This story is part of the Prospect’s series on how the next president can make progress without new legislation. Read all of our Day One Agenda articles here.
The next president can and should use executive authority to make our tax system more equitable. The Tax Cuts and Jobs Act, which passed in December 2017, had been drafted in secret and then rushed to a vote, leaving the Treasury Department and the IRS with many gaps to fill. And there are still plenty of old loopholes that need fixing, some of which can be addressed, or at least mitigated, without legislation.
The scope of executive authority is wide-ranging. The Trump administration recently toyed with unilaterally indexing capital gains for inflation, reducing taxes owed for those blessed with investment income. This simple tweak would have lessened federal revenues by about $100 billion to $200 billion over ten years.
Ultimately Trump ruled out bypassing Congress “at this time.” That’s good news, because indexing capital gains would be bad tax policy. But the more interesting question is whether the Treasury Department had the right to do this on their own.
The Treasury Department’s authority derives from its role in filling gaps in statutes. When a statutory term is unclear or ambiguous, the Treasury Department can interpret the term in order to provide guidance to taxpayers. The purpose of this authority is to allow Treasury to interpret the tax code, not to let the executive branch achieve by regulatory fiat that which could not be achieved through legislation.
Here, the argument would be that when the tax code says that your basis is equal to your “cost,” the term “cost” is ambiguous, and it could reasonably be construed to mean “cost, indexed for inflation,” rather than the amount of money that one actually paid. It’s a pretty weak argument in context; Congress knows how to index for inflation when it wants to.
In 1992, the Treasury Department’s general counsel and the Justice Department’s Office of Legal Counsel both concluded that Treasury did not have the legal authority to redefine cost in this way. But Trump only declined to take action because “he does not feel enough of the benefits will go to the middle class,” an aide stated. The issue shows how a determined president can reshape tax policy without any help from Congress. I tend to take an expansive view of Treasury’s authority to interpret the tax code, which is rarely crystal clear. Here are a few ways a Democratic president might do so.
BECAUSE THE TAX CUTS and Jobs Act (TCJA) was a drive-by, staff at Treasury and the IRS have been hustling to offer guidance on important areas such as the new deduction for pass-through business owners, interest expense limitations, and a new international tax regime. Treasury and the IRS have generally done a terrific job, particularly under the circumstances. But some of the proposed regulations have been overly generous.
Take opportunity zones, a tax break that is supposed to promote investment in poor neighborhoods. The statute is a confusing mess. For example, it requires that “substantially all” of the assets of a qualified opportunity fund be comprised of qualified opportunity zone businesses; “substantially all” of a qualified opportunity zone business must be comprised of eligible property; and such property must be used in the business for “substantially all” of the time it is held by the business. How this works in practice depends a great deal on policy choices made by Treasury. Proposed regulations define “substantially all” as either 90 percent or 70 percent, depending on which section of the statute is at issue. When one stacks these generous definitions of “substantially all” on top of one another, a taxpayer might as a result get the opportunity zone tax break—deferral and partial exclusion of capital gains—even though less than half of the investment fund’s property consists of eligible property. Only a very business-friendly Treasury Department would interpret “substantially all” to mean “less than half.” A more progressive administration could rewrite the regulations to ensure that more investment in fact flows to poor neighborhoods.
The TCJA included a number of international provisions with an alphabet soup of names (GILTI, FDII, BEAT) that have mostly been interpreted in taxpayer-favorable ways. Many of these provisions had an anti-abuse motive—that is, they were intended to ensure that U.S. corporations pay at least some tax on foreign-derived income, and that foreign corporations pay at least some tax on U.S.-derived income. A new administration could issue guidance that better reflects what Congress intended.
A new president could order Treasury to issue guidance cracking down on old abuses as well. The Obama administration, while generally good on tax policy, did not use its authority as aggressively as some of us would have liked. A new administration might take a different approach.
Perhaps the most important thing the next president can do is to allocate more IRS resources to auditing the super-rich.
Recall, for example, Mitt Romney’s IRA, which financial disclosure forms valued at between $22 million and $102 million. With contribution limits of a few thousand dollars per year, there is no way an IRA can grow that big without something fishy going on. The most likely explanation is that Romney’s contributions were grossly undervalued to squeeze under IRS contribution limits. Some wealthy taxpayers play similar games with Roth IRAs, where future gains are not just deferred but go untaxed altogether. The Treasury Department could write regulations to force fair valuations of property contributed to IRAs, limit the types of property that can be held by IRAs, and take other steps to reduce IRA abuse.
Conservation easements are another playground for tax evaders. A conservation easement is a legal agreement to limit the use of land (or a portion of a property) for conservation purposes. A 1964 IRS ruling authorized landowners to take a charitable tax deduction for the value of the easement donated to the conservation trust or government agency that would oversee the easement. Creative landowners enlist friendly appraisers to inflate the value of the easement, sometimes even well beyond the market value of the entire parcel. In the worst of these transactions, promoters sell off pieces of the deal to individuals. While the IRS has cracked down on these “syndicated” deals, it remains an area with tons of abuse. The IRS could do more to crack down on these phony valuations.
