Principles andPractice of Tax

ReformTransition

BY J .D. FOSTER, PH .D.EXECUTIVE DIRECTOR AND CHIEF ECONOMIS T

TAX FOUNDATION

Sinc e1937

TAXIFOUNDATION

MARCH1998

BACKGROUND PAPER \O . 23

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Principles andPractice of Tax

ReformTransition

BY J .D. FOSTER, PH .D .EXECUTIVE DIRECTOR AND CHEF ECONOMIS T

TAX FOUNDATION

Since1937TAXIFOUNDATION

MARCH1998

BACKGROUND PAPER I \O .

©1998 Tax Foundation . All rights reserved .

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Table ofContents

Introduction 1

Transition Principle One 2

Retroactivity and Tax Fairness 3

Retroactivity and Uncertainty 3

Constitutionality 3

Economic Windfalls 4

Second Principle of Transition : Simplification 6

Specific Issues in Transition 7

Grandfathering Existing Treatment 8

Orphaned Tax Assets 9

Past Investments, Future Income 1 0

Conclusion 1 1

Endnotes 11

IntroductionThe problems that have ledAmerican s

to turn thumbs down on the current incom etax system are now well known . Taxpayer sperceive it to be unfair. It is too complexfor both tax payer and tax administrator. Thecomplexities lead to unreasonable compli-ance costs and great uncertainties . The in-come tax hinders saving and investment andgenerally leads to an inefficient allocatio n

of resources. Thus it stunts job and wag egrowth and ultimately weakens the abilit yof American companies to compete in worldmarkets .

Likewise the principles that haveguided the authors of most tax reform pro-posals are equally well established . The taxsystem should be simple . It should be fairaccording to some consistently applied stan -dard of fairness. And it should be as eco-nomically neutral as possible so that the ta xsystem does not diminish the economy' sability to yield as many benefits as possible .

While the principles underlying tax

reform are well established, the principle s

underlying the transition from the existin g

tax system to a new system are not . The"transition issue" is often left as an after-thought to be handled later by technicians .Transition applies to the tax treatment o factivities and arrangements entered intobefore a new tax system is adopted . It doesnot apply to activities undertaken after th eadoption of the new tax system .

Whether politically appealing or not ,tax reformers must eventually come t oterms with a very long list of transition is -sues if tax reform is to evolve from campaignissue to reality. Rather than procrastinating ,tax reformers ought to address these issuesearly and directly. Doing so could providetax reform with extra momentum. Manyconcerns raised about fundamental tax re-form have more to do with the tax treat-ment of existing economic arrangementsthan with how such arrangements woul dfare under the new tax regime .

Compared to the great issues of policyguiding tax reform, at first blush there seem

to be no great principles of economic polic yor ideology at stake in transition issues . They

can be messy and complex . And their solu-tions are often expensive in that they shrinkthe tax base temporarily, possibly necessi -tating an unpopular higher tax rate to main-

tain a given level of tax collections .There are, however, at least two grea t

moral and economic principles involved i n

developing transitions rules — the need to

avoid the confiscation of wealth and incomeinherent in retroactive taxation and, con-

versely, the need to avoid through retroac-tive tax relief the creation of economic

windfalls . Without proper transition rules ,tax reform can become tax burden roulette ,yielding tremendous windfalls to some andimposing significant, retroactive tax in -

creases on others . Such consequence s

would violate the letter and spirit of tax re-

form and could ultimately doom it in a cloud

of confusion and opposition even fromthose who would otherwise support it .

In addition, there is a vital economic

imperative to developing a working transi-tion regime. Simply put, without such aregime the economy could suffer severeeconomic disruptions in the year or twoprior to the enactment of any new tax sys-tem. For example, suppose the new tax

system were to allow businesses to deduct

the full cost of their purchases of plant and

equipment in the year in which they wer e

purchased. Under current law, of course ,

businesses must generally deduct these costs

over some specified number of years . Sup-

pose tax reform included no transition rule s

for the costs of plant and equipment pur-chased in the years prior to tax reform' s

enactment . In this case, business invest-ment would decline dramatically, beginnin gas soon as tax reform appeared likely, andwould virtually cease in the months prior

to tax reform's enactment.

Similarly, the sale of homes woul d

come to a standstill as tax reform became

more likely if homeowners were unable t o

continue to deduct their home mortgag e

interest on existing mortgages . Businesseswould practically cease to borrow becaus e

1

interest, deductible under current law ,

might not be deductible after tax reform .In short, the economic results of failing toprovide transition could be calamitous . And,if the very prospect of tax reform absenttransition rules would harm the economy ,and if this is portrayed by its critics as a re-sult of tax reform itself, then fundamenta ltax reform could not possibly proceed .

