A sound tax policy raises a prescribed amount of revenue in a manner consistent with both economic efficiency and with society’s general concepts of fairness. Five principles provide a metric by which to judge whether the taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. system achieves these goals:
1. The tax system should be as simple as possible, so that citizens can understand the tax consequences of their economic decisions; 2. The tax system should be stable, so citizens can predict with some confidence the future tax treatment of their current decisions and plans; 3. It should be neutral with respect to those economic decisions, neither encouraging some activities nor unduly discouraging others; 4. It should discourage economic growth as little as possible; and 5. Changes in the tax law should never be applied retroactively except to relieve a class of taxpayers from an extraordinary and unwarranted tax burden.
This latter principle, that of avoiding retroactivity, is sufficiently important that the Congress codified it with respect to Internal Revenue Service regulations. In 1996, as part of the Taxpayer Bill of Rights 2 (H.R. 2337), the Congress established that the effective date of any temporary, proposed, or final regulation may not be earlier than the date the regulation is published in the Federal Register. It also established that the effective date of a final regulation can be no earlier than the date it was published in the Federal Register in temporary form.
Taxes affect virtually all economic decisions. In considering their options, taxpayers must be able to discern the resulting tax consequences of their choices to make their best decisions. Ideally, determining tax consequences should not impose a significant burden on the taxpayer, hence the need for a stable and simple tax system.
In making their decisions, taxpayers must also be able to rely on their reasonable interpretation of the tax law. While the law is always subject to change, taxpayers must have confidence that such changes will apply on a prospective basis only and not be applied retroactively to activities previously undertaken.
A taxpayer’s understanding of the tax law may be the result of a reading of the statute or regulation, letter rulings or other communication by the tax service. The retroactive application of the law arises whenever the statute or regulation is changed or whenever the tax service alters its interpretation of a statute or regulation and the new application of the law is applied to transactions undertaken prior to the announcement of the new interpretation.
The Importance of Prospective Treatment The Federal income tax, while not truly voluntary, nevertheless relies on a high degree of cooperation from taxpayers. Numerous mechanisms exist to ensure ultimate tax compliance, including interest on understated tax liability, monetary penalties, interest on such penalties, and even incarceration. Nevertheless, in a free society these mechanisms would prove insufficient without a basic willingness of taxpayers to comply. Penalties can support the smooth operation of a tax system, but a sense of civic duty is a much more important prerequisite to the proper functioning of the tax system.
Civic duty is and has been compelling to most citizens, resulting in a level of tax compliance that has made the United States the envy of the world’s tax administrators. Citizens will do their civic duty as long as they believe they have a voice in the operation of their government and as long as they believe the level of taxes and the manner in which they are collected is fair. Fairness can mean many things. Fairness may refer to the overall distribution of the tax burden. It certainly means that similarly situated taxpayers will be treated similarly. And it means that the tax service will abide by established rules and procedures in the administration of the law and in the resolution of disputes.
Regardless of the area of human activity or endeavor, changing the rules of the game after the fact is unjust and unfair. In the context of tax policy, therefore, fairness means that the tax law as interpreted by the tax service and as relied upon by the tax payer when entering a transaction will not change after the fact.
Taxpayers’ sense of civic duty is essential to the operation of the income tax. This sense of duty is maintained, in part, when changes in tax law are made on a prospective basis only. This prospective treatment establishes a consistency of tax treatment. Because the Internal Revenue Service (IRS) is charged with the administration, and therefore the preservation of the income tax as a primary revenue source of the Federal government, the IRS has a duty to be consistent in its administration of the tax law. “A duty of administrative consistency certainly exists; the tax laws must be interpreted as uniformly as possible.” (Bunce v. United States, 28 Fed. Cl. 500).
Confidence that changes in the tax law will only be made prospectively enhances the necessary sense that the tax system is fair. On the other hand, only a few instances of reported retroactive treatment may suffice to erode this sense of fairness significantly. Just as one need not suffer ill-health to know that a certain activity can be hazardous, and as one need not be robbed to fear crime, so, too, one need not be personally subjected to a current instance of a retroactively applied change in the tax law to be concerned about the possibility. Consequently, only a few instances of retroactivity applied to individual taxpayers may be sufficient to erode all taxpayers’ confidence in the tax system’s basic fairness. In short, fairness, and therefore the functioning of the federal income tax, demand that the tax law only change prospectively. The only exception to this rule arises when the change relieves a taxpayer of an anomalous and exceptional tax liability.
