The weather in Washington, DC, was beautiful; it was one of those Indian summer days with a crisp breeze and pale blue sky that makes October the most pleasant month in the country’s capital. Orange and red leaves on the trees glowed against the white marble monuments on Pennsylvania Avenue. On the South Lawn at the White House, surrounded by about two dozen senators and representatives from both parties, Ronald Reagan was sitting by a little wooden table, a fountain pen in hand, elated.
The president had made overhauling taxation with dramatically lower tax rates the top domestic priority of his second term. On that 22nd of October 1986, about to sign into law the Tax Reform Act, he had reason to be joyful. Starting on January 1, 1988, the country that had pioneered the quasi-confiscatory taxation of high incomes would apply the lowest top marginal income tax rate in the industrial world: 28%. After three weeks of floor debates, the tax bill had passed ninety-seven to three in the Senate. Democrats Ted Kennedy, Al Gore, John Kerry, and Joe Biden all had enthusiastically voted “Yes.”
The bill itself was not especially popular among the public,1 but it is hard to overstate the fervor it garnered among the nation’s political and intellectual elites. For them, it represented the triumph of reason, the victory of the common good against special interests, and the beginning of a new era of growth and prosperity. To this day, and although it is now widely recognized as one of the key contributors to the explosion of inequality,2 the bill is still fondly remembered by all those involved in its crafting. For card-carrying economists working in American universities, it borders on professional duty to profess its virtues.3
How did the government of a country that for decades had taxed high incomes at 90% come to think, in the mid-1980s, that 28% would instead be preferable? This monumental reversal in part reflects dramatic changes in politics and ideology that had contributed to Reagan’s victory six years earlier. Reactivating and modernizing the anti-tax rhetoric of the antebellum South, the Republican party had united high-income voters across the country with Southern whites. The small-government ideas championed by the Mont Pelerin Society from its creation in 1947, embodied by Barry Goldwater in his 1964 presidential run, and advanced by a network of conservative foundations in the 1970s, had finally spread into mainstream thought and prevailed politically.4 In this ideology, the primary role of government is to defend property rights and the key engine of growth is the profit-maximizing business, minimizing taxes paid along the way. “There is no such thing as society, there are only individual men and women,” according to this world view.5 For the atomized individual, taxation is a dead loss; it amounts to legalized theft.
And indeed, speaking on the lawn of the White House, pen at the ready, Reagan denounced a tax system that had become ‘‘un-American”; its “steeply progressive nature struck at the heart of the economic life of the individual.” The new bill, by contrast, was “the best job-creation program ever to come out of the Congress of the United States.”
But on those terms alone, Reagan’s tax reform would probably not have passed the Democrat-controlled Congress—let alone achieved such an overwhelming majority in the Senate. There was something else behind its triumph. According to both Reagan and the Democrats who championed the bill, lawmakers had had no choice. The income tax was a terrible mess and abuse was rampant. Given this state of affairs, all government could do was slash the rates while plugging loopholes to make up for the lost tax revenue.
The Tax Reform Act of 1986 illustrates how progressive taxation dies. It does not die democratically, struck down by the will of voters. Looking at most of the great retreats of progressive taxation, we find the same pattern: first, an outburst of tax dodging; then, governments lamenting that taxing the rich has become impossible and slashing their rates. Understanding this spiral—How does tax avoidance rise in the first place? Why don’t governments stop it?—is key to understanding the history of taxes and the future of tax justice.
THE PRICE FOR A CIVILIZED SOCIETY
In the simplified world of economists, tax enforcement is straightforward: the threat of frequent audits, penalties for tax dodgers, and a simple, loophole-free tax system are all you need to ensure that people pay. And certainly these things are important and necessary. If tax evaders are likely to be detected and face large sanctions for their crime, fewer people will cheat. If the tax code is riddled with breaks for special interests, tax avoidance will proliferate.6
In the real world, however, what makes taxation work is more than a simple tax code and diligent auditors. It’s a belief system: shared convictions in the benefits of collective action (the notion that we are more prosperous when we pool resources together instead of acting in isolation), in government’s central role in organizing this collective action, and in the merits of democracy. When this belief system prevails, even the most progressive tax system can work. When this belief system founders, the forces of tax dodging, unleashed and legitimized, can overwhelm even the most sophisticated tax authority and overpower the best tax code.
