Taxing Bankrupts

Abstract

When a debtor goes bankrupt and limited assets have to be divided between competing creditors, should unpaid taxes owed to the government be paid before the debts owed to other creditors? This Article defends the notion that some tax debts should be awarded priority. Insofar as bankruptcy protection transfers the risk of financial distress from a debtor to her creditors, the tax priority debate should be understood as a fight about how much debtor default risk the government should have to assume relative to other creditors. This Article argues that the government’s share of debtor default risk should be limited through the grant of tax priority because, contrary to the claims of critics, the government is constrained in its ability to diversify against such risk via both substantive tax policy and changes in tax administration. Tax priority therefore serves as an important structural limit on the government’s bankruptcy risk burden and safeguards the myriad important functions of government.