A Farewell to Stimulus?

The IRS' UBS prosecution is working. In fact, it is working so well that the IRS has decided to open up shop across the globe to ferret out secret accounts held by US residents.

From Bloomberg:

The IRS will open offices in Beijing, Panama City and Sydney in connection with the probe, which has revealed accounts held in 70 countries and every continent except Antarctica, he said. The agency also intends to hire more than 800 new employees in the next year and add staff to eight existing overseas offices, including Hong Kong and Barbados.

So is this a good thing? It seems clear that the current administration is bent on closing the tax gap by actually enforcing the existing tax laws (Hint: recent estimates put the tax gap, the difference between what is owed and what is collected, at well over $300 Billion). Good. Better to collect from people who under pay now rather than punish compliant taxpayers with higher rates in the future (for instance, through the imposition of a crippling Value Added Tax).

But there is a dark side to the IRS' increased enforcement efforts. The IRS will be draining private investment funds to pay the US' ballooning debt obligations. In effect, money will be moved out of the capital markets and (theoretically) productive investment opportunities to the black hole of government spending. Translation? An effective tax hike.

Of course, in any normal times, requiring taxpayers to pay what they already owe is not a controversial position. However, when an economy is in a recession, government generally acts to stimulate private industry back into action. This stimulus is usually accomplished by issuing debt, expending funds, and hoping the multiplier effect does the trick (essentially, allowing the money to flow through to private entities who spend it on other items which helps boost GDP).

But when government simultaneously increases the effective tax rates, it acts to damper the stimulus and can prolong the recession. Some argue this is exactly what happened in Japan in 1997: Japan prematurely increased taxes which helped prolong its asset price bubble recession. Nothing about what subsequently happened in Japan is something we want to happen in the US.

So while the IRS' collection efforts are warranted, perhaps they are badly timed. Of course, it could turn out that the IRS' bounty will amount to a mere pittance. But if it is any serious amount of cash, the government may just be shooting its stimulus package in the foot.

More Bad News for the Golden State

Things have not been going well for California. Despite the State's efforts to balance its budget and reform its tax system, revenue is still declining.

From Bloomberg:

Revenue in the three months ended Sept. 30 was 5.3 percent less than assumed in the $85 billion annual budget, state controller John Chiang reported yesterday. Income tax receipts led the gap, as unemployment reached 12.2 percent in August.

And this is after drastic shock treatment:

The latest figures show that California is facing resurgent fiscal strains brought on by the U.S. recession. Since February, Schwarzenegger and lawmakers have cut $32 billion from spending, raised taxes by $12.5 billion and covered $6 billion more with accounting gimmicks and borrowing. Even with those actions, state budget officials predict an additional $38 billion in deficits in the next three fiscal years combined, including $7.4 billion in the year starting July 1.

Other than Professor Stark's novel proposal, no one seems to have a good solution for what ails California. Meg Whitman, the former CEO of eBay and a candidate for governor, suggests that California should fire 40,000 state employees to help reduce spending. Of course, firing that many politically well-connected people smells a bit of unreality to me.

Alas, without further spending cuts and with a legislature unable to secure public approval for more tax increases, it looks increasingly likely that California will need a constitutional convention to save itself from the poor house.

Stay tuned for an article about what the California constitutional convention would entail and how it would reform the State's budget system. Creating a government from scratch? It's a law student's delight.

I'll be Taxed

Time for me to chime in on the tax reform proposals in the Golden State. California's budget system is broken. The recent patchwork by the legislature failed to fix the fundamental problem in California's revenue system: volatility.

California uses a steeply progressive income tax to generate the bulk of its revenue. In fact, the system is so progressive that:

More than half of California's income tax revenue is paid by those with incomes of $200,000 or more.

That is an awful lot of revenue generated from a very small group of people. That small group ("the Rich") tends to generate their income from volatile investment activities in the form of capital gains (i.e. gains on stocks, bonds, hedge funds, etc.). When asset performance degrades, the Rich tend to take the brunt of the losses and ultimately remit less money to the treasury. Conversely, when assets perform well, the Rich tend to make enormous gains and treasure flows from Sacramento to the rest of the State.