Transition Principle OneThe principles of tax reform establis h

a clear framework for the new tax system.The process of establishing transition rules

requires the development of a similar refer-ential framework . A proper framework willguide the discovery of areas requiring tran-sition rules and the formulation of thos e

rules. The backbone of this framework fo rtransition must be to protect taxpayers fro m

financial harm and to avoid economic wind-

falls resulting from tax reform . While thereare limits to the extent to which this prin-ciple can be practically applied, and thereare surely other principles to add to this firstprinciple, the ideal result of transition would

be to impose the same amount of tax on ataxpayer's pre-existing arrangements as th etaxpayer would pay had tax reform not oc-curred .

Taxpayers enter into economic ar-rangements assuming a whole panoply o f

conditions and factors ranging from the ex -

pected performance of the overall economyto developments in their personal situations .

Included in these factors are the full range

of government policies that may come tobear. Foremost of these for our purposes i sthe expected tax treatment of the transac-tion. All the economic activity, all the in -vestments, and all the contracts entered intobefore a new tax system is adopted wer epredicated on the operation of the curren tincome tax . A taxpayer buys a house as-suming he will be able to deduct the inter-est on the mortgage . A business purchasesnew machinery assuming it will be able todeduct the cost of the machinery agains tfuture income according to a prescribed

schedule. An investor purchases equities

assuming she will owe tax on dividends and

capital gains received . To be sure, in som ecases the taxpayer may suffer some uncer-tainty as to the precise tax treatment, an din others the taxpayer's understanding maybe inaccurate. Nevertheless, in the vas tmajority of cases the tax treatment is rea-sonably well known and certain, assumingno change in the tax system .

When any of the aforementioned ac-

tivities are undertaken after tax reform, th e

tax consequences may be quite different

from what they would have been under th e

income tax . Indeed, taxing each of thes e

activities in a more economically neutralmanner is a fundamental goal of tax reform .Taxpayers are sure to face altered market sand new incentives under a new tax syste mand they are sure to alter their choices base d

on this new information . The important

point here is that taxpayers will have th e

opportunity to determine these conse-quences before entering into arrangement s

once tax reform is enacted .In contrast, taxpayers who enter into

contracts and other arrangements prior totax reform do so on the basis of the existin gtax system and its effects on prices andmarkets . Applying the new tax rules to th eold arrangements can impose a much highe ror a much lower tax burden on these ar-

rangements. When the tax burden is muchhigher, it is a case of retroactive taxation .When the tax burden is lower, it is a wind-

fall . Neither windfalls nor retroactivity areappropriate consequences of tax policy ortax reform. Thus, the first principle of taxreform transition :

• Transition rules should prevent in-sofar as possible instances of retroactive

taxation or retroactive tax relief.

Avoiding retroactive taxation is a ba-sic principle of sound tax policy. The Con-gress deemed it sufficiently important tha tit is now codified in Internal Revenue Ser-vice regulations . In 1996, as part of the Tax-payer Bill of Rights 2 (H .R. 2337), the Con-

2

gress established that the effective data o fany temporary, proposed, or final regulationmay not be earlier than the date the regula-tion is published in the Federal Register . '

Retroactivity and Tax Fairness

Retroactive taxation is to be avoidedunder any sound tax system, but especiall yin the context of tax reform. An over-arch-ing principle of tax reform is tax fairness .

Tax fairness is certainly a term of artdefying universal definition. It is, however,

hard to overstate its importance. When atax system is perceived as unfair, tax com-pliance falls, tax revenues fall, and citizenswho choose not to comply fully are know-ingly breaking the law. As resentment to-ward a tax system increases, this resentmentsoon spills over to a general dislike and dis-trust for all government institutions .

Although a universally accepted gen-eral definition of tax fairness has yet to b efound, certain aspects of tax fairness can bereadily discerned. For example, it is fair tha tsimilarly situated taxpayers should pay simi -lar amounts of tax. (Of course, definingwhat one means by "similarly situated" ca nget tricky.) Another, more certain, aspec tof a fair tax system is that changes are ap-plied on a prospective basis only. Taxchanges applied retroactively are obviouslyunfair. Changing the tax rules retroactivelyis equivalent to changing the rules in th emiddle of the game . If tax fairness is a moti-vation for tax reform, then tax reform shoul dnot create a new dimension of unfairnessthrough poorly designed transition rules .

Consider, for example, a family thatbuys a home expecting to be able to deduc tthe interest on the mortgage. Suppose theinterest amounts to $1,000 a month and th efamily pays federal income tax at a 28 per-cent marginal rate . If the result of tax re-form is to eliminate the mortgage interes tdeduction even for pre-existing mortgages ,then this family would face a $280 permonth increase in its housing costs . Thiswould be unfair.