This story—the embrace and abandonment of a belief in collective action—is the story of the tax system inherited from the New Deal, perhaps the most progressive in world history. As we saw, it successfully taxed the wealthy for more than three decades—not only on paper, but in actual fact. By design, few people paid the 80%–90% top marginal income tax rates that prevailed from the 1930s through to the 1970s. But, all taxes included, effective tax rates for the very affluent exceeded 50%. Tax dodging was kept in check.
Roosevelt had pioneered, in the 1930s, the enforcement strategy that would keep tax evasion and avoidance under control for the decades that followed. He gave the IRS the legal and budgetary resources to enforce the spirit of the tax code. But, and perhaps even more important, he also spent time explaining why taxes mattered, appealing to morality, and shunning tax dodgers. “Mr. Justice Holmes said, ‘Taxes are what we pay for civilized society’ [the words inscribed above the entrance to the headquarters of the Internal Revenue Service in Washington, DC]. Too many individuals, however, want the civilization at a discount.” So said FDR in his message to Congress on June 1, 1937: Curbing tax avoidance was an issue on which civilization hinged. And through to the 1970s, social norms like this did limit the demand among taxpayers for dubious dodges. Laws and regulations expressing these norms prevented most Americans from exploiting loopholes in the internal revenue code.
The New Deal tax system was not perfect. The main loophole was that from the 1930s to 1986, capital gains were taxed less than other forms of income. Capital gains occur whenever an asset—such as corporate stock—is sold for more than it was purchased for. The resulting gains are included in taxable income but taxed at preferential rates in the United States. When the top marginal income tax rate exceeded 90%, capital gains were taxed at only 25%.7 We can debate the merits and demerits of preferential rates on capital gains—a question we’ll get back to in Chapter 7. But one obvious defect of such a policy is that it encourages the affluent to structure their affairs to earn income in the form of capital gains rather than dividends or wages. It creates opportunities for tax avoidance.
With high top marginal income tax rates in the postwar decades, you might guess that tax dodging was out of control. Surely the wealthy could not resist the temptation to transform—for tax purposes—their highly taxed wages and dividends into lightly taxed capital gains.
But let’s look at the data. Since 1986, capital gains have represented 4.1% of national income on average each year. From 1930 to 1985, when the gap between the top tax rate on capital gains and on ordinary income was much larger—and hence the incentives to reclassify ordinary income as capital gains much bigger—the corresponding figure was 2.2%. Despite a massive tax advantage, capital gains were small in the postwar decades. Some affluent middle-of-the-century taxpayers certainly did reclassify ordinary income into capital gains, but it did not happen on a large scale.
Why? Because governments did not allow it to happen. There aren’t so many ways to make ordinary income look like capital gains. The main strategy involves the use of share buybacks. When corporations buy back their own shares, this has, just like dividend payments, the effect of moving cash out of firms and into the pockets of shareholders. The main difference between the two forms of payouts is their tax implications: share buybacks generate capital gains for the shareholder who sells shares back to the company. Before 1982, share buybacks were illegal. The social norm, as enshrined in the law, was that dividends—subject to the progressive income tax—were how firms ought to distribute earnings to their owners.8
Another way that affluent people could avoid taxes was by earning income in the form of tax-exempt perks provided by their employers, such as company jets, lavish offices, gargantuan meals, company “seminars” in Cape Cod or Aspen, and so on. These things are harder to measure than capital gains. But there is no evidence, in any contemporary chronicles of how company executives lived in the 1940s, 1950s, and 1960s, that such perks were particularly common or large. Analyzing executive compensation shortly after World War II, the economist Challis Hall found that “company-paid-for expenses of the type which really reduce executives’ buying costs and represent extra income are of negligible importance in large companies.”9 Today’s CEOs do not seem to dine much more frugally than their peers from the 1960s, nor do they seem more economical in their use of company jets. Spending lavishly using corporate money was simply not the socially accepted way for company executives to behave before the 1980s.10
Schemes to avoid taxes did regularly pop up, but they were quickly prohibited. In 1935, the Revenue Act hiked the top marginal income tax to 79%, the highest rate to date. After its enactment, the wealthy looked for ways to shirk their new duties. In his 1937 message to Congress, Roosevelt attached a letter from the secretary of the treasury, Henry Morgenthau Jr., listing eight tax-avoidance devices that had blossomed and were to be outlawed immediately. First among these was “the device of evading taxes by setting up foreign personal holding corporations in the Bahamas, Panama, and Newfoundland, and other places where taxes are low and corporation laws lax.” In 1936, dozens of wealthy Americans had created offshore shell companies, to which they had transferred the ownership of their stock and bond portfolios. The shell companies, instead of their flesh-and-blood owners, collected dividends and interest, thus escaping American taxation. The government was quick in changing the law to render this operation explicitly illegal.11 From 1937 on, any income earned by foreign holding companies controlled by Americans would become immediately taxable in the United States. Instantly, owning foreign holding companies to avoid taxes became pointless.
