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The Tax ManThe Tax Man |
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Photo: Steve Gladfelter
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by Nina Nowak
The saying, "Nothing is certain but death and taxes," may have been true when Benjamin Franklin coined the phrase in 1789, but with today's fancy tax shelters, it sometimes seems as if certainty has been confined to death alone.
Couple an increasingly arcane tax system that can be manipulated by sharp accountants and attorneys with a growing number of wealthy individuals and corporations looking to pay fewer taxes—and it's no wonder that tax shelters have become big business—so widespread that state and federal governments are losing tens of billions of dollars each year in uncollected taxes.
Joseph Bankman is trying to change all that. Bankman, the Ralph M. Parsons Professor of Law and Business at Stanford Law School, is one of the nation's leading tax law experts. His scholarly research and writings have had a major impact in academic circles, and his real-world proposals for more severe tax shelter penalties and simplified filing have inspired lawmakers to enact tougher laws and approve a pilot program that might benefit millions.
When California found itself in the middle of a huge fiscal crisis in 2003, Bankman joined forces with two state legislators to author a groundbreaking bill that imposed severe penalties on users and purveyers of tax shelters, along with an amnesty program for tax shelter users who paid up. The amnesty program has netted the state about $1.5 billion. The huge take, collected from about 1,000 individuals and corporations looking to avoid hefty penalties, was vastly more than the $90 million the California Franchise Tax Board predicted would be recovered.
The offer for tax evaders to come clean before the April 15, 2004, deadline was hailed by the Los Angeles Times as "one of the most wildly successful programs in memory—an incidence of Sacramento thinking smart." The program made a noticeable dent in the $14 billion shortfall the state had anticipated for its 2004-05 budget, and is being offered again for the 2005 tax season. It earned Bankman and his coauthors —Assemblyman Dario Frommer (D-Glendale) and Senator Gil Cedillo (D-Los Angeles)—widespread kudos for foiling the state's tax evaders, one of whom coughed up a check for $30 million to cover his abuses.
"The success of the program showed how good he [Bankman] was," said Frommer. "He rolled up his sleeves, held lots of meetings with different stakeholders, and helped us do this right. We now have one of the toughest penalties in the country, not just for people using tax shelters, but for the promoters of tax shelters as well."
Bankman was as pleased as anyone at how lucrative the amnesty program turned out to be. But it didn't exactly surprise him. "It just goes to show how many tax shelters are out there and what a huge market exists for them," he said.
Bankman, 49, was born in Iowa, the son of a camera store owner who had a passion for business and a belief that everyone ought to pay his fair share of taxes. He went on to earn his BA from the University of California at Berkeley in 1977 and his JD from Yale three years later. The easygoing academic, whose common-sense approach and chummy manner belie the rigor of his scholarship, started his career as a tax attorney in Los Angeles. He joined the law firm of Tuttle & Taylor as an associate in 1980, and soon discovered an affinity for academia while coteaching a course on tax policy at the University of Southern California. He left practice in 1984 to teach fulltime at USC and in 1989 moved to Stanford Law School, where he has been ever since.
"He [Bankman] is one of a handful of top tax law academics in the country," said David Weisbach, professor of law and director of the Law and Economics Program at the University of Chicago. "His work has been influential in a variety of fields."
Reuven Avi-Yonah, professor of law at the University of Michigan, agreed: "He wrote two of the most famous articles in tax law in the past 50 years." Both articles were coauthored with Thomas D. Griffith, professor of law at USC. The first, published in 1987, was "Social Welfare and the Rate Structure: A New Look at Progressive Taxation," in California Law Review. The second, published five years later in the Tax Law Review, was "Is the Debate Between an Income Tax and a Consumption Tax a Debate about Risk? Does It Matter?" Bankman's reputation as one of the top experts in tax shelters was solidified with the publication of a third groundbreaking paper, "The New Market in Corporate Tax Shelters," in Tax Notes in 1999.