Retroactivity and Uncertainty

There is an important economic di-mension to retroactivity as well . Due largely

to its complexity, taxpayers are often uncer-tain about the operation and administratio n

of the existing income tax . Sometimes thi suncertainty is with respect to a specific as-

pect of the tax code and its application to a

specific activity or investment. Sometimesthis uncertainty relates to a general uneas eabout the tax system. Virtually every eco-nomic activity carries with it a degree of riskof loss or unmet expectations . In general ,riskier endeavors require higher expected

rates of return . For example, for financialinvestments the market has developed rig-orous means of evaluating the relative risk s

of different investment options and price s

them accordingly. Higher risk investmentsrequire the expectation of higher returns .

A greater sense of risk stemming from un-certainty about the possible tax conse-quences of an activity will usually mean th etaxpayer will require a higher rate of return .

To the extent taxpayers require higher

returns on their activities due to a general

uncertainty about the tax consequences, th e

range of activities they are willing to uncler-

take decreases . Heightened uncertainty

about taxation reduces the amount of eco-nomic activity. This is an argument for taxreform (that taxpayers would have greate rconfidence in their understanding of the ta xconsequences) and for subsequent stability.

To the extent taxpayers believe they maybe subject to harsh and retroactive ta x

changes, this prospect further enhances th eperceived riskiness of their activities and s ofurther reduces the amount of economi cactivity . Every instance of retroactivitystrengthens the prospect in investors' mindsthat the Congress may apply taxes retroac-

tively in the future .

Constitutionality

In addition to the unfairness and ba deconomics of retroactive taxation, there i sa serious question of the constitutionalityof retroactive taxation resulting from fun-

3

damental tax reform . In recent years, theSupreme Court has indicated that it will only

consider challenges to retroactivity on th ebasis of violating the Due Process Clause o f

the Fifth Amendment . The Due Proces sClause simply states that no person shall"b edeprived of life, liberty, or property with -out due process of the law." Since retroac-tive taxation clearly involves a deprivationof property, the issue is what constitutes"due process of the law."

Whether the retroactive application o fa statute violates due process depends onthe finding as to whether the applicationwas "arbitrary and irrational" l The test ofwhether the retroactive application was ar-bitrary depends on whether

" . . . the retroactive application of astatue is supported by a legitimate leg-islative purpose furthered by rationa lmeans, . . ." Usury v. Turner ElkhornMining Co. (US 1976)

The more interesting parts of the testare the conditions under which enactingretroactive taxation is deemed irrationa lbehavior on the part of the legislature . Inthe Supreme Court's opinion in UnitedStates v. Carlton (1994), Justice Blackmu nnoted three cases from the late 1920s . Thefirst two cases (Nichols v. Coolidge andBlodgett v. Holden) held the imposition ofestate and gift taxes on transfers consum-mated before the tax provisions were pro-

posed in Congress to be an unconstitutiona ltaking. The third case (Untermyer v.Ander-

son) involved the imposition of gift tax on

a gift made while the statute was pendingin Congress, but before its enactment. Inthis third case the Court held the imposi-tion of the tax to be unconstitutional on thegrounds that "the taxpayer may justly de-mand to know when and how he becomesliable for taxes — he cannot foresee and

ought not to be required to guess the out-

come of pending measures ." Justice

Blackmun went on to point out that these

cases apply solely in situations involving " th ecreation of a wholly new tax." Thus, it

would seem clear on this basis that addi-tional taxes owed due to the imposition o fa new tax resulting from tax reform couldbe unconstitutional .

Justice O'Connor, concurring in theCourt's judgement in Carlton, also empha-sized the length of the retroactive reach inassessing whether the means employe d

were rational. She noted that, in previousrulings in which retroactive taxation wa sfound to be constitutional, the retroactiv ereach was "confined to short and limite dperiods." Specifically, she concluded :

A period of retroactivity longer thanthe year preceding the legislative ses-sion in which the law was enacte dwould raise, in my view, serious con-stitutional questions .

Justice O'Connor went on further t o

pose her own rationality test :

The government interest in revisingthe tax laws must at some point giveway to the taxpayer's interest in final-ity and repose .

Against this proposition she concluded

that a "wholly new tax" could not be im-posed retroactively because it would be "ar -

bitrary to tax transactions that were not sub-ject to taxation at the time the taxpayer

entered into them ." Thus, tax reform tha t

would otherwise increase the tax burden

on existing transactions would appear t o

violate the Due Process Clause of the Fifth

Amendment unless there were some mate-rial, mitigating circumstances .

