To encourage production of new terrain, a tax subsidy for maps


This is a post about a paper I just put out to Elsevier’s SSRN, because I believe every academic paper should have a blog post explaining why it is useful.

The paper is about the intellectual property (IP) box. The proposal is to provide a lower tax rate to profits associated with a patent or other IP. IP boxes currently exist in a few countries, and a few bills have been introduced in the U.S. Congress to set up an IP box.

The bills proposing IP boxes—which they refer to as innovation boxes—could possibly be traced to a measurement problem. Innovation is hard to define, let alone measure, so many academics will use patent rates as a proxy, in a classic case of looking under the lamppost and replacing a complex concept with something that can be counted and looked up in a database. This seems to have become ingrained, and arguments about patent boxes seem to depend upon the assumption that patents==innovation. This column traces where that substitution leads us.

The math in the paper is a mixed-strategy Nash equilibrium of a two-player game, which produced actually policy-relevant results. I don’t see solutions of equilibria in continuous strategies all that often, so even if you think the IP box politics is uninteresting you may get something out of the paper by skipping straight to the game and its solution in the appendix.

Every IP box has a different definition of what is qualifying IP: some include movies, some include only patents, and so on. For simplicity I’m going to assume just patents here; see the paper for the details.

Claim: innovations are patented

Let us define research as inquiry that leads to knowledge in the public domain, and development as inquiry that leads to private property like a patent. Laws of nature are not patentable, so anything we have learned about mathematics, chemistry, biology, is research, not development. Even within the realm of inventing gadgetry, there are wide ranges of things, like software as such or “obvious to try” developments, that can not be patented.

Claim: Each patent is an innovation.

A lot of patents—I’d say most—provide an incremental step forward on something rather uninteresting. They are definite steps forward, but not necessarily what we picture as innovation.

There are some parties that benefit greatly from maintaining a general belief that there are distinct innovation industries that work differently from others. Maybe you’ve noticed that the software industry has lately taken to calling itself the “tech industry”. Especially given how broad some IP boxes are (including know-how or designs), chair makers and restaurants could claim IP box credits.

Claim: The spillover benefits to important inventions, like transistors or CT scans, are immense. If these had not existed, society would be much worse off.

This is true, but to make this statement useful for policy it is important to know the counterfactual of what would have happened if our favorite major inventions were not invented by their inventors. Pop history likes to characterize the people who invented fundamental technologies as Great Men without whom the invention would never have existed. But the academics who study these inventions, anecdotally or using data from various sources, find that simultaneous invention is the norm, and if the Great Men who got there first didn’t do so, humankind would be deprived of the invention by a few months or years, not forever.

This makes it hard to measure the spillover benefit from a single patent. If a grain provider has a higher-quality product than its competitors, it can charge a penny a pound more, and there’s our measure of the added benefit. If an inventor gets a patent first, then the second to invent (or second to file, let’s not get in to it now) is locked out entirely. With grain, the counterfactual of what life would be like if the better grain maker didn’t exist is easy—check the next one. With an invention, the counterfactual is an exercise in creative alt history. But only if we believe the Great Man theory—and I can’t find a non-pop writer who does—will the benefits provided beyond the counterfactual be the full benefits of a new invention.

Claim: Subsidizing development has immense gains because inventions have immense gains.

If we don’t know what would happen if an inventor were somehow halted, we also don’t know what would happen if an inventor were subsidized. Maybe we’d get something that would otherwise be impossible; maybe we’d get something two weeks earlier.

Note that we’re still talking only about subsidizing development. Research has a commons problem, meaning that if we don’t subsidize many threads of research, they are economically infeasible and may indeed never get done.

Claim: When patents leave the country, the country is less innovative.

A patent has an inventor and an assignee. If we believe that having smart people who come up with interesting ideas geographically close is beneficial to the economy (and I do), then we want to have nearby inventors of patents, of artwork, of all kinds. The assignee, meanwhile, signs the contracts and takes in the royalties.

Having the assignee geographically close has little or nothing to do with invention. It may be a holding corporation with zero employees. It may be registered in the island nation of Sargasso, but have all its cash in an account at Bank of America, where the funds are used to support loans to U.S. startups.

WTO trade treaties prohibit making restrictions on where a patent can be assigned. The inventor may be unable to leave or enter a country, but the ownership assignment must be able to.

Claim: Patents leaving the country is costing billions in lost tax revenue.