In a similar vein, by the 1960s a growing number of rich Americans had started abusing the law by making tax-deductible charitable contributions to private foundations that they controlled. “Charitable,” these contributions were not: the foundations provided grants to their own founders, their families, or friends; or they made politically motivated gifts. The Tax Reform Act of 1969 cracked down on this abusive self-dealing and the result was immediate: in a couple of years, from 1968 to 1970, the number of newly created private foundations plummeted by 80%. Following this reform, “charitable” giving by the rich fell durably by 30%.12
THE BIG BANG OF TAX DODGING
FDR’s strategy worked as long as successive administrations upheld the New Deal–era belief system. That changed in the early 1980s. “Government is not the solution to our problem; government is the problem,” Reagan famously said in his inaugural address of January 1981. If some people were tempted to eschew taxation, they were not to blame: high, “un-American” tax rates were. In the new ideology that swept through the United States in the early 1980s, dodging taxes became the patriotic thing to do. Since “taxation was theft,” according to the revived libertarian creed, it was also the moral thing to do. Until the 1970s, successive administrations had fought the tax-avoidance industry. When Reagan entered the White House in 1981, the industry became government-approved. The tax-sheltering frenzy could start.
And frenzy doesn’t begin to capture the scale of what happened. The industry mushroomed. A network of financial entrepreneurs, promoters, and advisers stormed the market. Some of these inventors required their staffers to come up with one new idea a week.13 They brimmed with creativity and produced groundbreaking tax dodges. Whenever the IRS shut down a particularly egregious scheme, several others would spawn. They’d be advertised in the Wall Street Journal and the financial sections of leading newspapers like toothpaste. The magic of the market economy operated in full swing; competition drove the price of these tax dodges down. Like any other product in a market economy, their invention enriched both producers and consumers. Financiers, promoters, and advisers pocketed commissions; tax avoiders rounded off their bottom line. A lot of surplus, as economists call these gains, was created. With a little twist: all of this surplus was generated, dollar for dollar, at the expense of the rest of society.
The iconic product of the Reagan era—the iPod of tax dodging, if you will—came to be known as the tax shelter. Here is how it worked. The income tax allowed taxpayers to deduct business losses against any form of income. So the tax-avoidance industry began selling investments in businesses whose sole charm was that they were making losses. These businesses were not regular corporations but partnerships, and as such not subject to corporate taxes. Instead, in a partnership profit is allocated each year to its investors (the partners), added (or subtracted, in the case of a loss) to the partners’ own incomes, and subject to individual income taxes. Whoever invested in these loss-making partnerships—or tax shelters—could claim a share of the business’s loss. For instance, a high-wage employee with a 10% stake in a partnership making a $1-million loss could deduct $100,000 from his earnings—and slash his income tax accordingly. Same thing for a wealthy individual living off interest or dividend income.
Some of these partnerships were sham companies with no economic activity whatsoever. Their raison d’être was to record fictitious paper losses that could be carried on to their owners’ tax returns. Others were genuine businesses that were actually profitable but generated tax losses because of specific provisions of the tax code, such as lavish depreciation allowances in the oil, gas, and real estate sectors. The first tax law of the Reagan era, the Economic Recovery Tax Act of 1981, allowed businesses to depreciate their assets more quickly, boosting the effectiveness of this type of tax shelter.
