A Fine Mess

by T. R. Reid

  Hollande and his backers fired right back, arguing that Depardieu would be nothing without France and noting that dozens of his films, like many French business ventures, had received financial help from the national government—that is, from French citizens who willingly paid their taxes. Hollande’s second-in-command, Prime Minister Jean-Marc Ayrault, pronounced Depardieu a “pathetic” (minable) figure. That comment in particular seemed to sting. A few weeks later, Depardieu showed up in Russia and accepted a Russian passport directly from the hand of Vladimir Putin. Russia, the Frenchman announced, “is a great democracy and not a country where the prime minister gets to call one of its citizens ‘pathetic.’”10

  But there was little political profit for the French president in a long-running contretemps with a famous matinee idol. And Gérard Depardieu was not the only prominent figure to gripe about the new levy. Once the 75% tax took effect, in 2013, other prominent representatives of les riches began to talk about giving up their passports as well. The Union of Professional Football Clubs, the French equivalent of our National Football League, announced that it would cancel several weekend matches to protest the tax on its top players. In the end, the supertax, which never raised any significant amount of revenue, proved costlier to the politician who imposed it than to the few wealthy citizens who had to pay it. A beleaguered Hollande announced that he would terminate the 75% tax bracket in 2015, just two years after it took effect. The whole experiment seemed to demonstrate clearly that there is a limit to how high any government—even in France—can raise tax rates.

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  THE UNITED STATES PROBABLY doesn’t have to worry about its wealthiest citizens fleeing the country to avoid high taxes, because of a strange quirk of American taxation: the richest generally pay lower rates than those who earn less. As a general rule, the rich pay a higher rate of tax than the poor or the average earner. This is the principle that Jesus Christ enunciated in the parable of the widow’s mite. The United States has adhered to this rule since the first days of the income tax a century ago; at its birth, Teddy Roosevelt declared that the progressive income tax would serve as “a cure for the disease of wealth.” Indeed, in those first years the income tax was much more about reducing inequality than raising revenue; for the first decade of its existence, only the richest 4% of Americans had to pay the new federal income tax. Edwin R. A. Seligman called the income tax a manifestation of “tax justice,” which he defined as “the principle that each individual should be held to help the state in proportion to his ability to help himself.” Even among the wealthiest Americans, Seligman wrote in 1914, “it is rare to find a cynical disregard of all considerations of equity.”11

  But today this basic principle does not apply to the so-called superrich—that is, to the tiny group of taxpayers who report adjusted gross income (Line 37 on Form 1040) of $10 million or more. In 2011—that’s the latest year for which we have data on this—an American family at the median annual income (just over $51,000 then) paid about 6% of adjusted gross income in federal income tax. A family earning double the median income paid about 13% in federal income taxes. In the higher brackets, a family with adjusted gross income of about $200,000 had an average income tax bite of 17.9%. And the “rich”—that is, taxpayers making between $500,000 and $10 million per year—paid federal income tax at an average rate of 24.5% of their adjusted gross income.12

  This fits the pattern of progressive taxation. But the pattern falls apart when we get to the tiny smidgen of the population with an annual income over $10 million—about twelve thousand taxpayers in all. They paid an average of 20.4% of their adjusted gross income in federal income taxes in 2011. That’s a lower rate of tax than the so-called rich. An even tinier segment—the four hundred or so taxpayers reporting more than $100 million in income—paid income tax at an average rate of 18%. Many taxpayers in the “superrich” category actually paid a lower rate of tax than people making 1% of their income.

  This strange peculiarity of the American tax code has been reduced to a popular bumper sticker: “Warren Buffett paid a lower tax rate than his secretary” (a statement that Buffett has confirmed). The explanation takes us back to the distinction that lies at the heart of Thomas Piketty’s bestseller—the difference between the return on capital investments (stocks, bonds, real estate, derivatives, and so on) and income from wages.

