

willingness to enact

countless special

provisions

for the sole benefit

of his constituent

gas

and oil industries.

The causes behind the enormous complexity

in the

tax laws cannot

be reduced to any single

factor. Thus, open-ended calls

for "simplifica-

tion" to cure

the problem

of complexity

ring almost

as hollow as the

claim that tax complexity

is attributable

to the search

for "more

per-

fect

justice"

in the tax code-both claims

are overly simplistic.

In order

to intelligently discuss tax simplification, it is necessary to consider

why

the tax laws

became

overly complex in past

decades,

and to recognize

the infirmity of overly complex tax

laws. Because

tax lawyers earn their

livelihood from such complexities, many

will be reluctant to acknowl-

edge that there

is even a "problem"

at all.

To understand the adverse effects caused

by overly complex

tax

laws, one needs

first

to view

the federal

income tax from a broad

histor-

ical perspective

to place

the development of the tax system as a whole

within the context

of the

peculiar

structure

of American

political

insti-

tutions. Complexity

does not

enter the

tax code so much out

of malevo-

lence

as through

misguided reform

efforts

and excessive

demands

made

on tax laws

as the

vehicle for implementing

public

policy.

After under-

standing the broader context, it is possible

to identify those trends

in

recent

tax policymaking

that have

contributed

to this unfortunate

rise

7 See Lane Davenport,

Marianne

Evans, and Sean Ford, Goldberg

Still Beating

Drum For

Simplifcation;

Says /RS Budget is Way

Out of Balance,45

Tlx Norrs 1398

(1989).

E

TrrvrorHv J. CoNlrN Er ,',L., TlxrNc Csorcrs l4l (1990) (quoting

Senate

Finance Com-

mittee Heailngs onTax ReIorm Proposal,Volume 3,99th Cong.,2d Sess.,53

(1986) (statement

of Senator Russell

Long,

Former Chairman,

Senate Finance Committee)).

32r

322 Gro. MesoN INorp. L. Rnv, lYol.2:2

in tax complexity. The dilemma

that we

may very well

confront is that

the more

we

attempt to do through

the tax code-whether to achieve

a

"more perfect

justice" or implement

social economic

policies-the

more we end up making

the tax laws

even more

complex.

In doing so,

we

undermine the capacity

of the citizenf taxpayer to comprehend

the

legal obligations imposed under the regime

of the federal income

tax.

I. Coupr-Exrry

Iu Tnn FnorRnr

INcour Tnx Llws

A. The First Regime

of the Federal Income Tax

L The Original Tax System

Tax complexity is not a new

phenomenon,

although

it has reached

new heights in recent

decades. Since 1913, excessive complexity has

been a constant complaint

of taxpayers as

well as a favorite

theme of

reformers.e But to taxpayers and

counsel

who

have

grown

accustomed

to the statutory

excesses and

regulatory

quagmires

that seemed

to be-

come the norm in the 1980s,

the first income tax laws would

appear

relatively straight-forward

and uncomplicated.

For instance,

the original Form

1040

("Return

of Annual Net In-

come of Individuals"),

put in service

by the Bureau of Internal Reve-

nue in 1913, was

only three

pages

long, including

all its various

sched-

ules. It contained

only a single

page of instructions.lo The return

required

taxpayers to compute

and report

just two separate items,

"gross

income"

and total "general

deductions," and

provided

relatively

straightforward schedules for computing

each.

The

tax was

imposed on

net

income above

a $3,000

exemption

that

was

"received or accrued"

during the calendar

year,

thus employing

a hybrid method

of tax ac-

counting that borrowed

concepts from the cash and accrual methods

of

e Senator Elihu Root

of New York in l9l3 wrote

to a friend

who

had complained

about the

complexity

ofthe Revenue Act

of 19131 "I guess

you

will have

to

go

tojail. Ifthat is the result of

not understanding

the Income Tax Law I shall meet

you

there. . . . [F]or no one understands the

Income

Tax Law except

persons

who have

not sufficient intelligence

to understand the questions

that arise

under it." Quoted

in Henolo Dusnorr, THr UNrrno

Srerns Tlx Counr: AN Hrsron-

rcAL ANALYSTS l2 (1979).

ro

The 1993

Form 1040 is

just two pages

long,

but completing a complicated return may

require

the use of dozens of schedules and workshcets.

Form 1040

alone

is now accompanied by

almost fifty pages

of instructions

and

worksheets.

19941 IllusroNs or Tlx Slrr,rplrrrclrloN 323

tax accounting

so familiar in the modern code.rr

Essentially,

the 1913

income tax resurrected the short-lived

Civil War income tax as

well

as

the tax return used

fifty years

earlier.r2

Of course, many sophisticated

taxpayers

struggled

with the new

relatively

"simple" income tax form.re Notwithstanding that the l9l3

version of the federal income

tax was rather basic and

pristine

by to-

day's standards,

it already

was

perceived

by contemporaries as

far too

complicated to be understood by the average taxpayer.ra

The impact

and shock

felt by those confronting

the

new federal income tax law for

the first time

in 1913 may have

been even

worse than the bewilderment

felt today

by those

who make

their first acquaintance

with the

present

incarnation of the code. The sheer novelty of the

idea

of measuring

an

individual's

"income,"

as the new

tax required,

was

part of the reason

that the first income

tax laws would

have struck

individuals as

so com-

plex

and shocking.'6 Corporations

were

already familiar

with the notion

of computing income over a defined

accounting

period,

both for finan-

cial and tax purposes.

A federal

business

privilege

tax, similar in es-

sence to an income tax, had been

enacted

and sanctioned four years

prior

to the

ratification

of the Sixteenth Amendment.ro

But individuals

were

not

yet accustomed to measuring their human endeavors in terms

!r See I.R.C. $ aa6(c) (cash

and accrual methods as "permissible

methods" for computing

taxable income).

[All citations herein

are to the Internal

Revenue Code of 1986, as amended,

unless otherwise specified.]

'1 The tax return used

during the Civil War employed a similar framework. However,

the

return used in 1865 listed separately each source

of income

(specifically,

all "profits from any

trade, busincss, or vocation,"

rental income

from land or buildings,

"profits realized" from the

sale

of real property,

as

well as

interest

and dividends)

and allowed for "proper" deductions related

to

that source of income. Allowing for deductions

for losses sustained

on the sale

of real

estate,

interest

paid,

rent actually

paid

for the taxpayer's "homestead," and

an annual exemption for

$600

of salary for military

personnel,

the

tax

was imposed

upon

net income above a $600

personal

exemption.

For an account of the Civil War income tax, see Roy C. Burny & Grrpys C.

BlrxEv, TxE FeoEnll INcorrar T,c,x 2-8

(1940);

R,rNpolru E. Plul, T,rxlrroN rr rHr UNrtnn

Srrres 7-29

(1954).

rE

Indicative

of the fact that even the rudimentary tax return used

for the Civil War income

tax was

difficult for taxpayers to comprehend, Abraham Lincoln overpaid

his taxcs for 1864 by

$1,250,

a sizable amount by contcmporary standards of wealth. The incident is rccounted in

Drvro BunNnru, A Lnw Unro Irsrlr: Tsn IRS AND

rHE Asusr or Powrn 13

(1989).

t' See supra note 9.

r! Except for the brief experience with the Civil War income tax, a half ccntury

prior to the

l9l3 income

tax, citizens had only known

"indirect" forms of taxation.

Whilc transactions and

salcs

wcre subject to excise taxes and custom duties, the concept

of treating an individual as a

taxable economic unit was

relatively new, even in 1913,

!! The corporate business

privilege

tax

was

included

in the Payne-Aldrich

Tariff Act of I 909,

which was

imposed

"with respect to the

carrying

on or doing business"

of corporations. In Flint

v.

Stone Tracy Co.,220 U.S. 107

(l9ll), the U.S.

Supreme Court

held the tax to be a business

324 Gro. M,c,soN INorp.

L. Rnv [Yol,

2:2

of "net income."

Nor were

they

accustomed

to being

treated as discrete

economic s1i1s-"4seounting"

for their lives

as so many living

balance

sheets.

No matter how benign

the federal income

tax may appear by

today's standards, it represented

a milestone

in the development

of the

relationship between

the citizen

and

the state, transforming

the Ameri-

can

citizen

into a new category

of being-the Taxpayer.

Oddly enough,

the simplicity

of the first "bare-bones"

tax laws

may have actually contributed

to the

initial confusion

because

they

pro-

vided

taxpayers

with insufficient

guidance

as to what was

being

mea-

sured and how to measure

it. Successive

decades

of refinement

of the

statutes by lawmakers,

as

well

as the issuance

of interpretive

regula-

tions by the Treasury Department

under the authority

granted

by the

Revenue Act of 1928,17

somewhat

clarified

the meaning

of the basic

concepts of the federal income tax. These interpretations

brought

greater

certainty

and predictability

of outcome

to subsequent

genera-

tions of taxpayers, attorneys,

and tax experts.

2. Role

of the Federal

Courts

During the first decades

of the federal income

tax, the federal

courts and the Board

of Tax Appeals

contributed much flesh

and

blood

to the statutes.r8 Indeed,

the basic

nature

of the statutes and

the broad,

expansive language

used

by Congress

in drafting the initial revenue

laws made extensive

litigation inevitable.

Accordingly,

the federal

courts

were

drawn into a process

of articulating the meaning

of the

most basic and fundamental

concepts

of the income tax.

privilege

tax, and not

an income

tax

which would

have been

prohibited

under Article I, Section 9

of the

U.S. Constitution

as a "direct

tax."

r?

Pub. L. No. 78-562,

ch.

852, 45 Stat. 790,

791

(1928).

'6 The Board of Tax Appeals was established

under the Revenue

Act of 1924, ch. 234,

$ 900, 43 Stat. 336-38.

The Board was

technically

an "independent agency in the executive

branch," rather

than a

judicial body. In fact,

the Board

(which

was

renamed the Tax Court of the

United States in 1942) functioned

much

as a federal

trial court. In 1969,

in recognition of this,

Congress renamed

the body the "United States Tax Court" and

reclassified it as a so-called

"Arti-

cle I" federal

court (i.e.,

a judicial entity created

under

the authority

granted

to Congress in

Article I of the U.S. Constitution).

26 U.S.C.A.

g 7441

(Law.

Co-op.

1993). Nevertheless,

the

hybrid nature

of the

Tax Court still raises

problems.

See,

e.g., Freytag v. Comm'r,

lll S. Ct.

2631

(1991) (concerning

the

power

and

authority of the "special

trial

judges"

of the Tax

Court);

see

also Note: Special Trial Judges, The Tax Couil and the Appointments

Clause: Freytag v.

Comm'r,45 Tlx Lrwynn 497

(Winter

1992). For

a history

of the

U.S.

Tax Courr, see

Hrnolo

Durnorr, Tnr UNrrro Srerns Tex Counr: AN HrsroRtcAl

ANALysrs

(1979).

19941 lt-t ustoNs or Tlx Sttr,tpLtErcntlott

a. Defining

Income

The federal courts

were

called upon to define the most fundamen-

tal concept of the tax laws-what is "income"

for purposes

of the new

tax. The statutory definition of "income" provided

in the Revenue Act

of 1913 merely mirrored the language of the newly

ratified

Sixteenth

Amendment, which sanctioned the imposition of a "direct" tax on "in-

comes,

from whatever

source derived. Since

1913, the statutory

language

has remained virtually identical.

The present

definition is

found

in Section

6l(a) of the

Internal Revenue Code of 1986

and

sim-

ply states,

somewhat

tautologically, that:

"gross

income means all in-

come

from whatever

source derived. . . ."2o The broad net cast by the

statute

provides

considerable

room for debate

and disagreement

be-

tween

reasonable

persons

over

what

constitutes'(ins66s"-especially,

where

the source is a gift, bequest, life insurance or some other source

of income exempt by statute or judicial doctrine.

Given the minimal and somewhat cryptic statutory

definition

of

income,

it was perhaps

inevitable

that the United States

Supreme

Court would

be called upon to provide

further clarification of the con-

cept of income very early in the history

of the new tax. ln Eisner

v.

Macomber, the Supreme Court struggled

with the concept, declaring in

1920 that "income may be defined

as the

gain

derived from labor, from

capital,

or from

both

combined.o"t

In this statement, the Court

(proba-

bly unintentionally) considerably

narrowed the constitutional and stat-

utory definition

of income

as it strongly implied that absent the contri-

bution of labor or capital, a gain would not be included in income.

Such an

interpretation would

leave vast

categories

of "gain" out of the

statutory scheme,

and

hence,

out of the

reach

of the federal tax collec-

tor. In construing

the statute so narrowly, the Court introduced

addi-

tional

confusion

into an already

uncertain

area'z and offered litigation-

minded

taxpayers a basis for disregarding the broad all-encompassing

statutory definition

of income

when

preparing

their tax returns.

le

U,S.

CoNsr. amend. XVI.

'?o

l.R.C. $ 6l(a). Thc 1939 Internal Revenue Code relied upon a somewhat more wordy

definition

of "gross

income" in section 61(a), while the 1954

tax code returned

to a definition

closer to that first used

in 1913.

r! Eisner

v. Macomber, 252

U.S. 189,

207

(1920).

ry See MlnvrN A. CHrnsLsrErN, Frornrl INcour TlxlrroN 7 (4th

ed. 1985)

("[C]ould it

be asserted that 'labor'

or 'capital'

somehow inheres in every human activity? The Macomber

definition

apparently

possessed

metaphysical

properties

which

made

it difficult

to apply

in an abso-

lutefashion....").

325

326 GEo. Mlsou INoEp. L. REv [Yol.2:2

From the practitioner's perspective,

this confusion was

a positive

development.