While the tax shelter industry was born a few years before Reagan entered the White House, it’s only in the early 1980s that it truly boomed. Let’s look at the numbers: In 1978, the amount of partnership losses declared on individual income tax returns represented the equivalent of 4% of the total pre-tax income of the top 1%. It rose first slowly, then exponentially, to reach the equivalent of 12% of the top 1%’s income in 1986—the highest level ever recorded in the history of the US income tax. From 1982 to 1986, fictitious losses reported by investors in tax shelters exceeded the total profits made by real partnerships throughout the country.14 That’s correct: the total amount of partnership net income—profits minus losses—reported on tax returns was negative, a truly unique phenomenon. Even during the Great Depression this had not been the case. Nineteen eighty-two was a recession year but from 1983 to 1986, the economy recovered and grew fast. Yet tax sheltering had reached such high levels that entire industries, from real estate to oil, looked like they were making losses—paper losses, that is, deductible from the personal income of their owners.
Income tax receipts collapsed. By the mid-1980s, federal income tax revenues—individual plus corporate—reached their lowest level as a fraction of national income since the recession of 1949, which had been one of the most severe downturns in modern US history. Meanwhile the federal government deficit rose to over 5% of national income between 1982 and 1986, the highest level on record since the Second World War.
This outburst of tax dodging ultimately strengthened Reagan’s hand when negotiating the 1986 Tax Reform Act. At that point the deficit was so high that Democrats insisted any change to the law must not further deteriorate the fiscal balance. Reagan obliged: tax rates would be slashed, but the cut would be made revenue-neutral thanks to the abolition of tax shelters. Gone would be the days when a fictitious $100,000 paper loss could erase a real $100,000 salary. Business losses, from then on, would only be deductible against business gains.15 Given the level that tax sheltering had reached in the mid-1980s, plugging this loophole was poised to bring in billions. And it did. After the enactment of the law, partnerships, as if by magic, stopped making paper losses. From 12% of the pre-tax income of the top 1%, the total amount of partnership losses fell to 5% in 1989 and 3% in 1992. By the early 1990s, the tax shelter had disappeared.
TAX AVOIDANCE VERSUS TAX EVASION: A FLAWED DEBATE
Markets are the most powerful institution invented so far to satisfy the infinity of human desires; the most efficient way to supply diverse products that address the changing needs of billions of individuals. But they are inherently devoid of any concern about the common good. The same markets that provide us with ever-speedier cellphones and more tasty breakfast cereal can without flinching supply services of no or negative social value: services that enrich one part of society but make another part just as poor, or even make us collectively poorer. The tax-avoidance market is an example of such a market. It does not create a dollar of value. It makes the rich richer at the expense of the government—that is, every one of us. Behind every epidemic of tax dodging lies not a sudden aversion for taxation among the population, but an outburst of creativity in the market for tax dodges.
To be sure, not all of the services provided by tax lawyers and tax consultancy firms are worthless from a social standpoint. Some help individuals and companies understand the tax law, clarify ambiguities, or more basically fill out tax forms on their behalf. These services are all legitimate. But manufacturing products that do nothing but slash taxes owed is not very different from selling burglary tools. At least that’s how this activity was treated before 1980: the market for tax dodges was considered repellent and it was not allowed to prosper. No market exists in a vacuum: governments decide which can exist and which can’t, or at the very least which are to be severely regulated. Tolerating tax avoidance is a choice that governments make.
Which brings us to a series of interesting questions. First, if it’s pure theft, how does the tax-dodging industry manage to legitimize itself?
In America, the rhetoric that condones tax dodging can be traced back to the earliest days of progressive taxation. In 1933, the New York Times revealed that J. P. Morgan—a titan of American wealth—had paid no income tax for 1931 and 1932. The financier soon found himself under attack by the Senate banking committee and became increasingly unhappy with the Democrats’ and FDR’s shaming of tax dodgers.16 Their sin, in Morgan’s view? Lumping tax evasion and tax avoidance together. Tax evasion was breaking the law; everybody agreed it was bad. But tax avoidance wasn’t: it was merely using loopholes in the tax code to keep more of one’s income. There was no moral responsibility to shun loopholes, he insisted. The responsibility was the government’s: if a loophole was there, policymakers had to fix it. In the meantime, those smart enough to exploit it were not to blame. No surprise, Morgan insisted he merely avoided taxes but never evaded.
