QOZs Illustrate How Critical Tax Theory Can Strengthen Tax Policy Analysis – Capital Gains Tax
Although Tax Day has passed on April 18, 2022, for some taxpayers a different kind of tax deadline is approaching. Many tax lawyers, like me, know that June 30, 2022 is the last day certain taxpayers who realized capital gains in 2021 can defer paying tax on those gains until 2026 by investing them in Qualified Opportunity Funds (QOF) – investment vehicles used to invest in Qualified Opportunity Zones (QOZ). According to the taxthe purpose of the QOZ program is to “stimulate economic development and job creation in struggling communities by providing tax benefits to investors”.
One of these tax advantages is that an investor who holds a QOF investment for 10 years enjoys a 100% exclusion of federal tax on the capital appreciation of the investment. This is an effective tax rate of 0% on a potentially unlimited amount of gain. But how does the 0% tax rate compare to that of a QOZ resident?
Today, there are 8,764 QOZs in the USA. One such QOZ is Central Harlem, where 29% of residents are below the federal poverty line, 77.2% of households do not include children, and the median household income is $57,720. The federal income tax payable for a single filer with no children, with an income of $57,720 and who take the standard deduction ($12,550) and therefore has a taxable income of $45,170, is $5,687. This translates to an effective federal tax rate of 12.59% for a typical Central Harlem resident.
In the United States, we have a progressive tax system, which means that as a person’s income increases, their tax rate should also increase. This is in line with vertical equity – one of the touchstones of traditional tax policy – which suggests that those with more income should be taxed more than those with less income.
Because most capital gains are realized by high-income households, the capital gain requirement of the QOZ program makes it more likely that QOZ investors are from high-income households. But, when a QOF investor’s 0% tax rate is compared to the 12.59% rate of a typical Central Harlem resident, traditional tax policy suggests that the capital gain requirement has an effect regressive: it forces high-income QOF investors to be taxed at a lower tax rate. than low-income residents of the Central Harlem QOZ.
Traditional tax policy, however, does not shed light on whether the capital gain requirement has a disproportionate impact on certain demographic groups. For this, we can turn to critical tax theory, a growing body of research seeking to uncover explicit and implicit biases in the tax system. According to Anthony Infanti, professor of law at the University of Pittsburgh School of Law, and Bridget Crawford, professor of law at the Elisabeth Haub School of Law at Pace University, critical tax theorists use a variety of methods of investigation, including the interpretation of “social science and economic data to show how tax law impacts groups differently. »
In the United States, while 85% capital gains are reported by households with adjusted gross income over $200,000, only
seven% capital gains are received by households with adjusted gross income below $100,000. According to the Institute for Taxation and Economic Policy“[b]Because capital gains go overwhelmingly to high-income households, they also tend to go predominantly to white households. In Central Harlem, the median household income is only $57,720 and 77.9% of residents are black or Hispanic. According to Monica Wendell and Gabriel Jones, Jr., professors at the University of Louisville School of Public Health and Information Science, QOF investors are not likely to reside in QOZs.
Looking through a critical tax lens, black or Hispanic residents of Central Harlem are unlikely to have capital gains, and white taxpayers who are not residents of Central Harlem are more likely to invest in the Central Harlem QOZ . Thus, critical tax theory suggests that the capital gains requirement is likely to disproportionately negatively impact Black and Hispanic residents of Central Harlem by creating an implicit structural barrier that excludes them from the tax benefits of the QOZ program, while limiting these benefits to outside investors, who are most likely white.
There is no denying that QOF investors are risking their fortunes by investing in QOZs, which are, by definition, economically distressed areas. It follows that if no tax incentive is offered to investors, they would be less likely to invest in QOZs. Supporters of the program argue that it leads to significant investments in the QOZs, stimulates economic activity and creates jobs in these communities. However, the Institute on Taxation and Economic Policy warned that the QOZ tax rules provide no mechanism to ensure that program benefits are allocated to members of QOZ communities.
Based on Nancy J. Knauer, director of the law and policy program at Temple University Beasley School of Law, critics of critical tax theory argue that those who apply a critical tax lens have no reliable data to support their claims. Knauer’s answer is that such an argument assumes that the lack of data showing a disproportionate impact of the tax system on various demographic groups is tantamount to proof that the tax system is fair. This debate highlights the need for reliable demographic data on taxpayers, that the IRS does not currently collect.
The Treasury Department recently announcedhis commitment to advancing the analysis of equity in tax policy by “examining the tax system through the lens of racial equity”.
The Treasury Department offered work with other federal agencies to develop a reliable methodology using statistical modeling techniques to impute race, ethnicity, gender, and other demographic characteristics for tax data. The resulting synthetically modeled data would then be used for tax fairness analysis. Thus, synthetic data could pave the way for meaningful and comprehensive critical tax analysis.
QOZs make up 12% of census tracts in the United States. If QOZs across the country are anything like Central Harlem, the capital gains requirement could have a substantial impact on racial equity nationwide. Since the first 10-year holding period is expected to expire in 2028, which will be the first year the 0% tax rate applies to QOF investors, the Treasury Department should prioritize data synthesis taxpayer demographics. This data should measure the benefits of the QOZ program distributed between QOF investors and QOZ residents to determine whether the capital gain requirement advances racial equity.
The capital gain requirement highlights a case where traditional tax policy is insufficient to show whether the tax system has a disproportionate impact on groups of taxpayers. Traditional tax policy should not be abandoned, but it can be improved by critical tax theory. By adding an additional dimension—taxpayer demographics—to the analysis of traditional tax policy, a critical tax lens might help us see what traditional tax policy fails to do.
Originally published by the Yale Journal on Regulation.
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