QOZs Illustrate How Critical Tax Theory May Bolster Tax Policy Analysis, by Islame Hosny
Although Tax Day passed on April 18, 2022, for some taxpayers a different type of tax deadline is approaching. Many tax attorneys, like myself, know that June 30, 2022, is the last day on which certain taxpayers who had capital gains in 2021 can defer paying tax on those gains until 2026 by investing them in Qualified Opportunity Funds (QOFs)—investment vehicles used to invest in Qualified Opportunity Zones (QOZs). According to the IRS, the purpose of the QOZ program is to “spur economic development and job creation in distressed communities by providing tax benefits to investors.”
One such tax benefit is that an investor who holds a QOF investment for 10 years receives a 100% exclusion from federal tax on appreciation on the investment. That is a 0% effective tax rate 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 United States. One of those QOZs is Central Harlem, where 29% of residents are below the federal poverty level, 77.2% of households do not include children, and the median household income is $57,720. The federal income tax liability for a single filer with no children, with income of $57,720, and who takes the standard deduction ($12,550) and, thus, has taxable income of $45,170, is $5,687. This results in an effective federal tax rate of 12.59% for a typical resident in Central Harlem.
In the United States, we have a progressive tax system, which means that as a person’s income increases, so too should their tax rate. This is consistent with vertical equity—one of the touchstones of traditional tax policy—which suggests that those who have more income should be taxed more than those who have 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 a typical Central Harlem resident’s 12.59% rate, traditional tax policy suggests that the capital gain requirement has a regressive effect: it causes 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 disproportionately impacts any demographic groups. For that, we can look to critical tax theory, a growing body of scholarship seeking to uncover explicit and implicit bias in the tax system. According to Anthony Infanti, a law professor at the University of Pittsburgh School of Law, and Bridget Crawford, a law professor at Pace University Elisabeth Haub School of Law, critical tax theorists use various methods of inquiry, including the interpretation of “social science and economic data to show how the tax law impacts groups differently.”
In the United States, while 85% of capital gains are reported by households with adjusted gross income of more than $200,000, only 7% of capital gains are received by households with adjusted gross income under $100,000. According to the Institute on Taxation and Economic Policy, “[b]ecause capital gains overwhelmingly flow to high-income households, they also tend to flow mostly 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 & Information Science, QOF investors are not likely to reside in QOZs.
Looking through a critical tax lens, it is unlikely that Black or Hispanic residents of Central Harlem would have any capital gains, and it is more likely that white taxpayers who do not reside in Central Harlem invest in the Central Harlem QOZ. Thus, critical tax theory suggests that the capital gain requirement is likely to have a disproportionate negative impact on 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 those benefits to outside investors, who are most likely white.
It is undeniable that QOF investors risk their wealth by investing in QOZs, which are, by definition, economically distressed areas. It follows that if no tax incentive is provided to investors, they would be less likely to invest in QOZs. Proponents of the program argue that it causes significant investment in QOZs, spurring economic activity, and creating jobs in those communities. However, the Institute on Taxation and Economic Policy has warned that the QOZ tax rules do not have any mechanism to ensure that the benefits of the program are allocated to the members of QOZ communities.
According to Nancy J. Knauer, Director of the Law & 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 supporting their claims. Knauer’s response is that such an argument assumes that the lack of data showing a disproportionate impact of the tax system on various demographic groups equates to proof that the tax system is equitable. This debate highlights the need for reliable taxpayer demographic data, which the IRS does not currently collect.
The Treasury Department has recently announced its commitment to advancing equity analysis in tax policy by “examining the tax system through a racial equity lens.” The Treasury Department has proposed working with other federal agencies to develop a reliable methodology utilizing statistical modelling techniques to impute race, ethnicity, gender, and other demographic characteristics for tax data. The resulting synthetically modelled data would then be utilized for tax equity analysis. Thus, synthetic data could pave the way for meaningful and comprehensive critical tax analysis.
QOZs account for 12% of census tracts in the United States. If QOZs across the country are like Central Harlem, the capital gain requirement could have a substantial impact on racial equity nationwide. Given that the first 10-year holding period is set to expire in 2028, which will be the first year when the 0% tax rate applies to QOF investors, the Treasury Department should prioritize the synthesis of taxpayer demographic data. Those data should measure the benefits of the QOZ program allocated among QOF investors and QOZ residents to determine whether the capital gain requirement advances racial equity.
The capital gain requirement highlights one instance where traditional tax policy is insufficient to show whether the tax system disproportionately impacts groups of taxpayers. Traditional tax policy should not be discarded, but it can be enhanced by critical tax theory. By adding an additional dimension—taxpayer demographics—to traditional tax policy analysis, a critical tax lens could help us see what traditional tax policy does not.
J.D., Fordham University School of Law, LL.M., New York University School of Law. Islame is an associate attorney and a member of the Tax Group at Pryor Cashman LLP. He is also a student at the Columbia University School of General Studies. All views expressed herein are those of the author and do not represent the views of Pryor Cashman LLP.