Changing Places, Changing Taxes: Exploiting Tax Discontinuities (by Julie Roin)

Posted on behalf of Julie Roin as part of the Legal Discontinuities Online Symposium:

President Trump’s decision to move his official state of residence from high-tax New York to no (income) –tax Florida has brought public attention to an issue that has long troubled scholars, as well as designers and administrators of income tax systems: how the interaction of tax rules deferring the taxation of income and tax rules based on residency allows taxpayers to reduce and even avoid taxation of their deferred income. These discontinuities in tax treatment may lead to excessive migration, as well as reductions in state income tax revenues.

Although trans-national moves of this sort are increasingly treated as “realization events” for tax purposes, triggering the immediate taxation of accrued but untaxed gains in the taxpayer’s country of original residence, the states of the United States have not tried to impose similar rules on residents moving to other states. This reluctance may stem in part from concerns that any attempt to do so would be struck down as a violation of the federal constitution’s Commerce Clause or its Right to Travel. But it may also stem from the fact that such a forced realization rule creates a different discontinuity; a tax rule accelerating the taxation of accrued gain penalize interstate movers (relative to those who stay put and continue to benefit from tax deferrals), disincentivizing such moves. Instead of too much interstate migration, there may be too little, interfering with both economic efficiency and what could be a valuable feedback mechanism about the performance of state governments. The same discontinuity problem arises in the international realm, of course, but there the difference in institutional structures and political sensibilities—not to mention larger revenue concerns due to higher tax rates—has led to a different policy outcome.

My paper analyses legal mechanisms or rules that might reduce both positive incentives and negative disincentives for interstate moves. A general move to mark-to-market taxation would eliminate the problem in its entirety. However, the practical and political obstacles to the uniform adoption of mark-to-market taxation for state tax purposes are significant; indeed, it is hard to see how this might develop without the federal government adopting mark-to-market treatment for federal tax purposes. And a move towards mark-to-market taxation by some states and not others would lead to a new set of discontinuities. The paper also analyzes the possibility of enhanced source taxation of nonresidents and of expanded taxation of part-year residents, only to encounter similar problems.

Ultimately, the paper concludes that this problem of discontinuous treatment is easy to identify but impossible to solve in a world in which state tax authorities rely on federal tax authorities for performing many of the hardest tasks involved in tax administration, while retaining considerable freedom to devise their own tax base definitions and set their own tax rates. There is a tax price to be paid for allowing states to be laboratories of democracy, catering to the heterogeneous desires of their populations.  

This post is adapted from a draft paper to be published in a forthcoming symposium issue in Theoretical Inquiries in Law. The papers were part of the Legal Discontinuities conference held at Tel Aviv University Law School’s Cegla Center in December 2019.