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Monday, August 20, 2012

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.


Tim said...

There are some bigger pictures issues here. One is Americans both right and left are very attached to the idea of the income tax as being the "sole" method of taxation and expressly against a GST/VAT. If there I one fantasy in life I would love to act out is being able to jam a GST/VAT down the throats of the American citizenery. By its very nature a GST is inherently a territorial tax so in some sense if individuals are only going to pay GST on an territorial basis why shouldn't they pay income tax on a territorial basis too. I have this strange fascination of watching old videos of when I was a kid back in 1991 when protestors were being dragged out of the Canadian Parliament by scruffs of their necks as the protested the GST being passed.

I remember controversy I forget who it involved but some commentator made a big deal about an illegal immigrant in Canada would have to pay GST everytime they bought a bag of doritos whereas in the US they did not have too. Several critics on the left called this highly "racist."

An interesting aside:
I found out that there is one circumstance where Passport Canada can revoke your Passport for "tax" reasons. That if you have a bill for non payment of consular services such as being airlifted out of a war torn country your passport can be revoked/refused to be renewed by Passport Canada. They actually have a good video below describing how passport services are funded.

Tim said...

The other thing I'll mention is the "fee for service" model that Passport Canada has is in fact quite common now for many government services in Canada. The shift in tax burden was actually a big part of the "reform" era in Canada from 1990 to 2000. Other examples would be things such as Nav Canada(the privatized Air traffic Control System), CPP, the Weather Office, Service Ontario have all switched to this very "corporate" user fee based model. Basically the obligation to evacuate Canadian citizens from dangerous situations is not that of the general taxpayer/society but that of Passport Canada financed by user fees paid by passport holder(To be clear as an individual you will charged for evacuation but one most clearly assume some charges are for whatever reasons uncollectable and must fall back to Passport Canada.

Some I suppose might argue Canadian citizenship is not as valuable as American if as a Canadian citizen you just treated like a "customer" of Passport Canada and marketed to as such(as in me previously linked videos).

Victoria FERAUGE said...

@Tim, Loved the videos. I've never been able to understand the hostility in the US to some sort of national VAT. As I understand the argument against it, the concern is that it would fall harder on the poor as opposed to the rich. That's probably true but here is something that is equally true: where some members of society do not have a "dog in the right" (i.e. don't pay any taxes at all or very little) this leads to some very poor decision-making because it's other people's money that is being spent - not theirs.

Imagine a world, for example, where factored into the decision to invade Irak there had been a real conversation about how to pay for it. Support for the war in the U.S. at the time was very strong. Would it have been so strong if it were clearly stated at that time "and the bill for the invasion will be X number of dollars and the average American family of four will pay X for X years to finance it." Given the climate at the time, I'm sure the invasion would have gone ahead in any case but it might have sobered people up to have clearly understood the link between spending (war costs) and financing (taxes). As it was, it seemed that there was this enormous disconnect between the two and now Americans have woken up to a huge hangover, blinking their eyes and saying, "what the hell happened and how is it that we owe all this money?"

I would argue that everyone should pay something in taxes. Everyone. Under the current U.S. tax system roughly 50% of Americans pay nothing at the Federal level and that is corrupting. A GST/VAT would ensure that everyone has a "dog in the fight" no matter their income level.

I'm very interested in the "fee for service" model. Again this draws a direct line between spending for services and how it is financed. I don't think that there is anything wrong with citizens being treated as customers (and I don't see that as devaluing Canadian citizenship). Much easier and cheaper to collect too.

Anonymous said...

Hello Victoria
Hope you are doing well and the heat wave has not made things worse for you.

I agree that taxation is the price one pays for civilization. The "agreement" to allow taxation is usually accompanied by some basic principles and these vary depending on the history and culture. Below the ones that are frequently mentioned.
*Equality could be one or any combination of the following four: horizontal, vertical, ability to pay (equal suffering), benefit (you pay what you use)
*Simplicity - simple and cheap to administer

So which of these might be associated with the current USA Citizenship Based taxation? Certainly not Simplicity. I'd also have to rule out Transparency for both expatriates and homelanders because the complexity of the IRS code is such that no one can fully master nor apply it. Efficiency, well I'm not sure. Do USA tax policies for expatriates drive the behaviors that will produce the desired outcomes?

I saved Equality for last.
**Horizontal equality. Everyone in the same situation receives the same treatment. The USA treats expatriates as if they were residing in the USA, more or less. This, I believe, is the root of the problem for most expats.
**Vertical equality. People in different situations are treated differently. Maybe this is what expats should aim for, recognition of the huge differences.
**Benefits. You pay for the services you receive. Expats should push hard on this one. Now this is where it gets emotional. The USA will claim that just being American is a benefit. We can laugh at the other claims such as protection when abroad, etc.
**Ability to pay. This one is tricky. The USA does not recognize the overall fiscal burden of expats in their countries of residence (direct - including consumer taxes - and indirect taxes), nor fluctuating exchange rates, nor cost of living, etc.

Now for a few emotional issues.

* Payback. Many people (not just Americans!) speak of payback. You mentioned education. Well, I believe that my parents paid taxes to the countries where we lived and where I received my education so that "debt" is extinguished as far as any government is concerned. My parents might request eternal gratitude, but oddly enough, they never did.

* Patriotism. I guess taxation could be considered as a demonstration of patriotism but I'm not convinced.

* Privilege of being a US citizen is something you need to pay for. What do you do with the accidental Americans? Or those who left the USA before adulthood? Or those who have lived 20, 30, 40 or more years abroad? Or those who hold mutliple nationalities?

* Benefits. I think you did an excellent job a while back on the cost vs benefit analysis!

I'll stop for now. I think folks need to be realistic. Citizenship based taxation in America is not going away. It is not in the American DNA.

Victoria FERAUGE said...

@anonymous, We made it through the heat wave just fine (thanks for asking). I have never however been so happy to be bald. It's amazing how much cooler you are without that hair on your head. I advise everyone to give it a try once the temps rise about 30. :-)

Wow, I really liked your analysis of the different principles about taxation. I think you could have written a much better post than I did. I agree that citizenship-based taxation does not pass the test for the most post. It's important to recognize I think that for someone living abroad who only makes a very modest amount of earned income (and has nothing else - no property, no pensions, no bank accounts that exceed 10,000 USD) it is pretty simple to fill out that 1040 and the 2555-EZ. It's almost as if they wanted to keep American abroad in modest professions that don't pay much (translation work or teaching) and make it hard for them to have a life abroad (thus encouraging them to come home after a few years). If what they want to do is encourage adventuring and discourage outright emigration, it's not a bad method IF everyone was clued in and understood the terms. My question is: Is that what the U.S. government and the American people want? It's a question worth asking. I suspect the answer would be "yes."

And that ties in nicely with the emotional issues attached to this subject. Tell a homeland American that you've been out of the country for nearly 20 years and you get a wide variety of reactions and often very negative ones. When we ask for treatment that is reasonable based on our situation, I'm finding very little sympathy or empathy in the home country. Roger Conklin says that in some ways you could see the onerous reporting requirements and double taxation as a kind of "sin tax." Yes, we have the right to live abroad but homelanders would like to see us pay for the privilege. If we don't like it, many say, well we should just renounce or come home.

Just for fun, I came across this interesting paper a few days ago called Patriotism, Taxation and International Mobility:

Some interesting thoughts and some analysis about taxation and the "people who move around."