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Hedge Fund Tax Avoidance Schemes–using (purported) offshore reinsurers

by Linda Beale

Hedge Fund Tax Avoidance Schemes–using (purported) offshore reinsurers

It seems that billionaires think they are entitled to it all and think they should be able to run their speculative games without paying much of anything at all in taxes to the government they depend on. And none of this is good for the economy or good for the taxpayers not in “the 1%”.

Case in point–John Paulson, the notorious hedge fund manager who got a CDO built to his desires with a bunch of iffy subprime mortgages and then took the short side of the bet, making a fortune off the bet against subprimes in the mortgage crashes underlying the 2007-8 Great Recession.  See, e.g., Zuckerman, Trader Made Billions on Subprime, Wall St. J. (Jan. 15, 2008).

What has Paulson done?  He established a new “reinsurance company” in Bermuda in April, that turned around in June and put the money invested in it  back into Paulson’s hedge funds in New York, as a portfolio of insurance “reserves” to be held to pay off insurance risks that go bad.   The result is tax deferment for Paulson and other executives of his hedge fund along with re-characterization of ordinary compensation income as preferentially taxed capital gains.

For a discussion of the hedge fund reinsurer gambit, see , e.g., any of the following.  The story at Bloomberg has reinvigorated media attention to this issue.

Barile notes that these hedge funds are using reinsurance premiums and investing in a very aggressive way, compared to traditional reinsurers”.  This aggressive position produces a downside if there are low investment returns, especially if there are catastrophes for which they have to pay claims when their investment strategies have produced losses.  He says that “it remains to be seen” whether hedge-fund reinsurers are in it for the long haul, since they have a shorter time frame on making greater returns on their money.

Looking at this as a global concern, Baker ultimately suggests that the Basle Capital Accord rules should be extended to hedge fund reinsurer operations,  “Another area in which the BIS should take a leadership position,” he says, “is the role in which reinsurance firms play in hedge fund operations.  The tax implications of hedge funds using reinsurance firms in their funds for tax advantages points to the need for more government regulation of this activity.”

He describes the basic problem as follows:  “wealthy individuals invest in private placement offerings of offshore reinsurance companies.  These companies, many headquartered in Bermuda, buy insurance policies written by name-brand insurers…and “may then invest its stock issue returns in a hedge fund.  …[That reinsurer] pays no taxes on the trading profits until it sells the fund shares and then the reinsurer is taxed at a lower capital gains tax.  The tax savings are passed on to the individual investor.

He goes on to say that “The problem … is that insurers are exempt from registering as investment companies….These reinsurers do not have to make annual distribution of profits as mutual funds do and they are not taxed by the Internal Revenue Service as investment vehicles.  …In short, the activity … is a method for wealthy investors to reduce their tax burden as a result of a tax loophole.  Since these insurance companies are mixing insurance business with investment business, they need more supervision.

This is especially true when hedge funds are involved.  “[H]edge funds work with reinsurers to reduce tax liabilities for their wealthy clients.  …U.S. hedge fund managers and investors form a tax-advantaged reinsurance company offshore in…Bermuda, which has no corporate income tax.  The Bermuda-based reinsurer sends investment assets to the hedge fund to invest.  Investors return to the United States with shares of the reinsurer and pay no taxes until the company goes public.  At that time, investors [and managers] sell their shares in the reinsurer company and are taxed at a lower capital gains rate.
These schemes are worrisome from both tax and insurer regulatory perspectives.  “Aside from the tax loophole problem, the real issue in these cases is the added underwriting risk incurred in the process. … [Hedge funds acting as reinsurance companies] have insufficient insurance expertise…. Much of this activity has stemmed from financial engineering and deal making of the 1990s. … [W]ithout the bailout of LTCM [Long-term Capital Management hedge fund] by national bank regulatory authorities, many banks and reinsurers might have collapsed as well.”

So why do it and how does the hedge fund reinsurer gambit work?  Remember that these hedge fund execs get a ridiculous amount in compensation in the form of a “fee” (usually 2% of assets under management) and a “carry” (usually 20% of the profits).  (The fee and carry are often represented as 2 and 20, but can be much higher for some firms with status, rising to as much as 5 and 50.)  Without more, hedge fund managers don’t get as much benefit from the claimed treatment of a “profits” partner as private equity fund managers do.  Though the managers claim classification as “profits” partners whose taxation is based on their share of the partnership’s gains and ordinary income and not as payments of (ordinary) compensation, hedges mainly yield ordinary income so don’t act directly as “converter” entities.   Private equity fund managers also claim they are “profits” partners whose income should not be classed as compensation but as pass-through shares of the  partnership items:  in their case, most of the private equity fund’s gains will be deferred anyway (for several years at least until the partnership sells the leveraged company) and they claim those deferred gains should be characterized as pass-throughs characterized by the partnership rather than being characterized as ordinary compensation income to them.  

So for hedge fund managers,  gaining deferment (of what is clearly in substance their compensation as managers) can achieve  minimal current tax.  If the money is cycled through an offshore corporation that pays no taxes, that’s even better because it gets preferential rates as well.  The deferment is achieved by waiting to sell the stock, and the sale of the stock is reported as a capital gain.  Thus what is really current compensation income is re-characterized, through the reinsurer “conduit” scam, as a deferred capital gain.   So hedge fund and private equity managers ultimately both claim to get the best of all possible worlds–their wages from work are not currently taxed as wages at ordinary income rates, they pay no payroll taxes on their compensation, and their compensation is deferred and taxed at preferential capital gains rates.

