Discussion of "Fringe benefits andemployee expenses: Tax planning and

neutral tax policy"

DAN THORNTON University of Calgary

As one savors the subtleties of the stimulating analysis and discussion in AlanMacnaughton's paper, it is easy to forget that taxes are only part of the govem-ment's portfolio of policies for pursuing social and economic goals. Often whentax mles change, the government's intent is not to be neutral but to subsidizecertain taxpayers at the expense of others. This, of course, creates tax-planningopportunities.

As a case in point, in the early 1980s, a provincial govemment introducedthe Quebec Stock Savings Plan (QSSP). A stated goal of the plan was to en-courage investment in Quebec equity securities by Quebec residents. Withincertain limits, Quebec residents were allowed to deduct the cost of investmentsin Quebec corporations' shares from their taxable incomes. A naive microecono-mist might have said that, absent evidence of market failure, this policy wouldmisallocate capital, Quebec firms getting more than their efficient share; but thegovernment's goal was to be anything but neufral.

The story does not stop there. Research indicates that the prices of the Quebecsecurities were bid up and consequently their expected retums fell, relative tofully taxable equity securities of similar risk. This produced an implicit tax,which wiped out the expected advantage of deductibility for investors in thelower aad middle income tax brackets (Kryzanowski and Sim, 1988). In ad-dition, almost incredibly, the ex post retums on these securities were negative(about —5 per cent) during a period when the average retum on the TorontoStock Exchange was over 10 per cent. Seldom have data shouted so loudly at re-searchers, govemment policymakers, and tax planners alike: The plan produceda subsidy for Quebec corporations but not for Quebec investors.

The story has three morals. First, neufrality is not always, or even generally, astated goal of policymakers—and they would probably be the first to admit this.Second, even when the goal is explicit, taxpayers (in this case, competing inan organized, impersonal market) do not eagerly cooperate with policymakers;

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Discussion of Fringe Benefits and Employee Expenses 139

consequently, the non-neutral result of the policy is often different from the gov-ernment's non-neutral intent. Finally, the stated objectives of tax policymakersare often so fuzzily enunciated that it is impossible to say, ex post, whether thepolicy was successful or not.

Perhaps ironically, I will argue that the analysis in Macnaughton's paper hasmuch in common with the QSSP parable recounted above. The author providesus with what is, in my view, the best analysis of neutrality in the literature.Neutrality, however, is unattainable in the real world because of imperfect in-formation and nontax costs (especially agency costs). Thus, the irony is that, insetting out so clearly what the neutral solution looks like, the author shows usprecisely how to benefit privately at the government's expense when the neutralsolution is unattainable.

In developing this argument, I will first consider "Utopia"—a world of neutraltax policy, so that there is no effect on taxpayers' choice of whether to consumegoods and services through personal expenditures or fringe benefits; then I willshow how this solution actually highlights tax planning opportunities for theemployee alone (unilateral opportunities) and Pareto optimal (bilateral) planningopportunities for the employee and employee together.

UtopiaIn the author's neutral world, employees are indifferent to whether they ac-quire a business car by buying it on personal account or getting it through theiremployers. In other words, there are no "clienteles." Clienteles would exist ifsome taxpayers (the "first" clientele) found ownership i»eferable and others (the"second" clientele) found fringe benefits preferable. In arranging their affairs tocomply with the tax law in this ideal world, taxpayers costlessly and cooper-atively reveal their preferences, perhaps (as the author suggests) by disclosingthe "virtual price" of the commodity or service in question. The wage marketis perfectly competitive and responsive to the evaluation of this trade-off. Thus,if I am willing to pay $2 for a cup of coffee during working hours, and if theuniversity brews it for me and my colleagues and makes it available at $.25, thebenefit accorded me will reduce my salary (though not necessarily by $1.75 percup, as the author so ably points out).

Tax planners and accountants, as we know them, do not exist in Utopia be-cause perfect information is a prerequisite of the model (or, equivalently, trans-action costs are zero—^see Thomton and Bryant, 1986, ch. 2). This short dis-cussions is not the appropriate venue for reenumerating all of the weU-knownreasons why Utopia is unattainable and why, if it were, it would be a very unin-teresting (and unremunerative) place for accountants to live; but a few aspectsof reality are especially germane to the discussion.