It supported aggressive

"reporting positions"

that would

exclude

from taxable income

accessions

to a client's wealth

not derived

from either

labor

or capital

(such

as

gifts)

and

invites litigation

over

such claimed exclusions.'3

It was not until 1955 in the case

of Commissioner

v. Glenshaw

Glass Co. that the Supreme

Court finally settled the issue by embrac-

ing the

broad language of the Sixteenth

Amendment, including virtu-

ally

everything in income. The

Court defined income as all "accessions

to wealth, clearly realized, and over which

the taxpayers

have

complete

dominion."2a

The

judicial

adoption of this

broad

definition also resolved

the issue

reasonably well

for purposes

of creating

an

administrable

defi-

nition

of income for the tax code. The statutory scheme is that

every

"accession"

to wealth is

presumptively

included in income unless other-

wise specifically excluded by statute,

and in some limited circum-

stances, by judicial

doctrine.26 The Bureau of Internal

Revenue

and

later,

the

Internal Revenue

Service, had always

adopted

this structure

2s

See, e.g.,

Bogardus v.

Comm'r,302 U.S.34

(1937);

Robertson

v.

United States,343 U.S.

7ll (1952);

Commissioner v.

Duberstein, 363

U.S.

278

(1960)

(donative

intent required

for non-

taxable

gift).

8' Commissioner

v.

Glenshaw Glass Co.,348

U.S.426,431

(1955).

26

Since the broad definition

of income was

adopted, there is little room left for judicial

exceptions to the

general

rule

that all "accessions to wealth"

are included in income. Howcver,

during the

years

of the Depression in the 1930's,

the courts commonly enunciated

exceptions to

the broad definition of inclusion in income. For instance, after outlining the rule for including

income realized

on the discharge of indebtedness-a

common occurrence during the Depression

when

the value of real

property

declined

severely, leaving

many mortgage

lenders inadequately

secured and

willing

to accept

partial pay-offs

of loans-the courts carved out a number of rather

dubious

judicial

exceptions

that are only recently

being

withdrawn

by the courts

(although

the

Treasury never

acquiesced in most of these decisions

from the first). See Kirby Lumber Co. v.

United

States,284

U.S.

I (1931)

(in

the majority

opinion, Justice Holmes holds that income

was

realized by a corporation upon

acquisition of its own debt instrument for less than face

value);

Dtt

sea Bowers

v. Kerbaugh-Empire,27l

U.S. 170

(1926)

(where

"overall transaction" was

a loss,

income not recognized

on discharge

of debt for less

than face

value); Fulton

Gold Corp.

v.

Comm'r,3l B.T.A.5l9 (1934) (reduction

in non-recourse debt

is treated as a basis reduction

rather than recognized

as income). Kerbaugh-Empire

and Fulton Gold have been severely criti-

cized by courts and

the IRS for years.

See, e.g., Vukasocvich,

Inc.

v. Comm'r, 790 F.2d 1409,

l4l4 (9th

Cir. 1986). Indeed, the whole debt-discharge

area is still not supported

on a firm theo-

retical

foundation, as evidenced

by the recent

bizarre

case of Zarin v. Comm'r, 92 T.C. 1084

(1989),

rev'd,916

F.2d 110

(3d

Cir. 1990)

(compulsive

gambler

lost

$3.5

million in casino

gam-

bling on credit and in settlement

with casino, he

paid

$500,000

of the debt-lRS asserted

that

taxpayer recognized

$3 million of income from cancellation of indebtedness). For

one of the better

discussions of Zarin,

see Daniel Shaviro, The ManWho Lost Too Much: Zarinv. Commissioner

and the Measurement of Taxable

Consumption,54 Tlx L. Rrv. 215

(1990).

t9941 IllusroNs or Tlx StrvtpLrErcntIoN 327

in litigation as the basic

framework

of the federal

income

tax even

prior

to the Court's adoption of a similar view of "income" in 1955.

In these and other early decisions,

the federal courts crafted a

practical

and administrable concept

of income for the new income

tax;

and

even as

the tax code

evolved and

provided greater

details of other

statutory definitions,

the definition

of "income" remained very much

a

question

determined by reference

to these early judicial decisions.

However, there still remains a sizeable

grey

area as

to what

amounts to

income subject to the grasp

of the federal

income

tax, even after de-

cades of judicial construction.26

The courts also

performed

the essential

task of drawing

the bound-

aries of administrative

power

by reviewing

the

governmentos

own inter-

pretations

of the tax statutes.

While

the courts

paid

all the usual defer-

ence to the expertise of the tax experts in the administrative

agencies

with respect

to their interpretation

of the tax

laws, there was little hesi-

tancy to find in favor

of taxpayers

against the tax authorities. Through

extensive litigation over the basic

issues

arising under the federal in-

come tax, the courts enunciated the broad

doctrine necessary

to fill in

the

considerable

gaps

in the tax laws

and

restrained

the tendency of the

government

to construe

the tax laws entirely in its own favor. In this

respect, the federal courts

played

an instrumental role in the develop-

ment of the federal income

tax.

3. Development

of the Tax System During the First Regime

During

the first

quarter

of a century

under

the new federal income

tax-the "first regims"-1fis statutory

framework

of the tax was

clari-

fied

by Congress, the administrative capabilities of the Treasury

were

expanded and refined, and the courts

acquired experience

and skill in

interpreting the tax laws. Likewise,

as the increasingly

professionalized

and specialized bar became more

familiar

with the meaning of the new

20

"Construction" has

been

defined

as the "drawing of conclusions respecting subjects that lie

beyond the direct expression of the text, from elements known from and given in the text -

conclusions

which

are in the

spirit

though not the letter of the text." FneNcrs LTEBER, Legal and

Polilical Hermeneutics 44 (F.H. Thomas

1880),

quoted

dn

William F. Harris ll, Bonding Word

and

Polity:

The Logic of American Constitutionalism,T6 Au. Por. Scr. Rrv. 34,40 (1982);

see

a/so

Frank H. Easterbrook, Legal Interpretation and the Power of the Judiciary, 7 Hlnv. J.L. &

Pus. PoL'v 87 (1984);

Sheldon D. Pollack,

Constitutional

Interpretation as Political

Choice,48

Utrrv.

Ptrr. L. REv. 989

(1987).

328 Gro. M,c,soN INnEp. L. Rnv. lYol.2:2

tax laws through experience representing

clients, a new

legal

specialist

was

born-the tax lawyer.2?

Thus,

the

first regime

of the federal income tax was marked

by the

gradual

institutionalization

of the tax system,

the

professionalization

of

roles

played

by the participants,

and the specialization

of functions

within the administration

of the tax system. This specialization in-

cluded locating the

power

to interpret

the tax laws through administra-

tive regulations and the

power

to actually collect tax revenues in sepa-

rate

offices

and agencies. During this period,

the basic

structure

of the

federal income tax was laid out and

the

participants

in the administra-

tion of the tax laws eventually came

to understand

the rules of the tax

system.

In addition, Congress

made

continual

refinements

to the tax

statutes based upon experience in administering the tax laws. These

statutory refinements,

along

with judicial doctrine

as it had evolved

since

1913, were

codified

in the

Internal

Revenue Code of 1939.'?t The

1939

tax

code included most of the

basic

features

of the

present

income

tax regime. The "expansive"

language

of the

first revenue statutes was

given

detail through decades

of statutory

amendments, administrative

pronouncements,

and

judicial review.

Yet, even after

paying

federal in-

come tax for more than a quarter

of a century, the new

tax code of

1939

struck

contemporaries

as

forbidding

and enigmatic.2e

During the first regime,

the existing administrative capacities of

the American

government proved

to be sufficiently

developed

to collect

the revenue from the income

tax. Because only l%o of the population

was

subject to the

individual income

tax in 1913, and only 57o subject

to the tax in 1939, there

was

no great pressure

for an expansion

of

1?

From 1905 to 1916, the American

Bar Association maintained a Standing Committee on

Taxation

which

participated

in the enactment of the Revenue Act of 1913.

The ABA's Special

Committee on Internal Revenue

was

instrumental

in the creation of the Board of Tax Appeals. In

1939,

the

ABA approved the organization

of the

Section of Taxation,

which

today

plays

a promi-

nent role in advising the Treasury

and

IRS on concerns

of the tax bar. For a discussion of the role

of the Tax Section, see Harry K. Mansfield, A Brief Unoficial History of the Tax Section

-

1939-1989,44

Tnx LewyEn 4 (1990).

'r Pub. L. No. 76-1.

20

No less

a distinguished figure than

Judge Learned Hand expressed these sentiments

with

respect

to the complexity

of the 1939 tax code:

ln my own case

the words

of such an act as the Income Tax, for example,

merely dance

before my eyes in a meaningless

procession:

cross-reference to cross-reference, excep-

tion

upon exception - couchcd in abstract terms that offer no handle to seize hold of

- leave my mind only a confused sense

of some

vitally important, but successfully

concealed,

purport,

which

it is my duty to extract, but which is within

my power,

if at

all, only after

the most inordinate expenditure of time.

Jerrrrs S. Eusflce, Tax Complexity

and the Tax Practitioner,45 Tt* L. Rrv. 7, 7 (1989).

tee4l ft-r-usroNs or Tlx SrupuRcerroN 329

administrative

powers

into the area

of taxation.so

Thus, the traditional

nineteenth century system

of administration-minimal state institu-

tions, organized by political parties, subject to judicial re-

viewer-predominated throughout the first regime of the federal in-

come

tax. However, the

gradual

development of the

federal income tax

system,

including the code itself and the collection system,

was radi-

cally and abruptly

altered by the revenue crisis occasioned by World

War I.

During the

fiscal crisis of the

war,

policymakers

learned

an impor-

tant lesson about the individual income tax-the amount of revenue

collected

can be increased

fairly easily through the tax system

with

only relatively minor tinkering and adjustments to tax rates and ex-

emption

levels. Accordingly, the wartime

crisis

for additional

revenue

led to higher

marginal tax rates,

thereby

transforming the nominal

structure

of the federal income tax into a highly

progressive

tax.82

Political scientist John

Witte has described the

impact

of World

War I on the development of the federal income tax as

follows:

The First World War had an important impact on the income

tax, rapidly

transforming it from a highly contested but insignificant

source of revenue

into a major tax. Rate and provision

adjustments

made over several

years

turned what was

almost a proportional

tax into one

with a highly progressive

nominal rate structure.ss

Despite the importance

of World War I on restructuring

the federal

income

tax,

the impact

of the

War proved

to be transitory. Even

during

the height of World War I, only a relatively small

proportion

of the

citizenry was ever subject to the federal individual income tax. In addi-

tion, as revenue requirements

of the federal

government

returned

to

more traditional

patterns

after the War, tax rates also

were

quickly

to Figures cited in Timothy J. Conlan

et al., Taxing Choices:

The Politics of Tax Reform 17

(

l 990).

8r

See SrnpnEN SxownoNsr, Burlprxc A NEw Aurnrclx Srrrr: Tsr Exprrxsrox of Ne-

rrour- AprralNrsrRArrvE

Crrrcrrrns, 1877-1920, 29 (1982) ("Together,

courts and parties

formed the

bulwark of the

early American state.").

tt The top tax rate imposed during World War I was 71% on income over one

million dol-

lars. Rosrnr E. Hrll & AlvrN RlausHrl, Txr Fnr Trx 20 (1985).

8r JoHN F. Wlrrr, THr Polrrrcs ANp DrvrlopurNr Or Tnr Fropnrl lxcorrlr Trx ll0

(

I 98s).

330 Gno. MsoN lNosp.

L. Rrv fYoL2:2

reduced

to pre-War

levels.sa

Furthermore, following

the War, the fed-

eral

government

actually ran

surpluses,

leading

Treasury Secretary An-

drew W. Mellon

on a crusade

for the repeal of the

wartime

excess

prof-

its tax.36

B. The Second Regime: The Transformation

of the Tax System

The critical need for revenue

brought on by World War II led to

dramatic increases in tax rates as well as the transformation of the

federal

income

tax from a "class tax" into a "mass tax" affecting most

of the citizenry.so

The expansion of the American administrative state

during the

New Deal had already established a conceptual and ideolog-

ical acceptance of public

administration,

paving

the

way

for the subse-

quent

expansion

of the tax administrative state during

World War II.37

During the War years,

tax rates and the volume of revenue

col-

lected increased

dramatically.ss

Similarly, the number of tax returns

filed by individuals increased nearly eightfold

from 1940 to 1945.80

From the

initial l%o of the

population

that was subject to the individ-

ual income tax in 1913, the figure had risen to only a modest

5Vo by

1939.40 However, this changed

dramatically

over the course of World

War II. Furthermore,

the

structural changes

to the tax code occasioned

by the war were not withdrawn following World War II as they had

been

after

World War I. The higher

tax rates

and the

expanded scope

of the tax did not return

to pre-War

levels, and they continued

to in-

crease,

although more slowly, throughout the

post-War years.

By 1950,

u Id. at 96; see also BLnrEv and Buxnv, supru note 12,

at 189-334

(account

of Mellon

plan

for tax reduction during 1920s, including legislation

that

reduced wartime surtax rates,

cstate

taxes, and corporation taxes in 1924, 1926 and 1928, respectively).

E5

Mellon, Treasury Secretary

undcr four presidents, played

the leading rolc in the return to

tax "normalcy." Under Mellon's long reign at Trcasury,

wartime debt was significantly reduced

and the budget actually yielded

surpluses

for eleven straight years,

cvcn as the wartimc excess

profits tax was abandoned. See Paul, supra note 12,

at 122-42.

While tax rates decreascd, thc

relative contribution of the income

tax to total federal

revenue increased during the 1920s.

RrcH-

enp B. GoopB,

THE INDrvrDUer

lNcoun Tu 2-3

(1976).

8"

,See C. EucnNp StEuEnLE, Trtr Tlx DEclonr How TlxEs Clur To Dorrrrx,rrr Tgn

Pust-rc Aonxpe l3 (1992);

Wnrn, supra note 33,

at 110-30.

The most comprehensive discussion

of the expansion

of the

income

tax during

World War II is

found

io Pr.r, supra note 12,

^l 249-

392.E?

See DoNlrp R. BneNo, Conponerrsru ANo Tnr Rur-E Or Lrw: A Sruoy Or Tnn Nn-

ttoNrt Rrcovrny Aotr,ttNIstnrnoN

(1988);

see also,

SrownoNnx, supra note 31, at 288-90.

86

See

Wtttr, supra note 33,

at l10-30.

8e

CoNLeN, supra note 8, at 18.