This is so obviously unfair to the vast majority of ordinary taxpayers who pay taxes on their compensation income even before the end of the tax year through the withholding mechanism that Congress should step in with legislation.   It seems hard to justify a “profits” interest in a partnership at all: it has been created by the “Wall Street Rule” that gains credence because big-money people claim it is correct.  As usual, tax administration eventually mostly went along with it (Rev. Proc. 93-27) and a few court cases (Diamond, Hale) mostly treat the notion of a profits partner who pays no taxes on his compensation as reasonable.  Congress could easily legislate away the profits interest and define partner in a partnership for tax purposes as someone who has made a genuine at-risk equity contribution of cash or property to the partnership. There really should be no such thing as a services partner with a “profits” interest who hasn’t contributed up front for a capital interest.  And all compensation shares to what are currently treated as profits partners could be treated as ordinary income –i.e., compensation currently subject to the income tax and to payroll (Social Security/Medicare) taxation.

This use of reinsurers by hedge funds is itself a tax dodge that has been around a decade or so.  In 2007, the Senate Finance Committee held a hearing on Offshore Tax Issues: Reinsurance and Hedge Funds (S. Hrg. 110-875, Sept. 26, 2007) (179 pages).  In his introduction, Baucus described insurance tax avoidance schemes as follows:

Insurance companies make a living by doing two things: they assess premiums based on the prediction of the likelihood of events against which they insure—that is called underwriting—and they also make money by investing the premiums that they collect until they have to pay out claims. If they are good at those two jobs, they  make a profit.

Customers buy insurance from insurance companies to guard against the risk of fire, disaster, or some other calamity. In exchange for paying premiums, the customers shift some of their risk to the insurance companies. Insurance companies also buy insurance. Property and casualty insurance companies pay premiums to reinsurance companies in exchange for shifting some of their risk to the reinsurance company. Sometimes the reinsurance company is also the parent company of the property and casualty insurance company. In that case, the property and casualty insurance company shifts risk to their parent reinsurance company at something less than an arm’s length transaction.

Here is where the tax avoidance comes in. Some parent insurance companies set their headquarters in low-tax jurisdictions, like Bermuda. Subsidiary property and casualty insurance companies shift risk to the Bermuda parent. Because of Bermuda’s low tax burden, the Bermuda parent can get a greater after-tax return on their investment activities. As a result, subsidiary property and casualty insurance companies can charge lower premiums for their insurance. They get a competitive advantage over insurance companies doing business in jurisdictions that tax investments.

The second setting that we will examine today involves hedge funds. Foundations and other nonprofits are some of the largest investors in the world. The law requires a nonprofit investor that invests directly in hedge fund partnerships to pay the unrealized business income tax, otherwise known as UBIT. The policy behind the law is that tax-exempt entities should not be able to have an unfair advantage over taxpaying entities doing the same thing. To avoid UBIT, nonprofit investors sometimes invest in hedge funds through offshore entities incorporated in low or no-tax jurisdictions, such as the Cayman Islands or Bermuda. These offshore entities are called blockers.

The third setting we will examine today is the compensation of hedge fund managers. Hedge fund managers receive fees from offshore blocker corporations used by nonprofits and foreign investors.Some hedge fund managers elect to defer their income, and deferring income means you pay taxes later, which is the same as a significanttax savings.

The IRS has already noted that offshore arrangements using reinsurers for hedge fund managers may be shams that are subject to challenge on audit.  See Notice 2003-34 (indicating that “Treasury and the Internal Revenue Service have become aware of arrangements, described below, that are being used by taxpayers to defer recognition of ordinary income or to characterize ordinary income as a capital gain.  The arrangements involve an investment in a purported insurance company that is organized offshore which invests in hedge funds or investments in which hedge funds typically invest.”)  Although the notice says that these purported insurers may be challenged as not insurers because they are not using their capital and efforts “primarily in earning income from the issuance of insurance”, and although it states that such arrangements will be subject to close scrutiny that could result in the application of the PFIC rules (leading to current taxation), it has apparently not bothered to challenge any of the big hedge funds’ reinsurer companies.

Again, why would they be subject to challenge?  On the basis that they are not real reinsurers, since the low amount of reinsurance that many provide is the less risky part of the business and provides a buffer to the very high reserves that they retain, sometimes invested solely in a single promoter’s hedge funds.  And if they are not insurers, they are at the least “passive foreign investment companies” (PFICs) on which shareholders are subject to current taxation on profits.  (Or perhaps the IRS might go further and re-characterize the arrangement as a sham , causing the hedge fund executive to have current ordinary compensation income.)    In other words, there is good cause to think that for many of these, the tax haven corporation is acting as an offshore tax-avoidance pocketbook for the hedge fund executive, and not really as an insurer.
By the way, if you think these hedge fund managers who are making multi-millions and billions from managing other people’s assets and hardly paying any U.S. taxes on those huge compensation payments are incredibly smart people who add to the economy’s well-being and therefore merit that kind of out-sized pay or because of the returns they bring to people that then invest them in needed projects in the good ole US of A, you need to rethink that. Hedge funds typically pay out very poor returns, when all the expenses and profits to managers are taken into account.

Roughly speaking, if the typical fund manager worked for free, and if the investment firms didn’t charge, these masters of the universe would still have underperformed a balanced index since 2003, by roughly 2.5 per cent per year. Andrew Hallam, Think you’re smarter than a hedge fund manager?, The Globe and Mail (Feb. 19, 2013) (emphasis added).

cross posted with ataxingmatter

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Right-Wing Mythology 101: the myth of the rich fleeing taxes

by Linda Beale

Right-Wing Mythology 101: the myth of the rich fleeing taxes

One of the right-wing’s most cherished myths is that highly progressive taxes will kill state revenues, since the rich who have the money to pay them will simply move to a more accommodating jurisdiction.
This is repeated in most conversations I’ve had with staunch right-wingers.  They cite their firm “knowledge” of this so-called “fact”.   “I work as a CPA and I’ve seen several rich people who left because of taxes”, they’ll say. Or “My friend is a private banker and he says lots of his rich clients are moving from California because of its high taxes.”  And similar anecdotes.

