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Return to Civic Virtue: Tax Meals

Posted on Feb. 15, 2021
[Editor's Note:

This article originally appeared in the February 15, 2021, issue of Tax Notes Federal.

]
Calvin H. Johnson
Calvin H. Johnson

Calvin H. Johnson is an Eagle Scout, has a Purple Heart from combat in the Vietnam War, and always has God and country as his clients. He holds the John T. Kipp Chair in Corporate and Business Law Emeritus at the University of Texas Law School.

In this article, Johnson argues that business meals should be taxed to the person eating them to prevent deadweight loss. Beyond meals, we should return to civic virtue in the post-Trump years by defending the tax base to make taxation more efficient, according to Johnson.

Copyright 2021 Calvin H. Johnson.
All rights reserved.

Excluding meals from taxation, when other forms of compensation are taxed, inevitably causes a loss of value — a waste — that economists call deadweight loss. The exclusion for meals causes a shift from cash to meals, until in equilibrium, the loss of value from the meals is just short of the tax avoided. In equilibrium, the loss is a tax-caused destruction of resources — not physically, but by value. The recent Consolidated Appropriations Act1 decreased the tax on meals by allowing a 100 percent deduction for some business meals, repealing the prior law’s 50 percent deduction, which is the wrong direction to go. The end of the limited deduction was instigated by former President Trump himself and was a high priority for the Trump Treasury in its negotiations with Congress over the appropriations bill.2 Trump personally takes advantage of tax-exempt meals and has interests in restaurants selling meals. Thus, the change in law was narcissistic and a betrayal of civic virtue.

With the departure of the Trump administration, we must recover our civic virtue. We must all join together, across the partisan divide, in the condemnation of unnecessary tax-caused waste, including that from the reduced tax on meals. A wise tax system needs to transfer money from private to public uses, but it also needs to minimize the deadweight loss in that transfer by defending the tax base. In a loophole-filled tax system such as ours, taxpayers move from taxed to untaxed items, doing damage to their real desires in the process. Tax avoided by the move to tax exemption is a lose-lose situation: Taxpayers inflict loss or waste on themselves up to the amount of tax avoided, and the government has to make up the revenue from some other, presumably inferior, source. A broad, unavoidable tax base keeps tax rates down for any given level of revenue needs and minimizes waste. High rates on an avoidable tax base maximize the damage from tax and minimize civic virtue. In the tax policy debate coming over the next months and years we must defend the tax base and make it fairer and more efficient.

Assume, to illustrate inevitable waste, that an employer has devoted $100 to an employee to pay for services the employee has performed or will perform. The employer can pay in cash, which would be taxable, or can loosen up and pay another $100 for an employee tax-exempt meal. The employer might say, “Take another $100 for a great meal while I send you out of town to Chicago on business.” Or the employer might say, “Take another $100 meal when you take a potential customer to a meal in town.” Assume the $100 meal is not taxable to the employee and is deductible in full to the employer, and that the employee is in the maximum 37 percent bracket, applicable to the cash compensation but not the meal.

Before the shift to equilibrium, the exclusion for meals just avoids $37 in tax for the employee. It is assumed in Table 1 below that both cash and meals are deductible business expenses and that the employer is a corporation paying tax at 21 percent. Before equilibrium, the cash gives the employee only $63 after tax, but the meal gives the employee the pretax $100.

Table 1. Cash and Meal Compensation Before Equilibrium

 

Cash

Tax-Exempt Meals

Employer

Pretax cost

$100

$100

Post-tax cost (21% tax)

$79

$79

Employee

Pre-equilibrium benefit

$100

$100

Post-tax pre-equilibrium benefit (37% tax)

$63

$100

Table 1 is not in equilibrium. The employer and employee working together could increase the employee’s after-tax benefit by having the employer pay for more meals but less in cash. The meal, indeed, need not give value of $100 to the employee for its $100 cost. Not all meals costing $100 are worth $100 to those who eat them. Thus, Table 2 shows a $100 meal that is only worth $80 to the employee — maybe because the employee has had too many of those meals — but is still a rational way to give resources to the employee.

Table 2. Some Shift From Cash to Meals, But Short of Equilibrium

 

Cash

Tax-Exempt Meals

Employer (same as Table 1)

Pretax cost

$100

$100

Post-tax cost (21% tax)

$79

$79

Employee

Pre-equilibrium benefit

$100

$80

Post-tax pre-equilibrium benefit (37% tax)

$63

$80

In Table 2 the employee is better off with the meal than with cash compensation even though the shift from cash to meals lost $20 of value for the $100 spent. The employer and employee will therefore work together to shift more resources from cash to meals to improve the employee’s after-tax position. The shift from cash to meals ceases to be rational when the value of the meal depreciates to become just equal to what the employee gets from cash after tax. Table 3 shows the equilibrium point that gives the employee the maximum benefit, but at which no further shift is rational.