Retroactivity and the Other Dimensions of Sound Tax Policy While fairness is the foremost and most obvious reason for prohibiting retroactive taxation, any tax system or tax administration that violates this ban must also violate each of the other principles of a sound tax system. One such principle, for example, is that taxpayers should be able to understand the tax system. Even the fairest of tax systems may be feared and mistrusted if it is poorly understood. Fear and mistrust lead to a disbelief in the system’s fairness, which threatens the system’s viability.
Imbedded in the principle that the tax system should be understandable by average taxpayers is the notion that taxpayers should be able to understand the system at the time they are making economic decisions. Such understanding is impossible, however, if the tax code is subsequently changed or re-interpreted by the tax service.
Also essential to the understandability of the tax code is its stability over time. Stability in the tax code fosters greater certainty about the future tax treatment of the results of long-term planning. Stability also gives some assurance to the taxpayer that his or her understanding of a particular tax treatment is correct. The greater the justified certainty, the more sensible those plans will be. Retroactively applied changes necessarily violate the principles of understandability and stability and further erode the taxpayer’s trust in the system.
Retroactivity and Tax Neutrality A neutral tax system is one that does not affect the relative prices that would exist in the free market absent the tax. As a general matter, when resources are allocated according to the signals sent by the prices of each activity relative to every other activity, national output grows most rapidly and the benefits reaped by society from national output are maximized. Every tax system distorts some relative prices to one degree or another. Therefore, every tax system reduces national output and national welfare. Some taxes have greater effects than others, however, and a goal of tax policy should be to affect as few relative prices as possible or, equivalently, to be as neutral as possible.
For example, interest rates generally reflect the market’s pricing of future consumption relative to current consumption. If the market traded a tax-exempt, inflation-indexed government debt instrument, then the interest rate associated with this instrument would reflect the relative price of future to current consumption. The imposition of income tax on interest income, however, increases the interest rate by the amount of tax the income earner will pay. If the income tax rate was 25 percent and the interest rate on a similar tax-exempt instrument was 6 percent, then the interest rate on the taxable instrument would be 8 percent. The increase in the interest rate reflects a tax-induced increase in the price of future consumption relative to current consumption.
It is impossible for a retroactive change in the tax law to violate tax neutrality directly because the taxpayer’s decisions that would have been affected by the new interpretation of the law were made in the past. However, the prospect of retroactive changes in the law increases the uncertainty a taxpayer may have about the activity.
Virtually every economic activity carries with it a certain degree of risk of loss or unmet expectations. Risk requires compensation. The greater the risk, from whatever quarter, the greater the gain taxpayers will expect and require to undertake the activity. When taxpayers may be subject to retroactively applied changes in the tax law, their uncertainty about the activity increases, which in turn increases their required return. This increase represents a deadweight loss to the economy and to society.
U.S. government debt is considered to be free of default risk. All other debt instruments must pay an extra premium to their holders to reflect the market’s estimation of default risk. This default risk varies depending on the deemed creditworthiness of the issuer and the default risk premium charged varies accordingly. Suppose, however, that debt holders were uncertain about the tax treatment of their interest income out of concern that the tax burden could be increased after the debt had been purchased. This additional uncertainty would compel potential debt purchasers to require a higher rate of return. The increased risk premium due to the possibility of retroactive taxation would represent an additional violation of tax neutrality.
A related dimension of tax neutrality is that the tax system should not favor one group of taxpayers over another. Most often, this sense of “horizontal neutrality” means, for examples, that trucking companies should receive the same tax treatment as railroads. Retroactively applied tax law changes open up a new dimension of possible violations of tax neutrality. Repeatedly when such issues have arisen in the past, “Courts have declined to give retroactive effect to regulations or rulings when retroactivity … would lead to inequality of treatment between competitor taxpayers”. (Anderson, Clayton & Co. v. United States, 562 F.2d 972, 981 [5th Cir. 1977])
Consider, for example, two companies competing in the exact same industry. Suppose company A has open tax years going back into the early 1980s, and that company B has closed its tax years through 1992. Now suppose the IRS reinterprets some provision of the tax code that significantly affects both companies. Finally, suppose the IRS is allowed to apply the new interpretation to prior years’ tax filings.
