Diaspora Taxes: Citizenship-Based Taxation

What I think I'm hearing from the defenders of the U.S. system of citizenship-based taxation (also called worldwide taxation) is that the three cases I used in my last post ought to be treated pretty much the same.  Why?  One argument is that it wouldn't be "fair" otherwise  It isn't right that someone removes their money from one country and invests it it another, they say, and there should be some penalty for doing that.  Homeland citizens also argue that it's equally unfair that people move to other countries and deprive their country of origin of their skills and talents.  Whether it's financial or human capital, they make the case that this mobility is a kind of freeloading.  Having invested homeland resources to create a business environment where individuals can prosper and having diverted public funds to nurture individuals from cradle to university, the home country is owed a slice of that person's production.  Citizenship-based taxation not only has the merit of rectifying this injustice caused by mobile capital and labor but it also discourages tax competition and the long-term migration of its most productive citizens.

So, from the perspective of any homeland, a system of worldwide taxation for its citizens looks like a pretty good deal.   It penalizes "bad" behaviour (investment outside the home country and migration) and encourages "good" behaviour  (keep your person and your money at home, folks) because it's the "right" thing to do.  For this reason some Americans are rather proud of their citizenship-based tax system.  It may be unique but no matter, it is a model system for other nations who simply haven't had the good sense to emulate the U.S.  Here is Joseph Stigliz in his recent book, "The Price of Inequality:"

"Here the United States has one advantage over other countries:  we are taxed on our worldwide income.  A Greek citizen, having benefitted from that country's schools and universities, and having enjoyed the benefit of its hospitals and healthcare system, can take up residence in Luxembourg, do business in all of Europe freely, and avoid any responsibility of paying taxes - even to repay the costs of her education."

Wow.  That sounds just terrible, doesn't it?  Clearly the Americans are on to something if they are trying to prevent that.  Or are they?

There are some very good reasons why other countries have not implemented their own citizenship-based taxation systems and have opted instead to limit their tax base to activity within their territory.  In fact the only other country beside the U.S. and Eritrea that did have such a system, The Philippines, abandoned it in favor of territorial-based taxation in the 1990's.  So the theory may be interesting (and attractive) but in practice it's not as straightforward as it seems.  Here are a few of the twists and turns that make the American system not terribly successful (so far):

High Enforcement Costs:    There are around 6-7 million American citizens living outside the U.S. plus any number of Green Card holders and other people with U.S. connections.  Only a few hundred thousand people file tax returns every year that report foreign income.

 So if we take a low number of 6 million Americans abroad and assume (just for the sake of argument) that around 250,000 of them file tax returns, how is the U.S. IRS supposed to determine the status of the other 5.75 million scattered in 192 countries around the world?  That's a big job.  The U.S. government would have to put in time, money and effort to find that American guy in Spain living in group housing doing translation work.  If there was a census of the overseas population that would make it easier but that wouldn't solve all the problems.

Many won't owe anything since they didn't make enough money to file in the first place. Students, for example, or au pairs (lots of American au pairs in Paris). Some will owe a small amount of money in taxes (and much more in penalties) and a few will owe big money. Today it's a mystery if the taxes/penalties gathered will cover the costs of the chase after the low to middle-income U.S. person.   The "Big Fish" of course are another matter but even they have some pretty good defenses:  powerful, expensive legal and tax advice.

It is entirely possible that, at the very end of all these efforts to enforce citizenship-based worldwide taxation, the result will be an even larger U.S. government bureaucracy with not nearly enough incoming revenue to justify it.  The American taxpayer in the homeland may experience a visceral thrill at having caught all those "tax evaders" but he will be paying for the privilege. I'm pretty sure that's not at all what he had in mind and I have to wonder if he will think that his fun was worth the price of the ticket.

Killing the Goose:   Jean-Baptiste Colbert once said, "The art of taxation consists in so plucking the goose as to obtain the largest number of feathers with the least amount of hissing."  And what if you kill the goose in the process?  Far be it from me, lowly IT manager and mother of two, to disagree with such an illustrious person as Joseph Stigliz (Nobel Prize winning economist) but I couldn't help but notice that he left something very important out of his paragraph on the hypothetical Greek tax evader. He implied that by moving to Luxembourg that Greek will no longer pay any taxes at all.

Uh, since when?

Of course our Greek is going to pay taxes if he moves to Luxembourg - the Luxembourg tax authorities are very clear about that.  Residents (not just citizens) of that country have tax obligations and they are pretty stiff.  Let's just look at the income tax.  The actual tax due depends on the level of income and the family status but nevertheless the top rate is 39%.    The Greek income tax rate is also progressive and their top rate is 45%.  (In the U.S. the top rate appears to be 35%.)

