Biden can’t pay for his ‘Build Back Better’ plan by going after tax cheats
The Achilles’ heel of President Joe Biden’s “Build Back Better” proposal is increasingly evident: Spending will be substantially higher and revenue significantly lower than what the White House asserts. Specifically, Biden contends that he can pay for the plan with beefed-up IRS tax enforcement: Adding $8 billion each year to the IRS budget will allow it, finally, to ferret out all the tax cheats, forcing them to pay more taxes. According to Biden’s math, the additional IRS resources will bring in a windfall of nearly $320 billion over 10 years.
Biden has promised not to increase taxes for households making less than $400,000 a year, so presumably he has set his sights on extracting this revenue only from rich tax cheats. The top 1 percent of U.S. households account for about 20 percent of all income and pay 40 percent of all income taxes. According to the IRS, they also account for 27 percent of unpaid taxes — or $163 billion. By White House estimates, there’s enough untaxed income in the ranks of the 1 percenters to generate $32 billion more in tax revenue every year. With the extra budget support, the IRS can hire more investigators, target that tax gap and finance the Biden plan.
A fundamental problem with this quest is the failure to recognize the origins of the tax gap — or the distinction between tax evasion and tax avoidance. Tax evasion is illegal. Tax avoidance is not illegal; it is an art. No amount of enforcement can change that.
The most obvious source of uncollected taxes is households that fail to report income to the IRS. This is called tax evasion and is a crime. Illegal activities like prostitution, loan sharking and gambling don’t generate tax filings. But the IRS itself says that such illegal activities are a small portion of tax evasion. Much more common is the failure of a broad swath of service providers and small businesses to report their (cash) income. Caregivers, independent contractors, landscapers, painters, waiters, hair stylists and others paid in cash don’t report all their income to the IRS. In the “nannygate” scandals of a few years back, the 1 percenters were faulted for not reporting or paying the payroll tax on the money they were paying their nannies, but it was the nannies who weren’t paying the income tax.
The IRS says the 1 percenters also engage in tax evasion to lower their tax bills. But the tax evasion allegedly undertaken by the 1 percenters rarely results from unreported cash payments. According to the IRS, much of that evasion flows through business entities they own. Those entities are often created for the very purpose of tax avoidance. Congress has stuffed the tax laws with hundreds of exemptions, deductions, credits and other provisions that permit corporations, partnerships and proprietorships to reduce their taxes and “pass through” to households comparable tax savings. The IRS suspects that many of these “pass-throughs” are not allowable but is only now researching the issue in detail. It assumes that the pass-throughs are tax evasion but can’t really exclude the possibility of tax avoidance. And this is the critical flaw in Biden’s calculation.
Paradoxically, Biden himself has proposed a slew of tax credits for child care, development of clean fuels and technology, and the purchase of electric vehicles for both businesses and households. Whatever the merits of these provisions, they allow households to reduce their taxable income, thereby contributing to the tax gap. With an army of accountants and tax lawyers at their disposal, the 1 percenters are particularly well positioned to exploit these loophole provisions. And this is all perfectly legal. Tax avoidance is not a crime.
Business entities are allowed, for example, to use accelerated depreciation and current expensing to reduce their taxable incomes. These provisions can turn an economic profit into a taxable loss. That loss, in turn, gets passed through to the owners, who are able to reduce their own tax bill. The IRS suspects something is awry with this pass-through, but it isn’t necessarily tax evasion. The law encourages tax avoidance.
Elon Musk has used business loopholes for years to minimize his tax bill. Rather than taking a salary from his business, Tesla, that would be taxed, Musk borrows money from
Tesla to finance his lifestyle and investments. Borrowed money isn’t taxed. Indeed, the interest paid on the borrowed money even creates deductions that reduce the taxable portion of other income. This creative use of a business entity allowed Musk to pay zero federal income tax in 2018. That wasn’t tax evasion, just creative tax avoidance. Musk got stuck with a gigantic tax bill this year only because he heeded a Twitter poll that urged him to sell some of his stock options, thereby realizing a capital gain, which is taxable. That must have driven his tax advisers nuts.
Biden himself has used business entities as pass-through mechanisms for years. He and first lady Jill Biden have routed their book royalties and speaking fees through two S corporations they set up, Celticcapri Corp. and Giacoppa Corp. These corporations in turn pay salaries to both Bidens. In 2020, Giacoppa paid them salaries of $90,854. The advantage of this business pass-through is twofold: It allows the Bidens to escape substantial payroll taxes, and it lets them decide when and in what form they want to get paid. Over the years, they have reduced their tax bills by more than $500,000 with this setup. Was this tax evasion or tax avoidance?
Tax avoidance is not limited to business pass-throughs. Congress has created even greater opportunities for direct tax avoidance, without the use of business pass-throughs. Biden reported an income of $607,000 last year (after the pass-throughs), placing him firmly in the class of 1 percenters, which has a threshold of $540,000. Then he used deductions for state and local taxes, mortgage interest and charitable contributions to reduce his 2020 taxable income by an additional $56,000, thereby shrinking IRS collections.
The IRS doesn’t have the authority to close any of these loopholes. Biden could triple the IRS enforcement budget and not get a dollar more from these sources of tax avoidance.
Consider another provision in the tax code: the exemption from federal income taxes of interest paid on municipal bonds. According to the Federal Reserve, outstanding muni bonds are worth more than $4 trillion. Currently, the rate of interest on those bonds is about 1 percent. That implies interest payments of roughly $40 billion per year that are going completely untaxed. Will steppedup IRS enforcement squeeze taxes out of these bondholders? Certainly not. Until Congress changes the law and subjects muni bond interest to income taxes, this piece of the tax gap will persist.
The failure to recognize the distinction between tax evasion and tax avoidance dooms Biden’s chances of tapping into the tax gap in a major way. The Congressional Budget Office projects that Biden’s plan will bring in $200 billion in added taxes from the 1 percenters over the next decade, far short of the $320 billion that Biden projects, largely because of new avoidance responses. But even that projection may fall short if 1 percenters adapt to steppedup enforcement and Congress adds, rather than closes, tax loopholes. Bottom line here: Beefed-up tax enforcement alone won’t pay for Build Back Better.
A fundamental problem with this quest is the failure to recognize the origins of the tax gap — or the distinction between tax evasion and tax avoidance. Tax evasion is illegal. Tax avoidance is not illegal; it is an art. No amount of enforcement can change that.