Table 3. Cash and Meal Compensation In Equilibrium

 

Cash

Tax-Exempt Meals

Employer (same as Table 1)

Pretax cost

$100

$100

Post-tax cost (21% tax)

$79

$79

Employee

Post-equilibrium benefit

$100

$63

Post-tax equilibrium benefit (37% tax)

$63

$63

Shifting from cash to meals to reach $63 for both is not a precise art; sometimes the employer replaces $100 cash with meals that are less valuable than $63. Still, both employer and employee working together do best at the equilibrium of $63 from each column of the comparison. As inevitably as water runs downhill, both sides will work to reach the equilibrium position.

Cash in the left-hand column of Table 3 will not have the deadweight loss that tax-exempt meals create. Presumably, the employee will find a use for the after-tax cash that best serves their needs. It is unlikely to be spent much on $100 meals. The employee might well spend the cash on children’s shoes, clothes, shelter, or other things with higher priority. The government will get $37 from the cash column and will spend it on the military, deficit reduction, or whatever, but at least it will not need to find $37 from some other source. On the right-hand side, however, the government gets no revenue from tax-exempt meals and will have to go to some other, presumably inferior, source for its revenue. The employee, down the meals column in equilibrium, will do themselves damage destroying the value of the $100, stopping rationally when the waste is equal to the 37 percent tax they have avoided. The loss is not physically a destruction of resources, but it has the same effect in terms of lost value.

Both the left and right columns have secondary effects from the spending of the $100. On the left, the $100 will have $37 go to government revenue needs and $63 go to the employee’s highest needs. On the right, the $100 will entirely go to pay for meals. For both columns, the $100 spent will circulate further in the economy. But the right side, entailing deadweight loss of $37 from the start, can never catch up with the greater benefit in total generated by the left column of Table 3.

The deadweight loss shift occurs even when the meals have a business nexus. If an employee is out of town on business, they must eat, and the meal is considered both deductible as a business expense and excludable from tax for the employee. Still, one eats for personal or consumption reasons, even when out of town on business. And the employer and employee working together will cause the waste in meal costs even when the employee is out of town. It might well be without the tax advantage; the employee could choose a meal costing less than $100. Indeed, if the employee would spend $63 of their own money, then they will spend $100 of employer money for the same meal. If the employee is just trying to get work done, moreover, granola bars, Ramen noodles, or peanut butter sandwiches might well contribute more to productivity than a $100 meal that includes liquor. Increased spending on luxury meals (that don’t give a value worth their cost) inevitably occurs for out-of-town meals and other business-related meals solely because the meals are tax exempt.

Meals are different from the collateral benefits that employees might get from employment conditions because meals are almost always provided to give the eater benefit. An employee appropriately gets a tax exemption for the collateral emanations that come from business conditions made to benefit customers or other business relationships.3 For instance, take art on the wall of a law office. Employees enjoy it, but the art is also justified by setting a tone for clients that this is a high-class operation with good taste, and that contributes to the firm’s revenue. If the art is justified by appealing to clients, we cannot be sure there is a benefit to the employee or what that is. Those in the office who hate the chosen art still must put up with it. Because of doubts about the value of the benefits, employees may enjoy the collateral benefits of the art directed to clients without tax. Meals, even business meals are different. The benefit of eating is not a collateral benefit; nobody enjoys watching someone else eat. One can imagine a hypothetical in which a taxpayer has to eat spicy meatballs for a commercial over and over again, whether the taxpayer likes it or not. But except for the rare hypothetical, the purpose of providing a meal is to give benefit to the eater. When, as usual, the justification for paying for a meal is the benefit to the eater, then tax exemption for that benefit will inevitably cause deadweight loss as to the business meals.

There is no justification for giving the employee a lower taxable amount below the $100 cost for the tax-caused loss in value. There is a cure to the tax-caused waste shown in Table 3, which is to tax the $100 spent on the meal in the right-hand column. The employee will then accept the meal in lieu of cash only when the meal gives value equal to its $100 cost. Is taxing the employee feasible? The employer has the information necessary to withhold tax, at the best estimate of the employee’s rate, and could be asked to withhold tax on employee meals that the employer pays for. The employer has all the necessary records. Employers withhold on taxable noncash benefits all the time.

Sometimes, however, the law needs to fall back on a less accurate remedy — attacking the employer deduction — because of the high burden of trying to determine who ate what or what their tax bracket was. If the eater of the meal is not an employee, perhaps a potential customer, the business paying for the meal does not have the tax information for withholding. If the employer had an open cafeteria or family-style serving of a meal, it is unclear who ate what. An alternative remedy is to take away the employer’s tax deduction, but ignore the meal in the employee’s taxable income. The loss of deduction will rarely reach equal tax of cash and meals, but it can help reduce deadweight loss.