Of course, there are always a few high-profile cases that seem to confirm the myth.  Celebrities like actor Gerard Depardieu who gave up his French citizenship for a Russian passport make the news.  Celebrities like golfer Phil Mickelson who huffed off a golf course saying he might move because California increased its top rate from 10.3 percent to 13.3 percent get lots of coverage.  These celebrities, of course, make many millions and 1) could afford to pay an additional 2% in state taxes but also 2) tend to develop huge egos that see themselves as the center of the universe and can easily move (since their work is not generally in a single locale).  The people’s response should be to shame them for being so greedy that they aren’t willing to contribute what for them is a piddling amount to make their state better for all its citizens–Phil M experienced a bit of that.  The government’s response should be to discount them as a major force, since they offer merely a rare example of someone with enough money, flexibility, lack of loyalty and ties to carry out a threat to move.

My personal response tends to be–well,go ahead and move, Mr (Ms) Disloyal.  You might as well move to Texas, where you can find a vast cultural lacuna along with a idiot Governor who denies global climate change, but you can always go barbecuing with George W. Bush on his ranch.  Best of luck with the lack of decent water and decent air (and decent anything else) in the future–I hear Halliburton has made quite a mess of parts of Texas…..

The media, of course, has covered these cases elaborately–but luckily at least some of the national media has paid attention to what the empirical evidence, rather than anecdotes, says about moves of the rich.  See, e.g.,  James B. Stewart, The Myth of the rich Who Flee From Taxes, New York Times (Feb. 15, 2013).
It turns out that various economists have studied the question of tax flight.  Jon Shure (Center on Budget and Policy Priorities), Robert Tannenwald (former Federal Reserve economist) and Nicolas Johnson wrote a paper in 2011 called “Tax Flight is a Myth” (executive summary and pdf available at the link).  Here are some excerpts from the summary.

The effects of tax increases on migration are, at most, small — so small that states that raise income taxes on the most affluent households can be assured of a substantial net gain in revenue.


Migration is not common. Most people have strong ties to their current state, such as job, home, family, friends, and community. On average, just 1.7 percent of U.S. residents moved from one state to another per year between 2001 and 2010, and only about 30 percent of those born in the United States change their state of residence over the course of their entire lifetime. …

The migration that’s occurring is much more likely to be driven by cheaper housing than by lower taxes. A family might be able to cut its taxes by a few percentage points by moving from one state to another, but housing costs are far more variable. The difference between housing costs in two different states is often many times greater than the difference in taxes.

Recent research shows income tax increases cause little or no interstate migration. Perhaps the most carefully designed study to date on this issue concerned the potential migration impact of New Jersey’s 2004 tax increase on filers with incomes exceeding $500,000. … At most, the authors estimated, 70 tax filers earning more than $500,000 might have left New Jersey between 2004 and 2007 because of the tax increase, costing the state an estimated $16.4 million in tax revenue. The revenue gain from the tax increase over those years was an estimated $3.77 billion….

The study goes on to look at several of the states that have been reported, anecdotally, to have considerable in-or out-migration due to low-or high-taxation–such as California, Florida, Maryland.  It shows that much of the rationale for movement out of California (and now, out of Florida) had to do with the exceptionally high cost of housing.  While taxes may sometimes be a factor in moves, the primary factors are housing costs, employment, weather, colleges, family, natural disasters and many other economic, democraghic and personal considerations.  In fact, the study reminds that “many of the factors deterring people from moving are most prevalanet among households with higher-than-average incomes”.

The claims underlying the tax migration myth are, in fact, “fundamentally flawed”: they confuse correlation with causation, misrepresent irrelevant findings, and improperly measure migration.

The study provides some useful appendices,  One illustrates how studies by a consulting firm drew arbitrary conclusions about migration patterns with the Portland metropolitan area. \

Interested readers can find another study showing that higher tax rates don’t cause significant numbers of wealthy taxpayers to flee, reviewing the new tax bracket created for millionaires in Maryland, at the Institute on Taxation and Economic Policy: Five Reasons to Reinstate Maryland’s Millionaires’ Tax, ITEP (March 9, 2011).

cross posted with ataxingmatter

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Mark Thoma puts Holtz-Eakin on (figurative) hot seat

by Linda Beale

Mark Thoma puts Holtz-Eakin on (figurative) hot seat

As most of the Angry Bear and ataxingmatter readers know, I do not frequently applaud the economic punditry of those freshwater economists who think the way to deal with the problem of failed market fundamentalism policies is to double-down on those failed policies.

I’ve noted that we tried that already.  We doubled down on  reaganomics policies of tax cuts/militarization/deregulation/& privatization throughout the Bush regime, and that got us into a witch’s brew of problems.

Because of that double-down mentality, where the neos told us war was good and greed was good and where we applied the laughable, made-up-out-of-whole-cloth “Laffer theory” that told us there was no evil that tax cuts (especially for the rich and big corporations) couldn’t conquer, the Bush regime very ably turned a budget surplus into a staggering deficit and a financil crisis that would guarantee more deficits and debt before we were done with it.

We ended up with failed (de)regulatory policies.  They allowed Big Banks and their big moneymakers to speculate their way into phantom billions of profits (all soaked up by the big jefes/big moneymakers).  But instead, we got a near-breakdown of the financial system, that forced all us ordinary taxpayers to subsidize the Big Banks’ losses without getting recompense from the banksters’ earlier oversized payouts.

We ended up with failed tax (cut) policies.  They cut taxes on big multinational corporations and the ultra rich, based on the claim that those are the “job creators” that we should reward.  But instead  they only ended up siphoning off needed revenues from programs that could build infrastructure and support quality education and research.  They privatized education by providing lots of federal loan money to students that went to for-profit schools, only to learn that those schools tend to be traps that don’t educate but just take money for the profit of the “education” business.  They quit funding the stuff we need, so they could subsidize those that didn’t need it.  And they kept the subsidy up–for Big Oil, for wealthy decedents–even when the money was just piling on for those that already had lots of it.

That’s what makes the current ultra-partisan Congress and the constant right-wing talk of deficits and debt as justification for stripping the safety net (while still conferring outsize gains on the ultra rich and Big Business) so disgusting.  The right still  refuses to pay attention to facts and justifies this oft-discredited, clearly wrong-headed market-fundamentalist and class-warfare orthodoxy as “plain as day” correct thinking.