Let's be realistic.  Adding together those two tax rates and telling our hypothetical Greek that he now owes 84% of income to two states just won't work.  And if he decided to become a US citizen as well?  And if all three states practiced citizenship-based taxation?  The sum of his tax obligation would be equal to 119% of his income.  Any way you slice it there just wouldn't be enough to go around.

Countries do recognize this and have come up with different strategies for "plucking the migratory goose" without stripping it bare and cooking it up for Christmas dinner.  As I understood former French President Sarkozy's proposed scheme, our Greek would pay Luxembourg first (39%) and then pay the difference between Luxembourg's rates and Greece's (45%-39% = 6%).  That seems fairly straightforward and a model of simplicity compared to the existing U.S. system.

Under the U.S. citizenship-based tax system there are two methods offered for avoiding onerous double taxation.  The first is something called the Foreign Earned Income Exclusion which allows a U.S. person to exclude $95,100 USD (77,000 Euros) of foreign earned income for U.S. tax purposes. Another option is Foreign Tax Credits where taxes paid to one state can be deducted from those owed to the U.S.  Neither method is perfect, however.   Even the IRS says, "Foreign tax credits allow US taxpayers to avoid or reduce double taxation. "  Please note that they fully admit that in some cases it will only "reduce" double taxation, not eliminate it.

The FEIE only applies to earned income (and what about investment income, unemployment and retirement benefits and other types of income?)  and the foreign tax credit is hit and miss at best.  It is entirely possible for the IRS to say that a tax in another country is not considered a tax from the viewpoint of the U.S.  Take the CSG (la contribution sociale généralisée) in France, for example, which is a kind of "solidarity tax" designed to address the deficits in certain social programs.   The rates vary from 3.8% to 9.5%.  The IRS has decided that this is a social security contribution and not a tax and is therefore not eligible to be taken as a foreign tax credit.

So the current U.S. system is cumbersome, bureaucratic, and does effectively double-tax American citizens and Green Card holders abroad.  Does it actually generate sufficient revenue to justify the expense?  Hard to say and to my knowledge no effort has been made to do a serious cost/benefit analysis.  However, the U.S. Taxpayer Advocate Service had some very sharp words for the IRS earlier this year.  To paraphrase Nina Olson's report, the system is just too complex, it's almost impossible for American abroad to be compliant, and she called for reform.  Hard to tell if anyone in the U.S. is paying attention.  But here is something we do know for sure:  The goose (Americans abroad) is definitely hissing.

Tied to citizenship:  Patrick Weil in a recent news article pointed out THE major weakness in citizenship-based taxation:  it is tied to a status (either citizenship or Green Card) that can be renounced or rejected.  That has not escaped the notice of U.S. lawmakers.  The U.S. does not make it easy to renounce.  The renunciant has to prove that he/she has filed tax returns and meet other reporting requirements and may be subject to a hefty Exit Tax.  Other efforts to make it even harder to give up U.S. citizenship like the ex-Patriot Act are in the works.  Nonetheless, it is a possibility that many are taking advantage of.  Turning in a Green Card is even simpler if the individual has not had it for too long.  On the immigration side, the word is out that taking on U.S. citizenship may not be in one's best interests.  Again, it is impossible to know to what extent revelations about the U.S. tax system will encourage expatriation and immigration but everyone is watching the numbers closely.

Those are just a few of the downsides to trying to tax the diaspora using citizenship as a basis for taxation.  Could they be overcome?  Could a state build a better system?  Absolutely.  But first those who are taxed and those doing the taxing need to come to some sort of agreement about what is both reasonable and fair.  Where such a system lacks any legitimacy, the costs of enforcing compliance will be very high.  No one likes to pay taxes but most of us grumble a bit and then cut the check anyway.  It is the price of civilization:  roads, schools, pensions, protection against fires and burglars and so on.  I know a lot of American in France who live here and pay MUCH higher taxes than they would in the U.S. and, yet, I hear very little complaining.  Why is that?  I speculate that they might agree with one elderly French grandmother I talked to one day (a woman so conservative as to make some Right-wing Americans I know look like raving revolutionaries) who told me that she didn't mind her taxes because she was getting good value for her money.

So perhaps the reason that American in the homeland and Americans abroad alike complain about the U.S. tax system is not so much the rates or even the cost of compliance but that both perceive that they are not getting "value for money."  That they have a government which simply isn't worth what they are being asked to pay.

And that, mes amis, is a far more serious problem than citizenship versus territorial tax systems.