This is true, but shouldn’t be. Say that WidgetCo holds a widget-making patent, and sells it to HoldingCo for $10 million. WidgetCo wants to keep making widgets, so they pay HoldingCo royalties of $1 million every year for the next eleven years, at which point the patent in our example expires. So WidgetCo has effectively shifted its risk to HoldingCo, and turned a long stream of future income into a big chunk of present cash. HoldingCo absorbed the risk, so it should make some profit off the transaction, but if it made too much then WidgetCo should have done all this with somebody else who would offer a better rate. In short, a patent reassignment paired with a licensing deal should be largely revenue neutral, and therefore also largely tax neutral. This would especially be the case with a patent portfolio, where the risk of dozens of patents are pooled.

This is not what we’re seeing in real life among U.S. companies and their subsidiaries overseas. When these companies assign a patent to their own sub, they consistently take a payment that is absurdly low relative to the future royalty stream: sell the right to a holding company in Sargasso for a million, creating an obligation to ship 100 million a year in royalty payments overseas. The million coming in to the U.S. is taxed; the 100 million a year going out is not. Incorrect transfer pricing is what makes IP shifting a tax avoidance scheme.

Claim: If we just lower tax rates to below Ireland’s, we can get those patents back.

A lowered rate is one step in a sort of auction for the assignation of the patents. As a baseline, consider a situation where two countries are bidding for the right to tax some mobile capital. They each have their own fixed capital in the country, and declare some tax rate at which both mobile and fixed capital will be taxed. The mobile capital will then flee to the lower-tax country.

If this were played as an alternating, turn-based game, the bids would never settle down. Bids would get lower and lower until one bidder realizes that it is better to just tax the fixed capital to the max than go so low chasing after the mobile. But then the other bidder won’t bid so low, and raises to just underbid the max-taxing bidder, and so on.

This is where mixed strategy equilibria come in, giving us a stable distribution to describe the outcomes. The claim that countries would randomly draw tax rates is a clear fiction, but it’s at least not incoherent, acknowledges that the U.S. setting its rate is not the last step, and produces predictions that are in line with reality.

First, in the unique mixed strategy Nash equilibrium, the country with larger capital, let’s call it the USA, will let the mobile capital go to the smaller country (the fictional tax haven of Sargasso) with a likelihood increasing in the disparity between capital rates. In the sequential game, Sargasso loses less in taxes from fixed capital when it bids lower, so it can always underbid the USA, and this fact from the equilibrium reflects that part of the storyline.

However, Sargasso doesn’t have to bid so low if the USA isn’t willing to bid low because of a loss of taxes associated with fixed capital. So the expected tax rate that the mobile capital sees is an increasing function of the amount of fixed capital held by the USA.

As a corollary, the expected tax revenue the USA sees from just the mobile capital is an increasing function of the amount of fixed capital it is taxing at the same rate. It wins the right to tax the mobile capital less often as it is less willing to bid low, but the rise in expected rates is enough to offset that.

Claim: The USA could better compete in the race to the bottom if there were a separate tax rate for IP.

How would we modify the model to describe an IP box? As it is, there is some fixed capital that is taxed at the same rate as the mobile capital, but the point of the IP box is to eliminate that linkage. If our interest is the tax rate on the mobile capital, the fixed capital associated with that rate is near zero.

We can then read the results off the model, and they’re not good for the taxing entities. The expected tax rate on the fixed capital goes to zero, and the expected revenue to the USA goes to zero.

Claim: Ireland and Luxembourg already have IP boxes, and the sky didn’t fall.

This is true, but is uninformative when considering a U.S. IP box. The model results are all asymmetric, primarily keyed to the fixed capital of the larger country. Why should Sargasso lower rates to zero if the USA can’t lower its rates below some high threshold without losing domestic revenue?

This is especially salient because, due to recent history, a lot of the high-tech happenings just aren’t in the countries that have IP boxes (it’s debatable whether China has an IP box, by the way), so the competition is still focused between countries with a higher high-tech stock like the USA and smaller countries trying to gain a foothold.

Claim: A lowered tax rate on IP-related profits would lead to increased research and development

First, remember that the lower rate on patent-related work isn’t about research at all. We’re not using tax revenue to fund the NIH or NSF, we’re lowering tax revenue to encourage patenting.

