Defeating Deferral: A Proposal for Retrospective Taxation | Tax Law Review
Updated: 5 days ago
This article was originally published in Tax Law Review (52 Tax L. Rev. 45) in 1996. The full pdf is linked below.
This paper begins where an earlier paper, Contingent Payments and the Time Value of Money, left off. That paper concluded with an appeal for a “yield-based” approach to the taxation of contingent payments, but did not fully explore the ramifications of the yield-based approach.
The issue never left my mind in the decade that separates that paper from this one. I had the feeling, and still do, that the growth of derivatives poses a serious challenge to the tax law’s attempt to tax different classes of income differently. Also, I have always viewed the combination of deferral and the capital gains preference as compounding the most serious problems of horizontal and vertical inequity in our tax system. While others debate how large the capital tax preference should be, this paper offers reasons why the tax on capital gains should be higher than that on ordinary income. The yield-based approach quantifies just how much higher that tax should be.
I found it astonishing that after nearly a century of the income tax, there was still something original to say about the realization requirement. My goal was to measure the benefits of tax deferral, so that appropriate adjustments could be made that would precisely offset those benefits. But a disturbing fact emerged: the resulting tax was non-linear, in the sense that, even with a fixed rate of tax, the taxes imposed on two separate investments was greater than the tax imposed on those same investments viewed together. This characteristic would seem to contravene any minimum standard of rationality that any tax system should satisfy.
Yet rather than being a fatal flaw, this feature of the yield-based approach turned out to be a fertile source of insights into how taxpayers make use of tax deferral, and how any system that corrects for it must look beyond individual assets to the entire scope of a taxpayer’s activities, including not just an asset portfolio but also liabilities and instruments, such as swaps, that are neither assets nor liabilities.
There is math in this paper, but I have tried to keep it at the high school level. I have relegated to the Appendix a bit of calculus that is needed to prove one particular point. Otherwise, the mathematical demands are limited to a willingness to deal with exponents and logarithms. Regrettably, these are unavoidable when dealing with a topic that is bound up with growth and compounding of income.
You can read the full article here:
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