{o See Gooon, supra rl.ote 35, at 3.

19941 h-lustoNs or Tlx Srtr,tplrrrcerroN

as

much as 59Vo of the

population

was

subject

to the

individual income

tax, and that figure increased to SlVo by 1970.4r Revenue

from the

federal

income tax rose to 45Vo of all federal tax receipts by 1950,

and

by 1985, the

figure

had

risen

to 73Vo.a2

Thus, the great

impact of World War II on fiscal

policy

was

that

the federal income tax emerged

as the most significant source of reve-

nue for the federal

government

as both tax rates increased

and

more of

the population

became

subject

to the tax. The federal income tax also

became one

of the most

wide-ranging

and all-encompassing

of Ameri-

can

public policies,

affecting many aspects of social

and economic life

of the citizenry through

the public policies

built into the tax code

and

imposing

what may very well be the most burdensome

obligation of

citizenship.

Perhaps the single most important change

in the tax laws imple-

mented

during World War II that made

possible

the creation and ex-

traordinary

growth of the post-War

tax administrative bureaucracy

was the introduction of so-called

"withholding

at the source."ns

With-

holding

was

contemplated and favored by those

who enacted

the first

income tax in 1913, in particular

Cordell Hull (Dem.,

Tenn.),

Chair-

man of the House

Ways

and Means Committee. Supporters

generally

viewed

with favor the British system

of "collection-at-the-source,"

which imposed a flat rate on prescribed payments

and

was indifferent

to the income or financial status of the recipient, and thus,

was

highly

administrable.aa

Withholding

at the source was not actually

put into effect until

1943

pursuant

to the Current Tax Payment

Act enacted

during the

wartime

crisis for revenue.

Until this legislation, the individual income

tax was

paid

solely through

quarterly payments

of estimated tax for the

current

year.a6

The Roosevelt

administration

had been

recommending

ar Id. at 19.

12

Id.

4' See, e.9., Bunxnlu, supra note I 3, at I 5 ("Although the

withholding

statute traditionally

receives

only passing

attention

from most tax scholars,

its importance

in increasing

the basic

power

of the IRS cannot

be overstated."). For a discussion of the

politics

behind the enactment of

the first withholding

requirements, see PrruI-,

supra note 12,

at 333-34.

tt .See BL,rKrv

eNo

BLnrnv, supra note L2,at75,5ll-20. Proponents

ofwithholding at the

source also looked to the English

experience

with envy as

it raised significant revenue through

this

device.

{r This is still thc method of payment

of tax with respect to sclf-earned

income. .See

I.R.C.

$S

6315,

6654

(Law.

Co-op.

1993). Technically, there is no requirement to pay

such

estimated

taxes. However, therc are penalties

for the failure to make adequate

quarterly

payments

of one's

annual income tax liability, Absent these

provisions,

individuals

would

not need to make

any

in-

331

332 Gro. MesoN INorp. L. Rnv fYol.2:2

withholding

requirements in order to speed up the collection

of the

badly

needed revenue to which

the national

government

now laid claim

under

the

newly

expanded

federal income

tax.

The new legislation cre-

ated a new obligation

for payers

of compensation,

interest

and divi-

dends

to withhold

a prescribed

amount of income tax from the

payment

itself.ao

In addition to the introduction of withholding

at the source,

"information

reporting" requirements

also

were

created and imposed

upon the same categories of payers.

Later, legislation

was

enacted to

require the payers

of compensation,

interest,

and dividends to report

such

payments

to the IRS on an annual

basis.az Over subsequent

de-

cades,

withholding

and information reporting requirements

were

con-

stantly expanded through the incremental

tax policymaking process.

Information reporting

provides

the IRS with independent notice

and

verification

of much

of the gross

income

of most

of U.S. resident

taxpayers.

With information reporting

applicable

to the payment

of

wages

to employees,

remuneration

paid

to independent contractors,

in-

terest

and dividend

payments,

and even the gross proceeds

realized

from the sale of stock and securities, the IRS now

has

available to it

significant

information regarding the tax status of a significant

percent-

age of taxpayers. Of course, such information

is useless

without the

administrative

capacity to digest the vast, and potentially

overwhelm-

ing,

volume

of information

that the IRS receives

from

payers

with re-

spect to taxpayers. Computers

now

offer the IRS the capability to cor-

relate and match all the vast and otherwise incomprehensible

information

gathered

from these

payers.aE

On the whole, withholding

and

information reporting

greatly

changed

the posture

of the IRS and

the

income tax from a "self-assessed"

tax paid

on an annual basis by

the taxpayer himself, to one in which

payments

and a good

deal of the

come

tax payments

until April lsth of the following

year

- the

due date for their income tax

r€turn.

16

The

withholding

requirements, expanded

greatly

since introduced in 1943, are now found

in the

I.R.C.

at $S

3401-06.

'? These

obligations are

imposed upon

payers

under I.R.C.

SS

6041-50N.

{t The IRS computer system is hopelessly out-of-date.

Under the Bush

administration

the

IRS began

an $8 billion modernization

program.

Scott R. Schmedel,

Tax Report: The IRS Is

Reshaping,

Wlu Sr. J., July 7,1993, at Al. Such a measure is believed to be cost-effective.

Memories

of a much-publicized

breakdown in the IRS computer collection

system in 1985 still

haunt the attempt to rely upon computers to keep track of so much of the economic activity

subject to the income tax.

t9941 lllusroxs or Tlx Srrrrpr.rnclttoN

relevant

information is in the hands of the taxing authorities even

before

the taxpayer

starts

to prepare

an annual tax return.ae

With the introduction of income

tax withholding

during the war

years,

the Internal Revenue Service was able to enhance the enforce-

ment of compliance

with the tax laws.60 This trend continued over the

next

decades as computers

have

allowed even

greater

and more exten-

sive

withholding requirements to be imposed upon

private,

third-party

payers

such

as

employers, banks, and securities and brokerage clearing

houses.

With such

new

and

enhanced

tools

for ensuring

withholding

at

the source,

the Internal Revenue Service

has

emerged

as one

of the

most

productive

of administrative agencies.

Notwithstanding the

popu-

lar perception

that the IRS is somehow inefficient in its operations,

its

ability to administer a mass tax with over one hundred

million tax re-

turns

filed

annually

and collect nearly one trillion

dollars

of revenue

each

year,

is truly a miracle of modern bureaucracy.ot

If World War II helped

to establish

the federal income tax as one

of the most important fiscal tools of the American

polity, tax poli-

cymaking

during the immediate

post-War

era

followed much

the

same

patterns

that had

prevailed

during

the pre-War,

Depression

era polit-

ics.62 Furthermore, the post-Wat

era

was

a period

of relative

calm in

the political

world with respect

to the federal income tax. During the

entire

decade

of the 1950s, there was little notable legislation other

than the enactment of the Internal Revenue Code of 1954-essentially

a recodification, rather than a departure from current

law.6s For the

remainder

of the decade, the federal

tax laws remained

quite stable

and

constant with little significant

legislation enacted.6{

ao

Even

with the

powers

derived from

withholding,

information reporting, and computers, in

1993 the IRS still faced a backlog of some

$71

billion of unpaid

taxes. Tom Herman, Tax Report,

Wnll Sr. J., Jan. 20, 1993, at Al.

!o For an interesting,

if uncritical

portrait

of the Internal

Revenue Service, see John C.

Chommie, The Internal Revenue Service

(1970).

!r The IRS predicted

that it would

receivc nearly 113 million individual tax returns for tax

year 1992

by the end of September 1993. This represents a slight decrease over the prior year.

Daily

Tax Report

(BNA), September 28, 1993,

G-3.

Nearly one trillion

dollars was

collected for

tax year

1988.

BunNH,c,l"r, supra note 13, at 22. The IRS'own budget is $7.4

billion under the

fiscal

year 1994

budget

put forth by the Clinton administration. Drrlv Tex Rnponr, June

10,

1994, G-4.

!r For a dcscription

of post-War

patterns

of tax policymaking,

see

Wnre supra note 33 at

I3l-54.

!E

For a discussion of the 1954 revenue bill, see

Wtttn, supra noto

33,

at 148-50.

6r

One

important

piece

of tax legislation enacted during the 1950s

was

the

addition

of Sub-

chapter S to the Internal

Revenue

Code in the Technical

Amendments Act of 1958, H.R, Doc.

No. 8381,

85th Cong.,

2d

Sess.

333

334 GEo.

Mnsou lNnnp.

L. Rrv fYol.2:2

The new mass income tax provided

the Treasury Department

with

significantly

more revenue and became the most important single

source of federal revenue. However,

to accommodate this expansion

of

the tax and the

rise

in tax rates, the tax administrative state had to be

augmented to collect the

revenue

available to the

government

under the

expanded federal

income

tax.66 While the traditional nineteenth

cen-

tury administrative state

had

been adequate in collecting

the

tariff, and

was

easily adapted to administer the early income tax laws,

the war-

time enlargement

of the income

tax required

a major expansion and

reconstitution of the federal tax bureaucracy to administer the

revenue

laws as a mass

tax applicable to millions of new taxpayers.66

A good

deal of the complexity

that invaded the tax code in the

post-War

era can be traced to this transformation of the income tax

into a mass tax and to the related

expansion of the tax administrative

state. However, the causes

behind the explosion in tax complexity in

the

post-War

era

go

beyond these factors

alone.

To understand the ex-

plosion

in complexity that has been

witnessed

since

the 1970s, it is nec-

essary to consider other factors

that have

contributed to the unprece-

dented rise in tax complexity.

II. Souncrs oF TAX

Corvrpr-Bxrrv

A. Economic

Complexity

The dramatic

increase in the

level

of the complexity of the federal

income

tax laws during

recent decades has not

gone

unnoticed.6T In-

deed, it has been a favorite

theme of tax academics,

politicians,

and the

05

See Cttotr,lr,ttE, supra note

50, at 24 ("The broadening of the income tax base

during the

early

years

of World

War II to embrace most

of the

nation's

wage

earners,

necessitated

the utili-

zation of a number

of new

and innovative collection

techniques.").

s The total revenue

collected by all levels

of government

in

the United States

was

$50

billion

in 1944 during the

height of World

War II; $100

billion

in 1956;

9500

billion in 1977;

and

$l

trillion in 1984. RoN,c,Lo F. Kruc, MoNnv, TruE, rNp Por-rrrcs: INvrsrurrr Tlx Sugsrorlnrrs

lNo At"tpnrclr Druocn,lcy 16

(1993).

67

Writing in 1950, Henry Simons elegantly lamented

the increased complexity of the tax

laws, but could offer only a vague

explanation for it and little hope for relief: "Simplicity in

modern taxation is a problem

of basic architectural design. Present legislation is insufferably com-

plicated

and

nearly

unintelligible. If it is not simplified, half of the

population

may have to become

tax lawyers and tax accountants." Srrrt',roNs, supra nole 5, at 28. See also Hlr-l and RlsusHrl,

supra nole

32, at 5 ("The current

U.S.

income tax system is a nightmare of complcxity.").

19941 II-I-usror.rs

or Tnx Sltr,tpt-lrtcnrIoNI 335

tax bar.68

However, the many explanations offered for the increased

complexity of the tax laws are less

than

convincing or satisfactory. The

problem

of tax complexity

goes

to the heart of what

is wrong with tax

policymaking

in the post-War period,

and thus, requires more than

simplistic explanations or eloquent lamentations.

The reason most often cited for the increased complexity in tax

laws is

the

purported

increase in the complexity' of the

"world"

in gen-

eral, and

in the

economy

in particular.

According to this common

argu-

ment, the tax laws

were

necessarily expanded durrng the

post-War pe-

riod in response to, and to cope

with, the

increasingly

sophisticated and

complicated

world of business, corporate finance, and economic rela-

tions. Purportedly, as business transactions became more complex,

Congress

was

required to modify

the income

tax laws

just to keep up

with the

new

practices

of business.6e

l. International Taxation

There is a good

deal of truth in the argument

that the increasing

complexity of business transactions leads to increasing complexity in

the tax laws. For instance after

the 1950s, American

businesses

pro-

gressively

expanded their activities in foreign markets

and

foreign

cor-

porations

increasingly

began

to do much more

business

in the

United

States.

This change

in the international

economic

environment de-

manded

adaptation of income

tax laws to govern

the taxation of mul-

tinational business transactions and corporations conducting business in

several

jurisdictions.

Accordingly,

the provisions

of the tax code with

respect to "international taxation"so

greatly

expanded beginning

in the

0E

For a discussion of the forces

pushing

toward

greater

complexity,

see

generally,

Stanley S.

Svrrey, Complexity and the Internal Revenue

Code:

The Problem of the Management of Tax

Detail,34

Lrw & CoNrrMp. Pnoss.

673

(1969);

Sidney I. Roberts et al., A Report on Complex-

ity and the Income Tax,27 TxxL. REv.325

(1972);

James S. Eustice, Tax Complexity

and the

Tax Practirioner, 45 Trx L. REv.

7 (1989).

os

See, e.g.,Wnre, supra

note 31, at 149

("[T]he U.S.

economy had

become

much more

complex by the 1950s,

and the rudimentary laws of the early

income

tax werc

no longer suffi-

cient.").

In a comparable

example,

Wildavsky

attributes the complexity of the budgeting

process

to similar factors.

Aenox B. WILorrvsry,

TnE Por-rrrcs or rxr Buocrrnny Pnocrss 8 (1964)

("Budgeting

is

complex, largely because

of the complexity of modern life.").

oo

Within the context

of the

U.S.

income

tax laws, "international

taxation"

has

a somewhat

misleading

usage, referring to the taxation

by the U.S. of domestic corporations and U.S.

persons

with foreign branches

and/or income

sources outside the United

States, as

well as taxation of

foreign

corporations and

individuals with U.S.

source income

gained

by conducting business and

investment

activities

in the United States. For an excellent and comprehensive three-volume trea-

336 Gro. MmoN INorp.

L. Rrv. [Yol.2:2

1960s.