California (and to a similar extent, the federal government) have placed a leveraged bet on the Rich. When their income goes up, the State profits handsomely via capital gains taxes and high marginal rates while sparing the rest of the taxpayers. When the Rich's income declines, however, the leveraged bet collapses (a dollar lost on someone who is taxed at 20% is a bigger hit to the State than a dollar lost on someone who is taxed at 5% or has no capital gains income to tax at all). A downward movement in the Rich's income creates an enormous drop in revenue that devastates the State's finances.

This is exactly what happened this year in California. With the demise of the Rich, so went California's budget.

The proposed solution is a fairly simple one: abandon steeply progressive rates in favor of flatter rates on more types of income (e.g., instead of 20% and 5% income brackets on individuals income, have a 10% flat rate and add a flat tax on businesses). If the State had a broader tax base and a flatter rate, volatility would decline. Of course, the odds of giving the Rich a tax break during a fiscal crisis, particularly in California's notorious Legislature, seem like a snowball's chance in...well...you know.

Perhaps there is a better way. Professor Kirk Stark at UCLA School of Law has come up with a novel suggestion. To reduce volatility, require the State to apportion out capital gains taxes over a period of years. The Professor explains his idea quite elegantly:

But rather than reducing taxes on wealthy investors, why not just unhitch the timing of their tax payments from the boom-bust cycle of the market? This could be done quite simply by giving taxpayers who incur capital gains taxes the option of claiming a "capital gains tax credit" that would be recaptured over the ensuing three years. As an example, let's assume that the amount of the credit is 75 percent of the capital gains taxotherwise owed in the year of the sale. In our example above, Mickey would be entitled to a credit of $1,500 (i.e., $2,000 multiplied by 75 percent) in the year that he sells his Disney stock. His tax liability for the year of the sale would be $500 ($2,000 minus $1,500) rather than the full $2,000. This credit would then be recaptured (i.e., paid back) in three equal installments over the next three years, with the result that Mickey would add $500 to his tax bill for each of the next three years. The bottom line is that a $2,000 tax bill would be paid over a period of four years.

The net effect of this system - i.e., combining an upfront tax credit with a recapture rule - is that capital gains tax revenue would drip into the state in smaller increments rather than surging during the boom years and later drying up completely. It also bears noting that this system offers something of a preference for capital gains, since it operates like an interest- free loan from the state to taxpayers who would otherwise have to pay the capital gains tax upfront all at once.

Tax the rich, reduce revenue volatility, and entice people to invest? I think the Professor is onto something. Perhaps he should run for office.

The UBS Effect (and TTT)

According to Bloomberg, the UBS prosecution is accomplishing exactly what the IRS intended: massive disclosure. Clients of numerous Swiss banks are disclosing their offshore accounts to the IRS to avoid criminal prosecution. (Hint: If you happen to have an offshore account, declare it before September 23 to avoid the Wesley Snipes treatment).


Further, the IRS is using the disclosed information to chase down other banks and law firms that may be holding out:

The disclosure program and the U.S. lawsuit settled by UBS are helping the U.S. crack down on offshore tax evasion by pursuing financial institutions and intermediaries including law firms, IRS Commissioner Doug Shulman said Aug. 19.

This makes sense.
Advising US taxpayers not to declare their income, from whatever source derived, is a crime. See I.R.C. §§ 7201 et. seq. As a US Citizen or resident, you are subject to tax on your income earned anywhere in the world (This is today's TTT). Thus, if a law firm advises a US Citizen or resident not to report their offshore accounts (or any other income from anywhere in the world) on their annual 1040, both the law firm and the taxpayer face criminal liability.

And that is how they got UBS. UBS was advising clients not to report their Swiss accounts to the IRS. The IRS went after UBS on criminal charges of facilitating tax evasion (Aside: the Swiss distinguish between tax evasion and tax fraud). UBS has substantial assets and clients in the US and opted to cooperate rather than see its US operations shut down.

Now that disclosure has started, expect to see a lot more cooperation by foreign banks, tax attorneys, and high net-worth individuals when it comes to their future dealings with the IRS. Maybe, just maybe, the extra added revenue will reduce the inevitable future tax increases imposed on the rest of us.