Company B has effectively inoculated itself against the IRS’s new position at least through 1992, because these years have been closed out. Company A, however, now has a significant and inescapable new tax burden. This new tax may endanger Company A’s competitiveness in many ways, but most directly by placing a new and unproductive drain on the company’s cash flow. As this example demonstrates, retroactively applied changes in the tax law will almost certainly violate horizontal tax neutrality within an industry and it will do so on a virtually random basis depending on which companies have open and closed tax years.
Conclusion Retroactively applied changes in the tax system, whether legislative, regulatory, or interpretive, are a curse to taxpayers, to the strength of the economy, and ultimately to tax policymakers and tax administrators. Whatever short-term gains to the fisc might be reaped from a retroactively applied change in the tax law are surely dwarfed by its broader costs to the fisc and to society as a whole.
Appendix: A Case Study in the Abuse of Retroactive Taxation In 1981, a leasing company purchased a number of cargo containers and made them available for transporting property to and from the United States. Its customers were shipping companies engaged in international commerce. In purchasing the containers, the company reasonably believed that it qualified for investment tax credits (ITCs) and accelerated depreciationDepreciation is a measurement of the “useful life” of a business asset, such as machinery or a factory, to determine the multiyear period over which the cost of that asset can be deducted from taxable income. Instead of allowing businesses to deduct the cost of investments immediately (i.e., full expensing), depreciation requires deductions to be taken over time, reducing their value and discouraging investment. . Prior to 1981, the company had been audited three times by the IRS over more than a decade. Each time the company’s ITC and depreciation deductions were approved.
Relying on established IRS interpretation of the rules relating to the ITC and accelerated depreciation, the company entered into various transactions between 1981 and 1985. In setting the lease prices, both the company and the customer were fully aware of the tax benefits received by the leasing company, and so the prices reflected those tax benefits.
In 1990, the Commissioner issued a Revenue Ruling significantly altering the treatment of ITCs and accelerated depreciation in these transactions. The effect of the ruling was to disallow the tax benefits. Further, rather than apply the new tax treatment prospectively only, the Revenue Ruling reached all the way back to the 1981 through 1985 transactions.
The issue here is not whether the new IRS position is right or wrong when applied prospectively. That is a matter to be decided through litigation. The issue is whether the IRS should be allowed to apply the new procedure retroactively. Clearly, the leasing company would have negotiated higher prices with its customers had it known it would be paying higher taxes on its profits from these transactions. Indeed, had it known about the ultimate tax treatment, the leasing company might not have entered into some of these transactions at all.
The Revenue Ruling and the IRS’s negotiating position further exacerbated the problem. In essence, and with full foreknowledge, the IRS Revenue Ruling established a procedure which required the taxpayer to acquire certain information from its clients. Thus the procedure made the taxpayer’s ability to justify its claims for ITCs and depreciation dependent on information outside the taxpayer’s control. Further, and again with full foreknowledge, the required information does not exist currently and was not kept by the customers even at the time the transaction was consummated.
Recognizing the situation it had put the taxpayer into, the IRS published a second Revenue Ruling contemporaneous with the first which provides a “safe harbor” option. Under this second procedure, the taxpayer would be allowed to make an irrevocable election to use a certain specific percentage to determine the amount of qualified ITC and depreciation. The election rate was set at 50 percent.
In summary, after years of approving a specific tax treatment, the IRS decided it had been wrong and sought to enforce a retroactive correction. When the taxpayer challenged the IRS, it came out with two new procedures. The first established an impossible methodology. Having put the taxpayer in an impossible situation, the second procedure offered an escape. The attempt at retroactive taxation is unfair and improper; the game the Service is attempting through the revenue rulings is little more than a novel form of extortion.
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