As for development, we already have some incentives that are proportional to the level of research and experimentation. The IP box incentive is proportional to the level of profits associated with R&E. The extra steps of finding associated profits give wide latitude to game the system. If you associate profits with R&E (taxed at 10%) but associate expenses with ordinary profits (taxed at 35%), you can score a negative tax rate from adding a profitable business line. If you contract out your lab to a bigger firm with a larger scale of profits (something that can be done entirely on paper), the bigger firm gets more IP box benefit, and then you can split the savings. The third part of the paper brainstorms all the ways you can game an IP box without doing additional bona fide research or development. It was fun to write.

Claim: An IP box leads to an overall lower corporate tax rate.

This claim is true. But the right way to lower corporate tax rates is to lower corporate tax rates, rather than producing something that can be gamed like crazy, would only win patent assignments back from Ireland if Ireland somehow was unable to respond, and is likely to distort behavior in many ways unrelated to expanding human knowledge.

Hiding at the bottom of the stack

You will recall from the discussion of the mortgage interest deduction that where a credit or deduction appears on the tax form can matter deeply for how it works in practice. To some extent, it reveals how high-priority the law is.

The pros refer to this as the stacking order. Something low on the order gets taken into account after everything else, and so may demonstrate funny interactions and side-effects with items earlier in the order.

As I covered over the course of two columns, Form 3800 lists a few dozen credits, but the total general business credits one can take are limited. The first two pages of Form 3800 calculate that limit, so it’s complicated, but let’s just say that the credits are limited to 25% of taxes otherwise owed.

So say that you have 300k in investment credits, 300k in low-sulfur diesel credits, and 100k in miner rescue training, but are limited to taking only half a million in credits.

This is where the stacking order comes in. You are deemed to have taken the 300k in investment credits, 200k in diesel credits, and that’s it. The rest (100k diesel, 100k miner rescue), you can carry over to next year and maybe use then.

This means that, in practice, the credits at the bottom of the stacking order are less likely to be taken.

The difference between a credit taken and a credit not taken can be subtle. As far as the taxes for the business this year go, all that matters is that credits were taken, not what their names were.

If the firm has the same finances next year, it’ll claim the same higher-in-the-stack credits, and over time it may wind up carrying an increasing amount of diesel credits. Recall how past losses can carry over and eventually be used, or make the company a more valuable asset. The same is true of a firm carrying unused credits, with the caveat that companies that are already hitting their limit on credits have no need for more.

Or, the credits may just atrophy. They aren’t inflation adjusted, and so lose value the way anything else earning 0% interest will. Or, Congress may cancel the credit entirely. Many of these credits are renewed every year, so if Congress forgets to do its homework, or the miner rescue industry loses favor, the credit is cancelled and it’s unclear what happens to potentially years’ worth of saved-up credits.

On the other side, credits carried forward have no real, present cost. That means that the earlier credits look bigger to Congressfolk and pundits. When you read CRS reports listing total costs for different credits, a credit carried over has zero cost, so it’s the higher-up credits that are brighter blips on the radar.

In short, credits at the bottom of the stacking order are cheap, economically and politically.If you’re feeling positive, this means that the credits are very well-targeted: small companies that fit the quirk the credit addresses will get their credit, while big companies exhaust their credit usage by the time they get to line 1c, so any carryover from the credit on line 1y effectively drifts away.

This is the eighth and last essay in a series on tax subsidies that divide the population between people who benefit from the subsidy and people who have no idea that the subsidy exists (which started here). Now you know where to find a few dozen of these sorts of subsidies, and see how the system is built so that even in the cost accounting, they maintain as invisible a presence as possible.

The problem of incentivizing nothing

Maybe this will sound obvious, but it is impossible to offer a tax credit on money nobody spends. This basic fact creates noticeable distortions in the landscape of the tax code.

Say that the Planning Committee has determined that sugary drinks are bad for you. One approach (`the stick’) is to tax drinks with high sugar content. One (`the carrot’) is to give a tax credit or subsidy for buying drinks that substitute away from sugary drinks, like low-calorie soda or carrot juice.

Setting aside Tang,  sugary drinks do not live in a vacuum. Perhaps last year the Planning Committee initiated another set of tax subsidies to handle malnourishment, and recognizing that carbohydrates are a necessary nutrient and that sugar is a pure form of carbohydrate, set up a tax subsidy for sugar.