UPDATE: The IRS has extended their disclosure deadline to October 15.

Today's Tax Tidbit (TTT)

This is a TTT post. The first of many more if it proves to be popular.

Did you know that the IRS considers any illegal gains to be income? See Treas. Reg. § 1.61-14 (2009).

Make sure you declare your earnings from rum running or pimping to the IRS or risk a nice trip to the pokey (Aside: ACORN offers great advice as to how to maximize your brothel deductions).

UPDATE: No, poor Mr. Snipes did not do anything illegal to earn his money, he simply failed to report and pay tax on his legitimate earnings (well, only if you consider proceeds from the Blade series to be legitimate).

Your Friends and Mine. . . .

Happy Labor Day! Now on to the post:

While the details of any health bill are still being hammered out, there will be one certain outcome of any bill: the IRS will have a whole lot more power.

Here is a laundry list of the (likely) new powers Congress will bestow upon the Service should any health care legislation pass:

1) You will have to report your health insurance status to the IRS;

2) Your insurer will have to report your health insurance status to the IRS (you thought they would trust you?);

3) The IRS will be responsible for fining you if you fail to purchase adequate insurance;

4) The IRS will be responsible for administering a web of subsidies and tax credits to help low-income individuals obtain health insurance, including releasing your tax information to a central authority who will determine if you are eligible for those credits and subsidies.

That last point is one of the scarier ones. If you thought having Progressive Auto Insurance watching you from the skies was unsettling, just imagine your earnings history, address, social security number, and any other juicy tax tidbits suddenly finding themselves spawned across several government computer systems.

But that's not all! Not only will your information be spread throughout the "system," but the government is also planning to use your tax returns to advertise other government services to you:

In H.R. 3200, the IRS would be required to provide taxpayer information to the Social Security Administration for the purpose of helping Social Security officials find qualifying seniors who can then be encouraged to enroll in the prescription drug program. 'There is no precedent for using taxpayer information for the purpose of identifying people to go out and advertise to them,' says the House expert.

Should your information really be used this way? Tax returns have generally been treated with a high degree of confidentiality. This confidentiality seems reasonable considering that everyone is required to provide their annual earnings information to the government (Tip: Your 1040 is not optional). Essentially, the government acknowledges they are invading your privacy, but in exchange, they promise to keep your information safe (theoretically). Maybe we are witnessing the end of that grand bargain.

Check your mailbox, the government may have sent you a notice indicating that you are eligible for their cheese.

The Taxman Cometh

Hello everyone, I will be (one of) your new bloggers here at BBL. I have a particular interest in tax law and economics so I found the following article interesting.

According to Bloomberg, Wegelin & Co., Switzerland's oldest bank, is requiring customers to dump their U.S. assets or close their accounts. As you might have guessed, Wegelin's decision has to do with the recent battle between UBS and the IRS. Essentially, Wegelin believes it will be less onerous to require its customers to dump their U.S. assets rather than comply with the ever increasing reporting requirements demanded by the I.R.S.

While the I.R.S. has a legitimate interest in collecting tax owed to it from U.S. citizens and certain foreign persons holding U.S. based assets, its efforts may cause more foreign banks to follow in the footsteps of Wegelin. And that my friends, is a bad thing.

Offshore financial institutions hold approximately $7 Trillion in assets. If these institutions start insisting their clients dump a certain asset class, the supply of that asset will increase and its price will tend to decline (assuming, like all economists, we ignore many of the realities of the universe). Thus, if offshore institutions start dumping lots of U.S. assets (likely a healthy chunk of that $7 Trillion dollars), U.S. asset prices will begin to decline.

Normally, it is not such a big deal that U.S. assets are getting cheaper. However, we are currently in the midst of a financial crisis that was precipitated in large part by the fall of asset prices. It is difficult for U.S. financial institutions to raise sufficient capital and "get healthy" unless the value of their assets begins to increase. Dumping large quantities of U.S. assets onto the market will make any financial recovery just a bit more difficult.

Should the IRS continue to pursue its crack down on tax-shelters? It depends. Does the short term gain of more (badly needed) revenue outweigh the potential cost of propping up more financial institutions in the future? The I.R.S. and our current administration certainly seem to think so!