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Perfectly Legal: The Covert Campaign To Rig Our Tax System To Benefit The Super Rich—And Cheat Everybody Else
By David Cay Johnson
In his new book, Perfectly Legal: The Covert Campaign To Rig Our Tax System To Benefit The Super Rich—And Cheat Everybody Else, Pulitzer Prize-Winning Reporter David Cay Johnson argues that the American tax system has been corrupted to benefit the super rich.
We learn that the richest 1% of Americans (about 1.3 million households) own one-half of the total financial assets in the U.S. This top 1% had an adjusted gross income of $313,000 in 2000, earning 21% of all reported income and paying 37% of the total federal income tax.
Doesn't this show that the richest 1% pay their share of taxes? No, argues Johnson, who tells us that when all state and local taxes are considered along with Social Security taxes, that America essentially has a flat tax, with all Americans paying about 19% of their income in taxes.
Further, Johnson tells us that many of the ultra-wealthy greatly under-report their income and over-report their expenses, which means they pay far fewer taxes than they should. The super rich also use their political connections to reduce their taxes and even avoid paying what they already legally owe.
According to Johnson, the first step in the covert campaign to reduce taxes on the super rich is propaganda. We learn that the super rich fund many organizations with the political agenda of convincing middle-class and upper-class Americans that tax cuts for the super rich actually help average Americans. Largely, Johnson argues, these organizations spread misinformation.
For example, the "Center for the Study of Taxation," which was founded by a Washington lobbying firm funded by wealthy individuals had the goal of eliminating the estate tax.
Johnson writes: "Despite its name there is nothing scholarly about the center. It publishes brochures opposing the estate tax, relying on anecdotes and witty quotes, not scholarship, to make its points. It is a pure marketing organization, no different from the big ad agencies except that it sells ideology instead of detergent."
After marketing research, the estate tax was given the catchy name "the death tax" in an attempt to repeal it. Claims about the estate tax included:
-It costs the IRS more money to administer the estate tax than it raises. This claim was repeated by George W. Bush during his first presidential campaign. However, there is no evidence to indicate this statement is true. In fact, tax researchers have shown the opposite—collecting an estate tax would raise a good chunk of tax revenue. Nevertheless, the false claim was repeated regularly by those who wished to eliminate the estate tax.
-The estate tax was affecting ordinary middle-class Americans and there was already popular support for eliminating it. It was argued that repeal of the "death tax" was necessary to protect family farms. George W. Bush was quoted as saying "To keep farms in the family we are going to get rid of the death tax."
When many Iowa farmers were asked how important eliminating the estate tax was to them, most said it wasn't important at all. Rather, they said eliminating the estate tax was more about giving a tax cut to billionaires than helping family farmers.
When the President visited Iowa, and was told that farmers weren't concerned about the estate tax, Bush said, "…I don't know who they're talking to in Iowa. I've talked to people who were forced to sell their farms in order to pay for the death tax."
It turns out finding farmers who lost family farms due to the estate tax was more challenging than finding weapons of mass destruction in Iraq. The Farm Bureau asked its affiliates for examples of farms lost due to the estate tax to provide Congress. None found. The White House was asked to supply some examples. No response. Farms had, of course, been lost. But, not due to the estate tax.
In reality, family farms already had special tax breaks that allowed the estate tax exemption to extend to $4.1 million, far above the typical value of a family farm.
Johnson writes: "That the White House and the Farm Bureau could not find any examples to substantiate their claims is not surprising because few farmers in America have the kind of wealth that would even make them subject to the estate tax. The IRS statistics on estate taxes returns show why. Only 2% of the 2.4 million Americans who died in 2000 left an estate that owed any taxes. Of the 52,000 estates that paid taxes, only 2,765 had any farm assets and their average value was $149,000, far below the threshold for estate taxes. Compared to other forms of wealth, farms were almost insignificant, equaling $3.16 out of every $1,000 of taxable wealth. Art in estates was worth more than twice as much as farms, but a campaign to save the family Rembrandts and Picassos would not have won much popular support. …"
Some wealthy individuals, such as Warren Buffet, support an estate tax. Quoting Buffet, Johnson writes: "Repealing the estate tax, Buffet said, is 'the equivalent in economic terms of choosing our Olympic team by picking the eldest sons of the gold-medal winners in the 2000 Olympics. We would regard that as absolute folly in terms of athletic competition. We have come closer to a true meritocracy than anywhere else around the world. You have mobility so people with talents can be put to the best use. Without the estate tax, you in effect will have an aristocracy of wealth, which means you pass down the ability to command the resources of the nation based upon heredity rather than merit.'"
