This article appears in the Spring 2016 issue of The American Prospect magazine. Subscribe here.
For every dollar appropriated to the Internal Revenue Service, the public collects more than $4 in taxes. Nonetheless, Congress has cut the IRS appropriations by $1.2 billion since 2010 while expanding the service’s administrative burdens by giving it responsibility for enforcing laws extraneous to tax collection, such as the Affordable Care Act. The IRS is also responsible for administering innumerable socioeconomic incentives in the tax code, including tax preferences for health care, retirement, social welfare, education, energy, housing, and economic stimulation, none of which are related to the IRS’s primary function of raising revenue—all with reduced funding.
Plutocrats, the richest 0.1 percent of Americans, get the most benefit from a weakened IRS. Because they have the money, the lawyers, the lobbyists, the accountants, and the secret campaign funds, they are able to ensure that the IRS won’t have the resources to effectively collect the money they owe to it. Plutocrats do this by devising tax shelters too complex for the IRS to challenge at an acceptable cost, and by having allies in Congress who intimidate the IRS from issuing tough regulations and who cut IRS funding to prevent adequate enforcement. (The top 0.1 percent consists of 115,000 individuals and families with an average income of $9.44 million. 40.8 percent of the top 0.1 percent are executives, managers, or supervisors of non-finance firms, and 18.4 percent are in the financial professions.)
All this weakened enforcement shifts the tax burden onto middle-income taxpayers whose income generally is reported by their employers, in contrast to the rich who derive most of their income from more complex and less visible sources. The IRS estimates that only about 1 percent of wages reported by employers to the government are underreported, but underreporting could be as high as 56 percent where there is no outside reporting of income to the IRS. That describes most of the income of the very rich, which comes from capital income and very complex financial plays designed to maximize profits and minimize taxes. The plutocrats’ wealth grew from 7 percent of all U.S. wealth in 1978 to 22 percent in 2012. Failure to enforce tax collection was not the primary reason, but it intensified the trend. Far more important were the tax expenditures (subsidies) that only benefited the very rich, enacted by Congress at the behest of the plutocrats’ lobbyists.
One way the IRS encourages taxpayers to pay what they owe is by helping them determine how much they should pay. Unfortunately, because of the 10 percent cut in IRS appropriations since 2010, there are fewer employees to respond. In 2015, only 38 percent of taxpayers could get through to the IRS on the phone. What does that do to a citizen’s respect for the IRS?
Internal Revenue Service (IRS) tax forms for 2015 are photographed in Frederick, Maryland, on January 10, 2016.
In response to pleas from seven former IRS commissioners, Congress did approve a $290 million increase in appropriations for customer service in FY2016, which should allow the hiring of up to 1,000 customer-service personnel. This should increase the number of calls answered this year from 38 percent to 60 percent, according to IRS Commissioner John Koskinen. Unfortunately, there was no increase in the IRS enforcement budget.
The other way the IRS encourages Americans to pay their taxes is by auditing, or by making taxpayers fear being audited. Cheating increases significantly when no one is looking. Overall, the budget cuts reduced IRS staffing by 15 percent since 2010. That budget cut translated into a reduction of more than 2,200 revenue agents. The result: Tax fraud investigations plummeted by 43 percent for individuals and 58 percent for businesses. And that trend is accelerating. In 2014 alone, almost 1,000 enforcement personnel were lost, resulting in 11 percent fewer examinations in FY2014 than FY2013. And the IRS expects to lose between 2,000 and 3,000 employees this year. What makes it even worse is that many of those departing are experienced employees who will have to be replaced by inexperienced ones who won’t get sufficient training—budget cuts have forced an 85 percent cut in employee training.
For all taxpayers, the average risk of being audited in 2014 was just under 1 percent. Interestingly, if you reported no adjusted gross income, the risk of being audited was 5.26 percent. Why? Because of Congress’s demand for more audits of Earned Income Tax Credit recipients—who are low-income earners. Meanwhile, the audit percentage for those who reported between $500,000 and $1 million in adjusted gross income was 3.62 percent. At the very top, the audit figure did rise to 16.22 percent for those who reported adjusted gross income of over $10 million a year.
But many such investigations into plutocrats’ creative tax accounting were aborted because a great deal of sophisticated manpower is required to breach the walls hiding tax avoidance or evasion that are erected by the plutocrats’ army of financial advisers, lawyers, and accountants. A relatively simple example is a maneuver in which an investor swaps dividend-paying stocks with a bank, which lends the stocks to a third party in a country with a low tax on dividends. This transaction provides no economic benefit except to the lawyers, accountants, and bankers; its sole purpose is tax avoidance. The bank earns a fee for arranging the transaction, and the original owner still owns the stock but receives more money than he would have if he just held the stock and had to pay taxes on the dividend income. Everyone wins but the IRS—and the other taxpayers who have to make up the difference.