ASIDE:  This seems sort of like the GOP’s plans for gaining the loyalty of our increasing diverse electorate by being careful to package their mostly white, Friedman-orthodox, oligarchy-favoring policies in the sheep’s clothing of multicultural spokespersons who avoid the “tell” of who they really are and use words that talk about ordinary people as though the policies were actually aimed at benefitting them.  Meanwhile they double-down on their claims that redistribution upward is all about job creation, and condemn those who talk about preserving the safety net by NOT reducing benefits as “socialists” who don’t understand the American way.

The American way they seem to be harking to is the era of the corporate titans of malfeasance that Teddy Roosevelt warned us against, who grabbed the gains of the market place well in excess of their productivity merit and didn’t give a damn about the rest of us. (Take Leland Stanford and the building of the great western railroads, subsidized by vast land grants and other programs from the federal government.  Stanford was quite willing to let the Chinamen he hired to use their explosive expertise to carve out railroad tunnels live in hunger because he withheld their pay and die because of inadequate safety , but meanwhile he lived a life of luxury supported by his corporate structure that sent all the money supported by the government subsidies his way and none of it theirs.)

Douglas Holtz-Eakin is a prime example of doubling down on failed policies by ignoring the facts of recent experience.  See Holtz-Eakin, We have to get US government spending under control, (Feb. 14, 2013).  Mark Thoma does a good job of putting him on the hot seat and telling it like it really is.  Read it at Holtz-Eakin Tries to Scare You. Don’t Let Him, Economist’s View (Feb. 14, 2013).  Here’s an excerpt:

Holtz-Eakin (in the Guardian essay): “Debt reduction produces jobs and better economic growth.”
Mark Thoma (in the Economist’s View take-down): “[R]eading that last line, he has learned nothing from the failure of the confidence fairy to appear.  Waiting to fix the debt–a problem driven mainly by health care cost escalation that won’t become severe for many years–is not risky, but his advice certainly is.”
Holtz-Eakin (in the Guardian essay): “Down with the orthodoxy.  It is time to get the deficit under control.”
Mark Thoma (in the Economist’s View take-down): “The notion that we are responding in the same way as in the 60s and 70s, and that we are faced [with] the same type of shock (that require[s] the same types of policies)–an oil price shock and other large supply-side distrubances from demography that we faced then–is wrong and he ought to know that.”…..”The ‘pundit orthodoxy’ he disses is from Paul Krugman.  Kind of funny, given how wrong Holtz-Eakin has been relative to Krugman … but Krugman can speak for himself, and has, on how wrong the ‘we’re about to become Greece!!!’ crowd has been.  There is, however, one thing he [Holtz-Eakin] is correct about.  Holtz-Eakin is right to say we shouldn’t listen to some pundits, especially those like himself who have been so wrong about how events would unfold at every step along the way.”

Holtz-Eakin does a lot more in the Guardian article that is just plain bad, such as claiming that the so-called  Affordable Care Act “entitlement” will contribute to the so-called “entitlement problem,” which will contribute to the “serious” problem that the “deficit orthodoxy” won’t acknowledge.  He then hammers on the right-wing orthodoxy’s pet do-away-with-it-if-we-can projects–Social Security, Medicare, and Medicaid, suggesting that “serious debt reform” requires “serious entitlement reform.” 

As I noted in another recent post, right-wingers like Holtz-Eakin love to talk about safety net programs as “entitlements”, whereas they talk about entitlements for the rich and MNEs, such as the percentage depletion allowance, the preferential capital gains rate, and the various subsidies that have handed outsize profits to big banks as though they were rightfully merited acknowledgements of the good those institutions do the rest of us! The talk about these safety net programs, when entering into a right-winger’s discussion of fiscal issues, is always lopsided.  It is always how we need to cut back on them, and never about how we need to consider if the programs are worthy, the funding currently provided needed or even currently inadequate, and, if the answer is yes, what means make sense, in a sustainable democracy to serve the people, to ensure the ongoing viability of the safety net.  Not reducing benefits but increasing revenues and decreasing rent-profit-taking.

So  Holtz-Eakin fails to acknowledge that actually the Affordable Care Act is a first step in addressing otherwise mushrooming health care costs which occur because we treat health care as a ripe field for rent-seekers to make rentier profits rather than acknowledging (like other advanced countries) that health care is at least a quasi-public good that must be heavily regulated to ensure accessibility.  And like all the right-wingers pushing the hand-wringing worry over deficits for which their own policies are the primary cause, Holtz-Eakin suggests that the core of what we have to do is, quelle surpise, “spending cuts and deficit control”, since “doing nothing or worse, increasing spending, is a profoundly anti-growth strategy.”

This is the doubling-down on failed policy orthodoxy that Americans should reject out of hand.  Spending cuts and efforts at “deficit control” that focus on taking away health care and pension benefits from retirees and others dependent on the safety net are perfect prescriptions for disaster.  We aren’t Greece.  But if the right-wingers like Holtz-Eakin get their way, we will be.

cross posted with ataxingmatter

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Rep Marsha Blackburn’s snow job. Explains how Social Security money flows

I was watching C span Washington Journal this morning.  Rep Marsha Blackburn was the guest.  I got to listen to her explanation of how the Social Security funds flow and just had to post the clip.   Copied from the transcript of the clip:


What she says should not be allowed to stand and if C-span were half of what it used to be, she would not have had the following go uncorrected.  Thus I leave it to the Angry Bears to correct her here and thus document her ignorance of the subject. 

I have not watched this lady before.  I could not help but think she is just a more polished version of Sarah Palin. She is totally capable of pulling off what we used to call a “snow job” when writing their essay.

