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Financial Planning > Tax Planning > Tax Reform

Richest in US Have a Few Tricks to Avoid Democrats' Tax Plans

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Rep. Alexandria Ocasio-Cortez Rep. Alexandria Ocasio-Cortez has suggested raising income taxes on the wealthy. (Photo: Bloomberg)

If Democrats want the wealthy to pay more into the U.S. Treasury, they’ll need to contend with one fact: The rich are very good at dodging taxes.

The top 0.1 percent have become expert in shifting and re-labeling their income in response to tax incentives. That skill is why some on the left are proposing blunter tools to tackle inequality. Massachusetts Senator Elizabeth Warren, who’s exploring a run for president, is proposing a wealth tax, a 2 percent annual levy on fortunes of more than $50 million and a 3 percent tax on the assets of billionaires.

Others, including Representative Alexandria Ocasio-Cortez from New York, have suggested hiking income tax rates.

“There’s an element, yeah, where people are going to have to start paying their fair share,” Ocasio-Cortez told Anderson Cooper on “60 Minutes” on Jan. 6. “Once you get to the tippy tops, on your 10 millionth dollar, sometimes you see tax rates as high as 60 or 70 percent.”

But new research on the U.S.’s largest fortunes shows that simply raising marginal income tax rates may not move the needle on inequality. Any proposal aimed at the wealthy will need to compete against the clever and complicated techniques that rich Americans can deploy.

“The lesson is that the details are going to matter a lot,” said Eric Zwick, an associate professor at the University of Chicago Booth School of Business, who co-authored the study with three other economists, including the Treasury Department’s Matthew Smith. “You have to enforce the rules and keep track of people and how they’re changing the nature of their income in response to the rates.”

Picture a rich person and you may imagine a big company CEO or a professional athlete collecting $40-million pay packages year after year. But these examples are salaried employees. Business owners are far more common among the super-wealthy. And being your own boss brings huge clout, including flexibility to decide exactly how and when to pay taxes.

Business owners have options. They can set up corporations, which pay their own taxes and whose employees and investors then pay taxes on their salaries and dividends. Or, they can establish pass-through businesses. These pay just one layer of taxes on their owners’ returns.

Pass-Through Income

The previous round of tax reform, in 1986, gave the wealthy larger incentives to use pass-through businesses, and they’ve become very popular: About 84 percent of the top 0.1 percent of America’s earners made some pass-through income, Zwick’s research found.

Among the top 0.1 percent, pass-through owners are far more common than well-paid execs. In 2014, there were 139,000 taxpayers with a combined pass-through income of $264 billion, the study finds. That’s eight times more income than collected by the top 10,700 executives in an S&P index.

Owners and entrepreneurs also have freedom in how much salary they pay themselves. By minimizing their salaries – and boosting profits – the wealthy can save a couple of percentage points in payroll taxes. That’s what the rich have been doing since 2001, the paper says, “paying themselves less in wages and more in profits.”

Zwick and his colleagues conclude most rich owners are actively involved in their businesses, no matter what their tax forms say.

‘Working Rich’

“Most top earners are working rich,” the study says. “They derive their income from human capital, not physical or financial capital.”

Typical pass-through businesses of America’s 0.1 percent are smaller regional businesses like car dealers, beverage distributors, or large law firms. And the last couple of decades have been good to these owners. Profits are up, along with the productivity of employees. But owners were able to grab most of these gains for themselves, rather than handing them to staff in the form of higher salaries.

The top 0.1 percent owner’s share of productivity gains rose from 40 percent in 2001 to 52 percent in 2014, the study finds. “As labor productivity grows, owner-managers appear to capture an increasing share.”

Business owners also have more ability to cheat on taxes than employees. While every dollar earned on a W-2 or 1099 form is automatically reported to the Internal Revenue Service, a private business can find ways to hide money or artificially lower profits.

Big Dent

Pass-through businesses put a big dent in the country’s tax gap — taxes that should have been paid but weren’t. According to the Brookings Institution, more than 40 percent of the gap from 2008 to 2010 — or $190 billion — was a result of pass-through businesses underreporting income for tax reasons. Even if business owners follow the law, they can finagle themselves tax-free prizes like lavish travel budgets and company-owned cars and jets.

The latest round of tax reform, signed into law by President Trump a year ago, delivered a fresh perk for many business owners.

The new pass-through break, valued by the nonpartisan Joint Committee on Taxation at $415 billion over a decade, creates a 20 percent tax break for owners who qualify. Well paid lawyers, doctors, accountants, investment bankers and other “service” businesses are barred from the break, but others can slash their top marginal rate to less than 30 percent, from 37 percent under current law and 39.6 percent pre-tax reform.

The law also gave a break to corporations, reducing their rate from 35 percent to 21 percent, and kept in place provisions that levied higher rates on wages than on capital gains and most corporate dividends. A salaried CEO pays a marginal tax rate of 37 percent, while a shareholder collecting dividends or a stock gain pays at most a federal rate of 23.8 percent.

Inequality and taxes are certain to be key issues among Democrats seeking to challenge Trump for the White House. Senator Kamala Harris of California, who announced her 2020 presidential run this week, proposed in October paying middle-class and working families a refundable tax credit of as much as $6,000 a year. Senate Democrats have also proposed repealing major parts of Trump’s tax overhaul.

To the Trump administration and conservative economists, lower taxes on investors and owners encourage investment and entrepreneurship. For those demanding higher taxes on the wealthy, however, levying so many different rates on various forms of income is a problem. By merely raising the marginal rate on wages or pass-through businesses, for example, you could end up pushing more income back into corporate structures, warns University of California Berkeley professor Emmanuel Saez, one of the economists who helped Warren develop her wealth tax proposal.

The latest research “shows that the distinction [between] capital versus labor income is overblown,” Saez said. “Hence it is critical to align tax rates on different forms of income to limit tax avoidance opportunities.”

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