Some of the most

complicated

provisions

to deal

with interna-

tional tax issues in the code

were

introduced during

the 1980s. For

instance, foreign

corporations conducting

business

in the

United States

must now confront extremely complicated statutes and regulations

which

require

them

to determine

their "U.S. source" income,ot their

"effectively connected" U.S. income,62 and their U.S. interest deduc-

tions.83 They

also

must negotiate the "branch

profits

tax"6a and compli-

cated economic analysis required

with respect

to so-called

"intercom-

pany transfer-pricing."66 There is little doubt that in international

taxation,

tax complexity caught up to international

business

practices

with a vengeance

of its own.

2. Tax Law and Business Forms

Whatever the initial appeal of the

argument

that the tax laws in-

creased in complexity in response to the increasing complexity of the

world,

the economy, or even life itself, it is not

entirely

convincing. For

instance, the

argument assumes that the

use

of new entities to conduct

tise covering all aspects

of international taxation,

see Joseps IsrNnnnoH, IxtgnNertoNer- Tlxl-

rroN: U.S. Tlxlrror or FonsrcN TlxplyEns eNo FonrrcN INcorur

(1990).

or See I.R.C. $ 861-62

(1986) (defining

income

from "U.S. sources" and income from

sources outside the U.S.). Specific

provisions

of the tax code

governing

the taxation of foreign

corporations and nonresident aliens are found in Subpart II of Subchapter N of the Internal

Revenue Code.

62

For

the deinition of "effectively connected" income, see I.R.C.

$ 86a(c)

(1986).

os

For example, the determination

of the

portion

of a foreign corporation's U.S. debt allowa-

ble as a deduction

under the U.S. income tax laws requires an allocation of world-wide

debt based

upon the

location

of the foreign corporation's assets.

See Treas. Reg.

S L882-5

(interest

allocation

rule)

promulgated

under the authority of I.R.C.

$ 882(c)(l)(A)

(1986).

Sea c/so I.R.C.

$ 863

(

l 986).

ot See

generally,

I.R.C.

$ 884

(1986).

o0

Intercompany

transfer-pricing is

governed

under I.R.C.

$ 482

(1986).

Spurred on by me-

dia accounts of foreign

corporations

grossly

underpaying their U.S.

income

taxes, the

Treasury

Department began to pay serious attention

to transfer-pricing

in the 1960s. A Srupy on IN-

rERcoMpANy PnrcrNc,

Notice 88-123, 1988-2 C.B. 45E,

at 6-10. Treasury

issued

a so-called

"White Paper" in 1988 on the

question

of transfer-pricing. A Sruov on

INrEncompnNv PnrcrNc,

Notice 88-123, l9E8-2

C,B.45E.

The White Paper

was

a radical departure from the usual at-

tempt by the Treasury to describe

and address every conccivable transaction

and

set of facts and

circumstances in its regulations. This paper

was

devoted

exclusively

to transfer-pricing.

Howcver,

after

publication

of the

White Paper, the Treasury

Department began the inevitable barrage of

regulations,

and many taxpayers objected to them on various

grounds.

The Treasury retreated

somewhat and issued

"simplified"

regulations in January

of 1993, Nevertheless, even

these

regula-

tions impose highly technical standards that must bc negotiated to avoid

having

the IRS recom-

pute a corporation's income, Treas. Reg. $$ 1.482-l through 1.482-2 and Temporary Reg.

$S

1.482-lT though 1.482-7T.

r9941 IllusroNs or T,c,x

SrupLrrlclttoN

business

led to the expansion of the tax laws to regulate

such

develop-

ments

in business

practice.os

This is contrary

to the thesis that Ameri-

can law evolved

and developed to accommodate

the needs and

interests

of the dominant economic interests of civil society-i.e., modern capi-

talism.67 The former implies

that autonomous

political

elites are capa-

ble of responding to attempts to avoid

the incidence of the income tax

by crafting new statutes

and regulations to cope

with such

develop-

ments in business

practice,

while

the latter argument

presumes

that law

develops

in conformity

with the needs of the business community.

It is relatively

easy

to find examples supporting

both sides of the

argument.

For instance,

in 1958

Congress

passed

legislation

that pro-

vided for the creation

of an entirely new tax entity, the so-called "S

corporation,"

for the express

purpose

of providing

business

with a new

"pass-through" entity as an alternative to the traditional business cor-

poration.sE

The S corporation

is strictly a creature of the federal

tax

code, and its creation illustrates how the tax laws

can develop to ac-

commodate

private

economic interests.

However,

just as often it is the tax laws that produce

changes in

business

practices,

as

well as

in state corporate

law. The impact

of the

tax law on business

practice

and state

law is illustrated by the creation

of another entirely

new legal

entity for conducting business-the lim-

ited liability company.so

ln 1977, Wyoming became the first state to

enact

a statute authorizing the organization of limited liability compa-

nies, and Florida followed suit

in 1982. However, as late as 1988, there

were

only a handful

of limited liability companies

actually organized

co

See, e.9.,

Wtrrn, supra note 33, at 149 ("To match the complexity,

the codc needed to

distinguish

between

corporations,

corporations

with income

earned

abroad,

partnerships,

holding

companies, and a wide variety

of tax-exempt and partially

tax-exempt

organizations. Complex

organizations lead to complex sources and flows of income and costs,

which in turn lead to de-

mands for different treatment.").

az

See, e.g., MonroN J. Honwtrz, THB TnrNsronMATroN or ArraEnrcltt Llw: 1780-1850

(1977);

and Tnr TnrNsronMArroN oF AMERTcAN Lew: 1870-1960

(1992) (evolution

of Amcri-

can law as reflecting dictates of private

capital).

6t Subchapter S (contained

in $$ 136l-79 of the 1986

Internal Revenue Code)

was

first

added to the tax code

by the

Technical

Amendments Act of 1958, H.R. Doc. No.8381,85th

Cong., 2d Sess. The provisions

were

not in the original House bill, but rather

were

added by the

Senate Finance Committee. Sea S. Rnp. No. 19E3, 85th Cong., 2d Sess., 1958 C.B, 1009. The

legislative intentions

behind the creation of this new taxable entity have never been

very clear to

the courts, thus making it difficult to construe the many restrictions and rules

governing

Sub-

chapter S corporations. Howcver, therc were clear statements as to the need to accommodate

the

interest of business

in some sort of corporate

pass-through

entity.

0o

For a discussion

of the benefits and problems

of using

a limited liability company, see

Sheldon D. Pollack,

Use of a Limited Liability Company

lor Conducting

Business in Pennsylva-

nia, LXIY Pr. Brn Ass'N.

Q. 142

(July 1993).

337

338 Gno. MesoN INpEp. L. Rrv. fYol.

2:2

under those

laws. Then in 1988, the IRS issued

a favorable

public

rul-

ing regarding the tax treatment of a Wyoming limited liability com-

pany.

Stimulated by the Service's classification

of the

Wyoming

limited

liability company as a partnership

for federal income tax purposes,

this

new business entity

became "hot" and

nearly

all other states

rushed

to

enact

their own

versions

of the statute.To As a result, the landscape for

business

and tax planning

includes

yet one

more

entity, as

well as all

the new interpretive

rules and regulations

now being considered by

Treasury tax experts

to distinguish

the limited liability company from

other

pass-through

entities-S corporations and partnerships.Tr

Here,

the

evolution of state corporate law accommodated

the

dictates

of eco-

nomic

interests and developments in federal tax law.

However, it can hardly be said, even in this strong case, that the

federal

tax laws developed to serve or even accommodate

private

eco-

nomic interests. Businesses and individual investors

already

had

turned

away

from the

traditional

forms

of business corporations. They

began

to utilize alternative business entities such

as

partnerships

and common

law creations, like the Massachusetts

business trust, precisely

because

of the

more favorable tax results

that could be achieved through use of

such entities. As tax lawyers came to recognize

the advantages

to be

gained

by "restructuring" the traditional

forms of business transactions

through the use of partnerships,

business

practices

changed to accom-

modate the federal income tax code. This suggests that tax laws

play

an independent role in shaping the development

of business

practices,

rather than merely reflecting

and serving the needs of private

capital.

The expansion of the federal

tax scheme

within civil society had an

impact

upon

how the economy developed

and contributed in its own

way to the increase in complexity of business

practices.

Thus,

the rise

in complexity of the tax laws cannot

be attributed solely to an increas-

ingly

complex economy

and

business world.

Rather, the tax laws them-

selves

contributed to the complexity in the business

world.

7o

As of September 1993, a total of thirty-frve states

had already enacted statutcs

providing

for limited liability companies. The

Limited Liability Company-An Emerging Business Form of

Choice,LXIY Corporation Guide

(P-H) P 18.1

(Sept.

15,

1993).

See also,State-by-State Tax

Treatment

of LLCs

Reviewed, Srern Tex Rnvrsw (CCH) (Oct. ll, 1993).

?t The IRS has not yet revised

the regulations

to adequately distinguish between S corpora-

tions and partnerships,

which are similar, but differ in important respects. This task has already

begun

with respect to limited liability companies. See,

e.g., Rev. Proc. 92-35, 1992-l C.B.

790.

1994! IrrusroNs or Tnx SrruplrncetroN

B. Tax Reform, Preferences, and the Rise in Complexity

Much of the increased complexity in the tax laws resulted from

the tax policymaking process

itself, rather than from the

external eco-

nomic environment. It is often the case that high-minded tax reform

proposals

end

up as nightmares

of complexity once

translated into reg-

ulations by the tax experts in Treasury.

In the wake

of the success

of

tax reform

efforts in the 1980s, it is apparent that many of the reform

measures adopted by Congress and

given

effect

through Treasury regu-

lations themselves caused much of the increased complexity in the fed-

eral income tax laws.

Consider, for example, such tax reforms as the

passive

activity

loss rules which

were

aimed

at eliminating tax shelters.

The

passive

activity

loss rules were

enacted by Congress to deal a death

blow to the tax shelter industry

once and

for all.72

The basic

idea be-

hind this reform

was

to prevent

taxpayers

from using

losses

generated

from "passive"

activities

(that is, tax deductions from tax shelters

and

other

passive

investments)

to offset

income derived from either

portfolio

investments

(dividends

or interest income) or earned income

(wages

or

self-earned income).73 This approach appears relatively simple

and

straight-forward, but looks

can be deceiving.

The

problem,

once again, was

that the

vague and overly-broad lan-

guage

introduced into

the tax code in the burst of tax reformism

proved

to be useless against the

planning

of tax lawyers. It again fell to the tax

experts at Treasury

and the Service to provide

through regulation that

which was

otherwise unattainable

through statute. Unfortunately, the

resulting

passive

activity loss

regulations issued by Treasury

are so

comprehensive as to be incomprehensible

to taxpayers, the

judges

who

adjudicate disputes

over the interpretation of the federal statute, and

even most tax lawyers.

Introduced in successive sets of Treasury

regulations,

the passive

activity loss

regulations already

amount to over

five hundred

of pages

that must

be navigated by any taxpayer

involved in multiple

investment

activities.

Indeed, the regulations require some forty pages

just to de-

fine what is meant by an "activity"-a vital enterprise

when it is

7r

The passive

activity

loss

(PAL) rules are found at I.R.C.

$ 469

(Law Co-op.

1993).

't Proposals

had been formulated

in the 1970s by Treasury tax experts

to limit the gse

of

artificial tax losses to shelter

other ordinary income. However, such proposals

were modest

ir,.

scope compared

with what was

ultimately enacted in 1986. The concept behind the

passivt

actir-

ity loss

rules

was

first set

out in legislation

in 1983

by Senators

Moynihan

and

Chafee,

and

later

was

reintroduced

in the Senate tax reform

bill.

339

340 Gso. MA,soN

INnsp.

L. Rrv fYol.

2:2

remembered

that the rules

generally

require

a taxpayer

to account

for

each such separate

activity.Tl

The increased

complexity

has

even

tem-

pered

the

enthusiasm

of those who

initially saw

the

passive

activity

loss

rules

as

the vehicle

to tax "fairness."76

Some

have

argued

that despite

the inordinate

complexity

of the

passive

activity loss regulations,

because

they successfully

shut down

the tax shelter industry,

the overall

effect has

been

to simplify

the tax

laws.76 whether

or not

such is

the

genuine

essence

of tax simplification,

the majority of taxpayers

have

never

had to confront

these

technical

rules

simply

because

they

do not invest

in businesses

in which

they

do

not actively

participate.

However,

for those who

do.

some

of the most

impenetrable

and

convoluted

regulations

await

them.?z

In much

the same

way,

the original

issue

discount

(OID) rules

which

were

intended

to prevent

tax avoidance

through

deferral

of the

payment

of tax78 and the infamous

Section

89 proposed

regulations

which

were

meant

to prevent

discrimination

in the use

of pension

plans

and other

tax-favored

benefits

by management

to the exclusion

of

workers.

The Section

89 regulations

imposed

complex

and incompre-

hensible

rules

on

employers

with respect

to qualified

retirement plans.?e

These

regulations

ultimately

were

withdrawn

by the Internal

Revenue

Service

in direct response

to the significant public

outcry

against

this

7' In an effort

to simplify these regulations,

the 6nal regulations

were

shortened

considerably,

purportedly

reducing

the complexity

of the

rules.

See Treas.

prop.

Reg.

$ 1.469-4.

7E

see,

e.9., Stephen

P.

Allen,

Fixing The passive

Activiry Loss

Rules,50

Tlx Norrs l4l9

(Mar. 25, 1991)

("The PAL rules

have

been

quite

effective in dealing with tax

shelters.

Unfortu-

nately,

they have

also

produced

a serious

side effect:

a substantial

increase

in tax law

complexity.

In making

the tax system

more

fair, congress

has

also made

it more incomprehensible.").

76

stanley A. Koppelman,

At-Risk and passive

Activity Limitations: can complexity be

Reduced?,45

Trx L. Rev.

97,

105-06

(1989)

("Notwithstanding

the length

and detail

of the

PAL rules,

they represent

a net simplification

of the tax system.

The success

of these rules

in

eliminating

complex

tax

shelter investments

has simplified

the investment

decisions

for

most high

income

taxpayers.").

