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IT WAS THE 10TH SHOT THAT GOT ME DRUNK

May 05, 2005

The tax and economics blogs have been tossing around the idea of whether taxes are a big cause of bankruptcy. Todd Zywicky (Volokh Conspiracy) cites impressionistic evidence that tax forces a significant portion of bankruptcies. Looking at the numbers, Harvard Law prof Elizabeth Warren disagrees via the TaxProf, who also posts a Zywicki response.

Victor Fleisher weighs in today, and his comment rings true with what we see in practice:

The problem that I have with this debate is that I don't understand what people mean when they say that a single factor --- whether it's tax, medical problems, gambling, or whatever, "causes" bankruptcy.

Bankruptcy happens when cash outflows exceed cash inflows for too long. A typical individual debtor has a number of significant outflows. It seems dangerous to choose just one as the "cause" and draw policy conclusions based on that one "cause." Warren and others have written about the rising cost of medical care causing bankruptcy. The jist seems to be that everything is going along fine, and then bam, an unforeseen illness or injury occurs, and things fall apart. Todd Z seems to be saying the same thing here about tax liabilities. I don't get it. Perhaps the medical care, or the tax liability, was the last straw. But you could just as easily say that low wages, or insufficient savings rate, or excessive consumption "caused" the bankruptcy. Am I missing something?

Which brings me to a broader point -- I would argue that one of the worst ways to figure out the "cause" of a bad event is to ask people why they think it happened. Ask someone why they got into a car accident and the top five reasons will never include "I'm a crappy driver."

As amazing as it seems, you do find businesses whose owners have a new Lexus every year and live in big houses, but somehow are unable to scrape up cash to make their payroll taxes. If you ask, they'll say it's the taxes that cause the problem.

More common are businesses that just aren't going well, in spite of their owners best efforts. They need to buy inventory or supplies to take care of their customers for one more week, and they fall to the temptation to use withheld taxes to meet their cash needs

It's also worth noting that income taxes are unlikely to be an immediate cause of bankruptcy because money-losing businesses generally don't have taxable income - so they don't have income tax. Sometimes they even get a cash infusion by carrying losses back for a refund. Unfortunately loss carryback is now a stingy two years; it should be at least three, which is the audit statute of limitations period. If an old year is under audit, and the the carryback period for the year under audit has expired, income taxes can trigger a crisis.

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