  The superrich get most of their income from capital. Capital income is taxed at a lower rate than “earned income,” which comes from labor. As of 2016, the highest tax rate on capital income was 23.8%; the highest tax rate on labor was almost twice as high: 39.6%. If you make most of your income from capital, you pay tax at a lower rate than people who make most of their income from working for wages. For the superrich, return on capital amounts to half their income; for average families, capital represents less than 2% of their income. The Tax Policy Center in Washington estimates that 75% of the savings due to the lower rate on capital gains in 2013 went to taxpayers with income over $1 million. That’s why the wealthiest of all Americans pay lower rates of tax than many people who get their income from wages.

  Most of the world’s industrialized democracies have a lower rate of tax for capital gains than for labor income, although each country has its own set of rules on the definition of “capital” and the length of time the investment must be held to get the lower rate. A few countries—for example, Belgium, Malaysia, and of course New Zealand, the home of BBLR—don’t tax capital gains at all. The argument for a lower tax rate on capital income—an argument supported by many economists—runs as follows: (1) economies need capital investment to grow and create new jobs; (2) capital investment by definition is risky (you could lose it all); and (3) therefore, a lower rate of tax on potential gains is necessary to encourage people to make those essential, but risky, investments.

  Historically, it’s not clear that the third part of this argument bears out. In 1986, none other than Ronald Reagan endorsed a new internal revenue code that taxed capital gains at the same rate (28%) as the top rate on labor income. For the next decade or so, investment soared and stock markets went through the roof, even without a reduced capital gains tax. Just after his election to a second term, Barack Obama signed into law tax changes that significantly raised the capital gains rate (from 15% to 23.8% for the wealthiest taxpayers). Again, it would be hard to argue that this increase suppressed capital investment. In the first four years of the higher capital gains rate, all American stock indexes hit new records over and over again. The S&P 500 index rose from 1,438 on December 1, 2012, to 2,191 on the same date four years later.

  Whether or not the preferential rate makes sense for investors who risk their capital in the markets, it is much harder to justify the special-case capital gains preference that gives investment bankers, hedge fund managers, and other salaried workers in the financial industry a generous tax break not available to employees in any other field. This giveaway is known as the “carried interest” rule; the name evokes a time when a clipper ship captain held a financial interest in the cargo he carried across the sea. It says that a broker or banker who invests other people’s money can count his own salary as “capital gains” and thus pay tax on it at the reduced, capital gains rate. Some of the biggest earners in the nation take advantage of this provision every year to save tens of millions of dollars in federal income tax. That explains why Warren Buffett pays a lower rate than his secretary (and it’s legal). The secretary’s pay is taxed as “ordinary income.” Much of Buffett’s pay is taxed as “capital gains”—at about half the rate. And this is a major reason why the superrich end up paying tax at a lower rate than workers making far less.

  For decades, economists and politicians from left and right have attacked the carried-interest rule as a distortion of the basic capital gains proposition. “Why should someone who does not put any of their own money at risk pay the lower tax rate that Congress intended to reward those who do win such risky bets
?” argues the business professor Peter Cohan, himself a former hedge fund manager. In the 2016 presidential campaign, politicians from Bernie Sanders and Hillary Clinton on the left to Donald Trump and Jeb Bush on the right called for termination of this loophole. “The hedge fund guys didn’t build this country,” Trump said. “These are guys that shift paper around and they get lucky.”13

  One smart line of investment that the hedge fund guys make every year is their contribution to members of Congress. The politicians, in turn, serve their funders by protecting the carried-interest preference from all challengers. Despite its unpopularity, this particular tax break has proven so hard to eliminate that Barack Obama sought to circumvent it instead: he proposed to keep the carried-interest provision but to add a new requirement—it’s been dubbed the Buffett Rule—that says anybody with adjusted gross income over $1 million must pay at least 30% of it in income tax. It was this presidential initiative that prompted the financier Stephen Schwarzman to evoke the Nazis: “It’s like when Hitler invaded Poland in 1939.” Warren Buffett himself has supported the Buffett Rule, but it has never been enacted. Because Obama knew when he proposed the idea that it had no chance of passage, he was (fairly) criticized for promoting a “rule” that was more political posturing than actual policy.