Notwithstanding

the implications

of Professor

Koppelman's

statement,

it is

probably

fair to say

that most

of the

taxpayers

who

previously

wrestled

with

complex

tax shelter

investments would gladly

do so

again

if only

given

the

opportunity.

7?

As one commentator

has

put

it: "It is

now

three

years

after the

enactment

of the limitation

on

passive

losses.

And something

is

terribly wrong.

From

a simple

idea

to limit tax shelters

there

has developed

a set

of statutory

rules

and administrative

regulations

of immense

complexity.

The

complexity

of these

rules is

so

Sreat

that

most taxpayers

will

never

be able

to understand

them."

Richard M. Lipton, PALs at Three: what we Know, what ll/e Don't Know And wat ltlent

l4trong,67

Trxrs 715

(1989)

(emphasis

in original);

see

also

Richard

M. Lipton,

pALS ar Four:

Living with the Regulations,

68 Tlxrs 779 (1990).

7E

See infra notes 90-91

and

accompanying

text.

?o

I.R.C.

g 89 (prior

to 1989

amendment).

r9941 lllusroNs or Trx Srupnrrclrtou

"regulatory nightmare."80 These

and other

regulatory nightmares

were

originally

conceived

of as reforms and implemented to prevent

abuses

of the tax laws. However, they ultimately

increased the complexity of

the tax laws to the point where they nearly become

dysfunc-

tional-where taxpayers and the Service can

no longer

understand or

apply the tax laws.sr

The

congressional tendency to implement

more and more domestic

policy

through so-called

"tax expenditures" is another significant devel-

opment in tax policymaking

that accounts

for a large

portion

of the

increased magnitude

and complexity of the tax laws. Paul

McDaniel

has

written

that "the use of tax expenditures constitutes

the single big-

gest

cause of complexity in our tax system."82

This may

be

something

of an

overstatement, but it is hard

to quarrel

with the

assertion that tax

expenditures contribute

much

to the increase in complexity of the tax

code.

Tax expenditures

have

been defined as

"those

revenue losses

at-

tributable to provisions

of the Federal tax laws

which

allow a special

exclusion, exemption, or

deduction

from

gross

income or which provide

a special credit, a preferential

rate of tax, or a deferral of tax

liability."83

By

the

1960s it was common

practice

to use tax credits and

prefer-

ences to implement

social and economic

policy.

The effort to incorpo-

rate so much domestic

policy

into the tax code requires tax

policymak-

ers to draw ever more subtle distinctions

between those taxpayers and

transactions intended to qualify

for the tax benefits and those

who

are

perceived

to be abusing these

provisions.

These distinctions inevitably

require increasingly complicated

rules and regulations. Social

policies

as diverse

as encouraging

"research

and

development"sa

and

low in-

60

Pub.

L. No. 101-40,

$ 203

(1989)

repealed I.R.C.

$ 89. See also Elin Rosenthal, Seaion

89 Foes Unimpressed

by Treasury's Attempts

at Compassion,42Te,x NorEs 528

(1989);

Elin

Rosenthal, Sobering

Thoughts Intrude on Eulogy of Section

89, 45 Tax Notes 930

(1989).

6t The tax laws become

dysfunctional when

they become unadministrable, and thus, no

longer raise sufficient

revenue due to the inability of even

well-intentioned taxpayers

to comply

with

them.

62

Paul McDaniel, Federal Income Tax Simplification: The Political Process, 34 Trx L.

Rrv.27 (1978).

18

The Congressional

Budget and Impoundment

Act,

Pub. L. No. 93-344,

$ 3(a)(3),88

Stat.

298,299

(1974).

For

a comprehensive discussion

of the dynamics

of the

political process

of legis-

lating

tax expenditures, see

SrlNr,ny S. Sunnny, Prruwrys ro Trx REnonu:

Tur CoNcrpr or

T,rx ExpENorrunEs

(1973);

SreNr,sy S. Sunnsy & Plul R. McDeNrnr-, Trrx ExpeNprrunns

(1985);

JoxN F. Wrrre, Tnr Polrrrcs eNo DsvEr-oprr{ENT oF

rHE

Frprnll lNcorlrr

Tlx, Chs.

14 and l5 (1985);

Josrps A. Ppcsrrmr.r, FrpEnll Trx Por-rcy 355-63

(1987).

E{

I.R.C.

$ 174

(Law.

Co-op. 1993),

34r

342 Gro. MmoN INnrp. L. Rsv. [Yol.2:2

come housingE6

through tax credits,

and

providing

deductions for chari-

table contributionsso all contribute in their own

way to increasing the

burden

imposed by the tax code.

While tax reformists have

attacked the use

of the tax system to

implement

policy,

congressmen find the use of tax incentives highly

conducive

to satisfying their own needs as electoral creatures. Even the

wholesale

assault on tax expenditures launched

through the Tax Re-

form Act of 1986, as radical

a departures

from traditional tax poli-

cymaking as that represented, made

only a dent in the

complexity

re-

sulting

from these

provisions.

As the traditional tax policymaking

has

reasserted

itself

since 1986, the use of tax

expenditures

to make

policy

has increased again, thereby

assuring that tax complexity

will remain

a

salient

feature

of the federal

income tax for the foreseeable future.

C. Economic Analvsis

in the Tax Code

The tax code

also

has

grown

in complexity as policymakers

and

the tax experts in the Treasury

Department became

increasingly

so-

phisticated

in perfecting

the underlying concepts of the income tax.

This is especially the case

with respect

to purifying and refining

the

statutory

definition

of income. The federal

income tax rests

upon the

concept of taxing

income

received

or accrued

during

the taxable

year.87

As the

tax experts

have

become more

adept at defining

taxable

income

in economic terms, statutory

provisions

have become more complicated.

Economic analysis has

been

introduced

into the tax code in order to

eradicate

perceived

abuses

of the tax rules

(i.e.,

avoidance of tax) by

those taxpayers

who themselves

understand how to manipulate

eco-

nomic concepts

to their own advantage.

The new

"economic provisions"

introduced in the 1980s

contrib-

uted some of the most

complicated rules to the

tax code. For instance,

taxpayers once could

purchase

so-called

"zero

coupon" bonds or other

corporate debt obligations and defer the receipt and taxation of the

"interest"

payable

on such obligations

until the date of maturity

(or

redemption).""

Such deferral is viewed

as unwarranted from the

per-

tc I.R.C.

$ 42

(Law.

Co-op. 1993).

to I.R.C.

$ 170

(Law.

Co-op. 1993).

tI See, e.g., Treas.

Reg.

$ 1.4a1-l(a)

(each

taxable

year

is

a separate unit

for

tax accounting

purposes).

8t For a cash basis taxpayer, the interest income would

not be taxed until actual or construc-

tive receipt.

See Treas. Reg.

$ 1.451-l(a).

19941 IllusroNs or Tlx SruplrnclttoN

spective of the Haig-Simons definition of incometo in that the

debtholder's economic

position

has

been

enhanced over the course of

the year

as much as

if the interest

had actually

been

paid,

especially

where the issuer

is in sound financial

condition

and there is no reason

to question

its ability to satisfy

the obligation

to pay the accrued un-

paid

interest at maturity.

Accordingly the original issue discount

(OID) rules

were

intro-

duced in the 1980s,

refining

prior efforts to control this deferral of in-

come

recognition.oo The OID rules

impose taxation

on the interest

(and

allow

for a related deduction to the payer)

based

upon the concept of

the economic accrual of the

interest

rather than

upon its actual receipt.

This may be sound

policy if the sole objective

of the tax laws is to

ensure that taxable

income replicates economic

income.

However, the

OID rules introduced an extraordinary

level of complexity into the tax

laws by adding

the economic accrual concept.

If simplicity in the tax

code is respected as one of the

goals

of tax policymakers,

statutes such

as the OID provisions

must be considered a mixed blessing."

Another

example

of how the introduction of economic analysis

into

the tax code contributed to an increase

in the complexity of the tax

laws was found in the campaign against

"tax arbitrage"

waged

during

the 1980s.e2 The simplest example of tax arbitrage arises

when

an

in-

vestor

borrows

in order to invest in a tax-exempt

municipal bond.

Under

prior

tax law, the investor could deduct all of the

interest

paid

to

carry such a tax-preferred investment,

while

the interest

income

paid

60

"Personal income may

be

defined

as the algebraic

sum of (l) the market

value

of rights

exercised in consumption

and

(2) the

change

in the

value of rights exercised in consumption be-

tween the beginning and end of the

period

in question."

Henry C. Simons, Personal

Income Tax:

The Defnition

of Income

as

a Problem

of Fiscal Policy 50

(1938).

This "economic" definition of

income formulated by Henry Simons,

but generally

referred to as the Haig-Simons definition of

income

in deference to economist Robert Haig's

earlier

contribution,

posits

that economic income

is the sum

of the accumulation of wealth

and consumption over

whatever

period

of time is

adopted

for purposes

of measurement. For a discussion

of the Haig-Simons definition of income, sec

Rich-

ard B. Goode,

The Economic

Defnition of Income, in CoupnnHENsrvr

lxcorvrE TlxrrroN l-36

(Joseph

A. Pechman, ed. 1977).

e0

The

original issue discount rules

arc found at I.R.C.

S$ 1271-75.

or The Treasury regulations interpreting the

OID rules are

441

pages

long and utilize ex-

tremely complicated

economic concepts. In some cases it requires a computer

to

perform

the com-

putations

required

under the

regulations.

er Tax arbitrage involves taking advantage of the

differential rate of return on investments

arising solely

from the different tax treatment

of different sources of income. .9ee EucrNn C.

Srrurue, Tlx DEcloE: How T,c,xEs

Clur ro DourNerr rnr PusLtc AceNol,30-33 (1992);

David J. Shakow,

Confronting

the Problem

of Tax Arbitrage,4S

Ttx L. REv.

I (1987).

343

344 Gno. MsoN lNonp.

L. Rnv fYol.

2:2

on

the investment

would

be

exempt from income

tax.e3

The result could

be

a profit

derived solely from the differential

created by the tax code

itself.

While

this

particular

simple

version

of tax arbitrage

is now disal-

lowed under the tax code,ea other forms

still remain

part of standard

tax planning.

For instance, investments

in IRAs, Keogh

plans, qualified

ERISA plans,

and deductions for home

mortgage

interest involve

tax

arbitrage opportunities available to most

taxpayers.ed

Each

of the provisions

that creates such an arbitrage opportunity

is really nothing more than a tax preference

enacted to encourage

tax-

payers

to move their capital

into favored

activities. Tax complexity re-

sults

when economic-minded reformers introduce

provisions

to the tax

laws

in order to limit the ability of taxpayers to benefit

from the tax

preferences

that generate

arbitrage opportunities.

D. "Back-Stop" Tax Reform

As Congress has relied more

and more on

tax preferences

to make

public policy,

it also has

been

forced

to adopt other

reform measures

(such

as those that govern

tax arbitrage and bond discount in original

issues)

precisely

to close the "leaks" in the tax base and prevent

the

"abuses"

attributable to over-use of such

tax preferences.

In such in-

stances, tax policymakers

can be seen

as

rectifying

their own

poor

judg-

ment

and

excess

generosity

in enacting

too

many tax preferences

in the

first place.

Charles Mclure has

referred

to measures designed to limit

the use

of tax preferences

as "back-stop"

provisions

intended

to "pre-

vent the abuse of tax preferences

andfor the appearance of inequity

Through back-stop reforms,

the tax laws necessarily become even

more complicated

as

new

provisions

are introduced today to limit the

es

I.R.C.

$ 265

(Law.

Co-op. 1993), added to the tax code in 1954,

was

enacted to prevent

such a result by disallowing

the interest expcnse incurred

to acquire or "carry" tax-exempt

obligations.

x This form of tax arbitrage is prohibited

by I.R.C. $ 265. Municipal governments

used to

engage

in the

reverse

of this transaction.

They borrowed at interest rates below market rates

(on

account of the

interest-free

treatment

afforded

such interest

under I.R.C.

$ 103) and reinvesting

the bond

proceeds

in higher

yielding

markets,

with

the interest income exempt

under I.R.C.

$ I l5

(exemption

from federal income tax for "governmental

entities"). This practice

is now

outlawed

by

I.R.c.

$ 148.

e! Charles Mclure points

out that there

are now more than a half dozen

different

types of

"interest" in the tax code and

various

tracing rules designed to distinguish

one

form from another

for tax purposes.

Mclunr, supra note 5, at 63.

so

Id. at 43.

tee4) ILr-usroNs or T,c,x

SlupurtcnrtoN 345

applicability of yesterday's

tax preferences.

The incremental

poli-

cymaking

process

that generates

tax preferences

is generally

incapable

of such

a radical step as

abandoning them altogether,

even once they

are denounced by the same

policymakers

as abusive.eT Incremental

policymaking

tends to produces

only minor

adjustments

to existing

tax

policies,

and

back-stop

reforms

are

highly compatible

with such a strat-

egy

of policymaking.

Perhaps the best illustration of how incremental

policymaking

is

conducive to back-stop

reform

was

the introduction

of the alternative

minimum tax (the AMT).08 Introduced

in the Tax Reform Act of

1969, the

AMT is a separate,

parallel

tax system to the "regular" fed-

eral income tax. It is an "add-on" tax intended to back-up or correct

for the inadequacies

of the federal income tax itself. This parallel

tax

system begins

with a comprehensive tax base in which deductions at-

tributable to those tax preferences

deemed to be most abusive are

added back to adjusted

net income.ee Under

current law, "alternative

minimum taxable

income" is subject to a two-tier

tax of 26Vo and

28Vo

for individuals. It was originally introduced as

a flat l0vo rate

and

in-

creased over

the course of the next twenty-four

years

of incremental

policymaking

by a series of back-stop reforms.roo

As the many

preferences

added to the tax code

have accumulated

over the years,

taxpayers have utilized them

to an increasing

extent to

reduce their overall tax liabilities. Not only is this all perfectly

legal,

but it is precisely

what the statutes

were

"intended"

to do-namely,

induce

individuals

and

corporations to engage

in those

economic activi-

ties or purchase

those

goods

which were

singled

out by Congress as

particularly

worthy

of subsidy.