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Charitable Contribution Deduction–Camp Hearings Feb 14

by Linda Beale

Charitable Contribution Deduction–Camp Hearings Feb 14

Rep. Camp’s Ways & Means Committee held hearings today on the charitable contribution deduction. To watch the hearings, you can go to this website. Camp is planning a tax code rewrite, which he says is intended to lower rates, simplify the code, and curb some tax breaks.
Regarding those Camp objectives–they are not generally the right ones.

  • Lowering rates is the wrong objective.  We already have very very low tax rates, especially when you consider that we do not have a VATalongside the income tax as most European countries do.  The primary motivation for lowering rates appears to be to cut revenues even more, in another ratcheting up cycle of the GOP “starve the beast” game.  Lowering rates allows wealthy taxpayers and corporations to retain more of their profits, when they already garner a higher share of that income than average Americans who toil in their businesses as regular employees.  Lowering rates also results in less revenues and increased borrowing, resulting in higher deficits and higher debt, contributing to the right-wing demand for cutting safety net programs like unemployment insurance, Medicaid, Medicare and Social Security.
  • Simplifying the Code is the wrong objective.  About 70% of US individual taxpayers do not itemize, meaning that their tax returns are quite simple.  For the 30% of taxpayers who do itemize, the complexity is necessary to prevent scams, manipulation and unreasonable subsidization of those who don’t need it.  A tax system intended to cover the many complex transactions of today’s globalized economies cannot be simple without being naive.
  • Curbing some tax breaks is a good idea. But it should be more than “some” and it should be vigorously done to shift the tax burden towards the upper class and business and away from those in the lower and lower-middle income distributions.  The tax breaks that should be curbed are the ones that are most regressive in nature–i.e., the ones that provide the majority benefit to the very rich.

The hearing today included lots of representatives of charities who were arguing their interest–keeping the tax-incentivized flow of money coming.  The typical argument from charities is that the tax deduction is necessary to incentivize the transfer of money to charities.  If it weren’t there, the argument goes, rich people might not give at all, or at least not nearly so much money.

There’s not a whole lot of empirical evidence to back this up.  On the one hand, there are studies showing that  non-rich people give much more of their limited assets away, proportionately, than the richest people (though of course it amounts to much less in absolute dollars), and many of them don’t get any break at all because they don’t itemize. Furthermore, rich people like the names-on-gold-plates-on-opera-house-chairs a heck of a lot, too.  Maybe they give most of the money they give because of the status, the recognition, the remembrance-in-perpetuity, and to get to attend the events they’ve sponsored, which are usually the kinds of cultural events that they enjoy (opera, ballet, elite art museums, etc.).  Does what a rich person says about why he gives hold a lot of weight in this debate?  I’d argue it should not, since those who give typically want to be thought of as important philanthropists and not as status-greedy opportunists who are just giving the minimum amount to get their name and face plastered all over the New York Times…..

Does the tax incentive come into play in determining how much a person will give?  Indubitably.  But it isn’t clear that people who want to give $20 million to their alma matter wouldn’t do so even without the charitable contribution deduction!  All that put together suggests that the deduction is highly inefficient.  Most rich people would give money anyway to the things that bring them prestige and status and recognition and that accomplish what they want to accomplish now that they are rich and can afford to spread money around.

In addition to the inefficiency of the charitable contribution deduction–at least in amounts above some reasonable amount to allow to those who are NOT in the top quintile (say, 10%  of  adjusted gross income), there is also the problem that the deduction is primarily beneficial to the very wealthy.  They pay tax at the highest rates (well, except when the system doesn’t work well because they have mostly preferentially taxed capital gains) and they get the most bang from the buck for the dollars they contribute.  They invariably itemize, whereas most lower-bracket taxpayers do not.  They give in ways that gives them prestige (there is really a quid pro quo for much of their giving, though it may not be financial).

Another complaint from charities and wealthy donors is that the absence of a charitable contribution deduction will result in the government just taking all that money that would have otherwise gone to the charity, because of higher taxes.  The implication is that such a result is disastrous, putting the recipients of the charity’s charitableness at risk.  But the truth is otherwise.  The government may be more likely to support the poor and downtrodden than the wealthy are through charitable donations.  How many wealthy are making contributions to Museums and Opera Houses and Elite Universities, versus a local homeless shelter or similar programs for the needy?  And the decision of what to support, when made by a democratically chosen government, should more accurately reflect the will of the people than the decision of the one (wealthy) donor who gets the tax benefit of a deduction (though of course in these days of partisan gridlock and GOP obstructionism, that is regretably less true).  Shouldn’t democracies favor taxation and redistribution via program selection over subsidizing the wealthy’s favored charities?

So some new, reasonable limits on the charitable contribution deduction make a lot of sense from the perspective of democratic egalitarianism.   My suggestion would be to limit the deduction to  10% of the adjusted gross income reported on the tax return. (Ideally, such a modification to the deduction would be accompanied by a rethinking of the estate tax, to limit the amount that can be passed on to heirs without tax to an amount that more or less approximates the average estate of a taxpayer in the fourth quintile of the distribution.)

What about other changes that would be easier to pass and make lots of sense?

  • Prime amongst them would be the elimination of the fair-market-value deduction (rather than basis) for contributions of certain properties.  This is a sheer giveaway to the wealthy that cannot be justified.  It allows zero basis stock where there is no remaining unrecovered capital investment to be contributed and yield a deduction for the full value, whereas if the person sold the stock, they would at least have to pay capital gains tax on the value.  This provision should simply be deleted from the Code.  That’s one simplification that would actually result in more fairness.
  • Another area to tighten is the rules governing private foundations, to prevent the kinds of abuses (where 20 family members receive exorbitant salaries) that give charities a bad name.
  • And Congress should eliminate the tax giveaway to large corporations (enacted in the Tax Reform Act of 1976) that permits them an enhanced deduction for donations of excess inventory–a deduction in excess of their cost basis and for more than the value of the inventory.  It’s not clear that the deduction incentivizes any additional donations–if a corporation has excess inventory, it will either give it away (which can serve a significant PR function) or sell it at fire-sale prices (which can serve a negative PR function).  IN most cases, it would likely give it away without the enhanced deduction.  Of course, instead of urging Congress to eliminate the large busienss excess inventory special treatment, small businesses (mainly, S corporations with wealthy shareholders) are whining about how tough a time they have and arguing that they should be given a “level playing field” by letting them get the enhanced deduction too.  See NAEIR President Gary Smith’s comments, below (in email).