Pundits suggested upping the estate tax exemption to $10 million and making the estate tax rate 25%. That would certainly protect all family farms and even very affluent individuals. And, it would certainly allow the children of billionaires a fair share.
Johnson also tells us the Bush tax cuts are largely a boon to the super rich, while being promoted as tax cuts for everybody. When there are large tax cuts for the wealthy, the average American needs to pay more taxes to make up the difference. This makes it difficult for average Americans to build wealth and save for their retirement.
After discussing how many of the super rich have developed several methods of deferring taxes on their income, or avoided paying any taxes at all, Johnson discusses Social Security. For average American wage earners, Social Security is a punishing tax. And, it represents double taxation. Wages subject to Social Security are also subject to income tax.
Initially, Social Security was designed as a pay-as-you-go tax. This meant that for every dollar spent for Social Security benefits, a dollar was collected. Then, Congress realized that in the future, pay-as-you-go might not work because of a growing elderly population. Congress decided to start collecting Social Security taxes in advance of when the amount was actually needed.
As Johnson explains, due to the time value of money, a tax paid in advance is particularly punishing. It's the opposite of deferring a tax. But, in theory, or rhetoric at least, this would allow the money to be available when needed to fund worker retirements.
Johnson writes: "Internal Revenue Service reports show that from 1973 to 2000, when the Democrats were mostly in control of Congress, Social Security and Medicare taxes grew 82 percent faster than incomes. Because Social Security taxes applied only to the first $76,200 of wages in 2000… this rising burden fell mostly on the middle class and upper middle class."
Unfortunately, both political parties invaded Social Security to cover government operating expenses over the years.
Quoting Johnson, "Fear that excess Social Security taxes would be used to finance tax cuts on which George W. Bush campaigned in 2000 prompted him to promise again and again on the campaign trail he would not touch the money. 'In my economic plan, more than $2 trillion of the federal surplus is locked away for Social Security,' Bush said. 'For years, politicians in both parties have dipped into the Trust Fund to pay for more spending. And I will stop it.' … 'And so the budget I set up says that payroll taxes are only going to be spent on one thing, and that's Social Security. But the Congress won't be using the payroll taxes for other programs. Lockbox, I think, is the terminology they like to use up here.'"
"What George W. Bush said about protecting Social Security was just another politician's promise, worth just what it cost: nothing[,]" writes Johnson.
While the IRS collected $1.7 trillion more in Social Security than it paid out between 1984 and 2002, today, the trust fund is empty, as acknowledged by Bush Treasury Secretary Paul O'Neill.
Johnson tells us that Social Security money was used to cover government operating expenses that otherwise would have been covered by taxes collected from the super rich. In other words, the Social Security fund was looted to give the super rich tax cuts.
Johnson writes: "Using Social Security taxes to subsidize tax cuts for the rich has taken a terrible toll on the finances of those who make up to the maximum wage subject to the levy [The Social Security wage base is about $90,000 today]. The 90 percent of Americans who make less than the maximum wage taxed for Social Security had $1.7 trillion in extra taxes taken out of their paychecks just to help the rich. That is a vast reservoir of money that people could have decided to spend or save, stimulating the economy either through their purchases of goods and services or by investing for the future."
Johnson writes: "On June 7, 2001, President Bush signed his tax cut package that lowered rates on the rich, eliminated the estate tax for one year and gave more than half of the estimated $1.3 trillion tax cut to the richest 1 percent."
Today, we learn not only is Social Security in jeopardy but so is Medicare. Americans will probably need to work more years until retirement and have reduced benefits.
According to Johnson, funding Bush tax cuts for the super rich will hit those earning between $50,000 and $500,000 the hardest because of the AMT or Alternative Minimum Tax.
Johnson says: "The Brookings-Urban Institute studied the issue and concluded that in 2010 about 97 percent of the families with two children whose income is between $75,000 and $100,000 would be forced off the regular income tax system and onto the alternative minimum tax."
Johnson argues that between 2003 and 2012, the Bush tax cuts also include a tax increase of $560 billion in upper-middle class taxes due to the continued existence of the AMT. The AMT will hit families, those with high state income taxes, and those with large medical expenses the most.