Economic Windfall sRetroactive taxation, the changing of

the rules as they apply to pre-existing ar-rangements so as to increase the tax bur -den, is unfair and is equivalent in nature tothe expropriation of income and wealth .The reverse of retroactive taxation, namelytax reform-created windfalls are also inap-

propriate and unfair, though obviously for

different reasons . These windfalls arise

4

when certain activities or investments, sub-ject to tax under current law would face alower rate of tax or would be tax free un-

der tax reform . A simple example of such a

windfall arising with a taxable bond is pre-sented in Example 1 .

Example 1

Suppose a bond pays 10 percent in-terest for 20 years, was purchased fo r$1,000, and that its owner is subject to acombined federal and state tax rate of 30

percent. In after-tax terms, this bond yields

its owner a 7.0 percent annual rate of re -

turn. In buying the bond the taxpayer fig-ured his or her return on an after-tax ba-sis and concluded that $1,000 was a fai r

and reasonable price given the bond's riskcharacteristics. Now suppose, after pur-chasing the bond, that a new tax system is

introduced and that the new system does

not impose tax on interest income. The

bondholder then receives an after-tax yield

of 10 percent and the price of the bond

would rise automatically to $1,318 .

Through the enactment of a new tax sys-tem, this bondholder has received a wind -fall of $318 on a $1,000 investment.

Taxes on capital income and principal

greatly reduce the ability of the economy

to create new jobs and higher wages. They

do this by raising the cost of capital to in-

vestment. The cost of capital increases to

cover the taxes and still yield investors a

satisfactory after-tax return . Thus, capital

income taxes, by increasing the cost of capi-

tal, reduce the desired stock of capital em-ployed .

When a taxpayer evaluates a potential

investment, the taxes that would be due play

an important role in determining whether

the investment is likely to yield a satisfac-tory after-tax return . If the taxpayer make sthe investment, he or she has determine dthat the price of the asset is reasonable give nthe expected income streams and tax liabili -ties. At higher levels of tax, the price th etaxpayer is willing to pay would be lower ,and conversely at lower levels of tax the tax -

payer would be willing to pay a higher price .Consider again the case of the $1,000

20-year bond paying 10 percent interest . If

the taxpayer purchases the bond for $1,000 ,

he or she is saying that this is a fair and rea -

sonable price for the bond . Suppose, asabove, that the tax on the bond's interes t

income is waived and that the price of the

bond increases to $1,318. The entire

amount of the $318 windfall becomes the

property of the bondholder. A subsequent

purchaser of the bond would pay the cur-

rent going price of the bond, namely $1,318 ,

which now yields him or her an annual rat e

of return of 7 .0 percent . Thus, subsequent

asset purchasers would be indifferent be-tween buying the bond for $1,000 and pay -ing 30 percent tax on the resulting interes tincome, or paying $1,318 and paying no tax .

As this example demonstrates, the ful l

amount of the windfall becomes the prop-erty of the asset holders at the time of th e

change in tax policy — subsequent owners

receive none of the windfall .Most tax reform proposals would elimi-

nate the tax on capital assets. Thus they

eliminate the taxes on dividends, interest ,

and capital gains, and they eliminate the

estate and gift taxes . Every asset producing

a taxable stream of receipts to its owne r

under current law would yield that owner a

one-time windfall under tax reform . In to-

tal, this would amount to hundreds of bil-lions of dollars of tax windfall .

Tax reform-created windfalls are inap-propriate for a number of reasons . First ,

without appropriate transition rules tax re -

form would bestow these windfalls on som e

lucky citizens and not on others . If all citi-

zens benefitted from these windfalls uni-formly, then they would be far less trouble -

some .The second problem with these wind-

falls is that they only accrue to taxpayer s

with wealth prior to tax reform . Indeed,

the more wealth one has prior to tax reform ,the more windfall one would receive. Thisis probably the greatest political difficultyfor tax reform proposals lacking adequat e

transition rules: They would bestow enor-

5

mous windfalls on the wealthy. The follow-ing example illustrates both dimensions ofthe windfall problem .

Example 2

Consider two individuals with likeamounts of current and expected futureincomes. In looking for a better future fo rherself, Ms.Jones reduces her personal con-sumption expenditures to pay for addi-tional education specifically to increase the

value of her labor services. Mr. Smith als oreduces his consumption expenditures, buthe uses the proceeds to buy shares in amutual fund that invests in corporate eq-uities. If Ms. Jones and Mr. Smith receiveequal amounts of additional income fromtheir investments, then under current lawthey would pay equivalent amounts ofadditional tax. Whether this treatment iscorrect or not on a theoretical basis, th erelevant fact is that both of them madetheir decisions expecting a certain futuretax treatment.