At the end of it all, the only people not getting some sort of tax subsidy are the people who don’t buy drinks. If you’re drinking tap water, buying two boxes of tea a year and calling that your beverage budget, growing carrots and juicing them yourself, then you are outside of the economy, and there’s no way for a tax subsidy to reach you.

To give another example, my local electric company will pay a not-negligible subsidy to people who agree to install a smart thermostat that slows down their air conditioner during peak demand periods. Except I’m ineligible, because my house doesn’t have an air conditioning unit at all. It may be cost-effective for me to install a cheap unit I never use so I can score the subsidy.

In those situations where there is a `sinful’ form of consumption, the first best outcome is to simply not consume, but not consuming can’t receive a subsidy. The second best is lite consumption, and this is where the tax code is able to nudge people.

Last time, I went over some of the more interesting credits on Form 3800 (PDF), but the bulk of the credits are energy-related:

1f renewable electricity, refined coal, Indian coal production
1l biodiesel, renewable diesel
1m low sulfur diesel
1o nonconventional source fuel
1p energy efficient home
1q energy efficient appliances
1r alternative motor vehicle
1s Alternative fuel vehicle refueling property
1y Qualified plug-in electric drive motor vehicle
4c Biofuel producer
4e Renewable electricity, refined coal, and Indian coal production again

There are a lot of fuel taxes (Form 720), but use Form 4136 to get a zero tax rate for certain uses of gasoline, undyed diesel, undyed kerosene, kerosene used in aviation, liquefied petroleum gas, compressed natural gas, liquefied hydrogen, Fischer-Tropsch process liquid fuel from coal (including peat), liquified fuel or gas from biomass, liquified natural gas, and diesel-water fuel emulsion blending.

And lest you worry that only the petroleum alternatives are getting the credits, I enjoyed this overview of the subsidies that oil extraction companies receive (PDF).

At this point, it is hard to imagine a U.S. motor whose operation is not somehow subsidized by the federal government.

Of course, if you run a fleet of bike taxis in San Diego, where the weather is always so perfect that your office needs neither a/c or heating fuel, there are no credits for you.

In total, the incentives on Form 3800 are consistent with the story I told above: you can’t incentivize doing nothing, but you can incentivize consumption lite, like buying efficient appliances and renewable diesel. More on reading these incentives next time.

The commune

An alternative hypothesis is that the goal of the code is not to shape society for some undefined better, but to push its members to move.

In a world where the only businesses are wholly self-sustaining yogic meditation communes, where everybody drinks juices made from fruits and veggies in the garden and they burn the cow’s manure on chilly nights, no money is exchanged and so GDP is zero. If your goal is maximum GDP growth and all you have are people who are blissfully self-sustaining, you have to find a way to get people to move. To modify a standard example, if you can get the people in commune A to water the plants in commune B for $10,000/year, and get the people in commune B to water the plants in commune A for $10,000/year, then the commune members are doing no additional work besides walking next door, but GDP is up $20,000/year (and tax rates follow accordingly).

My commune example may sound far-fetched, but more and more of the economy is about information, which is relatively costless to move, using open source or free-to-use software. The person who runs Pinboard broke down what he pays to run the web site that is his livelihood. He pays for four Amps a month. Doing some back-of-the-envelope math, four Amps at 110 volts for a month comes out to 317 kWh. For reference, my household of four people used 185 kWh last month, so this person’s entire business uses as much energy as two residential households. He’s not running a commune off the grid, but just about any business based on moving physical objects or maintaining a storefront or sending people around on frequent flights will show a greater mark on the GDP accounts.

By this reading, the basic message of the tax code is not that you should use energy efficiently, but that you should use energy. Form 3800 is consistent with this story as well.

Fun with Form 3800

This is part of a series on Form 3800. I started with this piece about how much the public can or should learn about obscure details of law, followed by this piece about laws that divide the population between people who directly benefit from the credit and people who have never heard of the credit. This section provides examples of such laws, diving into Form 3800 (PDF) itself.

The first two pages Form 3800, General Business Credits, are largely an equation stretched out over two pages, because IRS assumes that everybody does their taxes with an abacus. Skip to Part III on page three, which is the list of tax subsidies.

Each line is its own story. If I had a class of 36 or fewer students, I’d give each student one line to dig into.

Line 1u is miner rescue training credits, because apparently companies underinvest in the training to rescue their employees in case of disaster.

Line 1n is a credit for wholesalers on every case they buy of distilled spirits bottled in the U.S.