Bankman has found ingenious ways to share his intellectual preoccupations with his two sons—Sam, 12, and Gabe, 9—both loyal San Francisco Giants fans. In 2002, he published a lighthearted op-ed in the San Jose Mercury News on a possible baseball strike, suggesting a high tax on teams and players that went on strike. The tax could be avoided—but only if for each game missed, teams offered nickel hot dogs to fans for a game, and players donated money to local charities. He wrote, "I've spent my lifetime writing obscure tax articles. This is my one chance to be a hero to my kids. Go Giants!"
Bankman's work asks the seemingly simple question, "What is a tax shelter?" Some consider any tax-favored investment, such as an IRA or a home mortgage, a shelter. Others say that when a company moves offshore, it is finding a tax shelter. But according to Bankman these transactions don't qualify as tax shelters. "By investing in an IRA and taking tax benefits, a taxpayer is simply following the incentives that Congress set up. The same is true when a company relocates offshore," said Bankman.
The types of dealings that Bankman has his eye on are paper transactions, unrelated to a taxpayer's ordinary business or investments, that involve no real assets and no possibility of economic profit or loss. These deals produce huge tax losses in a manner that is inconsistent with legislative intent and existing case law, says Bankman. Most shelters involve what are called third-party accommodation agencies, such as foreign banks, whose role as an intermediary in the transaction is required for the elaborate schemes to work.
The shelters allow large companies to play shell games with profits, often channeled through offshore institutions in far-flung locales like Bermuda, the Cayman Islands, or Panama. The Cayman Islands, in fact, are now the fifth-largest banking center in the world, indicating just how pervasive offshore shelters have become, according to David Cay Johnston, the Pulitzer Prize-winning reporter for The New York Times, who probed the tax shelter business in his book Perfectly Legal: The Covert Campaign to Rig Our Tax System to Benefit the Super Rich—and Cheat Everybody Else.
The demand for tax shelters has exploded in the past two decades. The enormous wealth generated in the 1990s economic boom only fed the hunger. As more people earned more money, they sought new and improved ways—however dicey or inconsistent with the intent or common understanding of the law—to protect their gains, and abusive tax shelters proliferated.
"It's a little like the 'perfect storm,'" said Bankman. "The right elements came together at the right time." As a result, the market for tax shelters has "gone retail," as he puts it, with schemes so complex, they go over the heads of many of the clients who purchase them. An entire industry has evolved, comprised of accounting firms, banks, and law firms charging a king's ransom to keep the wealthy one step ahead of the IRS. And the market is growing. Individuals with as little as $10 million in capital gains to shelter can benefit from these products, which are marketed openly and aggressively. Shelters have outstripped audits as the biggest income generator at some of the nation's most respected accounting firms, according to reports in The Wall Street Journal. A February 7, 2003, Journal article on the tax shelter business revealed that, in 2000, BDO Seidman's tax sales team, dubbed "the Wolf Pack," managed to rake in more than $100 million in tax shelter sales, accounting for more than half of the firm's tax revenue.
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Photo: Steve Gladfelter
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Bankman was the first academic to put a price tag on tax shelter activity. In a 1998 Forbes magazine cover story about corporate tax setups, he estimated the government's lost revenue at $10 billion a year—the first time anyone had attempted to calculate the overall costs of tax shelter abuse.
Bankman says he wouldn't have attempted to pinpoint a specific number at all if it hadn't been for Larry D. Kramer, former law professor at New York University and now Richard E. Lang Professor of Law and Dean of Stanford Law School.
"It was Larry who convinced me to go public with the $10 billion figure," said Bankman, who met Kramer in 1998 while Bankman was a visiting professor at NYU. "He said it would be important for policy purposes, that it would give the issue a kind of relative merit important to legislators, which otherwise would have been tough to get."
Kramer said he knew politicians would normally "gloss over Joe's claim as just another academic piece," if no number were attached to it. Luckily, he says, Bankman possessed just the right mix of modesty and moxie to bridge the disparate worlds of academia and government and get the issue on the table. "Most people manage to get their feet planted firmly in one world or the other, and it's hard to be taken seriously in both," said Kramer. "But Joe is a respected academic who also does just as much important work in the policy world—a pretty unusual combination."