  Congressman Schock and Mr. Smith agree that the bill [H.R. 2592, introduced in the 112th Congres by Schock] would greatly benefit the small business community by establishing parity for S corporations and other small businesses and as such a level playing field with larger regular corporations.  In addition to the principle of fairness inherent in this legislation in the tax benefits it extends to the small business community on par with larger corporations, Mr. Smith notes that “The impact of this legislation must be understood on the grassroots level: promoting greater collaboration between businesses and charities at the local level.”  In brief, several million struggling small businesses and millions of individuals served by our nation’s charities would benefit through previously unavailable access to a wide variety of free donated products.  (NAEIR email release Feb 14, 2013)
Not surprisingly, NAEIR is busy promoting the “enhanced” tax deduction (for up to two times the value of the excess inventory) to businesse–see here.

cross posted with ataxingmatter

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Let the Wars Start–only when we are willing to pay for them

by Linda Beale

Let the Wars Start–only when we are willing to pay for them

The op-ed page of the New York Times often has some thoughtful items worth reading.  Russell Rumbaugh’s A Tax to Pay for War, New York Times (Feb. 11, 2013), at A17 is one of them.  As Rumbaugh notes, the slight delcine in military spending since 2009 has provided some breathing room on solving the fiscal crisis, but that breathing room could quickly vanish if we undertake new military interventions.  As he notes:

[W]ar spending–like all government spending–wrecks public finances only when more money is spent than is brought in.  …Three years ago, the Senate Budget Committee adopted a bipartisan amendment requirement that wars be paid for.  …[But] none of these proposals resolved the question of whether to pay for future wars through spending cuts or raising more revenue.”

Rumbaugh urges that we “make a choice and require a tax surcharge to pay for any military operation.”

He offers three primary rationales for instituting a war surcharge:

1) Historic norms and traditions for financing wars:  we have historically made major changes in tax poli:y in connection with undertaking wars, from the development of the income tax initially in the Civil War to its permanent inclusion in the US Code during WW I to the use of withholding in WWII and the enactment of a tax surcharge during Vietnam to pay for that war.

2) Ease of implementation: The “savings” from leaving Afghanistan coupled with the passage of the Budget Control Act with a cap on military spending offer a similar opportunity for a war surcharge.  Any “necessary” military spending above the cap would result in an automatic surcharge to raise the necessary revenues.

3) Proper consideration of the costs and benefits of war:  Rumbaugh notes that a surcharge will mean that argumnents for military action “would explicitly include a call for increased taxes, forcing the question of whether the stakes in the military situation are worth the cost.  If the American people agree they are worth it, the president will get both the political support and [the] financing he needs.”  After all, “[i]f military action is worth our troops’ blood, it should be worth our treasure, too.”

These arguments seem sound.  Certainly one factor in causing the Great Recession we are still coming out of was the decision to go to war in Afghanistan and Iraq–wars likely to be long and costly in terms of technical equipment as well as lives and costs of caring for wounded soldiers (physically and psychically) afterwards–and just put it on the credit card by LOWERING taxes at the same time for the very wealthy amongst us in particular.  Whereas tax rates in war have been very high in the past, the Bush wars of choice were fought with borrowed money.  And perhaps those wars were more easily entered into because there was no direct cost obvious to Americans at the outset.

The use of a volunteer armed force left most of us more removed from the conflict; the use of “embedded” journalists who did not have the opportunity to capture iconic images of the war outside the scope of what the Pentagon wanted to be seen left most of us with uncertainty about what was really going on in the war zones; and the use of borrowed money to fund the wars meant Americans could go about their daily lives with little recognition that we were a country engaged in a very costly military battle.

PS. I would note that government spending even when it is based on borrowing doesn’t necessarily “wreck” the economy as he implies–Krugman, Stiglitz and other economists will tell you that it is much better to borrow and spend after a recession than to adopt silly austerity measures.  When the private sector isn’t spending, government needs to.  But we should spend wisely–infrastructure spending, for example, might make a lot more sense than military intervention spending, as Blodget suggests in the post linked below.  Even wiser–tax ourselves to pay for whatever wars we decide to fight.  The war tax is a win-win Tobin tax–if we go to war, at least we have the revenues to pay for the war.  If the potential tax take discourages us from going to war, then we have less war, which I suspect most of us would think is a pretty good outcome……

cross posted with ataxingmatter

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Soon-to-be Google litigation with IRS over 2003-4 returns?

by Linda Beale

Soon-to-be Google litigation with IRS over 2003-4 returns?

Bloomberg dug into Google’s annual SEC 10-k filing to discover that the company plans to litigate an issue from the 2003 and/or 2004 tax years.  No suit has yet been filed, and there is no information regarding the substance of the dispute or the amount at stake.  See Google Plans Litigation Against U.S. Tax Authorities over Audit, (Feb. 6, 2013).

Google has been in the news lately because of its ability to offshore profits to low-tax countries like Bermuda using treaty countries like Ireland and the Netherlands.  Because most of Google’s assets are intangibles, it is relatively costless to claim “sales” through intra company transactions that offshore the intangible and then attribute the profits to other countries.  Valuation of such sales of intangibles is inherently manipulative–no company would actually sell such invaluable essential business property to a third party, and there are strong arguments that our laws should not permit companies to make such “paper-only” transfers of intangible properties to offshore affiliates that have the primary result of creating complex structures that achieve lower US taxes,  like the “Double Irish” and “Dutch Sandwich“.