There is a class of investment corporation aimed at low-income areas, with community members on the board. These corporations get a credit on Line 1i, “new markets”. Unpacking the IRS description of low-income areas of the U.S. as “new markets” is an essay that will have to wait for another day.

Does your business have fewer than 30 employees, and do you have to comply with the Americans with Disabilities Act, because it is a federal law? Line 1e will help you out. It also covers recording books on tape and other steps toward a more accessible world, as long as they are by a small business.

Are you a smaller railroad company (not one of the big seven) who has privately-owned facilities that you use to operate your business? Great, line 4g will help you out.

Does your company do research and experimentation (R&E)? It probably does, given that those broad terms are left undefined in the US Code, though please bear in mind that this credit applies to “research or experimental expenditure only to the extent that the amount thereof is reasonable under the circumstances.” First, you get to expense your investment instead of depreciating it (on Form 4562). It’s too boring for news coverage, but minor changes in depreciation rules can have a massive effect on what corporations pay in taxes, and the rule that R&E depreciates immediately is at this point a relatively major part of the tax code.

Second, did you increase your R&E spending this year relative to years past? That too merits a tax credit, on line 1c.

It’s up to you if you want to be outraged that these carve-outs exist, or delighted that there are subsidies in place for helping the disabled get to work, providing childcare facilities for employees (line 1k), and making wholesale purchases of Skyy vodka. My joking descriptions aside, I don’t want to make thumbs-up or thumbs-down judgments here.

But I’m betting that you didn’t know that these credits even exist. Yet here they are, clearly listed on page three of Form 3,800. You can see that it’s an active page, with spaces for new credits and blanks for elimination of old credits (like line 1v, which was a credit for theft prevention measures on fertilizers and pesticides). It’s certainly a long list, with line one alone going all the way through the alphabet to part 1bb. Check the instructions to line 1zz for the list of credits that have been dropped in recent history, like Hurricane Katrina-related credits, which is not nearly as long.

How an ostensibly universal deduction excludes lower income taxpayers

Some tax subsidies survive by dividing the population into those who benefit from the subsidy and those who have never heard of it. The mortgage interest deduction survives by going in the opposite direction: it benefits so many people that it is largely impossible to eliminate.

It doesn’t benefit everybody: you clearly can’t take the mortgage interest deduction (MID) if you don’t have a mortgage. And people who get a smaller mortgage may have such a small MID that the deduction provides no benefit. As you may recall from filling in your 1040, taxpayers have a choice of either itemizing deductions (including the MID) or taking a standard deduction, which is $6,300 for a single person with no kids and twice that ($12,600) for a married couple. So if you’re married and you have $12,000 in mortgage interest that you want to deduct and nothing else to itemize, then you’re better off eschewing the MID and taking the standard deduction. Total MID benefit: $0 reduction in taxable income. If you have $12,700 in interest to deduct, you’re now an itemizer taking the MID, but you can only itemize if you give up your $12,600 standard deduction. Total MID benefit relative to not having a mortgage at all: $100 reduction in taxable income (0.8% of the interest paid).

Conversely, consider a family that has large business expensess, or already has an existing mortgage on their first house, so that they started itemizing deductions long ago and the standard deduction is a distant memory. If they take out a new mortgage with $12,700 in interest, then their taxable income falls by $12,700 (100% of the interest paid).

In practice, few people making under $50k/year take the deduction to any great effect. This is a tax subsidy primarily for people who can afford expensive houses and have good enough credit to get large mortgages.

A chart of MID benefits claimed by income. Very little is claimed by those under $50k. Conversely, most of the people with severe housing cost burdens have incomes below $50k.

The mortgage interest deduction primarily benefits those who can afford more expensive houses.

In fact, in terms of encouraging home ownership among those making less money, consider a situation where one family wants to bid on a house, but knows that, as above, the extra $1,000/month in mortgage interest won’t be worth deducting. For another family bidding on this house, the purchase would be their second mortgage, so they will take the full MID, and on the bottom line of the tax form save $3,000 on their taxes every year for the next thirty years. Given that subsidy, they decide to raise their bid by $10,000. Thanks to the mortgage interest deduction, the lower-income family stands that much less of a chance of achieving homeownership.

The price of comparable houses is probably the foremost factor in how home prices are valued. So after this house sold for $10k more than it would have without the MID, expect the neighbors to tick up their asking prices—even in situations where none of the bidders are expected to use the MID. Soon every house will be more expensive than in the world without the MID subsidy, meaning that it will be that much more difficult to buy a house without some sort of subsidy.