As Kramer predicted, the $10 billion figure took on a life of its own, earning Bankman high-level supporters, as well as enemies. Lawrence H. Summers, former secretary of the treasury for the Clinton administration and current president of Harvard University, cited Bankman's figure repeatedly in official speeches and Treasury Department reports, calling shelters the biggest threat to the tax system. But naysayers like prominent Washington, D.C., tax lobbyist Ken Kies also chimed in, attacking the accuracy of Bankman's figure, saying it underestimated the recent progress government had made in reeling in the most egregious abuses.
For Bankman, who first began pursuing the topic while conducting academic research on the role of accountants in tax evasion, his snowballing notoriety gave him leverage in raising awareness of the issue among legislators. In 2003, he helped California write the first modern anti-tax shelter statute, which substantially increased penalties for transactions that fail to pass muster under existing law.
"In the past," said Bankman, "corporate shelters were mostly plays on the so-called audit lottery. Taxpayers knew the shelters were unlikely to survive government challenge. They hoped the deals wouldn't get noticed on audit and knew the worst case outcome was a 20 percent penalty, in addition to the tax they owed."
The California statute, along with new methods for detecting shelters, make the audit lottery much less attractive. However, the system faces a new challenge. Some courts are throwing out anti-tax shelter doctrines that have been part of the law for more than 50 years. These courts find the doctrines overly vague and inconsistent with a literal reading of the statute on which the taxpayer relies.
"The problem with this approach," said Bankman, "is that the income tax is riddled with potential loopholes. Without these doctrines, a shelter that is based on a loophole will work. By the time Congress has plugged one loophole, shelter promoters will have found another, which will work until it is plugged. Making the income tax loophole free is like retrofitting all of the buildings in California to make them earthquake proof. There aren't enough resources in the world to do it. And all it takes is one shelter, if it is known ahead of time to work, to siphon off most of the corporate tax revenues."
In the short run, Bankman favors keeping and enforcing existing doctrines as a way to safeguard the public treasury. In the long run, Bankman sees substantial tax reform as the only solution to the tax-shelter problem.
Whichever direction the shelter battle goes, Bankman isn't stopping there. He is currently helping to devise a simplified tax-filing plan for California, called Ready Return, which he says will eliminate the headaches associated with tax form preparation for more than 3 million Californians. Many individuals, especially those for whom the mere mention of April 15 induces a cold sweat, are sure to like Ready Return. It's a safe bet, however, that tax preparation firms won't like it because it would cut into their fees.
"Filing a tax return now is difficult even for taxpayers with simple returns," said Bankman. "The taxpayer has to save the W-2 and 1099s, find the right return to file, and so on. A large portion of the population cannot even understand the instruction booklet that accompanies the forms."
Bankman's solution is a tax filing system designed for wage income earners who do not itemize deductions. With the Ready Return, the state wouldn't wait for those individuals to send in a tax return. Instead, it would send them a bill, which they could simply pay.
Since the state already keeps track of income from employers as well as past filing information, it already has a pretty good idea of what these individual taxpayers owe, even before they fill out all the tedious paperwork. With the Ready Return, the state would calculate the tax liability for each of these taxpayers, and send each one a return with the amount of tax owed, or refund due, already filled in. The taxpayer would then have a number of options. He or she could sign and return the form, use the form as a starting point from which to calculate his or her tax liability, or give the return to his or her preparer to check.
The proposed system, which would also be available online, would be voluntary. If a taxpayer preferred, he or she could simply throw away the Ready Return and file a traditional form instead. Bankman says the system would be cheap for the state to maintain, and would not pose any privacy concerns, because it relies only on information the state already has on file.
Bankman helped convince the state tax authority to allocate $200,000 on a pilot program to test the proposal. Ten thousand taxpayers will get a Ready Return during this filing season; another 10,000 similarly situated taxpayers will serve as a control group to measure the impact of the program. The pilot program was opposed by Intuit, maker of TurboTax and other tax preparation programs. Intuit argued that the program interferes with private enterprise, and is expected to oppose any full-scale enactment of the Ready Return.
