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What We Can Learn From Cost-Benefit Analyses

Posted on Apr. 22, 2019

It might be the Golden Age of preambles. Besides addressing comments to proposed and final regulations in detail, Treasury and the IRS now must include cost-benefit analyses for economically significant rules, which has resulted in more work for the guidance writers but could help taxpayers.

There’s more work to be done to make the cost-benefit analyses useful and to bring them fully into compliance with the Office of Management and Budget’s Circular A-4 and the OMB Office of Information and Regulatory Affairs’ prescriptions for what should be in an analysis. “The cost-benefit analysis remains scattershot,” said Clinton G. Wallace of the University of South Carolina.

Treasury hasn’t tried to quantify costs or benefits, with the exception of some compliance costs. Wallace said the analysis has often ignored major costs and benefits that could be quantified. He added that the qualitative discussion focuses “on the benefits of clarity and certainty versus the costs of inequity due to different taxpayers taking different positions,” which makes sense against the no-action baseline, but “is not informative in any precise way.”

The requirements for economically significant regulatory actions — that is, those that have an annual effect on the economy of $100 million or more or that materially hurt some aspect of the economy — are to provide a statement of the need for the regulation, a description of how the rule will achieve the desired results, and a cost-benefit analysis called a regulatory impact analysis. The cost-benefit analysis is to be quantitative and qualitative and should include a discussion of alternatives the agency considered. Its purpose is to enable greater centralized review, so the audience for cost-benefit analyses includes OIRA and the administration, as well as taxpayers and other agencies.

Analyzing the TCJA

There are two sets of final regulations under the Tax Cuts and Jobs Act that have economic analyses so far: the final transition tax rules under section 965 (T.D. 9846) and the final regulations under section 199A (T.D. 9847) on how to determine the 20 percent deduction for qualified business income of passthrough entities. The final regulations under section 263A (T.D. 9843) also have a cost-benefit analysis. There are many more sets of proposed regulations with cost-benefit analyses, including rules on foreign-derived intangible income and global intangible low-taxed income (REG-104464-18), hybrid arrangements (REG-104352-18), and the foreign tax credit (REG-105600-18), as well as rules under section 199A (REG-107892-18 and REG-134652-18), section 163(j) (REG-106089-18), section 965 (REG-104226-18), and section 59A (REG-104259-18), that have been deemed economically significant.

The flurry of economic analyses sharply contrasts with preceding years. Between 2011 and mid-2016, only two tax regulations — both concerning tax return preparers — were reviewed because they were deemed significant or economically significant. In an article in the Alabama Law Review, Wallace noted that “dozens of tax regulations from this period appear to be significant or economically significant, especially given OIRA’s general standard of considering transfers as part of the economic effect for purposes of the $100 million threshold” (“Centralized Review of Tax Regulations,” 70 Ala. L. Rev. 455 (2018)).

How Can an Economic Analysis Be Useful?

The pros and cons of an extra economic analysis in preambles have been extensively discussed as the IRS, Treasury, and OIRA have worked to implement the new procedures over the past year. Possible drawbacks include diverted effort by Treasury and IRS economists and lawyers in explaining tax issues to OIRA officials, who generally don’t have tax expertise. (Prior coverage: Tax Notes, Dec. 17, 2018, p. 1493.)

But no one has had time to spend two years before the mast on this experiment in administrative practice, and there are bound to be some initial missteps. Wallace said faster isn’t always better for regulations and that the slower process can have benefits. Overall, Treasury and the IRS seem to have balanced the need to produce timely guidance with the new review process.

The potential benefits for taxpayers are more transparency on the government’s view of why a new rule is necessary and perhaps a new way to challenge regulations in court. Under the umbrella of Administrative Procedure Act challenges to regulations, there could develop challenges to cost-benefit analyses.

In a 2017 working paper, Jonathan Masur and Eric Posner argue that quantifiable measures such as cost-benefit analyses change the terms of the debate about how much deference is due to regulators because quantification promotes review (“Cost-Benefit Analysis and the Judicial Role,” Coase-Sandor Working Paper Series in Law and Economics No. 794 (2017)). They said that “when quantitative methods are appropriate for evaluating regulations, a ‘high’ level of judicial review is justified,” meaning that courts don’t need to give much, if any, deference to an agency’s judgment. They explained that “the key thing to understand is that at the current moment in the development of the regulatory state, cost-benefit analyses tend to be low quality rather than high quality, suggesting that greater judicial involvement will cause more good than harm.”

