The IRS’s “Hotel California” problem

Posted by Marc Hodak on May 29, 2008 under Unintended consequences | 4 Comments to Read

I want to follow up on my last post with the unintended consequences of Congressional policy on global taxation of U.S. citizens. As I mentioned earlier, many U.S. citizens living abroad are tiring of dealing with the IRS and renouncing their citizenship. This NYT article includes some excellent vignettes along those lines.

The legal ritual of renunciation is largely unique to the United States because other countries base taxation on residency, not citizenship, according to Ingmar Dörr, a tax lawyer with Lovells in Munich.

“We don’t have that issue,” he said. “We only have the problem that rich people who don’t want to pay taxes in Germany just move to a lower-tax country in Switzerland.”

That’s precisely the choice that the U.S. Congress wishes to deny its wealthy citizens. So, beginning in 1996, they have enacted increasingly draconian laws to make renunciation for tax avoidance purposes as difficult and costly as possible. They are, in a sense, trying a Berlin Wall solution.

To understand why Congress feels it needs a Berlin Wall strategy for American taxpayers, one only need look beyond the populist rhetoric about our wealthy paying their “fair share” to realize that our top 1 percent of households pay 28 percent of all taxes collected by the U.S. government. Congress will complain all day about “the rich,” but it does not want to let these people go.

The problem with this strategy, of course, is that what looks like a Berlin Wall to your own citizens looks like a Hotel California to outsiders who have a choice of where to check in.

How has that been working? Well, it used to be that everyone I knew from abroad was looking forward to American citizenship. Now, not a single one of my professional acquaintances wants it. They don’t mind paying their taxes while they’re here, but would just as soon be left alone by the IRS once they have departed to Toronto, Dubai, Shanghai or wherever opportunity might take them in this big world.

This is more than just an anecdotal trend. In the five years before the 1996 change in the law, the ratio of professionals to total immigrants was a steady 15-16 percent. In the five years afterward, which included the dot-com boom that attracted so many of the world’s entrepreneurial types here, that ratio dropped to 12 percent. It is currently below 10 percent. In fact, the raw number of professionals naturalizing here in recent years is below those from the mid-1990s in the lead up to the new tax laws.

In other words, the new rules that have kept an extra few hundred of our professional class from checking out have likely scared away tens for thousands from checking in. I’ve done the math, and it’s crazy.

Consider Jan and John, both earning enough to pay about $200,000 a year in U.S. taxes for the rest of their lives, including from their pensions and savings in retirement. They each expect to leave a nice little bundle for their kids and grandkids, a well.

John is a U.S. citizen working in Singapore. The U.S. tax authorities have made his stint there very expensive, but his firm is largely eating that nut, so far. John has plenty of reasons to stay abroad, and would even consider retiring abroad in the next ten years. But he is faced with paying U.S. taxes forever because of his citizenship. He would love to have an option about where he can live and pay taxes, especially in light of constant threats by politicians back home to raise his taxes, but the U.S. severely limits his options on that latter score. We can look forward to John’s taxes in his retirement years, including a chunk of his wealth at death.

Jan is a Czech citizen who works alongside John. Their firm is trying to entice Jan to come to the U.S. for a senior management position. If he comes here with his family, he will be paying those senior executive-type taxes to the U.S. He doesn’t mind that, except that he only wants to do that for the years he is actually here. He wants the flexibility to retire anywhere without having to worry about U.S. taxes forever. Therefore, it makes no sense for Jan to pursue U.S. citizenship or permanent residence, which rules out Jan retiring in the U.S., or perhaps raising his kids here so they become permanent residents.

Keep in mind that there are about 100 Jans making their choices for every John that we’re compelling to stay. As everyone knows, in love as well as business, one is much better off figuring out how to attract the Jans than trying to trap the Johns.