As the report notes, Google’s 10k reports an overall (state and federal) effective tax rate of only 19.4% in 2012, down from the 21.2 reported in 2010, even though the federal statutory rate on profits is 35%.   In 2012, at least $9.8 billion in profits shifted to a Bermuda subsidiary.  These tax-haven subsidiaries are often just token offices with some paper-pushing and no real business reason for existing.  The difficulty for the government here is action taken by the Bush administration–“In 2006, the IRS signed off on a 2003 intracompany transaction that moved foreign rights to Google’s search technology outside the U.S.”

cross posted with ataxingmatter

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More on PTINs for previously unregulated tax return preparers

by Linda Beale

More on PTINs for previously unregulated tax return preparers

After considering the problems caused by incompetent or fraudulent tax return preparers who were not attorneys, accountants or admitted to practice before the IRS as enrolled agents, the IRS released a study in 2010 on tax return preparation with recommendations for regulation of the industry. Amendments to Circular 230, the set of regulations providing standards for “practice” before the IRS under 31 U.S.C. section 330 (originally enacted in 1884), set forth various requirements to bring formerly unregulated tax return preparers under a set of standards, including use of preparer tax identification numbers (PTINs), competency testing, continuing education, and standards for the various work done in tax preparation.

Three tax return preparers that would be subject to those rules sued claiming that the new rules were beyond the IRS’s authority. In Loving v. IRS, No. 12-385, 2013 WL 204667 (D.D.C. Jan. 18, 2013); ECF No. 21 (Order), the United States district court for the District of Columbia found in their favor, granting both declaratory and injunctive relief on the basis that tax return preparers do not “practice” before the IRS and hence cannot be regulated under the statute.

The IRS moved quickly for a stay of the injunction against enforcement of the tax return preparer regulations pending appeal to the D.C. Circuit. That motion was denied, but the court did modify the injunction “to make clear that its requirements are less burdensome than the IRS claims.” See Loving v. IRS, No. 12-385 (D.D.C. Feb. 1, 2013) (link here is to BNA).

The court acknowledges that Congress specifically authorized the PTIN schema by statute in 26 U.S.C. section 6109(a)(4). The court claims that the PTIN provision does not fall within the scope of the injunction and the IRS may continue to provide PTINs, but it cannot condition eligibility on authorization to practice under the various conditions set out in Circular 230 as required in final regulation 1.6109-2(d). The court has enjhoined the requirement that tax return preparers who are not attorneys, CPAs, enrolled agents or enrolled actuaries must pay fees, pass a qualifying exam, and complete continuing education requirements.

It is to be hoped that the Circuit Court will quickly overturn this overreaching district court’s “stuck in the past” interpretation of the 1884 statute. If that doesn’t happen immediately, then Congress should act expeditiously to “clarify” current law by providing that the PTIN provision includes the ability of the IRS to regulate tax return preparation and that tax return preparation constitutes practice before the IRS. We have seen considerable evidence of tax return preparers who do not understand the tax laws or who intentionally misapply them (in the home office deduction, etc.). It is imperative that those who assist others in preparing tax returns demonstrate minimal competency in the tax law as demonstrated by the qualifying exam.

cross posted with  ataxingmatter

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S&P faces civil charges for mortgage bond ratings

by Linda Beale

S&P faces civil charges for mortgage bond ratings

The Justice Department’s efforts to reach a settlement with Standard & Poor’s Rating Services about the ratings provided to mortgage bonds leading up to the financial crisis have failed, and it appears that civil charges will be filed by the Justice Department and state prosecutors.  See S&P says it expects U.S. civil suit over mortgage bond ratings, New York Times (Feb. 4, 2013).

The suit is expected to be brought in California and focus on about 30 collateralized debt obligation deals (commonly known as “CDOs”) executed in 2007 at the height of the mortgage bubble.  The Justice Department has apparently seen “troves” of damaging emails among S&P employees.
S&P claims the suit is meritless, using hindsight to pinpoint a cause that wasn’t understood at the time.  McGraw-Hill, S&P’s parent company, lost 14% of its value after the announcement.

(Dan here…Yves Smith gives her take on the civil suit.)

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Red state tax "reform" and "economic growth"

by Linda Beale

Red state tax “reform” and “economic growth”

As most tax practitioners and academics know, Professor Paul Caron maintains a “tax prof blog” that provides timely links to most things tax in major papers, blogs, journals, conferences and the like, as well as announcements and releases from theIRS, Treasury and Congress related to tax.  Paul does not usually provide much analysis or opinion, but rather an excerpt or two and a title.

So a recent blog post was titled  “WSJ: States Embrace Tax Reform to Drive Economic Growth“.

This is not an atypical way of titling items on tax prof blog.  The observant reader will notice a slight bias in the title.  The Wall Street Journal article is actually titled “The State Tax Reformers: more governors look to repeal their income taxes” (Jan 29 2013 updated).  The article summarizes states that are lowering or eliminating their income tax (sometimes including their corporate income taxes) and sometimes replacing it with a broad sales tax–for example, in the Republican strongholds of Nebraska and Louisiana.  The Journal article then goes on to opine (and it is indeed opinion) that “this swap makes sense” because “income taxes generally do more economic harm because they are a direct penalty on saving, investment and labor that create new wealth” whereas “sales taxes … hit consumption, which is the result of that wealth creation.”  This is the typical “free market” pitch favoring capital income (and the rich) over labor income (and everybody else).

Of course, the Journal then proceeds to quote Art Laffer for the right-wing corporatist ALEC in an article claiming that a majority of new jobs are created in states without an income tax because of their lack of an income tax.
[Aside:  Laffer is (in)famous as the ‘free market’ economist who described his view of the maximum tax rate by drawing a bell curve on a napkin.  The Laffer Curve is more ideology than theory, as I explain in an earlier post:  CFP’s Laffer Curve Video, ataxingmatter (Feb. 2008). ]

Not surprisingly, Caron’s title suggests that the “real” policy reason for the shift is a “real” desire to create jobs.