Many tax reform proposals wouldeliminate the multiple taxation of saving andwould do so by shifting the tax burden ulti -mately on to labor income . At the individuallevel, for example, the Flat Tax taxes all la-

bor income and excludes from the tax bas eall forms of capital income such as dividend sand interest income, and excludes capita lgains . Suppose the Flat Tax were enactedsome time after Ms . Jones graduates . Un-

der the Flat Tax, Ms . Jones would continu eto see a rising tax burden as her educatio npays dividends in terms of higher wages . MtSmith, however, would reap a sure windfal las the taxes that would have been due onhis investments under the income tax areeliminated . Thus, we have two similarly situ -ated individuals, both of whom saved andinvested based on the existing rules of thegame. But the actual tax treatment of thei rinvestment is very different due entirely totax reform .

Tax reform that results in widesprea dtax windfalls would surely be welcomed b ythose receiving the windfalls . But all other

taxpayers would just as surely find the wind-falls to be unfair. This sense of resentmenttoward the new system by those left out o fthe windfall lottery would be enhanced bythe higher taxes that they would have t opay to underwrite these windfalls . Even iftax reform provides every taxpayer a tax cut ,those receiving windfalls would receivegreater tax relief and those not receivingwindfalls would receive less tax relief . Thi sdisparity is likely to be intolerable, especiallysince the wealthy would reap the greatestshare of the benefit .

Tax windfalls could be justified if theyproduced some salutary economic effect . Asa rule, no such effect exists . Consider onceagain Mr. Smith's windfall that resulted fromthe elimination of the tax on capital incomeand capital gains. This capital income an dgains result from pre-tax reform saving .Changes in tax law affecting the taxation o fsaving will obviously affect saving behavio rgoing forward, but just as obviously suc hchanges cannot affect decisions made prio rto the changes .

Second Principle ofTransition: Simplification

A chief goal of tax reform is to simplifythe tax system dramatically. This goalshould apply with equal weight to the de-

sign of transitional rules. The simplest tran -sition system would be to have no transi-

tion rules at all . This would obviously maxi -

mize the gain in simplicity, but it would alsomaximize the violation of the proscriptionagainst retroactive taxation and the creationof windfalls . Thus, there is often an inher-ent tension between the need to avoid ret-roactive taxation and the need to preservethe benefits of tax reform's simplification .The tension can often be relieved if we re -

member that simplification ought not be a

standard applied in a vacuum . Hence the

second principle of transition :

• Tax reform transition rules shouldbe as simple as possible, recognizing tha t

simplicity must be considered given the ar -

6

rangements the taxpayer has already under -

taken to comply with the income tax .

No transition system can be simple rthan allowing the taxpayer to continue touse existing compliance systems for thei rpre-tax reform arrangements . However,some tax reform proposals containing tran-sition rules would require the taxpayer toadopt a new set of tax rules on a going-for-ward basis and a second new set of rule sfor transition, jettisoning all the previous taxrules . A good example is the case of depre-ciation allowances .

Businesses generally deduct the cos tof their plant and equipment from taxableincome over many years according to sched-

ules prescribed by law. Thus, a business may

have hundreds of millions of dollars in as -

sets the costs of which have not yet been

deducted in calculating taxable income . For

a given company, the total of the amountnot yet deducted is sometimes called the

aggregate remaining basis . Under tax reformproposals adopting some form of cash flowtax or transfer tax at the business level, plan tand equipment purchased after tax refor m

may be expensed. That is, when a companybuys a new machine following tax reform ,

the company will be allowed to deduct thefull price of the asset from taxable incom e

in the year the machine is purchased . The

question then is what to do with the remain -ing basis from prior purchases of plant an dequipment .

One answer is to disallow any deduc-tion for the remaining basis of these assets .

While simple enough, this approach wouldviolate the first principle of transition, whic h

is to avoid retroactive taxation. The amount

and type of investments businesses are will-ing to undertake are often heavily influ -enced by the applicable depreciation rules .Eliminating the deduction for depreciatio nretroactively would directly increase the ta xon income produced by the underlying assets .

A second solution would be to allow

businesses to deduct immediately the ful lamount of their remaining basis on prior

years' investments . But there are two prob-

lems with this approach: It would dramati-cally reduce the size of the tax base, reduc-ing tax revenues and presumably necessi-tating a higher tax rate, and it would pro-duce an economic windfall because the cur-rent value of the deduction would exceed thepresent value of the deductions the busines swould have taken under current law .