This line of defense is still at the core of today’s tax-dodging industry. But it was wrong when J. P. Morgan advanced it and it is wrong now. Why? Because the law of the United States—like that of most other countries—contains a set of provisions, known as the economic substance doctrine, that make illegal any transaction that has no other purpose than a reduction of tax liability. Everyone understands that the market for tax dodging will always be one step ahead of governments: it’s impossible to anticipate the myriad ways in which highly paid and motivated tax accountants and consultants will try to circumvent the law. That’s why the economic substance doctrine preemptively invalidates transactions that have no other purpose than avoiding taxes. Investing in sham partnerships to generate tax-deductible paper losses? Creating shell companies in Bermuda with the sole purpose of dodging taxes? Even if they are not explicitly prohibited by the law, these transactions violate the economic substance doctrine. As such, they are illegal.
Of course, it can be hard to know why individual taxpayers enter certain transactions. Sometimes, schemes that look like pure tax dodging also advance a legitimate economic goal. Governments also use the tax system to promote certain activities, for instance investing in local government bonds (whose interest payments are tax-exempt in the United States). Granting these incentives is often bad policy—because it reduces tax revenues for dubious reasons, often under the pressure of special interest groups—but exploiting them is not reprehensible. J. P. Morgan was correct about that. The problem is that a great deal of supposedly “perfectly legal” tax dodging—like the creation of shell companies in small tropical islands—evidently violates the economic substance doctrine, and as such breaks the law.17
POLITICS AND THE LIMITS OF ENFORCEMENT
Which brings us to the second fundamental question. If many transactions that cost billions in tax revenue really are illegal, why aren’t they challenged in court? What prevents governments from enforcing the economic substance principle?
To understand this puzzle, we must start with the fact that tax authorities can’t possibly investigate all suspicious transactions. There is, to start with, a basic information problem: learning about the universe of schemes that pop up takes time, and the tax-avoidance industry can easily overwhelm the examination capacities of the IRS. In 1980, the US Tax Court had 5,000 tax-sheltering cases pending; by 1982, as the tax-dodging frenzy was gaining steam, that number had tripled to 15,000.18 In a few months, the court had to learn about and rule on thousands of different schemes that had spawned, an impossible task.
There’s also a resource problem. The most tax-averse Americans collectively spend billions of dollars each year to craft their tax-optimization strategies, and they spend larger and larger sums. The human and monetary resources available at the IRS are smaller, and they are dwindling. This makes it harder not only to discover dubious schemes, but also to investigate, prosecute, and ultimately invalidate illegal transactions. Even when a fishy stratagem is identified, deep-pocketed taxpayers can hire the best lawyers to defend it (including former lawmakers), extending the legal battle for years and boosting their chances to prevail in court.
In an ideal world, the IRS would rely on self-regulation within the tax-planning industry. Tax lawyers and accountants would follow high ethical principles and see it as part of their professional duty to help enforce the spirit of the law; they would refrain from commercializing dodges that violate the economic substance doctrine. The problem, however, is that these lawyers and accountants are paid by the very promoters and consumers of tax dodges, and thus face a serious conflict of interest.
A good illustration of this issue is the business that has developed since the 1980s wherein aggressive tax dodges are sold along with written legal opinions affirming their plausible legality. These opinion letters, in effect, serve as fraud insurance, protecting tax avoiders against potential penalties in case the scheme they adopt is dubbed abusive by the IRS. Tax lawyers are bound by ethical guidelines (and their conscience) to provide a fair legal opinion. But opining on whether a grey-zone dodge is closer to the black than to the white involves a good deal of subjectivity, and when the monetary reward is high enough, the temptation to supply the “correct” opinion—meaning the one that will whitewash even the dirtiest scheme—can be overwhelming.