  Generally, we don’t get to see the benefits of the carried-interest preference for any specific taxpayer. But that changed, briefly, in 2012, when the Republican presidential nominee, Mitt Romney, was pressured into releasing a couple of his tax returns. In the year 2010, Ann and Mitt Romney reported adjusted gross income of $21.6 million; most of this was deferred salary paid by the investment firm from which Romney had retired twelve years earlier. The couple gave generously to charity—about $7 million—and reported capital losses on various transactions. This reduced their taxable income to $17.1 million. Had this income been reported as salary, they would have paid more than 35% of it in income tax. But under the tax code, almost all of the Romney income was deemed carried interest. Consequently, their tax rate fell to 13.9%—a lower rate than taxpayers earning less than 1% of their income. To add to the candidate’s embarrassment, the return showed that Romney held some of his money in the Cayman Islands, a famous haven for people trying to hide money from the tax authorities. Romney conceded that he had accounts in the Cayman Islands but said this was not for tax purposes. To which the attorney Frank Schuchat responded, “To say you put money in the Caymans, but not for tax purposes, is like saying you bought a condom, but not for sex.”

  The carried-interest tax break is one of those things that make the United States exceptional when it comes to tax policy. “Most other countries would never think of a dodge like ‘carried interest,’” notes the tax expert Richard Bird. “It’s proof—as if any more proof were needed—that big money gets its way in the U.S. Congress.” And this mammoth tax gift to the richest Americans is one of the reasons that the problem of inequality is so much “more pronounced” in the United States than in other developed democracies. As Thomas Piketty’s unlikely bestseller said, government principles, including tax policy, contribute in major ways to inequality of income and wealth.

  This is why stiffer taxes would be the most powerful antidote to the venom of inequality. But there’s clearly a balance to be drawn. As the French Socialists discovered amid the ruin of their “supertax” idea, if personal taxes get too stiff, people find ways not to pay them—or simply flee, à la l’affaire Depardieu. And it’s not just multimillionaire film stars who cross a border to duck high taxes. Corporations do the same thing, using “convoluted and pernicious strategies.”

  8.

  CONVOLUTED AND PERNICIOUS STRATEGIES

  Caterpillar Inc., the maker of those bright yellow bulldozers, earthmovers, and rock scrapers that have built roads, dams, bridges, and mines all over the planet, is an iconic American manufacturing company, headquartered since 1930 in the quintessential heartland city of Peoria, Illinois. Caterpillar’s mighty machines were present at the creation of Boulder Dam and the Golden Gate Bridge, the interstate highway system and the Superdome; they have diverted the Nile for the Aswan project and leveled the tundra for the Trans-Siberian Highway. Unlike many of its American counterparts, Caterpillar has largely resisted the temptation to move planning or production overseas. The design of its construction machinery, power generators, and industrial-strength engines is still largely carried out on the drawing boards of Peoria. Most of its products can still bear the proud notice “Made in U.S.A.” In 2014, the company reported global sales of $56 billion and generated $3.7 billion in profit. Caterpillar Inc. ranks among the top fifty manufacturing companies in the world, and its stock has been included for decades in the Dow Jones Industrial Average.