But Bankman has been through this sort of thing before. His battle with accounting and law firms over tax shelters has provided him with a wealth of experience in the rough-and-tumble world of public policy. And he remains mostly upbeat in spite of it all. "I think the folks in the pilot program are going to love the Ready Return. And if our survey data shows this is true, we've got a pretty good chance of getting the state to move forward," said Bankman. Once that happens, one can be sure that he will turn his sights on yet another part of the tax system that needs fixing.
Editor: What's wrong with the federal tax code? Bankman: The common perception that it's too complicated is correct. The complaint that a lot of complexity hurts business is also correct. Most of the complaints about the tax code are correct, although the payoffs for the cure are usually exaggerated.
What's wrong with complexity? It's expensive for business to deal with complexity, and it drives the average citizen nuts. It fosters a sense of paranoia. If you can't understand a provision, you assume that someone else must be taking advantage of it. Sometimes that might be true, but other times it's not. Finally, to the extent that we treat similar transactions differently because of the complexity in the law, we're going to discourage productive investment and invest unwisely. All else being equal, complexity is an evil.
Complexity also adds to the cost of complying with, and collecting, taxes. How much does it cost to collect income taxes? Around 15 percent of the tax rate is a ballpark figure. So if we raise a trillion dollars, the cost of raising that is at least $150 billion. This includes the value of everyone's time when they do their taxes, everything they pay to have taxes done, everything business pays to have taxes done, along with the cost of running the IRS and other government agencies.
That is a huge number. Yes. On the other hand, all taxes are expensive to maintain. Even a sales tax, or VAT [value added tax], costs about 10 percent. It isn't enormously cheaper because you've got to have a huge bureaucracy to collect the sales tax, and you've got to have all the merchants collect the sales tax. Look at Europe. They've got lots of different VAT rates, and every new product that's introduced has to be evaluated to see what rate it qualifies for. There was a case several years ago involving Head & Shoulders dandruff shampoo—was it a cosmetic or a medicine? If it's the former, it's taxed at a high rate. If it's the latter, it's taxed at a low rate. When you go to a European accounting firm or law firm, you still see lots of tax lawyers, even though they have a VAT. The income tax is more expensive to comply with, but all taxes are expensive to maintain.
So complexity costs money. Yes. And it also distorts investment. That's another important cost—maybe more important. Current tax law discourages investment because we tax investment, and it distorts the decision to invest in one area rather than the other.
Doesn't complexity also make it easier to slip in a tax break for a special interest? Probably true. And some of the tax breaks are not to corporate America, but to individuals with a cause. So you might have a tax break for higher education or for teacher supplies.
Doesn't complexity also make it easier to devise tax shelters? That's right. You can think of a tax shelter as someone interpreting the language of a law to produce a result that's never intended. Today, we have to worry about whether any of these tens or hundreds of thousands of rules can be misinterpreted. If you have a simpler system, you don't have so many points of vulnerability.
What are the alternatives to our present tax code? There's only one main alternative with different varieties, to tax consumption rather than income. There are several reasons to do this. It is easier to measure consumption than income, which makes it simpler to enforce, and less expensive to comply with and administer. A consumption tax also lets individuals and businesses invest without the distortive effects of tax laws. And by not taxing investment there is reason to believe that the economy will grow faster. How could you tax consumption? One way is the value added tax, which, as I've already explained, is complex to implement. A simpler way is to create what is in effect an unlimited IRA. You can deduct anything you put into it—$3,000 or $3 million. You're only taxed when you take money out, and you can take the money out whenever you want. Then, by definition, we'd only be taxing consumption, because you wouldn't withdraw money until you wanted to spend it. It's a cash flow tax, and the way to do it is to have an unlimited IRA for everyone.
Are there other forms of consumption tax? We now have two forms of IRAs—the "regular" IRA and the Roth IRA. In a Roth IRA, you get no deduction for contributions, but you're never taxed on your investment returns. It turns out, for reasons I won't go into here, that the two forms of IRAs are equally advantageous for taxpayers. In one, taxpayers get a deduction going in but are taxed later on; in the other, there's no deduction going in, but no tax later on. We could have a consumption tax based on the Roth IRA model. It would look just like a graduated payroll tax. I think we're less likely to adopt this form of consumption tax.