Finally, and perhaps most importantly, there can be a lack of political will to enforce taxes. The clearest case in point is the slow death of the estate tax. While estate and gift tax revenues amounted to 0.20% of household net wealth in the early 1970s, since 2010 they have barely reached 0.03%–0.04% annually—a reduction by a factor of more than five. Some of this fall owes to the rise in the exemption threshold and the decline in the top marginal tax rate (from 77% in 1976 down to 40% today), but the bulk of it stems from a collapse in enforcement. In 1975, the IRS audited 65% of the 29,000 largest estate tax returns filed in 1974. By 2018, only 8.6% of the 34,000 estate tax returns filed in 2017 were examined.19 The capitulation has been so severe that if we take seriously the wealth reported on estate tax returns nowadays, it looks like rich people are either almost nonexistent in America or that they never die. If we believe the wealth reported on estate tax returns, wealth is more equally distributed in the United States today than in France, Denmark, and Sweden.20 When people listed by Forbes as being among the 400 richest Americans die, the wealth reported in their estate is on average only half of the Forbes estimate of their true wealth.21
What happened? There has always been estate tax avoidance.22 But successive administrations have addressed the problem with varying degrees of enthusiasm. Since the 1980s efforts have been, to say the least, minimal. Disparaged as a “death tax” by its opponents, the estate tax is the only federal tax on property. It’s also the most progressive of all federal levies—having exempted since its inception more than 90% of the population.23 As such, it has been one of the prime targets of the property-sacralizing, inegalitarian ideology that has shaped American politics since the 1980s. It is impossible to understand the success of today’s estate tax planning industry—the proliferation of “charitable” trusts, the abuse of valuation discounts, not to mention well-documented cases of outright (and unprosecuted) fraud24—outside of this political context. Politics shapes enforcement priorities, most importantly the choice to implement the economic substance doctrine or to tolerate transactions that have the sole purpose of reducing one’s tax bills.
Enforcement decisions are why, in contrast to what’s commonly believed, tax compliance does not necessarily increase whenever tax rates are slashed—quite the contrary. When Reagan reduced the top income tax rate from 70% to 50% in 1981, tax sheltering escalated. Ever since top estate tax rates were cut in the early 1980s (from 70% in 1980 to 55% in 1984) and then again in the 2000s (from 55% in 2000 to 40% today) estate tax dodging has similarly gained steam. In both cases, changes in tax enforcement—changes that reflected the deeper political and ideological shifts driving the decline in statutory rates in the first place—trumped the supposed pro-compliance effects of lower top tax rates.25
“THE POOR EVADE, THE RICH AVOID” . . . OR VICE VERSA?
Who evades taxes today? Answering this question is difficult: measuring illegal activity and the underground economy is by definition fraught with uncertainties. However, we are not completely in the dark. There are two key sources to estimate the size and distribution of tax evasion. The first is random tax audits. In addition to its operational audits, which are targeted at people most likely to be cheating, the IRS examines the tax returns of a subset of randomly selected taxpayers each year. In so doing, the agency’s goal is not to pursue likely tax dodgers but to estimate the size of the tax gap—how much taxes in total go uncollected—and learn more about who evades. That’s why the audited returns are, for the purpose of this research program, selected at random.26
Random audits are a powerful tool that can uncover unreported self-employment income, abuses of tax credits, and more broadly all relatively simple forms of tax evasion. But they have one main limitation: they do not capture the tax evasion of the ultra-rich well. It is almost impossible in the context of a random audit to detect the use of offshore bank accounts, exotic trusts, hidden shell corporations, and other sophisticated forms of tax evasion. Most of these forms of tax dodging occur via legal and financial intermediaries, many of which operate in countries with a great deal of financial opacity. To supplement random audits, one needs to use other sources of information that can capture these complex forms of tax evasion. These sources include leaks from offshore financial institutions—like the 2016 “Panama Papers,” a leak of internal documents from the Panamanian firm Mossack Fonseca—and tax amnesties—government programs where tax evaders are encouraged to come clean in exchange for reduced penalties.