The AMT was originally conceived as a way to make multimillionaires pay their share of taxes. It prevented them from taking excessive deductions. Today, the AMT can essentially disallow many reasonable deductions, including the standard deduction.
So, why haven't politicians worked to correct the AMT gone awry? Johnson argues that the middle class and the upper middle class represent a juicy tax base. Yet, these individuals aren't truly affluent enough to join the political donor class, as Johnson labels them.
The political donor class includes those individuals who can easily give politicians hundreds of thousands or millions of dollars to get elected and reelected. When a politician gets a call from a big political donor, the phone call gets returned. That helps assure the political donor class will get special treatment and legislative favors from the politician. Johnson points out that favoritism of the rich is truly bipartisan.
So, what is the result when the super rich make huge political contributions and are able to get their Congressmen on the phone? Unfortunately, the result is often that the super rich are able to skirt paying taxes they legally owe. A call to the IRS from a Congressman accusing the IRS of harassing a wealthy donor unfortunately often leads the IRS to back off the wealthy donor, even if the individual is committing tax fraud.
Johnson tells us that accounting fraud was discovered at Enron by the IRS two years before the scandal at Enron became public.
Johnson writes: "An IRS audit discovered that in 1993 and 1994 Enron had made false reports to shareholders and to the Securities and Exchange Commission, inflating its profits significantly. Congress does not allow the IRS to report such discoveries to the SEC or to prosecutors, just as it cannot tell authorities when a tax return shows that an individual is a marijuana farmer or a pimp. But if the IRS demands more taxes after an audit and sticks by its position, and if the taxpayer is unwilling to pay the extra taxes, then the case will eventually enter the public record through a lawsuit in tax court, a federal district court or the federal court of claims."
Continues Johnson: "IRS auditors denied Enron various tax breaks, so the Houston energy trading company took the matter to an IRS appeals officer, still safely inside the veil of secrecy imposed by Congress, the Senate Finance Committee revealed in 2003 in the back pages of a massive report on Enron. The appeals officer, Bradley Herbert, wrote memos and letters to superiors arguing that the audit should be upheld because that would force Enron to take the issue to court, where its fraudulent reports to shareholders would have been exposed. 'Should the IRS condone this?' Herbert asked in one memo."
Yet, the IRS did not pursue the audit, allowing Enron to continue defrauding investors for over two years after the IRS knew of the fraud, ultimately leading investors to lose tens of billions of dollars.
Johnson makes it clear that honest IRS auditors who wish to pursue rightful audits against super rich donors are placing their careers in jeopardy. And, high ranking officials at the IRS often go on to receive lucrative positions at larger companies.
According to Johnson, over time, the IRS has been remade so that it seldom punishes the super rich who fail to pay their taxes. In some cases, it actually allows them to commit obvious tax fraud. Rather, Johnson tells us that the IRS has a political mandate to pursue more audits against the working poor and the middle class.
Johnson tells us the working poor who claim the earned income tax credit are audited at the rate of one in every 47 filers as of 2000. Johnson says the working poor are more heavily audited than businesses with assets between $1 million and $5 million dollars.
Further, while audits of the working poor have increased, Johnson writes: "The IRS also cut back sharply on audits of the types of business entities favored by the rich. One is the subchapter S corporation, which is favored by many doctors, lawyers, and other professionals because it does not pay taxes directly, but instead passes tax liabilities to their owners. Their audit rates fell to one in 233. Sole proprietorships, businesses that file a schedule C on an individual tax return saw their audit odds plummet to one in 83 if they had $100,000 or more of revenue, but those with revenue of less than $25,000 had a much greater chance of being audited, one in 37."
Johnson points out that it's silly to audit the working poor so heavily because even if the audit produces extra taxes, the amounts are typically small. Yet, auditing wealthy individuals and larger companies has the potential to collect tens or even hundreds of billions of dollars in unpaid taxes.
While audits are down for corporations and partnerships, Johnson says another large part of the problem today is the creation of a new legal business entity called the LLP. The LLP or Limited Liability Partnership allows lawyers and accountants to shield themselves from liability if their business partners commit wrongdoing.
Johnson writes: "The problem is that the LLP structure destroys the self-policing mechanism that helps keep legal and accounting firms from using their enormous power to the detriment of others, especially the third parties like investors who rely on the integrity of audited financial statements to make decisions about buying and selling stocks."
