Faculty Bibliography

In previous articles, we have argued that European Court of Justice’s reliance on nondiscrimination as the basis for its decisions did not (and could not) satisfy commonly accepted tax policy norms, such as fairness, adminstrability, production of desired levels of revenues, avoidance of double taxation, fiscal policy goals, inter-nation fiscal equity, and so on. In addition, we argued that the Court cannot achieve consistent and coherent results by requiring nondiscrimination in both origin and destination countries for transactions involving the tax systems of more than one member state. We demonstrated that - in the absence of harmonized income tax bases and rates - the Court had entered a “labyrinth of impossibility.” Ruth Mason and Michael Knoll claim to have discovered a single, normative criterion that not only resolves this dilemma, but also explains the existing nondiscrimination tax jurisprudence of both the European Court of Justice and the United States Supreme Court. In fact, their crucial, but unrealistic, assumption that taxpayers can never move from one state to another confines the actual scope of their analysis to a very small set of cases involving cross-border workers. Although they endorse economic efficiency as the guidestar for judicial decisions regarding tax discrimination, Mason and Knoll fail to provide any evidence that their proposed norm would reduce tax-induced distortions more than competing norms, even in the limited situations to which their analysis applies. Nor do they make a convincing case that they have found the key to understanding the confusing and inconsistent U.S. and EU judicial decisions, which are not confined to cross-border workers. Finally, implementation of their proposed norm by legislation or litigation is not practical, given the particular tax systems that they say would be required. In short, their proposed norm does not provide a way out of the “labyrinth of impossibility” created by a nondiscrimination approach to taxation of international transactions.

In recent years, the European Court of Justice (ECJ) has invalidated many income tax law provisions of European Union (EU) member states as violating European constitutional treaty guarantees of freedom of movement for goods, services, persons, and capital. These decisions have not, however, been matched by significant EU income tax legislation, because no EU political institution has the power to enact such legislation without unanimous consent from the member states. In this Article, we describe how the developing ECJ jurisprudence threatens the ability of member states to use tax incentives to stimulate their domestic economies and to resolve problems of international double taxation. We conclude that the ECJ approach is ultimately incoherent because it is a quest for an unattainable goal in the absence of harmonized income tax bases and rates: to eliminate discrimination based on both origin and destination of economic activity. We also compare the ECJ's jurisprudence with the resolution of related issues in international taxation and the U.S. taxation of interstate commerce, and we consider the potential responses of both the European Union and the United States to these developments.

The innovation in capital market contracts over the last twenty years has been remarkable. A limited set of familiar instruments (essentially stock, debt, convertible debt, and some options and futures) has been replaced by an array of hundreds of contracts, some of which are marketed to retail investors, whereas others are used primarily by financial managers. This innovation has had many sources, including fluctuations in currency and interest rates, avoidance of government regulation, inconsistencies in the income tax, and analytical advances in understanding and managing risk. Much of the innovation can be decomposed into three continuing developments: 1. Disaggregation: Traditional financial contracts, such as stocks and bonds, have been disaggregated into their constituent parts and separately marketed. For example, government debt securities have been "stripped" into principal and interest components. 2. Recombination: The disaggregated parts of traditional instruments have been recombined into new financial products. For example, interest payments on what is otherwise debt may depend on the value of a specified index of stock prices. 3. Risk Re-allocation: A group of innovative products, collectively known as notional principal contracts, has been developed to allow hedging or speculation with respect to commodity prices, interest rates, currency exchange rates, and other risks. Continuous disaggregation, recombination, and risk reallocation have produced a changing array of new financial contracts that pose a serious challenge for the income tax. 6 The purpose of this Commentary is to elucidate one of the underlying reasons for that challenge and to identify potential responses. In brief, the argument is that our realization-based income tax has relied on a dichotomy between fixed and contingent payments that has never been completely coherent. Recent innovations in financial contracts allow taxpayers to further exploit that incoherence. Part I of the Commentary develops this argument, while Part II illustrates the resulting analysis with three examples of new financial contracts. This two-part approach is followed because the basic conceptual analysis is independent of the contracts in existence at any given moment, but the challenge to the income tax is best understood by reference to actual transactions. Simple numerical examples are used to illustrate the points made in both Parts. Although this Commentary focuses on realization, which concerns the timing of taxation, financial innovation presents other significant difficulties for conventional tax distinctions. For example, many commentators have pointed out that the character (capital versus ordinary) and source (domestic versus foreign) of income and deductions are unsettled in many new products.8 Rather than addressing all such questions, the goal of this Commentary is to show why innovative financial contracts provide a serious challenge to an income tax based on realization, even in the simplest case of purely domestic transactions without special treatment for capital gains and losses.