Why is that a consumption tax? Because it has the same effect. If one IRA leaves taxpayers in the same position as the other, then by definition we can say you're in the same position if we have an explicit consumption tax or this odd form of payroll tax.
But wouldn't a payroll tax have a much greater impact on wage earners? And how would other forms of compensation, like stock options, be treated? You've pointed out two important things. Comparing an unlimited IRA consumption tax to a payroll tax shocks people, because they say, "Well, a payroll tax, we're just taxing the working stiff. We're not taxing the wealthy as well." In fact, any form of consumption tax will raise distributive concerns. The people who will benefit from an unlimited IRA are the people who are making an investment. They'll benefit by getting a deduction going in. If you're poor, and you don't invest anything because you don't have any money to invest, you get none of the break, and you'll be bearing a proportionately larger share of the tax burden. It's also true with the Roth IRA. Both are going to favor the wealthy, and under plausible circumstances, both favor the wealthy just as much. The second point you make is quite correct and quite subtle, that we can't really distinguish income from labor and capital. A good example is someone in Silicon Valley who gets stock options. That is why we're more likely to implement a consumption tax through an unlimited IRA than a payroll tax. And if we want a progressive consumption tax, we're more likely to have an unlimited IRA than a VAT. With an unlimited IRA consumption tax, we can have progressive rates, so that somebody who spends $1 million a year pays a higher tax rate than someone who spends $20,000 a year.
Aren't there ways to mitigate the impact of a sales tax on lower income people? The most obvious thing to do is what Europe does, by having different rates on different goods, so that luxury goods get taxed at a higher rate. The problem is that you've got to classify every good sold on whether it's a luxury or necessity. And the fact of the matter is, even Bill Gates drinks milk, maybe, and even poor folks in Houston need air conditioning. So that turns out to be a messy and expensive way of building progressivity in, and it doesn't do a very good job. You could give a rebate to people with low incomes for the sales tax they pay. The problem with that is then you really have two tax systems. You have the new sales tax system, and you have to maintain an income tax to know whether you get the rebate. My guess is that it's more likely we would simply go the unlimited IRA route rather than adding on a federal sales tax.
How would businesses be treated under a consumption tax? If you had a consumption tax, what's the proper level of tax on corporate income? The answer is zero, because corporations don't consume. Imagine putting your auto supply business inside this IRA, metaphorically. Everything you put in is deductible off your salary income. The auto supply business can make a trillion dollars, but you won't be taxed until you take that money out of your IRA to spend it. That would simplify life for business taxpayers. It simplifies life, though, by effectively getting rid of the business tax.
What percent of federal taxes is provided by the corporate income tax? Maybe 15 percent or 20 percent, when you consider other sources of income that individuals get from investment. But the vast majority of what we're getting comes from salary, so the argument in effect is, let's just write off the business income. That would reduce the aggregate amount of money we spend on tax planning, because it's more expensive for businesses than for individuals. It would help our economy because businesses would no longer invest in one arena rather than the other for tax reasons, because effectively we're not taxing them anymore. And it would lead to a greater pie over the long term because reducing the tax on business income to zero would stimulate investment. It has the unfortunate effect, for some of us, of concentrating most of the gains at the very top end. But economists agree that we get a bigger pie with the consumption tax. If anything, that's understated because economists consider mostly the fact that investment is going to increase, and don't count the payoff from getting rid of complexity—the tax planning costs and the tax planning distortion. So you have to ask the question, would you like a society where the pie is much bigger for the top 2 percent, and a little bigger for a lot of people, but the pie is more unequally divided?
Isn't there a way of getting rid of complexity that doesn't put the tax burden more on the mass of people? There probably isn't. If all we care about is helping people at the bottom with complexity, there are lots of things we can do. But if what we're talking about is reducing the aggregate cost of collecting taxes, there doesn't seem to be a way of doing it that doesn't benefit the wealthy more. So there's a trade-off between efficiency, getting the biggest pie, and what some people would call equity, having the distribution of the pie the way you want it. Most everybody would rather come up with a tax reform plan that gave us all the payoffs of a consumption tax, and benefited just the middle class and the bottom, but it's just not in the cards.