There are proposals to solve some of the asymmetry between the two families by making the mortgage interest deduction a credit. There are different ways to put a credit on the tax form, but for now we’ll just assume that it is a separate space from the standard deduction, allowing people to take both. This article (the one I copied the above bar chart from) goes into great detail on many variants of the deduction-to-credit option. In each, the family with $12,700 in mortgage interest payments would first deduct the $12,600 standard deduction, then deduct the full $12,700 as well, not just the sliver past the standard deduction.

The deduction-to-credit trick could be done with any deduction, by the way, so you’ll often find politicians propose to give a tax cut to the poor by shifting something or other from the list of deductions to the list of credits.


Even if you own your house mortgage-free, or you got over the hump and bought with no tax benefits, the price of your most valuable asset is bolstered by the mortgage interest deduction. If the deduction were eliminated, your house price would suffer. [If your plan is to sell your house and buy a more expensive home, it would basically be a wash, but people tend to not be so subtle in their thinking, and there can be complications.]

The National Association of REALTORs, which represents a group of people whose pay is calculated as a percentage of house price, has this official position: “The mortgage interest deduction (MID) is a remarkably effective tool that facilitates homeownership. NAR opposes any changes that would limit or undermine current law.”

So there are people who indirectly benefit from the subsidy, and people who directly benefit from the subsidy. And on the other side, the only people who wouldn’t see an immediate loss from the elimination of this subsidy are renters who for some reason never want to be home owners [let me tell you about my ritzy Velux skylights that leak every time it rains…].

There are two points to take away from this. First, order matters deeply in the design of tax incentives. The one-sentence version of the subsidy (you can deduct mortgage interest from your taxes!) sounds equitable and potentially beneficial to families at the bottom end of homebuying. But because of the exact positioning of the deduction on the tax flowchart, low-income families and those with smaller mortgages get almost no benefit from this subsidy.

Second, regardless of the original motivation, regardless of whether the mortgage interest deduction actually improves homeownership rates despite its complete ineffectiveness among the lower-income people most on the homebuying fence, regardless of whether home ownership is even something the federal government should spend billions of dollars encouraging, the deduction exists and is self-sustaining. The price of every house or condo in the United States takes into account the subsidy on the mortgage virtually every buyer will take out, and it is difficult to eliminate in direct proportion to its upward distortion of prices.

Why failing startups that do stupid things get bought for millions

Year zero. Your hip new startup—it’s like Uber, but for trees—just got off the ground, and lost a million dollars. On the plus side, it had no taxes. Year one: it took off, and made three million bucks. Your company is allowed to carry over the losses from the prior year, so that the reported taxable profits in the second year are only two million. This story of a company that loses in its first years and then starts gaining is a common one, but any year that a company records a loss means that next year’s taxes will be a little lighter.

Bolstered by your success, wealthy investor Eva Peronosi gives you $3 million to develop your new startup. It’s like, but with more square dancers. Year zero: lose a million dollars. Fine, but year one: lose another million. Year two: lose another million dollars, and go out of business. You call a friend at Multinational Business Ventures, and ask MBV to buy your company, which is like but with more square dancers.  Naturally, MBV offers to pay a million dollars for your startup.

After MBV buys your company, your $3m loss carries over to the now-parent company, and they can use it to lower their business expenses. If their balance sheet showed $30 million in profits after the purchase, then your $3m loss turns that into $27 million in taxable income. With a corporate tax rate of 35%, a $3m reduction in MBV’s taxable income equals a $1.05m reduction in taxes. Taking into account the million it just paid, and MBV saved $50,000 by purchasing a worthless asset.

To whom the million dollars MBV paid depends on contracts, existing debts, and other such details we could only guess at. But Eva got where she was by making sure that payments like these go back to her. With a corporate tax rate of about a third, Eva can always gets back a third of her losses by selling the company and its carried-over losses. The papers said Eva bet $3m on your project, but if the existence of a $3m loss is itself worth $1m, then she really only put $2 million on the line (which is still more than I’d put on a gamble…).  And as per the title of this post, when you read about a company that got pounded in the market getting bought anyway, this carryover of losses has to be at least part of the buyout story.