  Caterpillar’s prices can be hefty. If you’re in the market, say, for a medium-sized all-wheel-drive road grader, the Caterpillar 140M2 Motor Grader will set you back some $515,000. Yet these machines sell like mad, because they are rugged enough to work anywhere on earth and they last for decades, even if used every day. In fact, that legendary longevity is the real key to Caterpillar’s ongoing financial success. After making a reasonable, but not huge, profit on the initial sale of a machine, the company cashes in big-time by selling spare parts for that same machine for the next twenty, thirty, or forty years. It’s the heavy-equipment equivalent of selling the razor cheap and making the big money selling blades. An internal report to the company’s board in 2012 said that the sale of spare parts acts like “an annuity continuing long after original equipment sales, and generating . . . profits.”1 Because no construction company wants to see a $500,000 machine sitting idle because of a broken crankshaft, Caterpillar aims to replace any part for any machine anywhere in the world within twenty-four hours.

  Accordingly, the spare-parts trade is a crucial element of Caterpillar’s overall business and a key contributor to the company’s profits. And those profits, of course, are subject to the 35% U.S. corporate income tax rate. Thanks to exemptions, allowances, and credits, Caterpillar has never had to pay income tax at the nominal 35% rate. Still, its actual rate of corporate income tax, the company says, runs about 29%—higher than what its competitors in lower-tax countries have to pay. In return, of course, the Peoria-based firm gets all the benefits of being an American company: the world’s richest home market, the patent system and courts to enforce it, the rule of law, a well-educated workforce, extensive transit infrastructure, embassies and consulates in every nation to help it deal with foreign clients, and so on.

  As François Hollande learned, though, a heavy rate of tax generally leads to heavy-duty efforts to avoid paying the tax. Sure enough, early in this century, Caterpillar Inc. was searching hard for ways to cut its tax payments. Into the breach stepped PricewaterhouseCoopers (or PwC), the giant accounting and consulting firm that had audited Caterpillar’s books for decades. PwC offered major American firms a service it called GTOP, or the Global Tax Optimization Program. The “tax optimization” it had in mind was, in fact, tax reduction; that is, PwC promised to look around the world to find places and ploys that could give a traditionally American firm a much lower rate of tax. For Caterpillar, the auditors quickly decided that the lucrative spare-parts business was the best place to launch a cross-border tax-avoidance scheme.

  Until this “tax optimization” program came along, Caterpillar had run its parts business on a fairly simple formula. It designed the parts in Peoria and then contracted with manufacturers—almost all of them in the United States—to build them. Caterpillar bought the parts from the manufacturer, stored them in warehouses (the largest is in Morton, Illinois), and then shipped them to its dealers, around the country and around the world, to sell to the end customer. The profit on those sales accrued to Caterpillar in the United States and was taxed at the U.S. corporate rate.

  But PricewaterhouseCoopers, through the GTOP service, designed a different mechanism (different on paper at least). Under PwC’s guidance,
Caterpillar created a subsidiary in Geneva, Switzerland, called Caterpillar SARL (“SARL” is a Swiss legal term for a corporation). CSARL was then designated—on paper—as the official spare-parts supplier for all Caterpillar customers overseas. The mechanics of design and manufacture didn’t change; almost all Caterpillar parts were still designed, built, and warehoused in the United States, and Caterpillar employees in America still dispatched them to the dealers. But now CSARL, the Swiss subsidiary, became—on paper—the official buyer and seller of those parts. When the parts were sold, the profits on these sales were assigned to the Swiss company and taxed by the Swiss government at a top rate of 6%.

  It was an aggressive tax-avoidance mechanism—the kind of thing that IRS auditors might question when reviewing the company’s corporate tax return. So Caterpillar felt the need to get some legal-sounding imprimatur for its new arrangement. Accordingly, the brass in Peoria decided to ask licensed auditors to judge the legality of the profit-shifting ploy. For this purpose, the company called on its regular auditing firm, PricewaterhouseCoopers—the same firm that had designed the whole Swiss-subsidiary-gets-the-profits scheme in the first place. The PwC auditors concluded, conveniently, that the organizational structure recommended by the PwC tax planners was perfectly legitimate. The auditors also declared, conveniently, that there was no conflict of interest in PwC’s auditing PwC’s proposals.