If the employer and employee are in the same tax bracket, then disallowing the deduction of the cost of a meal is a fine remedy. Disallowing the deduction would collect the same tax (for example, $37) as is collected on cash compensation, and that would prevent the deadweight loss shifts. The after-tax cost of cash to that employer would be $100 minus $37, or $63. If there were no deduction for the meals, the employer would reduce the benefit given to the employee for services from $100 to $63 to equal the after-tax cost of cash. Because the employee gets $63 worth of value out of cash, the employee would insist on $63 value from the meal as well — that is, its cost — and there would be no toleration of deadweight loss. Table 4 illustrates the point.

Table 4. No Deduction to 37 Percent Employer for Meals

 

Cash

Tax-Exempt Meals

Employer (37% tax bracket)

Pretax cost

$100

Reduced to $63 cost because no savings from deduction

Post-tax cost (37% tax)

$63

$63

Employee

Post-equilibrium benefit

$100

$63

Post-tax equilibrium benefit (37% tax on cash but not meal)

$63

$63

The deny-the-deduction remedy does not work very well, however, except when the employer and employee are in the same tax bracket. Denying the deduction of meals has no effect on a tax-exempt employer, including my employer, a public law school. Denying the deduction has less effect if the employer’s tax bracket is lower than the employee’s. The federal corporate tax rate, now at 21 percent, is lower than the tax rate applied to the highest-bracket employees. Still, the deny-the-deduction remedy may restrict some deadweight loss.

For example, before the Consolidated Appropriations Act, section 274(n) of the code disallowed the employer’s deduction of half the cost of a meal, even for meals otherwise allowably deducted because of some business nexus. The loss of the deduction is a proxy for tax on an employee; except as a proxy tax, the employer appropriately deducts costs of costs to produce a profit, whether paid in cash or meals. Section 274(n), however, prevented some deadweight waste, but not all of it. Table 5 shows the employer reducing the expenditure for meals from $100 to $88.26 because of the lesser deduction in the right-hand meal column. Deducting half the cost of the meal in the employer’s 21 percent tax bracket gave a deduction of only 10.5 percent of the meal, and in equilibrium, the employer will reduce the expenditure for meals so the meals have the same after-tax $79 cost to the employer as the cash compensation. The employer’s pretax cost that will have an after-tax cost of $79 can be found by trial and error, but algebra or the Excel goal seek function is faster.4 Table 5 shows the remaining deadweight loss in equilibrium under prior-law section 274(n).

Table 5. 50 Percent of Meal Deducted by 21 Percent-Tax-Bracket- Employers

 

Cash

Tax-Exempt Meals

Employer (21% tax)

Pretax cost

$100

Reduced because reduced savings from deduction to $88.26

Value of deduction of half of meal at 21%

 

($9.26)

Post-tax cost (21% saved by deduction)

$79

$79

Employee

Post-equilibrium pretax benefit

$100

$63

Post-tax equilibrium benefit (37% tax on cash but not meal)

$63

$63

Table 5 shows meals costing $88.26, which in equilibrium give value of only $63. That is waste or destruction of value of the difference of $25.26, or 28.6 percent of the resources. That is less than the $37 (37 percent) waste caused (as shown in Table 3) by a full deduction of the cost of the meal. Still it creates significant deadweight loss at equilibrium. Even under prior law, we needed more dedication to the civic virtue of getting rid of tax-caused waste.

The recent appropriations bill permits a deduction of 100 percent of the cost of a meal for the years 2021 and 2022 if the meal is provided by a restaurant, suspending section 274(n) for two years. The structure is a stimulus or subsidy to restaurants after what have been hard times for them, but it is subsidy that induces waste. And at 37 percent of the pretax cost, the waste is unacceptably high. As shown in Table 3, in equilibrium the differential treatment of cash and meals will inevitably lead to destruction of 37 percent of the value of the cost of the meal. Tax policy, loyal to civic virtue, should not be increasing the harm and inefficiency of tax.

Beyond the importance of waste as to meals, the waste is a lesson that needs to be generalized. Tax loopholes induce taxpayers to warp their behavior to get the loophole instead of being taxed. The behavior warp in equilibrium reduces value up to the tax avoided. A wise tax system reduces the tax-caused waste as far as possible by making the tax base firm and unavoidable. In the coming years — indeed, in the coming months — we should retrieve our civic virtue by defending the tax base and making the tax system fairer and less wasteful.

FOOTNOTES

1 Consolidated Appropriations Act, 2021 (P.L. 116-260).

3 Henry Simon, Personal Income Taxation 53 (1938) (relating the classic example of Fleugeladjant who was required to go to the opera and hunting as security and companionship for the Crown Prince whether he wanted to or not).

4 The employer’s calculation to make the after-tax cost of cash and meals equal in Table 5 is X - ½ * 21 percent * X = 79, when X is the resources devoted to meals that will have the same after-tax burden of $79 as cash had. The solution is X = $88.26.

END FOOTNOTES

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