Is there a conservation of tax liability, like the conservation of energy, so that when one body subsumes another, it absorbs all its liabilities? Is a corporation a “going concern” that has an annual tax check-in, or can we treat it as a new corporation every year?  That MBV bought a worthless company for big bucks is certainly odd, a distortion of market behavior caused by the tax system, but it is the product of not-insensible answers to these questions about the meaning of a corporation.

Why people tip in US restaurants

Here, I’ll discuss a tax incentive by the federal government to encourage bosses to have employees paid via tips instead of a typical wage.

The waitress is the only person who knows how much she got tipped. [I flipped a coin to write this example, and she came up female]. And, unless she’s in the narrow band where EIC (earned income credit) kicks in, she pays out a tax on those tips and so wants to understate her tip income.

Typically, employers pay payroll taxes on income, meaning social security tax (6.2%) and medicare tax (1.45%). In such a case, her boss would be very OK with her under-reporting her tips.

To give a more precise example, say that the boss pays the waitress the minimum wage, but she takes home $20/hour in tips on top of that. She works a typical full time of 2,000 hours/year, so she takes home $40,000 in tips. Payroll taxes, totalling 7.65% of $40k, would be $3,060. That’s a $3,000 incentive for the boss to write down a small number on the waitress’s W-2.

For the IRS, the big problem is the waitress. Reporting herself at minimum wage, she gets a refund of $689 (thanks to EIC); reporting all income, she pays $6,906; for a total swing of $7,595. So the IRS’s goal in this game is to get the waitress to pay taxes, in opposition to the goal of both the waitress and the boss. If you expect that the waitress is making less money than the business owner, then this is a case where the IRS does better going after the poorer person.

The official record of tips is not what the waitress says she has in her apron at the end of the day, but the W-2 that the boss prepares. So the IRS offers the boss a credit on payroll taxes. Whatever tip income the waitress reports (past minimum wage), the boss pays zero payroll taxes.

[Formally, he pays the payroll taxes, but then reclaims the taxes as a credit when he fills in his annual taxes. I’ll get to how this can create some exceptional cases later, but in the typical case, this is a full refund of all payroll taxes associated with above-minimum tips.]

Form 8846: Credit for employer social security and medicare taxes paid on certain employee tips

I asked myself, what’s the most exciting image I could put on this blog about restaurants and waiters?

With this arrangement, the boss is a neutral party, and has no reason to tell the waitress to hide her income or lie about it himself when he prepares her W-2. There may also be incentives in how the restaurant operates to get her to be forthright about her tips.

Next year, the owner reads this enthralling series of articles about no-tip  restaurants, and decides that he’s going to do it: instead of expecting customers to calculate 15 or 18 or whatever percent, he’s just going to add 18% to the price listed on the menu. Customers eat, pay what the menu told them to pay, and leave. The waitress gets paid $25 for an hour of work, and if the business does badly or well it’s the boss’s risk, not hers. When it was a tip-oriented restaurant, the waitress always knew that if she was an inexcusable slacker and ignored tables, the boss would fire her, and that doesn’t change once she’ll be getting a fixed wage like everybody else with a job. Say goodbye to customers who think 15% of $50 is $5, explaining to Europeans that they shouldn’t leave the tip line blank, all the weirdness about splitting tips between the waitress and the kitchen, all the creepiness of customers who think they own the waitress and can be jerks because they’re leaving a $5 tip, it’s all delightfully out the window.

So he calls his accountant and tells him that everything is going to be a lot more simple from here on in. And his accountant points out that simplifying the experience for his customers and employees is going to cost $3,000 per waiter per year in un-refunded payroll taxes. Our imaginary restauarant has five waiters, so the owner has to decide whether his experiment is worth an up-front loss of $15,000/year. Knowing the margins of the restaurant business, and knowing the limits of how many expenses can be passed on to somebody buying a ten dollar burger, that ends the story right there.

The tip credit is a clear incentive for a custom that a lot of people would be fine seeing gone. If tipping were not a concept today, it’s hard to imagine a restaurant pitching customers that they’ll have a better time because they can pay less for food but must leave a variable wage payment on the table. The credit is an incentive for compliance, where in most parts of the tax code the only incentive for compliance is that you won’t get arrested. As we’re drifting toward an economy where every payment involves electronic access to an account, it seems that the problem of under-reporting of tips is on its way to obsolete. But the tip credit is a nice example of the sort of tax that divides the population into restauranteurs who benefit from the tax and everybody else who has no idea that the tax exists, so it is unlikely to go anywhere any time soon.