Without question, the current depre-

ciation allowance system is complex and

compels taxpayers to develop sophisticated

accounting systems to track assets for tax

purposes. Recognizing this complexity andthe need for transition rules, some tax pro-posals have suggested applying alternate ,simpler depreciation rules to remaining ba-

sis . While well intended, these transitio n

rules would actually exacerbate the exist-ing complexity. Taxpayers spend large sum s

developing accounting systems to record

and track depreciation on their assets . While

wasteful and unfortunate, businesses have

already incurred these expenses and th e

systems are already in place . No transitionsystem could be simpler, then, than to al-low the taxpayer to continue to apply th eold depreciation rules to the old assets .Thus, to a first approximation at least, sim-plification and a proper transition rule go

hand-in-hand when the existing deprecia-tion is "grand-fathered" in this way . '

Specific Issues inTransition

If addressed on an item-by-item basi s

and if taken to the extreme, the number o f

issues requiring a transition rule could run

into the hundreds, if not the thousands . Theissues present a natural taxonomy, however ,which may greatly simplify the process .Under this taxonomy, the issues may b e

grouped according to whether :

1) A correct and simple solution is tograndfather the existing tax treatment forthose economic arrangements and activitie sundertaken before tax reform .

2) The existing tax code has create d

tax assets such as excess Foreign Tax Cred-

its for which there is no natural analog in

7

the new tax system and so grandfatherin gwould be ineffective .

3) The taxpayer has a claim on futureincome from currently owned assets and theincome would be taxed more lightly or no t

at all under the new tax system .

We shall next consider examples o f

each of these issues in turn . This discus-sion is intended solely to be illustrative ofthe issues involved and how certain solu-tions may or may not be appropriate .

Grandfathering Existing Treatment

The discussion above regarding depre -

ciation of existing assets under transition

demonstrated how grandfathering of prio r

tax treatment might be an appropriate tran -sition rule in some circumstances. Depre-ciation, however, is just one item on a long

list of provisions relating to costs incurre d

by a taxpayer that must be capitalized an d

deducted over a period of years under cur-rent law. There are many such expenses ,

including those associated with inventoryand research and experimentation .

Perhaps the most important expens e

for which grandfathering of previous treat-ment may be appropriate is interest expense

that is currently deductible . Recall the ex-

ample above of the homeowner expectingto deduct home mortgage interest expense .As the example showed, the loss of the de-duction would dramatically increase thi sborrow's costs .

Some commentators have noted tha tborrowers would receive some relief froma general decline in interest rates followin gtax reform. The implication they draw isthat transition relief for pre-existing debtmay not be needed . There are, in fact, soun dreasons to assume that the elimination oftax on interest income would cause inter-est rates on currently taxable debt instru-ments to decline (the price of the debt in-strument would increase) after tax refor msolely because of the elimination of the ta xon interest income . It is important to not ethat this change in interest rates is virtuallyautomatic and is not dependent on any

change in saving or investment behavior. It

results simply because an asset was pricedassuming the income from the asset wastaxable and it would no longer be taxableafter tax reform. For example, a bond thatwould pay 8 percent interest on a pre-taxbasis currently where the marginal effectivetax rate facing bondholders is 25 percentwould, if issued after tax reform, pay 6 per-cent interest .

While the decline in interest rates fol-lowing tax reform is important for futuredebt issuers, it offers existing debtors n orelief unless they are able to refinance thei r

debt at the new interest rates immediately

and costlessly. Instead, as with the exampleof the family with a home mortgage dis-cussed above, the loss of the interest deduc -tion for pre-existing debt would impose asevere financial hardship and would be un-

fair. It is therefore essential that any tax re-form eliminating the interest expense de-duction for businesses or individuals pro-spectively also grandfather the deduction fo rpre-existing debt .

Fortunately, unlike those instance ssuch as depreciation where grandfatheringprior tax treatment results in a temporarilyreduced tax base, grandfathering interestexpense is roughly revenue neutral . This i sbecause the tax on the interest income ac-cruing to the holder of the debt must als obe grandfathered to prevent'a windfall ac-cruing to creditors. Unfortunately, som esimplicity preserved through grandfatherin gis offset by additional complexity becaus ecreditors holding debt issued prior to taxreform must continue to report and pay taxon interest income from this debt . Theseissues are demonstrated in Example 3 below.

Example 3

Suppose a bank has lent a business

$100,000 to upgrade its machinery an d

charged 8percent interest on the loan . The

business purchased the machinery expect-ing to be able to deduct the interest expens e

while the bank expects to pay tax on its

interest income. For simplicity, supposeboth the business and the bank face a mar-

8

ginal tax rate of 25 percent, so that thebusiness is paying 6 percent interest andthe bank is earning 6percent, each on a nafter-tax basis. Now suppose Congressenacts tax reform, eliminating the inter-est deduction and the tax on interest in -come. The business's after-tax interest ex-pense and the bank's after-tax income theneach increase to 8 percent. In effect, taxreform has effected a one-time transfer ofwealth from the business to the bank. Ifhowever, both the business's interest deduc-tion and the bank's interest income fromthis pre-existing debt are grandfathered,then the business is held harmless and thebank receives no windfall — all with n onet effect on federal tax collections.