The IRS could have gone after this kind of scheme for being a sham with no economic benefit except the avoidance of tax. But because of its lack of resources and political vulnerability, the IRS hasn’t made challenging swaps a priority—even though such swaps generated about $259 million in fees for Bank of America alone in 2013. The most that the IRS was willing to do was suggest that these dividend arbitrage deals were essentially risk-free, had no economic substance, and might be considered tax evasion. That declaration and the threat of possible action by the IRS did dampen the enthusiasm for such deals, but still left many deals intact, leaving the plutocrats with the benefit of lower taxes. According to sources within the IRS, the agency temporized by making an oblique threat of possible action; otherwise they would have to expend too many scarce resources litigating one case and making an example out of a “respectable” company with a lot of friends in Congress and the administration. Fortunately, the Federal Reserve Board and the Securities and Exchange Commission are looking into these activities and may take action even if the IRS doesn’t.
Another example is carried interest—a method that hedge fund managers use to convert ordinary income into capital gains. It has been cited by the press for years as a prime example of an unjustified tax loophole, but nothing has been done to close it—even though it could be closed by a simple revision to the IRS regulations. Why? Because too many powerful members of Congress have threatened holy war if the IRS tried to close it, by eviscerating appropriations and having donor allies cut off campaign contributions to those who support closing the loophole.
President Barack Obama makes a statement on the economy and closing tax loopholes called inversions that let big companies operate in the U.S. without paying federal taxes in the Brady Press Briefing Room of the White House in Washington, D.C., on Tuesday, April 5, 2016.
Audits get even more complex and more subject to political resistance when a multinational corporation is involved. A classic case is the use of so-called inversions, where a U.S.-based company shifts its nominal headquarters overseas to avoid U.S. taxes. The most recent examples include Pfizer and Johnson Controls. In 2014, the IRS issued regulations intended to stop inversions by requiring taxes to be paid if U.S. shareholders owned 60 percent or more of the new nominally “foreign” company, but this provision has failed to stop them. For example, Johnson Controls, which has $8.1 billion in untaxed profits offshore, just announced it was going to claim Irish citizenship, although its production facilities in the U.S. will remain. All they had to do was shuffle some more paper and redraft the terms of the deal so that only 56 percent of the shareholders in the Irish company are technically considered former shareholders in the U.S. company.
These are the same “American” multinationals that have pleaded for and received huge tax subsidies, only to abandon American citizenship when they discovered they could save taxes by claiming foreign citizenship. Johnson Controls, for example, got over $300 million in taxpayer subsidies before abandoning its U.S. citizenship. What we should do is eliminate deferral of taxes on income earned abroad and the deductibility of interest in these transactions that are designed to avoid U.S. taxes. (See companion piece by Reuven Avi-Yonah, page 63.)
Among the more egregious examples of tax abuses are those in which companies use transfer-pricing to shift profits to low- or no-tax jurisdictions. Transfer-pricing is a technique in which different units of the same corporation charge one another for services or goods, so as to book profits mainly in tax havens. According to the latest IRS data, U.S.-based corporations claimed that their subsidiaries earn $51 billion a year in the Cayman Islands. Not bad for a country with only 59,000 people and an economy of just $3 billion. Clearly this makes no economic sense, except as evidence of artificially shifting the locus of transactions to avoid taxes. Every IRS commissioner has admitted that the IRS cannot police transfer-pricing because of the complexity and the fact that, when challenged, they are outgunned by the battalions of accountants and lawyers hired by the companies. To make matters worse, the Treasury continues to fight to preserve transfer-pricing. Indeed, Robert Stack, the U.S. Treasury deputy assistant secretary for international tax affairs, recently flew to Brussels to personally attack the European Commission’s attempt to collect taxes from “American” multinationals that have hidden profits in tax havens.
This abuse is widespread in the drug industry. Typically, a pharmaceutical company expenses (or deducts) the cost of developing a drug, and then, when it looks like the FDA will approve it, transfers ownership of the patent to a Bermuda affiliate. It then deducts from its U.S. profits the “royalty” it pays to its Bermuda affiliate, where it is not taxed. The same problem manifests itself in the computer industry because of the difficulty of valuing something intangible like a patent or copyright. This is one of the main reasons why Facebook paid only 4 percent in taxes on its worldwide income.
While more resources would help, the real problem is that companies know far more about their business and markets than does the IRS. We need to shift to a unitary tax system in which profits are apportioned for tax purposes by formula, reflecting such factors as the location of sales, property, or personnel—an approach the U.S. Supreme Court has already ruled is an effective, if not more effective, way of determining where profits are really earned. However, this would require legislation that would be directly contrary to the territorial taxation being proposed in Congress by Republican leaders.
In 2006, the IRS was unable to collect about $385 billion in taxes, according to the Government Accountability Office, equivalent to roughly one-third of total federal discretionary spending. According to Koskinen, this has accelerated because of the recent IRS budget cut. These estimates of underreporting are probably too low. The Senate Permanent Investigations Subcommittee reported in 2008 that 95 percent of the 20,000 bank accounts held by Americans in the UBS bank in Switzerland were hidden from the IRS. Indeed, Gabriel Zucman, an economist at the University of California, Berkeley, estimated that about 8 percent of the world’s financial wealth is stashed in offshore accounts, resulting in a global loss of $200 billion in income-tax revenue, and that, since 1980, the volume of U.S. equities held by tax-haven investors has more than quadrupled. America’s rich now have at least $1.2 trillion in financial wealth offshore.