When each lawyer or accountant is responsible for the behavior of their partners and their own personal financial assets are at risk, it's a strong motivator to prevent shenanigans.
According to Johnson, due to tax evasion by the super rich, the average taxpayer needs to pay about $3,000 more in taxes per year to cover the shortfall.
Other interesting points discussed in Perfectly Legal:
- Illegal tax shelters cost honest American taxpayers between $10 billion and $50 billion per year in lost tax dollars.
- Offshore tax fraud might cost honest America taxpayers as much as $70 billion per year in lost tax dollars.
-Due to a lack of IRS resources, only 25% of those individuals who fail to file tax returns are pursued by the IRS.
-Due to a lack of enforcement, in 2002, the IRS assessed only 22 negligence penalties against corporations, a decline of 99% from 1999.
While few people really like taxes, Johnson argues that all wealthy countries tend to have high taxes because the citizens of those countries demand much from their governments. Further, allowing the tax system to be manipulated to serve the interests of the super rich could have dire consequences:
Johnson writes: "Our society cannot remain healthy, with a robust middle class that provides economic and political stability, if we continue to rob average Americans of time and the opportunity to save so that those with five mansions can own seven, and those with one corporate jet can afford two. In the long run this trend will promote political instability. In time many people will question the value of democratic society if they conclude that its rules do not reward those who work hard and play by those rules."
Johnson makes several recommendations for reforming the tax system, including:
-Require that corporations keep the same set of books for the IRS as is used for shareholder reporting
-Eliminate the LLP structure
- Pay informants for turning in tax cheats. Tax cheats are, after all, committing a crime.
- Make an investment in the IRS. The IRS has been intentionally underfunded so that it is handcuffed in pursuing affluent tax cheats. In particular, the IRS probably needs 30,000 new auditors, most of whom should audit large corporations, partnerships, and wealthy individuals.
- Update IRS computer systems to flag possible tax cheats. Surprisingly, while some tax data is checked against other records (such as employment tax data) for consistency, many tax returns and forms aren't adequately scanned to flag potential violators.
In particular, Johnson points out that just capturing one more line of information in K-1 tax returns (K-1s are used for partnerships and S-Corporations) would cost the IRS only $15,000, but would probably lead to collecting billions more in tax dollars. Making the change wasn't politically popular and was abandoned.
- Make every tax bill the subject of public debate. Johnson points out that most tax bills sneak through legislation with little debate and with many goodies for the super rich political donor class.
Johnson writes: "Taxpayers would come out far ahead if every tax bill had to be the subject of open debate with the names of sponsors attached to each change. Transparency is good for taxpayers overall, bad for the favored few.
-Simplify the tax system. Johnson argues that complexity in the tax code arises because legislators modify tax code to provide special breaks to their political donor base. Note: simplification doesn't mean a flat tax rate. Having multiple income tax rates provides no real complexity.
So, is tax reform possible, given the power and interests of the political donor class?
Johnson writes: "The unfairness of the poorest Americans facing a tax burden almost equal to that of those who are far better off has begun to sink in with some Americans who have long been in the thrall of the political donor class. As a congressman, Bob Riley of Alabama never met a tax cut for the rich he did not embrace. He actively modeled himself after the great tax cutter Ronald Regan. But as governor of Alabama in 2003, Riley sought fundamental reform of a system that he said wrongly burdened the poor. Alabamans who earn less than $13,000 pay almost 11 percent of their incomes in state and local taxes, while those making more than $229,000 pay just 4%."
Johnson points out that to Riley and some others, heavily regressive taxes that hit low income individuals and families the hardest and make it impossible for them to save and get ahead are seen as immoral.
Continues Johnson: "The most powerful interests in Alabama soon came out against Governor Riley's plan, which would raise their taxes while lowering those on the poor. He fought back, saying that as a Christian he believes government has an obligation to help the poor, not exploit them. 'If the New Testament teaches me anything, it teaches me not only to love thy neighbor but also to help those who are the least among us.'"
However, Johnson notes that the poor wanted to vote against Riley's plan, showing how misinformation again helped the rich.
Overall, Perfectly Legal: The Covert Campaign To Rig Our Tax System To Benefit The Super Rich—And Cheat Everybody Else by David Cay Johnson is a thorough analysis of the U.S. tax system. I highly recommend it to readers who want to better understand how politics and taxation interact.