Orphaned Tax AssetsTaxpayers accrue many tax deduction s

and credits other than those listed above ,and for some of these items grandfatherin gmay not be a viable or sensible solution .Such items might well be termed orphanedtax assets. They are assets because to th etaxpayer they represent expected reduc-tions in future tax liability, which is finan-cially equivalent to an increase in after-taxrevenue. They are orphans because theremay be no simple, practical rule-of-thumbfor developing transition rules for such pro-visions .

A good example of a potential orphanis accrued foreign tax credits . Under cur-rent law, the United States imposes tax o nthe worldwide income of its citizens. Thismeans, for example, when a U .S. companyearns income abroad the U .S . taxes that in-come as though it were earned in the UnitedStates . Generally, foreign-source income i ssubject to a variety of foreign taxes, includ-ing foreign income taxes . To avoid doubl eincome taxation the United States employsa foreign tax credit . This credit allows tax-payers to use foreign income taxes paid asa credit against their U.S . tax liability aris-ing from foreign income. To prevent th etaxpayer from using the foreign tax credi tto offset U .S.-source income, the credit i slimited to the amount of tax the taxpayer

would owe if the income was U .S . source . 4An example of the taxation of foreign in -come and the Foreign Tax Credit is pre-sented below.

Example 4Suppose a US.-owned foreign com-

pany earns $2 million in manufacturingincome in Germany and pays $1 millio nin German income tax. The German in-come tax liability creates a potential $ 1million U.S. foreign tax credit. Suppose th eforeign company repatriates the income tothe U.S. parent company, thereby creatinga $750,000 U.S. income tax liability. TheUS. parent company would then apply$750,000 of its $1 million foreign taxcredit against the US. income tax liability,fully offsetting the US. tax liability. At thesame time the U.S. parent would lose theamount of the excess credit, namely$250,000 .

U.S. corporations frequently use par-tially- or wholly-owned foreign subsidiarie sto carry out their international operations .Just as United States incorporated entitiesare considered U .S. citizens for U.S . federalincome tax purposes, U .S.-owned foreignsubsidiaries are considered to be foreig ncitizens for purposes of foreign and U .S . taxpurposes. Consequently, as a general rulethe United States has no direct claim on anyincome earned by these subsidiaries until aU.S. taxpayer becomes involved, normallywhen the foreign earnings are repatriate dto the U .S. parent. Until such time as th eearnings are repatriated, the recognition o fthe foreign income and associated foreig ntax credits is generally "deferred" for U .S .

tax purposes .One of the advances in tax policy of-

fered by tax reform is that most proposalswould, in most cases, eliminate the U.S . taxon foreign-source income and the foreigntax credit . This change would dramaticallyreduce the complexity of the tax code an dthe uncertainty about how many transac-tions would be treated. It would also im-prove the ability of U .S . companies to corn-

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pete abroad . Unfortunately, eliminating th etax on foreign-source income also create ssome particularly difficult transition issues .For example, eliminating the tax effectivelyextinguishes accrued foreign tax credits fo rsome companies while simultaneously pro-viding significant tax windfalls for othe rcompanies .

When a company is in a net excess for-eign tax credit position, the value of its ex-cess credits is recorded as an asset on the

company's balance sheet . They are prop-erly treated as an asset because they reflecta reduced future income tax liability. If taxreform eliminated the foreign tax creditwithout some appropriate transition withrespect to accrued excess foreign tax cred-its, these assets would disappear. While thefederal government would not receive th eresources, from the company's perspective

tax reform would have extinguished som e

of its shareholders' wealth . Obviously, this

is just the sort of tax reform result demand -

ing transition relief.It is not immediately obvious wha t

form that relief might take. One optionwould be for the Federal government to paytaxpayers for their lost foreign tax credit sas though the taxpayers' loss was effectively

a "taking" resulting from tax reform . just

about the same result could be achieve dmore easily if companies with excess for-eign tax credits were allowed to apply thos ecredits against the U .S . domestic income taxliability. It is hard to imagine, however, hav-

ing the U.S. government make direct pay-ments to U .S . international companies t ocompensate them for the fact that they paid

high taxes to foreign governments . And it

is equally difficult to imagine allowing thesesame companies to use foreign tax credit s

to reduce their U.S . income tax liability aris-ing from U .S. domestic income. Neverthe-less, some solution to this transition prob-lem must be found to avoid violating the firs tprinciple of transition relating to retroactivetax increases .