RealityIn reality, I may find it advantageous not to reveal my virtual price to myemployer. Knowing it, however, will definitely point me toward my natural

140 D. Thomton

clientele. For instance, if Macnaughton's neutral solution is that I should pay$300 a month for my employer-provided car, and if the employer offers it to mefor $200, there being no other effects on my compensation package, my choiceis clear. This is an example of what I referred to above as "unilateral planning."Also, who ever said that the government "should" pocket the $100 consumersurplus that I might enjoy in my natural tax habitat?

More interestingly, Macnaughton's analysis highlights opportunities for meto get together with my employer and to do some bilateral planning, treatingthe govenunent as a strategic dununy in the analysis. Once we know the neutralsolution from my point of view, we can see which way of providing the fringebenefit most benefits the employer, perhaps "splitting the difference." This isprobably the most interesting and important contribution of the paper, becauseprevious analyses have fallen short of delineating clearly what a Pareto optimalsolution to the planning problem would look like. For instance, if I work for achocolate factory whose candy bars are available for $2 each in the dmg storeacross the street, but the cost of manufacturing a bar is only $.40, there may beroom for some mutually beneficial negotiations between me and my employerin my establishing my compensation package (Thomton, forthcoming, chapter8).

Of course, both of these planning opportunities arise precisely because thegovernment cannot enforce the neutral solution at a reasonable cost. Short ofhog-tying me and administering a lie detector test under threat of electric shocks,how would the government ever elicit my virtual price? How, as Macnaughtonrecognizes, would it compute marginal tax rates in a world of uncertainty andimperfect deductibility and carryforward of losses? It is easy to see that, con-ceptually, a marginal tax rate is merely the first derivative of lifetime taxeswith respect to income; but measuring this rate is tricky, to say the least, evenconceptually (Shevlin, 1990).

These and other problems quickly become apparent even under fairly in-nocuous assumptions. For instance, Baiman, Evans, and Noel (1987) and Rein-ganum and Wilde (1985, 1986) show that there cannot exist a sequentiallyoptimal equilibrium in which the taxpayer, as a Stackelberg leader in a tax com-pliance game, chooses never to cheat, yet the government rationally responds bychoosing to audit at some strictly positive level.' Consequently, some cheating,slippage, and enforcement problems appear to be unavoidable in any tax regime.

ConclusionThe upshot of this discussion is that the first-best, cooperative solution is likelyto be unattainable at finite cost. In the messy, second-best solution hinted atin the discussion of "reality" above, tax policy will not be neutral and wealthwill be reallocated for one (or both) of two reasons. First, often the govemmentwants to reallocate from rich to poor, from province to province, or from sector

1 See also Robbins and Sarath (1991) for an interesting extension of this analysis.

Discussion of Fringe Benefits and Employee Expenses 141

to sector in the economy and finds tax policy the surest way of attaining thatgoal. Second, even if the government desires neutrality, it may be cheaper tolive with a putative misallocation than to institute a costly program to remedyit—especially given that the program may fail for unintended reasons. Even so,Macnaughton's analysis is an excellent contribution to the literature. If nothingelse, it shows policymakers what neutrality would look like if it were attainable;and often it is easy to see that cenain activities are unjust, even it we cannotagree on a definition of justice.

ReferencesBaiman, S., J. Evans, and J. Noel, "Optimal Contracts with a Utility-Maximizing

Auditor," Journal of Accounting Research (Autumn 1987) pp. 217-244.Greenberg, J., "Avoiding Tax Avoidance: A (Repeated) Game-Theoretic Approach,"

Journal of Economic Theory (February 1984) pp. 1-13.Kryzanowski, L. and A. Sim, "The Performance of the Quebec Stock Savings Plan:

The Individual Investor's Perspective," Working Paper, Concordia University(1988).

Reinganum, J. and L. Wilde, "Income Tax Compliance in a Principal-Agent Frame-work," Journal of Public Economics (February 1985) pp. 1-18.

, "Equilibrium Verification and Reporting Policies in a Model of Tax Compli-ance," International Economic Review (October 1986) pp. 739-760.

Robbins, E. and B. Sarath, 'The IRS's Grim Solution in Tax Auditing," WorkingPaper, University of Hawaii at Somoa (1991).

Shevlin, T., "Estimating Corporate Marginal Tax Rates with Asymmetric Tax Treat-ment of Gains and Losses," The Jourrutl of the American Taxation Association(Spring 1990) pp. 51-67.

Thornton, D., Managerial Tax Planning: A Canadian Perspective (forthcoming).Thornton, D. and M. Bryant, GAAP vs. TAP in Lending Agreements: Canadian Evi-

dence (Toronto: Canadian Academic Accounting Association, 1986).