Tax Hikes Are Coming - The Only Question Is How Big

By Thomas Kirchner for RealClearMarkets

Tax hikes are coming. Key proposals by the White House involve an increase in long-term capital gains rates to income tax levels, an increase in the corporate tax rate, and an elimination of the step-up basis on estates.

Taken together, they have the effect of creating a confiscatory tax environment. We look at how such confiscatory tax regimes have failed in other countries in the last decade and discuss some of the academic studies that claim to show massive tax evasion by the wealthy.

Finally, we debunk the widely-held belief in offshore tax evasion by the wealthy on a massive scale.

Confiscatory rates justify abolition of the estate tax

A key element of the Administration’s tax hike proposal is the elimination of the so-called step-up basis. Under current tax laws, a deceased person pays an estate tax of up to 35% on assets upon death. The heirs then receive what is left, and their tax basis reflects the value of the assets upon receipt.

The U.S. differs with this approach from the rest of the world where not the deceased person is taxed, but the heirs on their respective share of the inheritance. Hence, the term “inheritance tax” rather than “estate tax” is used everywhere else.

The problem with the elimination of the step-up basis lies in its combination with the estate tax and the proposed higher tax rates on long-term capital gains, which will lead to overall tax burdens of nearly 90%.

A simplified example illustrates the toxic interaction of these three taxes. Consider an estate worth $100 million that consists of founders’ shares in a business, so we can assume a tax basis of zero.

Upon the death of the founder, an estate tax of 35% is due. For simplicity, we ignore the current $10 million exemption, which is going to sunset in a couple of years anyway.

After paying the estate tax, the heirs will be left with $65 million. The problem is that most heirs won’t have an extra $35 million lying around that they can hand over to the IRS. So, they will be forced to liquidate the estate.

With the tax basis of the shares at zero, they will need to pay $52 million in long term capital gains taxes if they are located in high-tax states such as New York or California. Add to that the $35 million in estate tax, and the total tax burden is $87 million, or nearly 90%.

These are confiscatory tax levels. We believe that eliminating the step-up basis is a good reason for the abolition of the estate tax altogether. After all, it leads to a triple taxation of income: corporate taxes are paid on the profits of the business.

Capital gains are merely the discounted cash flows of the after-tax corporate earnings, so that capital gains taxes are already a form of double taxation. Taxing such gains again with an estate tax then amounts to triple taxation.

Parallels to the French tax debacle

Former French President Hollande gained infamy for not only stating that he hates rich people, but also for acting this way. In 2012, he introduced a 75% “supertax” on earners over 1 million Euros, who were faced with a total tax burden, including social security, of well over 90%.

He found out the hard way that such confiscatory taxes don’t work: many high earners moved to London or Geneva and conducted their business from there; those who stayed behind avoided realizing gains in anticipation of a future repeal.

Actor Gerard Depardieu took the most drastic step of taking on Russian citizenship. While we won’t speculate which Hollywood stars might vote with their feet, we note that Senator Warren is trying to prevent this from happening by calling for an increase of the exit tax on the wealthy.

The end result of Hollande’s tax hike, derided as “Cuba without the sunshine” by then little-known economic adviser Emmanuel Macron, the current President, was that an estimated 10,000 high income earners left France permanently.

Despite this small number of people, income tax receipts fell €16 billion short of projections. Moreover, a mere €200 million per year was raised by the tax, nowhere near enough to offset the drop in tax revenues. Hollande had to rescind the tax two years later.

The confiscatory tax hikes proved to be transitory, as was Hollande, who ended up as a one-term President with approval ratings in the low teens. Permanent, however, was the damage to the French tax base, as few of the tax refugees returned.

Revenue-optimizing tax rates

The proposed tax increase on the highest income earners to 39%, when combined with state and local income taxes, will lead to total tax rates in California and New York of roughly 52%. We believe that this number is no accident.

In 2014, Fed researchers published a study that claimed that the peak of the Laffer curve, at which maximum government revenues are achieved, is 52%.

But just because there is a study that shows that 52% is optimal does not mean it really is optimal. After all, the French “supertax” of 75% is close to the theoretical optimum of 73% that none other than economist Emmanuel Saez calculated as optimal.

That is the same Emmanuel Saez who rose to fame with his monstrous tome “Capitalism in the 20^th Century” a few years earlier, which claimed that rich people were getting so rich that they were becoming a threat to democracy and advocated income tax rates in the range of 54% to 80%.

Of course, we know now that while that 73% tax rate may have been optimal in ivory tower theory, in real life it was terribly suboptimal and had to be nixed.

It might be a good bet that the 52% “optimal” rate calculated by the St. Louis Fed researchers will have the same fate as the French “supertax” and turn out to be dramatically suboptimal and revenue-minimizing.

Do the top 1% really evade 20% of their income taxes?

All this talk about tax hikes comes against a background of an academic study purporting to show that the top 1% of earners evade 20% of their income taxes. That claim made headlines a few weeks ago, but its dubious assumptions remained unchallenged.

Uncontested are the raw data: IRS audit data show that as you climb the income ladder the percentage of tax evasion relative to total income declines sharply.

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In this data, the largest percentage of tax evasion occurs just below the median income group in the 40^th percentile, where taxpayers evade 6% of their income (interesting side note: half of that evasion occurs through Schedule C /sole proprietor income).

For the top 0.1% earners, tax evasion is half that rate, or 3%, while for the top 0.01%, tax evasion is less than 1% of income. To us, the raw data suggest that the system works: penalties for tax evasion become more severe as the amounts evaded increase, with jail time being a realistic prospect for 7-figure evasion.