Elements of a Cost-Benefit Analysis

To taxpayers, the economic analysis sections might amount to a bonus discussion of the new rules in the preamble. If more guidance is always preferable for planning, more information in the cost-benefit analysis section is an unqualified boon. But to regulation writers, the exercise is supposed to be substantive. OMB has well-established practices for agencies to use when developing regulatory analyses. The challenge is conforming the established principles of analysis to tax regulations. There are some risks inherent in writing economic analyses, and it will probably be up to OIRA to ensure that they’re useful.

The estimates of costs and benefits should be both quantitative and qualitative, according to OIRA’s primer on regulatory impact analysis. Circular A-4 stipulates that regulatory analysis should include a clear, plain language executive summary and a table summarizing the benefit and cost estimates for each regulatory action and alternative under consideration as well as the qualitative and non-monetized benefits and costs.

The purpose of a regulatory analysis is “to inform the public and other parts of the Government (as well as the agency conducting the analysis) of the effects of alternative actions,” according to the circular. The cost-benefit analysis is “a primary tool used for regulatory analysis,” because it gives decision-makers “a clear indication of the most efficient alternative, that is, the alternative that generates the largest net benefits to society (ignoring distributional effects).” The circular prescribes the elements of a cost-benefit analysis: an explanation of how the actions required by the rule are linked to the expected benefits, a baseline (typically a no-action one), and expected undesirable side effects and ancillary benefits of the proposed rules and alternatives.

OIRA’s primer expands on the cost-benefit analysis requirements. Agencies should include estimates of private sector compliance costs and savings, government administrative costs and savings, gains or losses in consumers’ or producers’ surpluses, and gains or losses of time in work or leisure settings. The primer explains how to evaluate non-quantified and non-monetized costs and benefits, but gives as examples of those costs and benefits the protection of human dignity, equity, or privacy, which suggests that tax rules don’t fall into that category. A “complete” regulatory impact analysis should contain the need for regulatory action, the baseline, the time frame of analysis, a range of regulatory alternatives and their consequences, quantified and monetized benefits and costs and non-quantified and non-monetized benefits and costs, and any uncertainty in benefits and costs.

Case Study 1: Opportunity Zones

Two sets of rules — one proposed and one final — illustrate how the first attempts under the TCJA at writing economic analyses went. The proposed Opportunity Zone rules (REG-115420-18) were designated as economically significant because Treasury and OMB “believed that significant investment will flow into qualified opportunity zones as a result of the TCJA legislation and proposed regulation,” according to the special analysis section of the preamble.

The analysis explains that the proposed rules are necessary because taxpayers may not make investments in qualified opportunity funds without the added clarity on whether they qualify for the preferential treatment, which could reduce the amount of investment below what Congress intended. The clarifications and definitions are necessary so that taxpayers don’t interpret the statute disparately, which might lead to a distortion of investment across Opportunity Zones, according to the analysis. As in other recently proposed regulations, Treasury used a no-action baseline. The analysis doesn’t include a time horizon, although it may have been deferred until the publication of future, related rules. There’s no table summarizing the costs and benefits monetarily, either.

Treasury and the IRS took identifying benefits and discussing alternatives relatively seriously. Although some of the anticipated benefits, such as reducing planning costs for taxpayers, might be said of many regulations, others are specific to the Opportunity Zone rules. The benefits identified in the analysis are mainly clarity for taxpayers on ambiguous aspects of the statute.

Treasury did a reasonable job of examining the alternatives to its choices in the proposed regulations. The analysis spends some time discussing the option of not issuing regulations, which reads a bit like unnecessary boilerplate because it was obvious that some regulations would be needed to implement section 1400Z-2. Congress held hearings and legislators wrote letters after the passage of the TCJA asking Treasury to write regulations, so the no-action alternative probably didn’t need to be discussed.