In this April 24, 2014 file photo a Swiss flag flutters beside the logo of UBS bank in Zurich, Switzerland.
These numbers do not include the approximately $2.1 trillion in profits that are not taxed because they are kept offshore by multinational corporations. A 2015 economic analysis by Reed College Professor Kimberly A. Clausing estimates the amount of taxes being avoided by multinational companies shifting profits offshore to be between $77 billion and $111 billion each year. This results in increased budget deficits, lower government spending, and higher taxes on other taxpayers, including domestic companies that have to compete against the multinationals.
The theme underlying all these problems is that they primarily benefit those in the top 0.1 percent income category, at the expense of the rest of our nation’s taxpayers. If the top income earners don’t pay their fair share of our taxes, the middle-income folks, who have been convinced that cutting taxes is a good thing, will have to fill the void left by the plutocrats. While trying to appeal to lower- and middle-income voters who feel, correctly, that the government is in large part responsible for their economic and social problems, the Republicans are proposing solutions that will add to the middle-class tax burden and encourage the rich to fill their campaign coffers.
Everyone admits the tax code is too complex, but the reason is that it was designed by the best-connected (and best-paid) lobbyists to exempt the rich and powerful from paying taxes. Lee Sheppard, one of the world’s leading tax experts, estimated that our so-called business tax code hands out twice as much in tax expenditures (subsidies) as it collects. A classic example of the plutocrats’ power is the so-called “reform” being pushed by multinational corporations and the Republican leadership to adopt a “territorial” tax system. Under a territorial tax system, all the profit the multinationals claim they earn offshore would be 100 percent exempt from U.S. taxation. Talk about a job-killing tax proposal! It would accelerate the multinationals’ shifting of profits and jobs offshore, and increase their competitive advantage over domestic companies that would have to pay taxes the multinationals don’t pay. Note that I used the term “multinationals,” rather than “American multinationals,” because they will invest wherever in the world they can make the most profit. They are called multinationals for a reason.
You would never know that the IRS is essential to funding the government we want by listening to the Republican presidential candidates. Senator Ted Cruz wants to abolish the IRS. Former candidate Carly Fiorina promised to reduce the tax code to three pages. Unfortunately, many of their supporters believe those promises are possible, thanks to the tax-cutting theology spewed out by “think tanks” funded by plutocrats like the Koch brothers. This represents a failure of our educational system and the media, which all too often merely report the most outrageous statements without analyzing whether those promises are based on a tax-cutting theology—or on evidence that shows that such a solution doesn’t work. Ironically, Cruz, for example, is trying to shift the burden of funding the government from the plutocrats, who are financing his campaign, to the disaffected and clueless middle class, which has lost income and social status over the last 30 years because of just such policies. And each of the tax-cut proposals by the Republican candidates would increase the deficit significantly. So much for fiscal responsibility!
Many Democrats are not much better. Senator Chuck Schumer, who is the chief fundraiser for Democratic senators, is proposing a territorial tax to exempt the “foreign” profits of multinationals from taxation. Deputy Assistant Secretary Stack, the lead U.S. delegate to the OECD’s Committee on Fiscal Affairs, was named 2015 “Tax Person of the Year” by Tax Notes* because he successfully protected the interests of “U.S.” multinationals. He proudly claimed he preserved their ability to shift income to tax havens through transfer-pricing, and prevented the OECD from adopting an apportionment system for allocating profits—the only effective way to prevent multinational corporations from hiding income in low- or no-tax countries.
The importance the plutocrats and their campaign recipients attach to crippling or intimidating the IRS is clearly seen in the hysterical attacks on Lois Lerner, then the IRS director of exempt organizations, whose office decided to investigate whether some conservative secret fundraising groups were entitled to tax-exempt status. After millions of dollars were wasted in congressional investigations, it turned out that the decision to look into these groups was made by mid-level IRS employees, and was not targeted at “conservatives” as alleged. But that hasn’t stopped the attacks, which were aided by IRS inability to produce emails—because of the very budget cuts imposed by its congressional attackers. Indeed, the chair of the House Oversight Committee, Republican Jason Chaffetz of Utah, and 18 of his Republican colleagues are now trying to impeach Commissioner Koskinen.
The media need to do a better job of informing the public of what is at stake and what needs to be done. Voters have to know who has been selling them out to the plutocrats so they can hold them accountable. Those politicians who have hidden behind the tax-cutting theology so as to feed off the plutocrats’ money have to understand that opposing an effective IRS and opposing real tax reform will result in lost elections. Otherwise, the shift of wealth to the top 0.1 percent, away from the middle class, will continue to undermine our economy.