The alternate minimum tax demonstrates

how the tax law lends

itself

to incremental

tax policymaking.

It was

politically

easier for Con-

gress

to adopt this parallel

tax regime,

publicized

as a reform, rather

m To be somewhat more critical, the back-stop

reform provisions

reflect a lack of integrity.

Measures that wer€

once introduced

as favorable to the enhancement of the public interest are

recharacterized

as abuses

when

taxpayers take advantage

of the tax benefits

previously

offered by

Congress. Examples include investment tax credits, accelerated

depreciation, interest expense and

the

possessions

tax credit under I.R.C.

$ 936.

ot The alternative minimum tax is found at I.R.C,

$$ 55-58.

s In computing alternative minimum taxablc income, the taxpayer

must add back deduc-

tions allowed

for purposes

of regular income

tax such as

certain

interest deductions, depreciation

and exemptions. See I.R.C.

$ 56.

roo

The latest rate increase,

from a flat 24% to the aforementioned

two-tier rate schedule,

was

implemented by the recently enacted Revenue

Reconciliation

Act of 1993, Pub. L. No. 103-

66, at $ 1320, 107

Stat.

416

(1993).

346 Gro. M,'\soN

lupnp. L. Rnv [Yol.2:2

than

to sweep the

tax preferences

out of the tax code altogether. After

all, if use of the tax preferences

to reduce

tax liabilities

was

the

prob-

lem, then

reducing or eliminating them from

the tax code would

be the

logical

solution.ror

As such, the alternate minimum

tax reflects the

worst

tendency

of

incremental

policymaking-tinkering with change at the margins

rather than confronting the

underlying

problems.

And once a provision

such

as the AMT finds its way into

the tax code, it is

virtually

impossi-

ble to repeal it other than in the enthusiasm

of a massive tax reform

effort such as occurred

in 1986. Of course,

even if repealed

in such

reformist's zeal, old provisions

have

a nasty habit of being recirculated

as the

next decade's reform. This was

true

of the

investment tax credit

which resurfaced only eight years after its most recent repeal in

1986.'0' Likewise,

incremental

policymaking

succumbs too readily

to

the temptation

to expand the scope of back-up reform

provisions,

as has

been the case

with the alternative

minimum tax, both in terms of ap-

plying

it to more tax preferences

and in increasing tax rates for AMT.

Because

of this expansion of the back-up

reform, more and more tax-

payers

now find themselves subject

to the alternate

minimum

tax, al-

though a high percentage

of them

apparently remain entirely unaware

of the tax or their obligations and liabilities

under this

provision.

Back-

up reform

provisions

have

once again contributed to tax law complexity

in that they have created confusing

statutes to which

taxpayers do not

adhere.

III. Tsr Tlx Gevrn

One

way

to comprehend

the

dynamics

behind the expansion in the

complexity of the tax laws is to imagine

the income tax

laws

as estab-

ror

Some have

suggested that the

problem

is "piggishness"

in over-using tax preferences

to

reduce

one's tax liabilities. The

alternative minimum tax is the kind

of solution

put forth

to im-

pose "selective

limitations" on such

abuse of tax preferences.

See Daniel

Shaviro, Selective Limi-

tations on Tax Benefits,

56 U. Csr. L. REv. I 189

(

1989). Determining

when

a taxpayer takes too

much

advantage of tax preferences

is

an entirely open

question,

and attempting to determinc

when

a taxpayer has over-used

tax

preferences

inevitably

results in one more set of complicated calcula-

tions which taxpayers

will be forced

to confront. The AMT has

produced

exactly

this result.

ro2

In his 6rst State

of the

Union on

February

17, 1993, President Clinton formally

set

forth

his new

economic

program

to Congress. This included a proposal

to reintroduce

the

investment tax

credit. The investment tax credit was

first introduced in1962, suspended briefly in 1966,

termi-

nated in 1969, reinstated

in 1971,

and finally abandoned

pursuant

to

the Tax Reform Act of 1986.

This

proposal

was

ultimately dropped

in the wake

of much criticism.

.See

Mortimer M. Caplin,

. . . And Drop Investment Tax Credits,

WALL

Sr. J., Mar. 29, 1993, at Al2.

r9941 Ilr-usroNs or Tex SruplrrrcnttoN 347

lishing a kind of game.'oe

The tax laws create

a vast edifice, complete

with rules and

procedures

that must be

followed

by those

who, for bet-

ter or worse,

are

required to play.loa

As with any

game,

different

strat-

egies

will produce

superior outcomes, and

in the course of playing

the

game

over time these

strategies

become evident

to the players

them-

selves,

and they

will adapt accordingly.

But the concern here is not so

much the

dynamics and

logic

of play-the subject

of game

theory-but

rather

with the development

of the structures

of the

game

and the im-

pact

of such

development on the rules.

Toward this end, consideration

of the players'

interests in playing

the game

sheds

light on why the

rules developed as they

did.

The

point

of the tax game

from

the

perspective

of the taxpayer

(or

tax lawyer)

is to minimize one's tax liability (or that of one's client)

while

complying

fully

with

all of the rules directly on

point.

Of course,

since the "rules" are really federal statutes buttressed by criminal

sanctions, a failure to play by the rules can result in significant fines

and imprisonment.106

However, notwithstanding

such

penalties

for fail-

ure

to comply

with

the tax

laws

("tax evasion"),

there is no shortage of

methods

by which taxpayers can minimize or avoid taxation ("tax

avoidance").

Indeed, it becomes

quite

evident

rather early in the career

of every tax lawyer that any business transaction

can be structured

in a

number of different

ways,

and different tax consequences

follow from

different structures for the deal; this is true notwithstanding the doc-

trine enunciated by the Supreme Court that substance rather than

form should dictate the characterization and taxation

of a particular

economic arrangement or transaction.loo

As successive

generations

of taxpayers and

lawyers confronted the

tax laws, the rules of the

game

became apparent

and the meaning, con-

ro3

This analysis of the tax system as a game

can be traced

to the seminal

writings

of Oskar

Morgenstern and John

Von Neumann.

See Tne THEoRy or Glurs nNo EcoNotrrlc BEs,qvton

(1944).

Among the first applications of game

theory to social science

were WILLIITU H. RIrEn,

Tnr TsEonv or Pourrcll CoelrrroN (1962);

J,c,rrrEs

M. BucseNr.N and GonooN

Tullocr,

Tnr Clrculus or CoNsnNr: Locrcel FouNoerloNs or CoNstltutroNlr- DEtrrocnlcv

(1962).

r0{ The fact that taxpayers are forced

to play the tax game

does not affect the strategies or

outcomes of play,

nor is it particularly

unusual that a game

is coercive. For instance,

William

Riker analyzed the dynamics of the competitive relationship between the United States and the

Soviet Union in terms

of an involuntary "two-person"

game.

See Rtrrn, supra note lO3.

to6

See I.R.C.

$$ 7201,

"1206,7343

(criminal

sections

for tax evasion

and fraud). See Shel-

don

D. Pollack, The Penalty For Tax Fraud Against A Corporation,

Tun Tex ADvrsER

464

(July

1992); Hrnny G. BrlrEn, Trx Fneuo,rNo

EvrsroN

(1983).

ro3

CIR v. Court Holding Co,324 U.S. 331,

334

(1945)

("The

incidence of taxation depends

upon the substance of a transaction. . . . [T]he

transaction must

be viewed as

a whole, and each

step,

from the commencement of negotiations to the

consummation of the sale, is

relevant.").

348 GEo. MsoN INonp. L. Rrv. lYol.

2:2

sequences,

and outcomes of particular

sets of tax rules

were

revealed.

Much of the initial "learning stage" of the game

was

played

out be-

tween

1913 and

1919 during the first regime of the federal

income

tax.

In any

game,

the

level

of play

will rise to higher levels as

players

fully

learn the range of moves

possible

under the rules.roz Furthermore, as

the

players

become

more

and

more sophisticated

in their play,

the

rules

of the game

also may be modified to counteract

and balance

the in-

creased level of skill of the

players.

As a result,

the

game

itself becomes

more and

more

complex as

it becomes highly institutionalized.ros

It is impossible to predict

a priori who will benefit

from an in-

crease in the complexity level of a game.

For instance, in a game

such

as chess,

the beneficiaries of the enormous complexity

are those

players

with the

greatest

capacity to foresee

the outcome of the

possible

succes-

sive moves of an opponent. In baseball, the

progressive

institutionaliza-

tion of the game

resulted in shifting the balance of power

among the

players.toe

In the early stages of the

game,

before the

rules

and

logic of

the game

were

fully revealed to players,

hitters

prospered.

This was

because

players

in the field had not yet fully "learned"

their roles,

meaning they had

not

yet mastered their play.

Accordingly, hitters had

what

today

would

be considered improbably high batting averages from

1900

through the 1940's. Thereafter,

players,

especially the pitchers,

became more

proficient

in their skills,

and

rules

were

changed

with

the

express

intention

of restricting

the success of hitters. One example

was

the raising of the pitching

mound which resulted in batting average

declines in the

post-War

era of the l950s.rr0

In the tax game

it is difficult to know

with much certainty

at any

particular

moment

who

is winning-the tax lawyers

or the IRS. The

dynamics of the tax game

appear to be that once some clever tax law-

roz

As every

child quickly learns, the range

of possible

outcomes for the

game

of tic-tac-toe

is

too limited, and hence,

play soon becomes boring. Likewise, checkers soon bores most players,

although, in fact, there

are millions of possible

outcomes in checkers

(as

opposed to tic-tac-toe). It

is

just that the

games

all resemble

each other, and thus, offer no

great

excitement.

'ot For instance,

the U.S. House of Representatives became

increasingly

institutionalized

throughout the course of the nineteenth century. The role of "rcpresentative" became morc

profcs-

sional, decisionmaking

became routinized and formal, leadership became hierarchical, and rules

became more

complex as the House became

progressively

institutionalized.

.See

Nelson

W. Polsby,

The Institutionalization

of the U.S. House

of Representatives,62 Au. Pol. Scr. REv. 144

(

l e68).

'oo

The following

argument concerning the

effects of institutionalization on baseball statistics,

in particular

batting

averages,

was

put forth by Stephen Jay Gould,

Losing the

Edge,

VrNrrv

Fltn. March 1983. at 120.

rro Id,

t9941 luusroNs on Tlx Srrr,rpllrrcnrroN

yer

recognizes a new maneuver

around a particular provision

of the tax

code, and uses

it successfully to reduce

the tax liability for a particular

type

of transaction, the maneuver

quickly

becomes known throughout

the tax bar and

the

IRS eventually learns of it.rrr

Thereafter,

new reg-

ulations and perhaps

even new

statutes

(the "rules" of the tax game)

are adopted, shifting the

advantage back to the taxing

authorities

for a

period

of time.rr2 As this

occurs, the

rules

of the

game

inevitably

be-

come a bit more complicated, and

the tax lawyers must learn to play

and

devise new

strategies under the new rules. The tax game

is

unusual

in that one

participant

also acts as the referee of the competition,

em-

powered

to write

new rules

to favor its own side.tts In such a game,

it is

not surprising

that the rules

grow ever

more

complex as the competi-

torf

referee constantly

rewrites the rules

to its own advantage.

This increased

complexity in the tax

laws

can

result

in greater

un-

certainty

when

the complexity of the

rules

of the

tax game

reach the

point

where

players

no longer

understand them, and hence, cannot

pre-

dict the outcome. In a variation

on this theme, it has

been

suggested

that a moderate level of tax complexity is desirable from the perspec-

tive of both the tax bar and the tax authorities.lra According

to this

argument, higher levels

of uncertainty increase the cost

of litigation,

and accordingly, increase

the taxpayer's interest in pre-trial

settlements

which

reduce

the tax lawyers' fees.

The

IRS,

too,

generally

favors mod-

erately high levels

of complexity which make for greater

uncertainty,

and impels

taxpayers to comply with the tax laws, or upon audit, to

settle their disputes

(thereby maximizing revenue for the govern-

Irr Because

the tax experts in the Treasury Department

and

the IRS generally

come

out of

private

tax practice,

these techniques

of tax avoidance eventually become known

to the taxing

authorities. This

should be seen

as one benefit from the

so-called

"revolving

door" between busi-

ness

and

government

officials.

Itt Examples

of such new IRS regulations

relate to the so-called "May Stores transaction"

utilizing

partnership

distributions,

the use

of the Section 754 election to step-up

basis

in partner-

ship assets in the context of a consolidated return, and the taxation of new complex financial

instruments

designed to take

advantage of the treatment of contingent interest under the OID

rules.

See, e.9., Treas. Reg.

$ 1.1275-4(g)

(bifurcation

of contingent debt instruments).

rr8

In this respect

the tax game

is analogous to what would

result were

gambling

casinos

permitted

to amend

the house rules in response

to success by gamblers

in beating the odds - for

instance,

by banning "card-counting."

Of course, state

gaming

officials can usually be persuaded

to make such rule

changes on behalf

of the casinos.

rr{ See Michelle

J. White,

Why Are Taxes

So Complex and Who Benefits2,47 Trx Norns

341

(1990).

A tax attorney in the

film made from John

Grisham's best-selling novel, THe FrnM,

(1991),

states

this cynical

view

as

follows:

"It's a game.

We

teach

the rich

how to play

it so they

can stay rich - and the IRS keeps changing

the rules so

we can keep

getting

rich teaching

them."

Quoted

by

George

Will, The Tangle

of Egos and Rules, NEwswEEK, July 26, 1993, at 60.

349

350 GEo. Mmon INoEp. L. Rsv. fYol.2:2

ment).rrd Presumably,

the

policymakers

who

create tax complexity, in-

troduce complexity into the tax code,

or at least

tolerate it, to enhance

the

Treasury's collection

of revenue

under

the income tax laws.

This kind

of application of game

theory to an

analysis

of the devel-

opment of tax complexity focuses

on

the conflicting interests of the

key

players

of the

game

in determining what

they consider

to be an optimal

level

of complexity

with respect

to the rules

of the game.

However,

such analysis

demonstrates

the limits in applying

game

theory

to the

tax

system. The

analysis

is

useful in explaining

the behavior of taxpay-

ers,

tax counsel, and the IRS in terms

of elucidating the economic in-

terests of the

respective

players.