A famous saying among American tax lawyers is that “the poor evade but the rich avoid.” Only boorish taxpayers violate black letter law; the wealthy use civilized and legal loopholes to slash their bills, according to this view. Once we combine random audits with leaked data and amnesty data, however, there is scant evidence that the saying conveys any truth. As shown in Figure 3.1, taking into account all taxes at all levels of government, all social groups in the United States evade part of their tax duties. But the rich seem to evade more than the rest of the population. The fraction of taxes owed but unpaid is stable across most of the income distribution, from the working class to the upper middle class, at a bit more than 10%—before rising to almost 25% for the ultra-rich.27
3.1 THE RISE OF TAX EVASION AMONG THE WEALTHY
(Taxes evaded as percentage of taxes owed, by pre-tax income groups)
Notes: The figure depicts the amount of taxes evaded as a fraction of taxes owed, by groups of pre-tax income, in 1973 and 2018. All taxes at all levels of government are included. In 1973, the rate of tax evasion was fairly constant across income groups. In 2018, the rich evaded more (around 20% to 25%) than the working class and middle class (who evaded around 10% to 12% of their taxes). Complete details at taxjusticenow.org.
How can we explain this finding? First, the working class and the middle class are unable to evade much. Most of their income consists of wages, pensions, and investment income earned through domestic financial institutions. These income sources are automatically reported to the IRS, which makes tax evasion impossible. There is, of course, tax evasion at the bottom of the income pyramid—mostly evasion of consumption taxes (for instance through the use of cash transactions) and of payroll taxes (for instance, in the case of self-employed individuals), the two main taxes paid by working-class Americans. But tax dodging, for the vast majority of the population, is limited by the systematic reporting of information by employers, banks, and other third parties to the IRS.28 As we move up the income pyramid, less and less income is third-party reported, making tax evasion possible.
The second and main reason why tax evasion rises with income is that, in contrast to the rest of society, the rich can count on the tax-dodging industry to help them shirk their duties. This industry has become more elitist over time: it targets wealthier taxpayers today than it did four decades ago. Back in the early 1980s, promoters of tax shelters advertised their creations in mainstream newspapers. On the plus side, they had hundreds of thousands of clients: doctors, lawyers, regular employees, and wealthy heirs alike. But the scams they created were highly visible and always at risk of being shut down by the IRS. The modern tax-planning industry targets the global economic elite through invitation-only events such as galas, golf tournaments, and art exhibition openings. As inequality rises the big wealth management banks—as well as the law firms and fiduciaries that create shell companies, trusts, and foundations—can earn large fees by courting a few extremely rich clients.29
That’s how tax evasion, which back in 1973 (the first year the IRS random audits program was carried out) was roughly constant across the income spectrum, today rises as we move up the income distribution. With the deregulation of the financial industry and the rise of inequality, the tax-dodging industry has never been more extensive—and more concerned with servicing the ultra-rich. This evolution has been reinforced by two concurrent trends. The first is changes in enforcement—as we saw in the case of the estate tax. The second is globalization, which has opened new forms of tax dodging: the shifting of corporate profits to tax havens (which we will study thoroughly in the next chapter) and wealth concealment in secrecy jurisdictions.
3.2 “THE POOR EVADE, THE RICH AVOID” . . . OR VICE VERSA?
(Taxes evaded as percentage of total taxes owed, by pre-tax income groups)
Notes: The figure depicts the amount of taxes evaded as a fraction of total taxes owed, by groups of pre-tax income, in 2018. The graph also displays the composition of tax evasion by type of tax. All taxes at all levels of government are included. In 2018, the rich evaded more than the working class and middle class due to weak estate tax enforcement, aggressive corporate tax dodging by multinationals, and offshore individual income tax evasion. Complete details at taxjusticenow.org.
THE GREAT ESCAPE: TAX EVASION ACROSS BORDERS
At the heart of today’s tax dodging lies a powerful and versatile technology: the offshore shell company. Popularized in 2016 by the revelations in the Panama Papers, the offshore shell company is like a multi-tool. It can be used to avoid estate taxes, capital gains taxes, ordinary income taxes, wealth taxes, corporate income taxes, withholding taxes on cross-border payments of interest, dividends, and royalties. It also comes in handy if you want to defraud the IRS, ex-spouses, children, business partners, or creditors. It’s not unhelpful if your goal is to practice insider trading, launder money, pocket illegal commissions, fund an electoral campaign under the table, or finance terrorist groups. As an emblem of the zero-sum economy, the offshore shell has no rivals.
