Kahng & Fellows: Undertaxed Business Owners and Overtaxed Workers

Lily Kahng & Mary Louise Fellows recently published Costly Mistakes: Undertaxed Business Owners and Overtaxed Workers, in which they take issue with traditional attempts to distinguish between outlays that constitute "investment", which may be used to reduce income (sooner or later) and those that constitute "consumption", which never get to be used to reduce income. Every tax professor must address this line-drawing issue in the first tax course and in my experience students are often frustrated by  number of clearly arbitrary designations. Typical example: why is it that a consultant's outlay for box seats to woo clients is an "investment" but my law school tuition is "consumption"?  Lily & Mary Louise's answer: because the powers that be have in general determined that businesses only make outlays for the pursuit of profit, while employees are equated with consumers, so their outlays must typically be considered personal. I am glad to see Lily & Mary Louise take on this line-drawing challenge, and I think they do a good job showing the normative failures that have been allowed to direct tax policy in this regard.

From the abstract:

This Article advocates fundamental changes in the federal income tax base by systematically challenging conventional understandings of consumption and investment. As signaled by its title, “Costly Mistakes,” this Article’s thesis has to do with the disparate treatment of expenditures incurred by business owners and workers. Where the current tax law treats a business owner’s expenditure as investment, the Article sometimes finds consumption and questions why the law should allow the expenditure to be deducted. Where the tax law treats a worker’s expenditure as consumption, the Article sometimes finds investment and questions why the law does not allow at least a partial deduction. 

...[T]he Article demonstrates that the deference the tax law traditionally has accorded business owners results in their undertaxation. Through an analysis of the tax law’s treatment of workers, it further shows how its structural and substantive rules treat workers primarily as consumers, rather than as producers, and why that results in their overtaxation. 

The Article then investigates the economic inefficiencies produced by the tax law’s generous treatment of business owners’ outlays and its unduly restrictive treatment of workers’ outlays. It goes on to suggest how to scrutinize and reform the tax treatment of workers and how to extend that approach to business owners with far-reaching implications. Finally, the Article relates the undertaxation of business owners and the overtaxation of workers to the broader social policy discussions concerning the high rate of unemployment in the private sector and the escalating deficits in the public sector. 

It concludes that the success of the U.S. economy in the twenty-first century requires the tax law to treat both business owners and workers as producers. It further concludes that the tax law’s continuing failure to acknowledge that business owners and workers are both consumers and producers undermines the goals of efficiency and fairness.

In addition to making the normative case against preserving the status quo on both efficiency and ability to pay grounds, the article walks through the major issue areas covered in an intro tax course, so this looks like a good candidate to add to any intro tax canon.