In doing

so,

game

theory assumes

that

the

players

make decisions

based

upon a rational assessment

of their

own self-interests narrowly

defined in terms

of the maximization

of

their economic

positions.

However, when

this analysis is applied

to the

political

elites who

actually make

the rules of the tax game,

it breaks

down.

When

political

elites are

portrayed

as

"players"

and their

behav-

ior is explained

in terms of the calculation

of economic

and rational

interests, the

conclusion is that they

will be

revenue-maximizers,

behav-

ing as

"predatory" rulers.tto

Similarly,

a pure

economic model will con-

clude

that political

elites

will raise

tax rates

to "point

E" on the so-

called "Laffer" curve,rrT disregarding

the interests

of civil society.rrs

lrc Accountants

are

said

to benefit from high

levels of complexity

as

well as

it pushes

taxpay-

ers to seek

professional

advice in preparing

their tax returns. According

to one economist, for most

U.S. corporations with assets of less

than

$l million

(constituting

90% of all U.S. corporations),

the

cost of compliance with the federal

tax laws is significantly

higher than their tax liabilities.

See Arthur P. Hall,

Accounting

Costs, Another Tax, Wlll Sr. J., Dec.

9, 1993

at Al6. A study

by Professors Joel

Slemrod and

Marsha Blumenthal

has estimated

that

for 1992,

the total cost of

compliance for the

Fortune 500

companies amounted

to $1.055

billion, or $2,1I

million

per

com-

pany

- seventy

percent

attributable

to federal

taxation,

and the rest to state and local

taxation.

"" See Margaret

Levi, A Theory

of Predatory

Rule, l0 Pol. & Soc'y 431 (1981).

Levi

presents

the

general

thesis that "rulers

are

predatory

in that they try to extract as much revenue

as they

can from the

population."

Id. See

also, Or Rulr eNp RpvrNur 3 (1988).

rr7 The Laffer curve was put forth by supply-side

economist Arthur Laffer, a member

of

President

Reagan's Economic

Policy Advisory

Board,

to show that at some hypothetical

point

on a

curve

comparing revenue with

tax rates, revenue will reach

a maximum

("point

E"), and

thereaf-

ter decline

as tax rates

increase

further. See

FouNo,c,rroNs

or Supply-Sror EcoNorvrrcs:

Tnnory

ero EvtprNcr (Victor

A. Canto

et al. eds., 1983);

Surrlv-SrnE Ponrpolro

SrnerEctrs

(Victor

A. Canto

& Arthur B. Laffer eds.,

1988). For

a discussion

and

assessment of thc theories

behind

the Laffer

curve, see

Drvrn G. D,rrvrns,

Ulnro srlrns Tlxrs exo Tlx Poucv 6l-68 (1985).

"E It is an axiom

of supply-side

theory that revenue will decrease

as tax rates increase be-

yond

some

hypothetical

revenue-maximizing

pcak ("point E') on a curve comparing

revenuc

with

tax rates

(the so-called "Laffer" curve). At point E, revenue will reach a maximum, and thereaf-

ter decline

as tax rates

increase further.

For a critical

discussion

and

assessment

of the theories

behind the Laffer

Curve, see Drvrrs, supra note

l17, at 6l-68.

19941 IllusIoNs on Tex SrnaplrrlclttoN

Yet, it is clear

that political

elites

do not behave this way.

Such

rational explanations take into account only pure economic motives

such as revenue maximization and ignore all the personal

and

institu-

tional motives and interests

behind tax policymaking.

For example,

policymakers

do not want

to raise

tax rates

too

high

because they

will

have to answer to their constituents for the higher rates. In open

and

democratic

politics,

such as that

which

prevails

in the

Western democ-

racies,

political

elites

are

continually subjected to popular

controls ex-

erted through electoral

politics

and the open expression of public

opin-

ion. Arguably, electoral competition and public opinion imposes a

significant

degree

of popular

control over

political

elites

and renders

them accountable to the citizenry in some fashion.tre The interest of

political

elites

in maximizing

state revenue at the expense of overall

economic

growth

can be tempered

and

restrained by electoral and

pop-

ular pressures.

The behavior of political

elites forced to compete in

elections

for the right to hold office may be effectively checked and

restrained even

without

the electorate understanding the specific details

of this conflict of interest over marginal tax rates. Recent experience in

American

politics

suggests that sharp increases in tax rates can

provoke

strong

populist

resistance

that is quickly

translated

into restraints im-

posed on political elites through the mechanisms of democratic

politics."o

Likewise,

the

impact

of ideologies

(such

as tax reformism

and the

liberal

political

tradition itself)

on the behavior

of political

elites is left

out of game

theory. So while

game

theory does offer insights into the

dynamics of the tax

game

in which

taxpayers, tax authorities, and tax

lawyers

all participate,

it provides

little insight into how

and

why

the

tax game

developed

over time. Ultimately,

the political

elites

who

are

responsible

for making the rules

of the tax game

(which

account

for

rro The seminal statement of this view of electoral politics is found in JosEpH A.

ScxutrrRrrEn,

Certteusl.r, SocrrLrsrr,r, lr.ro DErrrocnncv

(Ch. XXII, Another Theory of Democ-

racy) 269-83

(1950).

Robert Dahl built upon Schumpeter's theme, arguing that elections

insure

that "political

leaders will be somewhat responsive

to the

preferences

of some

ordinary citizens."

Ronpnr A. Dnul, A PnnElcr to DEuocnlrrc TsEony l3l (1956).

Others have

suggested that

elections also create a sense

of legitimacy and stability that benefits

political

elites and the regime

itself. See, e.g., BrNlrrurx GtNsrrnc, TUE

CoNsEeurNcEs oF CoNsEm:

ElrcrroNs, CrrrznNs,

CoNtnol eNo Popur-ln AceurEscENcE

(1982);

TnE CrprrvE PusI.rc: How Mlss OprNroN

Pnomorns

SrArn Powrn (19E6).

'ro For example,

consider the

grass-roots, populist,

anti-tax movement that began

in Califor-

nia with Proposition 13. For a discussion of this anti-tax

politics,

see

Susrn B. HlNsrN, Tnr

Potttlcs oE TrxerroN: REvrNue Wrrnour RrpnEsruurrox (Ch.7 - The 1978 Tax Revolt:

Causes and Consequences) 212-50

(1983).

351

352 GEo. Mesou INprp. L. Rrv fYol.

2:2

the increased complexity)

are driven

by much more complicated mo-

tives

and

interests

than what is assumed by game

theory.

IV. Tlx Rnronu: Tlx SItvtpI-IrtcenoN?

A. The Consumption

Tax: Changing the Tax Game?

Notwithstanding the many significant efforts to reform the tax

laws over the course of the

past

decades,

the tax code

has only become

more complex and confusing. Such

"innovations"

as the alternative

minimum tax only add to the complexity of the tax

law

without

really

addressing the underlying

factors

behind the perceived problems.r2r

The result is that the problems

of the old system are preserved

while

new

problems

are created as the

reform

provisions

are

inadequately in-

tegrated

into

the

present

tax regime.

While incremental

policymaking

so often results

in back-stop

re-

forms that clutter the tax code

with

ever

greater

complexity,

the lesson

of 1986 is that

occasionally

an extraordinary

political

coalition can suc-

ceed

in breaking

out of the pattern

of incrementalist

policymaking.

Such

radical departures from "politics

as usual" and

incrementalism

are rare in tax policymaking.

Indeed,

the 1986

Act may be

the only

example

in our experience.r22

But, as the tax code

becomes more com-

plex

and cumbersome, it may eventually reach

the

point where

the tax

system can no longer raise revenue

efficientlyrze and

compliance

with

'2r Sae discussion supra

part III.D.

t22

See,

e.g., Srrurnlr, supra note

36, at I ("By mid-1984, analysis and

debate on major

tax

reform was

underway, culminating

in the Tax Reform Act of 1986-the most

comprehensive

reform of U.S. tax

laws ever

undertaken."); John F. Witte,

The Tax

Reform Act of 1986: A New

Era in Tax Politics? 19 AMERTcAN Polrrrcs

Quenrnnlv

438,441

(Oct.

l99l) ("TRA can only

be viewed

as a remarkable legislative accomplishment

and

by far the most

radical

example of

peacetime

tax reform in history."); Daniel Shaviro, Beyond Public

Choice

and Public Interest: A

Study of the Legislative Process as lllustrated by Tax Legislation in the 1980s,139

U. Pr. L.

Rrv. l, 5 (Nov. 1990)

("[T]he 1986 Act was

the all-time leading example

of tax reform.").

rrt Increasing

complexity and

the inability

to simplify the tax laws may

eventually

result in

some form of system failure:

Because of the scope of tax reduction

provisions

and the complexity of the code, it is

doubtful . . . that the income tax can meet

potential

revenue needs in the future .

[or] that

it can

be

"reformed"

to expand the tax base and/or simplify the

system. Thus,

the radical nature

of change over time and the inability of the system

to resist change

create a policy

morass that is perpetuated

by its own structure.

'\Nnrt, supra note

33,

at 20. Even if Witte was

overly

pessimistic

in his

assessment of reform

efforts to expand the tax base, he was

correct in viewing the complexity

of the tax code

as a

19941 ILlusroNs or Tex Sur,rplrrrcnrror.r 353

the tax laws

will

decline.t" Such

developments could increase

pressures

for a radical restructuring

of the tax code.

As the legitimacy

and revenue-raising

capacity of the federal in-

come tax have

been

questioned

over the past

decades, there

has

been

considerable

interest

in abandoning

the

federal income

tax scheme

alto-

gether

in favor

of an alternative

tax system. This

sentiment

is reflected

in academic

proposals

for various forms

of a consumption tax. Dump-

ing the federal income tax in favor

of a national consumption

tax would

be the

ultimate

form of tax "reform" - abandoning all the tax expendi-

tures, back-stop reforms and special interest

provisions

accummulated

over the course of the eighty-year history

of the

income

tax. Addition-

ally, such a radical

change

would

have a major

impact on the practic-

ing bar.

A good

deal of the expertise of the tax bar gained

from eight

decades of experience

under the federal income

tax would

be negated

as a new tax game,

complete

with its own

rules

and dynamics,

took

its

place.

While there

is little likelihood

that the federal income

tax

will

be

abandoned soon, or even that

a national consumption

tax

will be intro-

duced as a supplement

to the income

tax, such

proposals

are no longer

matters of mere

speculation among

tax academics. The consumption

tax has

emerged on the political

agenda.r26

The primary argument of proponents

of a consumption tax rests

upon the assertion that there

are advantages to be derived from

taxing

consumption rather

than income.

The notion

is that the present

tax

regime

taxes

"income,"

including

the return

on investment capital and

thereby creates disincentives

for savings and incentives

for consump-

tion. This

taxation of savings, it is argued, is unwanted in an economy

that on one hand depends

upon

capital

formation

from the investment

of savings and simultaneously

saves

relatively little. This is not

a new

observation.'26

However,

the appeal

of the argument

has

increased in

potential

cause of system

failure. A four trillion

dollar national debt is

one

good

indicator

that the

tax system

is already reaching

that point.

ua There

is merit in the argument that

the

increased

complexity of the tax laws has resulted

in less compliance,

and hence

less

revenue

for the Treasury.

See, e.g., Eugene Carlson, Tax Com-

pliance

by Small Businesses

Eroded in the'80s, Wrll Sr. J., June

27,1991, at B-2,

(quoting

former I.R.S.

Commissioner

Fred T. Goldberg,

Jr. from testimony

before the House:

"We believe

that most

noncompliance is

unintentional. Much

of it is due to the complexity of the tax laws.").

r35

Numerous

bills have

been

in the

works

for

the introduction of a national consumption

tax.

None

have actually

been reported out of the

House Ways and Means Committee for a vote on the

floor of the House.

rrc.See,

a.9., Tnouls HoBBEs, LrvtlrrrlN Plnr II, chap.30 (1651):

"For what

reason is

there, that he

which

laboreth

much, and sparing

the fruits of his labor, consumeth

little, should be

354 Gro. MesoN lNprp. L. REv lYol.2:2

recent decades as the U.S. economy has failed

to achieve satisfactory

levels

of savings

and investment.

There are many

different

variations

of consumption taxes.127 Ex-

amples of different versions of consumption

taxes include excise

taxes,

sales taxes, the

value-added

tax (VAT) and expenditure taxes. Excise

taxes are imposed upon

particular

commodities

(e.g.,

cigarettes, alco-

hol, gasoline,

or such luxury items

as

yachts

or furs). Sales taxes

are

imposed

upon

sales

of broad categories

of commodities

or services, and

are generally

collected

by the seller.

The VAT is a common form of

national taxation in Europe, and also

was recently

adopted by New

Zealand and Canada

(in the case of the latter, in the form of the

Goods and Services Tax adopted in l99l).r'z8 This

type of tax is im-

posed

upon the value

added to a particular

commodity

by the busi-

nesses engaged in the various

stages of the manufacturing

process.

(Thus,

the tax essentially is imposed

upon the difference between

the

business's sales and its

purchases.)

The basic feature of all these

taxes

(sales,

excise

and

VAT) is that they

are ultimately

imposed

upon the

consumption

of goods

and servicesn rather

than on savings.

An expenditure tax is a consumption

tax that essentially is im-

posed

upon

individual

consumers,

rather than upon sellers or manufac-

turers. An expenditure

tax may be structured

following

a "cash-flow"

model in which

taxation

is imposed

upon

net

consumption of the indi-

vidual

over

the accounting

period.l2o

One of the purported

advantages

of taxing "consumption" is that it results in greater

"equity."rso The

notion is that an individual's

consumption

presents

a fairer base for

taxation than income.

Others argue

that consumption taxes are simply

more

"efficient"

with respect to avoiding distortions in the formation

of

capital

(an

argument commonly made

by economists).r8r On the other

charged, more

then

he

that living idley,

getteth

little, and spendeth all he

gets;

seeing the

one

hath

no more

protection

from the

Commonwealth then

the other?"