Past Investments, Future IncomeThe taxation of foreign-source incom e

provides an excellent example of anothe r

difficult transition problem, aside from whatto do with earned excess foreign tax cred-its . Taxpayers, whether individuals or busi-nesses, have made an entire economy' sworth of investments all with the expecta-tion that they would have to pay some tax ,and in some cases a great deal of tax on th eincome and capital gains from these invest-

ments . In some cases, the effect of tax re-form is to eliminate entirely the income ta xburden on the streams of future income re-sulting from these investments .

In the international arena, U .S . taxpay-ers have made billions of dollars of foreigninvestments in the expectation that theywould eventually owe some residual U .S .income tax . As discussed above, most ta xreform proposals would eliminate this taxon foreign-source income . This obviouslycreates an economic windfall to these com-panies entirely outside the normal forces o feconomics . '

The problem of past taxable invest-ments yielding income that is not taxable

due to tax reform extends across theeconomy from complex areas such as inter-national taxation to as simple a matter asthe interest income earned by an individua lon a bank Certificate of Deposit . Every in -stance in which tax reform would eliminat e

the tax owed on the income or capital gain

from a past investment creates a windfall t othe asset's owner. This applies to every share

of stock, every parcel of capital gains tax-

yielding real estate, and every bond held by

a U.S . taxpayer. And, as demonstrated i n

Example 1, the amount of the windfall ca n

be sizable . In that example, a holder of a$1,000 bond yielding 10 percent annual in -

terest would enjoy a $318 windfall unde rtax reform. Such windfalls must be avoidedif fairness is to remain a goal of tax polic y

and tax reform .

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ConclusionAs tax reform moves forward it is im-

perative that tax reformers give due andearly attention to the problems o ftransitioning from the existing income taxto the new tax system . The more fundamen-tal the reform, the greater will be the nee dto attend to transition issues .

At the heart of the need for proper tran-sition rules is the need to avoid insofar a spossible retroactive tax changes, whethe rthose changes are in the form of tax in -creases or tax relief. Retroactive tax in -creases constitute a confiscation of wealt hand income. Retroactive tax relief, or wind-falls, would be wonderful for those receiv-ing the windfalls, but are harmful to all othe rtaxpayers because the cost of these wind-falls is a higher tax rate . Either way, the needfor even-handedness in the imposition of th e

tax burden is clearly violated .Compared to the apparent simplicity

of most tax reform plans, transition issue scan be quite complex. Often, however, thiscomplexity is due to the complexity of th eexisting system and of economic activitygenerally. In many cases, the complexity canbe minimized with due care and by maximiz-ing the use of the grandfather principle .

Finally, many transition rules would b equite costly in terms of reducing, albeit tem -porarily, the tax base . However, there woul dbe offsetting transitional revenues to theextent tax reform transition adequately re -captures the many economic windfalls tha twould otherwise occur . These windfall soccur when the tax base under the new taxsystem excludes income currently taxe dunder the income tax . The extent to whichthe transition regime addresses retroactivetax increases and these tax reform-generate dwindfalls will determine the net effect the

transition regime will have on federal rev-enues and thus on the initial tax rate . Theability and willingness of tax reformers t oaddress these issues directly will affect th epace at which tax reform moves from dreamto reality.

Endnotes' For a more complete discussion of

retroactive tax policy, see "Sound Tax Policyvs. Retroactivity," by J.D. Foster, publishe das an Extra Point, July 1997,Tax Foundation .

'This section draws extensively from ,"The Post-Carlton World : Just When is a Ret-roactive Tax Unconstitutional," by Richar d

Belas which appeared in Tax Notes, Octo-ber 30, 1995 .

3 Allowing taxpayers with remaining

basis to continue to deduct the costs of thei r

previous investments provides a good ap-proximation to a transition rule that is con-sistent with tax neutrality. It is only an ap -proximation, however, because the value ofthe tax deduction changes according t owhether the tax rate in the new tax syste mis higher or lower than was the tax rate i nthe previous system. The value of a deduc -

tion to a firm is equal to the tax rate time sthe amount deducted . Thus, if the margina ltax rate is 35 percent, then the value of a

deduction is 35 cents on the dollar . If thetax rate in the reformed tax system is 2 5percent, then the value of the deductiondrops by 10 cents per dollar of depreciablebasis . This loss due to the decline in thevalue of depreciable basis due to a lowertax rate is roughly offset by the lower taxrate applied to the income produced b ythese assets .

4 For a more complete explanation of

U .S . international tax policy, see "Promot-ing Trade, Shackling our Traders", by J .D .Foster, Tax Foundation Background Pape rNo. 21, November, 1997 .

5 In an ideal world, companies withexcess foreign tax credits made worthles sby tax reform would also be the companie swith like amounts of expected residual U .S .

tax from foreign investments. This, how-ever, would be the rare exception, ratherthan the rule, and so separate solutions t othe excess credit and future residual taxproblems will be needed .

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