The use of this technology has skyrocketed since the 1980s. In 1936, as we have seen, a number of wealthy Americans incorporated offshore shell companies to try to avoid income taxes, before Congress made it illegal to earn income abroad without paying tax in the United States. But it’s only over the last three decades that the market for shell companies has taken off. Consider Mossack Fonseca, for which thanks to the Panama Papers leak comprehensive data are available. From its creation in 1977 to 1986, Mossack Fonseca incorporated a few hundred shell companies a year. From 1986 to 1999, thousands a year. From 2000 to 2010, more than ten thousand a year. After the financial crisis, the number of new company formations fell back to slightly less than 10,000 a year. At the time of the leak in 2016, Mossack Fonseca alone had created 210,000 companies in twenty-one offshore financial centers, most prominently the British Virgin Islands and Panama.30 There are no reliable estimates of the total number of active shell companies globally, but it’s likely to be in the hundreds of thousands, and possibly in the millions.
In the United States, shell companies have gained new notoriety thanks to the fraud of Paul Manafort. In August 2018, jurors in Virginia found that President Trump’s former campaign chairman had forgotten to report on his tax returns millions paid by Ukrainian oligarchs to his bank accounts in Cyprus. Just like the vast majority of the offshore bank accounts used by tax evaders throughout the world, his Cypriot accounts belonged on paper to shell companies incorporated in zero-tax places. Why? Because shell companies disconnect bank accounts from their owners, creating financial opacity that makes it harder for tax authorities, investigators, and regulators to know who really owns what. In Switzerland, historically the global epicenter of offshore wealth management, more than 60% of the wealth held by foreigners is owned through shell companies, primarily incorporated in the British Virgin Islands and Panama.31
FIGHTING TAX EVASION: THE LESSON OF FATCA
For a long time, the notion that offshore tax evasion could be fought effectively was greeted with polite circumspection, to say the least. Isn’t Switzerland, like all sovereign nations, entitled to its own laws? If it wants to enforce strict bank secrecy, forbidding financial institutions from sharing information about their clients, what on earth could make it change?
And yet change happened in 2010, when Congress passed and President Obama signed into law the Foreign Account Tax Compliance Act (FATCA), which imposes an automatic exchange of data between foreign banks and the IRS. Financial institutions throughout the world must identify who among their clients are American citizens and tell the IRS what each person holds in his or her accounts and the income earned on them. Failure to take part in this program carries stiff economic sanctions: a 30% tax on all dividends and interest income paid to the uncooperative financial institutions by the United States. Under that threat, almost all countries have agreed to apply this law. Emulating the United States, many other countries have secured similar agreements with tax havens and the automatic sharing of bank information has since 2017 become the global standard. The main tax havens, including Luxembourg, Singapore, and the Cayman Islands, participate in this new form of international cooperation.
Although it is still too soon to provide a quantitative assessment of this policy, it marks a major qualitative departure from earlier practices. Before the Great Recession, there was almost no exchange of data between banks in tax havens and other countries’ tax authorities.32 Hiding wealth abroad, in that context, was child’s play. Doing so nowadays requires more sophistication and determination.
The new regime is imperfect. It would be naïve to think that the same bankers who, for decades, have been hiding their clients behind shell companies, smuggling diamonds in toothpaste tubes, and handing out bank statements concealed in sports magazines, are now all honestly cooperating with the world’s tax agencies. Financial opacity is still extreme, and it’s too easy for offshore bankers to pretend that they don’t have American or French clients—but that they only manage accounts “belonging” to shell companies in Panama or the Bahamas—and thus send no information to the relevant authorities. Even so, it is important to realize the progress made since the mid-2000s, when secrecy and lack of cooperation prevailed.
Time and again, the key lesson emerges: What’s been accepted yesterday can tomorrow be outlawed. New forms of international cooperation, deemed impossible by many, can materialize in relatively short periods of time. Tax evasion is not an unchangeable fate that condemns any project for greater tax justice to failure. Tolerating tax evasion is a choice we collectively make, and we can make other choices.