Not to mention that legal ways to minimize the tax burden through deferral and shelters increase with incomes. Therefore, we would expect that the top of the income pyramid has very little evasion.

Of course, the data runs counter to the narrative that the rich don’t pay their fair share. To make the data fit the narrative, the authors of the study took the percentage of tax evasion found by those IRS auditors who come across the most tax evasion and applied that rate to everyone.

The assumption behind that approach is that the rate of tax evasion is the same for every income group. The outcome is the headline-grabbing result that the top 1% evade 20% of their taxes.

However, as we pointed out, penalties increase as the amounts evaded become larger, so the assumption of a uniform rate of tax evasion for all income groups is highly questionable. Moreover, it runs counter to the actual IRS data. In fact, the methodology is a simple trick that will always yield sensational headlines.

For example, if we take those police officers who encounter the highest incidence of violent crime and then apply that percentage to all demographic groups, we find that the “adjusted” violent crime rate shows massive “undetected” crime.

With this dubious approach, the top 1% of earners will commit massive amounts of “undetected” violent crimes, as do the university professors who create these types of nonsense studies. The differential between actual and theoretical will be largest in the group that has the smallest actual incidence.

The policy response will be to increase policing of those groups who have the lowest actual incidence, because that’s where the most supposedly “undetected” violent crimes happen. Most likely, this will reduce policing and exacerbate problems in those areas where the actual incidence is the highest.

The methodology is arguably useless and purely of academic interest because it applies the worst case scenario to everyone. Basing policy, in particular tax policy, on a worst-case scenario based on unrealistic assumptions is a bad idea.

The myth of offshore tax evasion

Finally, we would like to clarify a myth about offshore tax evasion that underlies many other studies. The fact is that most industrialized countries impose withholding taxes on dividends and interest on foreign-held accounts.

For example, the U.S. generally imposes withholding taxes of 30% on foreigners, while Switzerland, supposedly a tax haven, imposes 35%. That means that anyone stashing away their investments in Switzerland faces a tax rate of 35%. Of course, you can get these foreign taxes back under most tax treaties.

But that requires you to declare the income to your own tax authority, who will then issue a certificate that can be used with the foreign tax authority for a refund. So any American hiding money in Switzerland faces a 35% tax rate on dividends.

If the person invests their hidden Swiss money in U.S. stocks, they face a 30% U.S. withholding tax on dividends, more than the 20% federal tax rate they would pay on qualified dividends on investments fully disclosed to the IRS. Of course, that’s the point of withholding taxes: they are supposed to make hiding assets uneconomic.

And because the assets are undeclared, their owners cannot claim a refund for the withholding taxes. In light of these heavy disincentives, we doubt the claims about the exorbitant amounts of taxes supposedly evaded by the rich through offshore accounts.

In fact, for smaller investors, the cheapest option is to simply pay the withholding tax and forego the refund. This is not because they are hiding assets, but because the cost and complexity of the refund process exceeds what they expect to recover.

Therefore, if someone doesn’t request a refund of their withholding, that alone cannot be taken as evidence of tax evasion, but is simply a cost-benefit tradeoff.

Moreover, in our experience, few financial advisers are familiar with the intricacies of holding foreign stocks and withholding taxes and refunds, so that many end clients probably forego significant refunds due to such ignorance.

To the extent that undeclared offshore wealth actually exists, overall tax receipts would not necessarily increase if all of it were to be declared. As discussed above, the U.S. government already withholds taxes on dividend and interest payments paid to foreign accounts.

If these assets were declared, these withholding taxes would no longer be collected. Moreover, to the extent that these accounts are invested in stocks listed in other countries, taxpayers would be able to claim a tax credit for withholding taxes paid in such other countries.

Depending on how the net effect of all of this would play out, U.S. tax receipts may actually decline if all currently undeclared offshore wealth were to be declared. The absence of considerations of withholding taxes in academic studies on offshore tax evasion is a red flag that these academics lack a good understanding of the complexities underlying offshore investments.

How it will end

Taxes are a hot button topic. A significant proportion of the population is convinced that the rich do not pay their fair share. Much of that is based on myths, which are reinforced by questionable studies and statistics.

Overall, there may be plenty of legal ways to defer and reduce taxes, from special IRA accounts, MLPs and REITs, 1099 exchanges or insurance wrappers to a myriad of other structures. American investors have no need to go into illegality to reduce their tax burden.

Moreover, the increase in individual tax rates may lead to a revival of the C Corp for small businesses.

Rather than passing through all income to the owners, who pay a high tax rate on that income, it will make sense for many highly profitable closely-held businesses to become C Corporations and pay salaries to their owners, while the majority of profits are kept in the corporation, where they are taxed at a much lower tax rate and can grow, with these gains also taxed only at the (lower) corporate tax rate.

The result of the reduction in pass-through entities would be lower income inequality, because the income is no longer reported by the taxpayer but by the corporation. This effect may be one of the reasons why the White House is adopting such tax policies.

For the tax hikes themselves, we foresee three scenarios: in a worst-case scenario, a confiscatory tax regime will be implemented. In this case, the economic boom will end.

Depending on the length of such a tax regime, America may no longer be seen as the land of opportunity and IPOs by the world’s most talented technologists, but as the land of confiscatory taxes. This will do long-term damage to the tech industry and, by extension, the economy as a whole. In a best-case scenario, taxes will be raised only moderately.

In the third, most likely scenario, taxes will be hiked substantially but this will be undone by future elections, as the economic consequences become apparent.

Syndicated with permission for RealClearWire.

Thomas Kirchner, CFA, is a portfolio manager at Camelot Portfolios.

Tax Hikes Are Coming – The Only Question Is How Big