There is the carried interest loophole, of course, which allows hedge fund and private equity managers to take much of their income as a capital gain, taxed at a lower rate. Treasury might have the authority to close that loophole entirely. Treasury could also act on related issues, such as revisiting regulations (proposed in 2016 but withdrawn by the Trump administration) that would have cracked down on “fee waivers,” a technique that fund managers use to convert ordinary income into low-taxed carried interest.
A new section of the tax code, enacted as part of TCJA, imposes a three-year holding period requirement for fund managers to take advantage of the carried interest tax break. The drafters of this code section allowed some loopholes that make it easy for fund managers to avoid. Under the code section, fund managers can still keep that low capital gains rate by borrowing money from the fund itself and claiming it as a personal capital investment. Treasury could step in and shut down this and other techniques that make the code section easy to work around.
Another old chestnut is the “Gingrich-Edwards” tax shelter, most famously used by former Senator John Edwards and former Speaker of the House Newt Gingrich, which allows professionals to avoid the 3.8 percent Medicare tax by funneling income from professional services though a Subchapter S corporation. That could be closed by treating more of the income passed through to the owner as salary income subject to payroll taxes rather than investment income, which is not subject to payroll taxes.
But perhaps the most important thing the next president can do is to allocate more IRS resources to auditing the super-rich. Our tax code is already peppered with perfectly legal opportunities for the rich to sharply reduce their tax burden. We ought to have little sympathy for those who, irked by paying any tax at all, cross the line from legal tax avoidance (such as holding on to appreciated stock) into illegal tax evasion (such as inflating charitable deductions with fake valuations).
In general, the IRS allocates audit resources like Willie Sutton, focusing attention at the high end, where the money is, and in areas with known compliance problems, such as EITC fraud. But audit rates at the top have plummeted in recent years as Congress has starved the IRS of resources. In 2015, the IRS audited 8.42 percent of taxpayers with adjusted gross income between $1 million and $5 million. By 2018, that figure dropped to 2.21 percent. The decline is even starker for super-rich taxpayers who make more than $10 million per year. In 2015, the IRS audited 34.69 percent of taxpayers who made more than $10 million. In 2018, that figure was 6.66 percent. But only the rich have benefited from this decline in IRS attention: Audit rates have mostly held steady for income groups below $100,000, and have even increased for those making between $50,000 and $75,000 (from 0.47 percent to a still-modest 0.54 percent).
Allocating more resources toward high-income earners could also enable more disclosure to policymakers about the nature of income and wealth and the ways the existing tax code is circumvented. It’s hard to make policy decisions without good information. For example, we would know a lot more about whether a wealth tax was viable if we forced wealthy taxpayers to disclose the value of their assets every few years. We could better understand the impact of changing the tax treatment of carried interest, founders’ stock, and other sources of private wealth by forcing large privately held partnerships and corporations to disclose the financial statements they provide to investors. These sorts of advances can only happen by shifting IRS resources to where the money is.
The temptation for tax evasion is even greater for those, like President Trump, who hold their business interests in partnerships. Slightly more than four million partnerships filed tax returns in 2017. Only 8,945 were audited, for an audit rate of only 0.2 percent, less than half the rate from 2015.
When I was a young lawyer, a partner whom I worked for explained to me that in certain areas of partnership tax, we—the tax lawyers hired by the partnership—effectively enforced the law. The law was complex and difficult, he said, and IRS resources were limited. The chances of an IRS agent ever questioning our work were about zero. Twenty years later, with audit rates at 0.2 percent, the partner’s exaggeration has almost become literally true.
What the partner also meant was that we, as lawyers, had a duty to ensure that our clients obeyed the law, even if no one was watching. Playing the audit lottery was not a legitimate tax planning strategy. I wonder how many lawyers continue to hold that view. President Trump, after all, has bragged about not paying taxes for many years and has said that if he had paid taxes, the money would have been squandered. By cracking down on a few of these abuses, a new president could certainly change the tone at the top.
Candidate Spotlight
The candidates have focused less on taxes than you would expect in a presidential campaign. But there’s one executive action that’s been promised by some in the field that the front-runner might find ominous. Both BERNIE SANDERS and ELIZABETH WARREN have promised to eliminate the “Gingrich-Edwards” loophole, where wealthy individuals use S corporation distributions on their earnings to avoid payroll taxes. JOE BIDEN not only hasn’t made this promise, he’s used this loophole. In 2017 and 2018, Biden and his wife Jill sheltered $13 million in earnings from speeches and book royalties through an S corporation. The tactic also conceals the source of the funds, leaving unclear who paid Biden for the speeches and how much. This could become an issue later in the race.