Four possible options for the 10-year gain exclusion were considered, but Treasury thought the relative costs and benefits were difficult to measure and compare. The proposed rule “would likely produce the lowest compliance and administrative costs among the alternatives, and any associated economic inefficiencies are likely to be small,” the analysis explained. The discussion of the working capital safe harbor said that Treasury could have chosen a longer or shorter period than 31 months, and Treasury noted that a 90 percent threshold was considered for the “substantially all” test.

Unlike with the anticipated benefits Treasury identified, the explanation of anticipated costs is brief and reads more like benefits than costs. Treasury and the IRS said they expect taxpayer compliance costs and government administrative and enforcement costs to decrease because of the proposed rules. Left unaddressed is how the proposed rules could affect residents of Opportunity Zones. (Prior coverage: Tax Notes, Apr. 1, 2019, p. 19.)

Case Study 2: Section 199A

The final regulations under section 199A were designated as economically significant and therefore subject to a cost-benefit analysis. Treasury methodically described the costs and benefits of each of the seven sections of the new rules, but not quantitatively. For example, in defending the aggregation rule in reg. section 1.199A-4, Treasury explained that “economic tax principles are called into play here because a large number of businesses that could commonly be thought of as a single trade or business actually may be divided across multiple entities for legal or economic reasons.” The discussion attempts to address issues like distortions to the economic incentives that the proposed rules would have created. The only table summarizing the costs of the final rules is on the annualized effect on compliance costs.

Treasury addressed what the guidance writers considered “significant issues brought up in the comments for which economic reasoning would be particularly insightful.” Although that discussion might have been included in another section rather than forgone altogether had Treasury not been required to conduct an economic analysis, it’s a sign that the government is now paying particular attention to the economic costs and benefits of new rules.

Improving on Precedent

Treasury’s regulatory analyses have fallen short of the Circular A-4 and OIRA requirements before. The cost-benefit analysis of the section 385 rules proposed in 2016 (REG-108060-15) was brief and missing some analytical components. The statement of need “casts the proposal as a technical response to a technical problem,” wrote Wallace, adding that, “by focusing on the technical issue, the formal justification for the rule appears not entirely forthcoming.”

The cost-benefit analysis of the section 385 proposed regulations looked only at the anticipated revenue and compliance costs. Wallace noted that the analysis didn’t specify what alternatives Treasury considered, where the $843 million that was estimated to be collected came from, or what the behavioral effects of the proposed policy were. The analysis included a table that summarized the rule’s annual revenue and compliance costs.

In contrast to the more recent proposed and final regulations, the regulatory impact analysis for the section 385 rules wasn’t part of the preamble published in the Federal Register, but was in a separate document. Publishing the economic analyses in the preambles seems like the best way to ensure that taxpayers actually see them. Putting the cost-benefit discussion in the preambles also avoids some duplication of items like the description of the need for the rules and gives context to the economic analysis.

Possible Improvements

To increase efficiency of guidance drafting and reading, OIRA should probably generally excuse Treasury from considering the option of inaction. That requirement seems more appropriate to the actions of other regulatory agencies and when there isn’t a newly passed tax law that Treasury must provide guidance on.

The list of the benefits conferred by the proposed and final regulations frequently includes certainty, but certainty could be a slippery concept in the cost-benefit analyses because it’s vague. OIRA might want to question the more generalized claims of certainty as a benefit, particularly when it’s the chief claimed benefit, to prevent it from becoming a default. A general explanation that providing clarity will improve economic efficiency is probably best avoided, even though that type of explanation appears in many of the recently issued proposed and final rules.

There’s a focus on economic efficiency to the exclusion of any other considerations in the analyses. For many tax rules, that’s reasonable and appropriate — and probably mainly addressed to OIRA — but it’s insufficient for others, like the Opportunity Zone rules.

Wallace’s paper suggests other ways to improve centralized review of tax regulations, including distinguishing between the three main functions of regulations — private allocation, public allocation, and implementation — and adjusting the review for each. He proposed skipping a review of interpretive regulations that fit into the implementation function because review “serves little substantive purpose.”

Wallace suggested that distributional analysis would be a useful addition to the cost-benefit analysis, even though it would add another layer to it, because “together, these modes of analysis have the potential to illuminate a diversity of trade-offs necessary in formulating tax regulations.” Those improvements could refine cost-benefit analyses for tax regulations and increase their usefulness to both taxpayers and the IRS and Treasury.

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