"? For a broad discussion

of various

forms

of consumption taxes, see JosEpH A. PEcurrrlN,

Frorur Trx Por-Icy

(Ch. 6 - Consumption Taxes)

(1987);

see also Nrcsol,ls Klrpon, AN

ExprNoIrun,E

Tex (1955);

EcoNoMrc

CnorcEs 1984

(Alice

Rivlin

ed. l98l); Drvrrs, supranote

117,

at 77-90.

rrt The Canadian

Goods and Services Tax, Bill C-62, effective January I, 1991, replaced

the

federal

sales tax in Canada.

lfe See William D. Andrews,

A Consumption-Type or Cash Flow Personal Income Tax,87

Hnnv.

L. Rrv. lll3(1974).

180

See, a.g., Alvin Warren, llould a Consumption Tax Be Fairer Than

an Income Tax? 89

Yrr-E L. Rrv. l08l (1980).

'E' This perspective

is reflected

in PncnmeN, supra note 100;

Joseph

Bankman

& Thomas

Griffith, Is The Debate Between

an Income

Tax and a Consumption

Tax a Debate About Risk?

19941 It-r-uslol.rs or Tex Stuplrrrcnuon 355

hand, some argue

that consumption

taxes

are "regressive"

since con-

sumption

by lower income

individuals

represents a higher

percentage

of

their

income than

it does

for wealthy

individuals. This

problem,

if it

indeed is a problem,

can be solved through an expenditure tax, which

can

include a progressive

tax rate structure.

In the end, however,

perhaps

the most significant obstacle

to

adopting an expenditure-styled consumption

tax is the great

difficulty

in phasing

out the present

income

tax and phasing

in a consumption

tax.ls2

The problem

arises

because

savings

previously

taxed under

the

old tax regime

(savings

in after-tax dollars) must be

identified

and

pro-

vided

with some form of exemption under the new

regime; otherwise,

these

dollars

would be taxed a second time if they are subsequently

consumed. Proponents recognize

such

problems,

but often dismiss them

as

solvable. However, if there is some extended

period

during which

the

new

tax is phased

in while

the income

tax is phased

out,

there

will be

two tax

regimes which

taxpayers must follow and

plan

around. Accord-

ingly, since a radical

break with the

past

is impossible,

the tax scheme

in effect during the transition

period

would be

even

more

complex than

the

current system since two tax systems

(three

if the

alternative

mini-

mum tax is counted)

would

be in place.

For this reason, the problems

from introducing

a consumption tax into an economy already

governed

by an income tax regime

are much greater

than those confronted by

nations

with developing, emerging

economies

that have never had an

income tax.r33 In such cases, the choice of a consumption tax as op-

posed

to an income

tax is considerably

more appealing. However, intro-

ducing

a consumption tax into

an economy having eighty

years

of expe-

rience with an income

tax would

be far more

problematic.

Because

of the

difficulty

in implementing an expenditure-type con-

sumption tax, excise-type

consumption taxes have been more commonly

used in recent decades

as

revenue

enhancers to complement the

federal

income

tax. For example,

excise taxes

have recently

been

imposed

on

luxury items such

as

yachts

and high

priced

imported automobiles, and

have been

proposed

for gasoline

and energy consumption. Such taxes

are more conducive to incremental

policymaking

and can be more eas-

ily grafted

onto the current

tax regime.

Does It Matter? 4'1

Tlx L. Rrv. 377

(1992).

Supply-side economists also

favor

consumption taxes

to the extent thcy encourage

savings.

r8r

Mclure identifies

transition rules as

one

source of the complexity of the tax laws. See

Mclunr, supra note

5, at 51.

18"

See, e.g., Charles A. Mclure, Jr. & George R. Zodrow, Implementing Direct

Consump-

tion Taxes In Developing Countries,46 Trx L. Rev. 405

(1991).

356

B.

Gno.

MnsoN

lNorp. L. Rnv

The Problem of Complex Tax Laws

[Yol.

2:2

While there has

been much

concern

of late

with a tax code

that is

beyond the ability of the "average"

taxpayer

to comprehend,

little has

been said to identify

precisely

the

problem

caused

by such complex

tax

laws.

Rather, it is simply

generally

assumed

that because

the tax code

is complex, there must

be a problem.

Such a simplistic

position

is powerless

against

the

retort

that most

of the complexity

of the tax code is seldom

confronted

by the avera1e

taxpayer, who

generally

files

a simple

Form 1040,

or more

likely,

Form

1040-EZ

(the

"easy" version

of the

individual

return for those in the

unenviable

position

of having

few

deductions

to claim).

Presumably,

if

most

of the tax law

complexity

affects

only wealthy

taxpayers

and

busi-

nesses

for whom

hiring professional

tax advisers is standard

procedure,

there

really is

no

problem

with

the many

complex

provisions

of the

tax

laws.

In other words,

complexity

is a problem

only if it reaches

the

middle

class.

To the extent

that the computation

of tax liabilities,

filling out

forms

and satisfying

the multitude

of filing

requirements

can be

simpli-

fied

for

a

majority

of individual

taxpayers,

as it was

by

the 1986

Act,rsa

even

while businesses

and wealthy

taxpayers

confront increased

com-

plexity, political

expediencies

very

well may be

satisfied. That may be

sufficient

to alleviate

the

pressures

on policymakers.

But there

is some-

thing

cynical

about

the view

that tax complexity

is a problem

only if

felt by the average

taxpayer

for it misperceives

the nature

of the

prob-

lem

of complexity

in the

tax laws.

Recordkeeping

is burdensome

and

confusing

for the taxpayer,

and

the ability of the average

taxpayer

to understand

the fundamentals

of

the tax law and

prepare

his

or her

own

tax return is a prerequisite

for

effective

tax policy.rsd

But the focus

of tax reform

should not be on

simplifying

the

preparation

of tax returns.

Simplification

of preparation

is usually accomplished

by eliminating

tax deductions

or imposing

r8{

see

sre,FF

on tuE JorNt

corrruttrEg

oN

TlxltroN, Grlrnll ExpllNltrop or tur Tlx

Rpronu Acr oF 1986

I I (1987)

(stating

that

"[S]implification

of the tax

code itself is

a form of

tax reduction.

. . . The Act reduces

the complexity

of the tax code for many Americans.

Taxpayers

who will use the standard

deduction

rather than

itemize

their deductions will be

freed

from much of the recordkeeping, paperwork,

and

computations

that were

required

under

prior

law.").

rEo

See, e.9.,

Deborah

H. Schenk, Simplification

for Individual Taxpayers:

problems

and

Proposals,"

45 T,rx L. REv. l2t, 166-6'l

(1989)

(discussion

of how

complex recordkeeping

re-

quirements

breed

noncompliance).

t9941 ILLustoNs oE Tex Srupr-rrrcntlox 357

threshold requirements

(such

as adjusted

gross

income) which most

taxpayers

will be unable to satisfy, and therefore,

they

will not be

per-

mitted

to use a particular

deduction.'36

Such a notion

of simplification

will be of little comfort to those

who

lose the benefit

of the deduction.

The reasons for tax simplification

go

beyond the

difficulty

of filling

out tax returns and computing

deductions. The

present

system of taxa-

tion has contributed much to the bureaucratization of modern life and

the

increased regulation

of economic life, for both individuals

as

well

as

businesses. Those

unsympathetic to the problem

of government

over-

regulation of business should recognize

that an overly complex tax sys-

tem also adversely

affects

individuals.ls?

The

tax laws

have a peculiar

impact

upon

private

behavior insofar

as they

do not

strictly

prohibit

particular private

action or conduct, but

rather establish a broad framework

of incentives and disincentives

through

which

private

activity is

subtly altered. The tax laws impose

a

superstructure

above and beyond

the legal framework

that prevails

under

the

liberal

political

tradition. For

example, a certain activity may

be entirely

"legal" in the sense

that there are no

prohibitions

against

such behavior. However,

under the tax laws, such

activity can carry a

price-the burden of additional

taxation. Tax liability creates a disin-

centive to transacting

one's business

activities

in that particular

form

just

as surely as if there

were

an outright legal

prohibition

against such

conduct. In this respect,

the tax laws seem

to be exempt

from a tradi-

tional tenet

of the liberal political

tradition-specifically, the rule of

law.tsE

The rule of law assumes that citizens are

governed

by clear legal

standards, and that

these standards

are enunciated

prior

to taking ef-

fect,

thereby

providing

citizens with notice

of prohibited

behavior and

t8o

For instance,

see the discussion

of tax simplification in SrEurnlr, supra note

36, at 136-

37

("Among

the major simplifications

achieved by tax reform was the elimination

of record

keep-

ing and tax calculations

for those no longer

eligible for certain deductions.").

re?

Speaker

of the Virginia

Senate,

Richard E. Byrd (1910),

in opposition

to ratification

of

the Sixteenth Amendment,

gave

the following

prophetic

warning

of the dangers of a national

income

tax: "A hand

from Washington will be stretched out and

placed

upon

every

man's

busi-

ness; the

eye of the Federal inspector will be in every

man's counting house.

. . . The law

will of

necessity

have inquisitorial

features, it will provide penalties,

it will create complicated machinery.

Under

it men

will be hailed

into courts distant from

their homes. Heavy fines imposed by distant

and unfamiliar

tribunals will constantly

menace

the tax payer.

An army of Federal inspectors,

spies and detectives will descend

upon the state

[of Virginia].

. . . Who of us who

have had

knowledge

of the doings

of the Federal

officials

in the Internal

Revenue service can be blind to

what will follow?"

Blerny and Bllrrv, supra note 12, at'10.

'8E

The classic

statement of the

principle

of the rule of law is found at FnrronrcH A. Hlvrr,

Tsn CoNsrrrurroN

oF Lrsnnry 162-75

(1960).

358 Gno.

Mnsow INorp. L. Rrv. lYol.2:2

the sanctions

attached to violations

of these

rules. Fundamental to the

concept

of the

rule of law is the notion that legal standards

of public

behavior

be

known, or at least

knowable,

by the citizenry.

To

the extent

that

the tax

laws are

public

laws

that similarly should

be

governed

by

the

principles

of the

rule

of law, the

excessive complexity

means that

the legal standards

enunciated thereunder cannot be

comprehended by

those

subject to sanctions

for a failure

to comply.

Perhaps the best ex-

pression

of the

case against overly complex and changing

laws is found

in an oft-quoted

passage

from James Madison in The Federalist:

It will be of little avail to the

people,

that the laws are made by men of their

own

choice, if the laws be

so voluminous

that they cannot be

read, or so inco-

herent that they cannot be understood; if they be repealed or revised

before

they are

promulgated,

or undergo such incessant changes that no man, who

knows what the law is today, can

guess

what it will be to-morrow.

Law is

defined to be a rule of action;

but how

can that be a rule,

which is little

known, and

less fixed?r8e

When the

level

of complexity of the law becomes

so

great

that those

who are subject to its sanctions cannot comprehend

what it is that the

law requires

of them, then the rule

of law has been abandoned as an

operative

principle.

In many respects,

this has become the sad state of

tax policymaking.

CoNcI-ustotr

The tax law should

develop through

judicial

construction of gener-

ally stated

principles

laid

out by Congress

in the tax

laws, rather than

through

"ever

more

complicated

prescriptive

rules"l4o

made

by tax bu-

reaucrats.

Unfortunately,

the tax laws

have developed

over the course

of the

past

decades

in entirely the opposite direction.

The tax code has

become a massive

and impenetrable edifice of rules and regulations

that describe

and

govern

nearly all spheres of economic

life and busi-

ness activity.

Reform legislation such as the Tax Reform Act of 1986

only

added

new complexity to the tax code

even

while

purporting

to achieve

!3e

THE FsorneLrst No. 62, at 381

(James

Madison)

(New

York:

New American Library,

ed., l96l).

r'o Peter C. Canellos, Acquisition of Issuer Securities

by a Controlled Entity: Peter Pan

Seafoods, May Department Stores, and

McDermotl,45

Trx Lrw. l, 14

(1991).

tge4l IllusroNs or Trx SrnrpuncenoN

an aesthetically

purer

income tax.

Provisions

enacted

in 1986 contrib-

uted

additional complexity

as

policymakers

were required

(first

in stat-

utes, and

later in administrative regulations)

to draw increasingly sub-

tle distinctions between what is allowed and

what is disallowed.

Such

over-legislating, aptly described as

"hyperleXis,"rrr

threatens to swamp

the tax code

with the accumulated

weight

of such

subtle distinctions.

One consequence of excessive

complexity in the tax laws is that it

periodically

stimulates demands for simplification of the federal income

tax.

Tax simplification has been championed by politicians,

academics,

bureaucrats.

and even at various

times

the tax bar itself. The issue of

overly complex

tax laws

also

raises

a number of important

philosophi-

cal issues that are beyond the scope of the immediate inquiry. Never-

theless, these

concerns

should be kept in mind as the impact

of tax

policy

upon the broader American

political

system is considered.

What

are the

implications

for domestic

policymaking

when

the tax

code becomes overly complex? What is the underlying

political

agenda

of those seeking specific reforms, such

as closing

loopholes or abolishing

tax shelters? How are individual taxpayers

(the

citizens comprising the

political

community) and their rights and liberties affected

by an al-

most incomprehensible

system

of tax

laws, regulations,

and

rule

by tax

bureaucrats? Are there limits

to how far the

tax administrative state

should intrude into

the

lives

of individual taxpayers

(as

well

as corpora-

tions and businesses) to raise maximum

revenue from the tax laws?

Or

to achieve an "aesthetically" pure

tax code?

These are the kinds of questions

that we will need

to collectively

grapple

with through

political

discourse as the tax laws increase in

complexity

and tax policy

plays

such an important

role in contempo-

rary American

politics.

t'! The term was defined

as

"a pathological

condition caused by an overactive law-making

gland." Bayless

Manning, Hyperlexis:

Our National Disease,

Tl Nw. U. L. REv. '767,76'l

(1977).

Manning wrote: "Statutory

codes, such

as those

in the fields ofcommercial

law and taxa-

tion, are

becoming ever more

particularistic,

longer, more complex, and less comprehensible.

We

are drowning in law." Id.

359