I have significant doubts.  Most of the anti-income tax proponents are pro-Big Business and pro-wealth.  A shift from an income tax to a consumption/sales tax is a move from a somewhat (often minimally) progressive tax system to an explicitly regressive tax system.  Such a move favors those with capital assets and mainly capital income.  Claims (like that made by the Civitas Institute cited in the Journal article) that shifting from income tax to sales tax will result in “average annual personal income growth” mean almost nothing since averaging income growth across a population doesn’t really tell you whether almost all of it goes to the wealthy or not–if that growth goes to those already in the wealthy distribution, then inequality increases and in fact most everybody else is worse off, in spite of the “average” growth.

The Journal acknowledges the regressive nature of a sales tax swap, but suggests that exemptions of necessities (e.g., food, medicine, utilities) and rebates for low-income families will suffice.  I also find that doubtful–the very low absolute benefit to the poor of the exemptions and/or rebates, while important, is substantially less than the very real high absolute benefit to the wealthy of the switch to a consumption rather than income tax.  Accordingly, the so-called “reform” will inevitably increase an already devastingly problematic inequality that has resulted in lower quality of life for most Americans on many different areas from literacy to access to health care to teenage pregnancy to death rates and all the many other factors in which Americans enjoy a lower level of quality of life than most other OECD nations.

Not, in other words, a good idea.  As noted in Nick Carnes (who teaches at Duke University), A Tax-Reform Plan that Rewards the Wealthy and Stalls the State, (Jan 24, 2013, modified Jan. 25, 2013), these proposals are being pushed by right-wing propaganda tanks, including a “wealthy conservative foundation [that] has paid [Arthur] Laffer to write another report and to fly to our state to  promote it.”  Id.

The goups behind these proposals have their one-size-fits-all state-level strategy down to a science, but they don’t have a handle on the actual science of state tax reform. It’s easy to see why their ideas are appealing. Who wouldn’t like to grow our economy and lower taxes without cutting vital services like schools and public safety?

However, independent economists in every state where the Laffer plan has been introduced – including North Carolina – have found serious problems with the evidence its proponents have used to back it up. No matter how low the tax rate is, businesses and wealthy people won’t relocate to a state where the schools are bad, the streets are unsafe and the infrastructure is crumbling – things that all tend to happen when taxes are cut to the levels that the Laffer plan outlines.  Id.

The Carnes article goes on to note that “Kansas, which earlier passed the Laffer bill, is now projecting $800 million annual budget deficits and has extended an emergency sales tax that should have expired years ago” while state agencies are facing a 10% across the board cut, with education expected to lose a billion dollars in state funding over the next five years.  Yet no businesses have flocked to Kansas because of the legislation.  Id.

And guess what.  It is the wealthy who would benefit if North Carolina were to carry through with enacting its own form of the “Laffer bill”.  Carnes notes that families earning $24,000 a year would pay $500 MORE in taxes under the Laffer plan, whereas wealthy families with incomes of more than $900,000 a year would pay $42,000 LESS in taxes.  Id. Shifting the tax burden from the wealthy who can easily bear it to the low-income who cannot, while at the same time cutting government support for essential public services that build a shared community is a disaster in the making.

The Wall Street Journal isn’t flummoxed by such facts (which it doesn’t even acknowledge).  The Journal article suggests that the idea (set forth in some Big Oil/Fracking states) of replacing income taxes with revenues from oil and gas extraction would be good (and maybe better than regressive sales taxes) because “it would make everyone a stakeholder” in increased drilling and fracking, thus “help[ing] to build a politicial constituency for more mining and drilling.”  Note the presupposition that supporting “more mining and more drilling” is inherently a public good! (One assumes that the Journal staff think this because Big Oil/Big Gas is Big Business, and the Journal is ALWAYS in favor of whatever Big Business wants.)

That idea strikes me as truly worrisome–we have a climate-change problem, and trying to “buy” votes to support environmental degradation at whatever cost through the swap of income taxes for some (probably minimal) increased royalties (probably also accompanied by less in the way of services, especially for the poor or for public goods like public education) is not a good idea.  Yes, probably those very people who are the poorest and most harmed by environmental degradation would tend to be able to be bought off by that swap–they would not realize that the wealthy are again getting the mountain of the share of the benefit, and they are bearing most of the burden in terms of the long-term costs of the environmental degradation as well as the long-term costs of lower public revenues spent on programs especially important to them because of their lack of a cushion of wealth (schools, public parks, fire/police, health care, etc.).

Interestingly, the Journal article notes that Alaska got rid of its income tax in the 1980s and suggests that’s been a good deal.  Of course, Alaska also gets more back from the Federal government than it gives in Federal taxes–ie, Alaskans have replaced their income tax revenues with federal handouts.

The Journal calls these plans for revamping state laws to provide substantial benefits to wealthy individuals and corporations a “rare bright spot in the current high-tax era.”  That is garbage from both sides.  We do not live in a “high-tax era.”  IN fact, we live in a low-tax era and we are already paying for that with the significant drop in state support for higher education, state support for parks and other public amenities (police and fire protection, protections for workers, fair and easy access to voting, etc.), and state support for K-12 education as well as the failure of the federal government to fund the kinds of infrastructure and education and basic research projects that could make the difference between a continuing great economy and the continuing muddle we are in after the Bush recession. 

All of those costs are borne more substantially by those in the lower-income brackets.  With the proposed “reforms”, the wealthy will be sailing through with even more wealth, able to shut out even more effectively any association with the “lower class” elements and giving even less to support schools, colleges, unemployment benefits, etc.  Meanwhile, the poor and near-poor will get much, much less (when they didn’t owe much in taxes anyway).  Not a bright spot at all.  More like class warfare.

The real reason behind these shifts is to benefit the major members of the Republican base–i.e., Big Business and the wealthy.  It has little to do with jobs…  That’s just a handy obfuscating claim to make about policy moves that substantially shift the benefits of the economic system to the rich and the burdens of the economic system to everyone else.  This is just another element of the class warfare that has been waged for the last few decades to allocate gains to the wealthy.

cross posted with ataxingmatter

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