Is Residence-Based Taxation Compatible With Progressive Idealism?
Senior couple driving convertible car at sunrise on rural highway getty  Here I go again, harping on the United States stubborn adherence to citizenship-based taxation. I have previously argued that residence-based taxation (RBT) is the superior model for how a government should tax individual income, which could explain why the doctrine is (almost) universally relied on outside the United States. The preference for RBT stems from the benefit principle, which reflects the common-sense notion that households should pay tax where they routinely consume public services. By choosing to live in a particular place, a person implicitly decides to purchase the bundle of public services associated with that geographic turf. Citizenship-based taxation is problematic because it creates a potential mismatch between the place in which you live and the bundle of public services for which youre charged. The mismatch is easily overlooked if you assume people are stationary objects. This column assumes human beings are a species of roamers. Other factors might include, for example, whether the taxpayer is living abroad while operating a U.S. trade or business. A source rule should (and does) catch that category of income. Im not talking about taxation based on source principles. The case for RBT is best illustrated when we assume away source of income as a basis for the imposition of U.S. taxes. The debate centers on whether its fair and just for U.S. expats (and accidental Americans) to be subject to U.S. tax on their foreign-source income. Citizenship-based taxation answers that question in the affirmative. RBT says no. Heres an odd thing Ive noticed over the years: When presented with the same question, many people lean toward an indecisive response. They say the answer depends on the details  specifically, how wealthy the U.S. expat is and whether the person relocated to a country that imposes a normal level of taxation. Such a response is less than unfettered support for RBT; its a qualification. Lately Ive been asking myself why these qualifications are necessary. The quibbling puts the focus on the expats income or wealth status, as well as the adopted place of residence. These reservations are understandable. They reflect an instinctive concern about the stereotypical jet-setting U.S. expat who seeks to scam the system by playing fast and loose with the residency rules. I get that. The worry is that if you come down squarely on the side of RBT, without reservation, you could inadvertently acquiesce to the lax treatment of tax dodgers with passports. As a group, that is not a body of souls who merit special treatment via the tax code. Tax Notes has published some insightful commentary on that very point. While acknowledging the risk, I maintain that the circumstances of these rich folks should not become an obstacle to broader adoption of RBT. The policy should have nothing to do with going soft on scofflaws. Not to beat a dead horse, but every other country in the world (apart from Eritrea) has somehow managed to balance these concerns in a satisfactory manner and is no worse off for it. Thats despite the occasional example of a very rich person leaving the country, as happened with Sir James Ratcliffe, who was the wealthiest person in the United Kingdom until he expatriated to Monaco. Those who are skeptical about RBT will point to what happened with Ratcliffe and see a reason for caution. Ineos Chairman Jim Ratcliffe reacts during a media event to reveal the new livery for Mercedes AMG ... [+] Petronas F1 Team's race car the for the upcoming 2020 season, at the Royal Automobile Club in London on February 10, 2020. - Mercedes Formula 1 boss Toto Wolff said on Monday that his team's tie-up with Lewis Hamilton is the "obvious pairing", with the future of the six-time world champion still unclear on the eve of the new season. "It is the obvious pairing going forward," said Wolff as Mercedes unveiled a five-year partnership with Jim Ratcliffe's chemicals company Ineos in London. (Photo by Tolga AKMEN / AFP) (Photo by TOLGA AKMEN/AFP via Getty Images) AFP via Getty Images  My response is that RBT is not a mischievous plot to assist the rich. Nor is it a social science experiment perpetrated by libertarian think-tanks. It is the international norm for delineating the fiscal bond between the sovereign and the individual. Globally speaking, it is what normal taxation looks like. We live in an era in which discussions of income inequality hold much sway in terms of orienting economic policy. Thats a good thing. (Not the inequality, but the fact that policymakers have identified it and are prioritizing its mitigation.) It would be irresponsible for governments not to be actively thinking about how income inequality can be addressed. These days, any tax proposal that seems reasonable  if not outright desirable  will be judged in terms of whether it helps shrink the income gap between the 1 percenters and the rest of us. Thats not to say that each new proposal must be developed with income redistribution being a foremost concern, but merely that we should expect that measures that are directionally indifferent will draw scrutiny. Someone is bound to ask whether the proposed measure will benefit the wealthy. If youre not anticipating that kind of reaction, you should be. That doesnt mean each tax measure that flunks the progressivity test will be scrapped  far from it. The tax code is stuffed full of measures that disproportionately benefit the wealthy, often by design. Carried interest treatment is widely acknowledged to be a scandalous tax perk for the wealthy thats devoid of substantive merit. Yet it survived eight years of the Obama administration and will likely survive the Biden years. There are many other examples; too many to name. Their presence in the tax code, and their resilience to change, reveals the practical limits of progressive liberalism. Many people will privately admit to discomfort with citizenship-based taxation, especially when discussion turns to the Foreign Account Tax Compliance Act. They even concede that residence is the more enlightened taxing concept, offering a nod of approval to the benefit principle. But tax reforms are seen through a political prism, and for many Democratic voters, that implies a reluctance to deviate from the Biden administrations stated goal of extracting a bit more income tax from those at the top end of the income strata  more precisely, the pledge to not increase income taxes on those earning less than $400,000 per year. I propose the answer is yes, but readers are welcome to disagree. I suspect many of them will for the reasons discussed below. To further explore this issue, Ill examine the recent submission by Democrats Abroad to the Senate Finance Committee. As you can detect from the groups name, they represent the interests of U.S. expats with the added twist that they happen to be loyal Democrats. It follows that the groups membership would have no desire to oppose the things President Biden is trying to accomplish, including his proposed changes to the tax code. Thats simple. As a source of thematic material, the view from the political right lacks the same internal tension. As the purpose here is to explore the RBT debate as a manifestation of cognitive dissonance, we must look at the Democrats. That explains this weeks headline. The document were scrutinizing is a May 7 correspondence from Julia Bryan, global chair for Democrats Abroad, to the Senate Finance Committee. It comments on matters covered during an April 27 hearing of the Fiscal Responsibility and Economic Growth Subcommittee. The subcommittee is chaired by Sen. Elizabeth Warren, D-Mass., who famously supports increased taxes on corporations and a wealth tax. The ranking minority member is Sen. Bill Cassidy, R-La., who opposes increased taxation generally. Passport of United states of America and flag of USA in hand on green blurred background. getty  Bryan begins the letter by outlining the circumstances of the 9 million U.S. citizens who live outside the country. That number excludes military personnel stationed at overseas installations, as well as those studying abroad or otherwise engaged in short-term or transitory foreign living arrangements. The clear theme is that U.S. tax law falsely portrays these individuals as high rollers. Bryan cites research, published at the urging of congressional staff, showing the primary reasons why these people ended up living abroad. The most common reasons are personal relationships (love, marriage, and raising a family) or the pursuit of employment and educational opportunities. A set of statistics fill in the picture of who these expats are:  32% moved overseas for marriage or a relationship;  25% moved overseas for employment;  61% have household income under $100,000;  64% have no plans to return to the United States; and  71% are married to non-U.S. spouses. Bryan further describes U.S. expats as follows:  The vast majority of us are middle-class Americans, working, raising families, and retiring in countries with a higher overall tax-burden than the U.S. The tax policies and regulations that affect Americans abroad do not reflect this reality, but instead penalize millions of us ordinary American citizens in attempts to foil a few bad actors. Filing taxes from abroad and navigating the convergence of the U.S. and a non-U.S. tax system is stunningly complex. Research has found most seek the services of expensive tax return preparers to produce filings that commonly show that we owe no U.S. tax.  The point about most expats not owing any U.S. tax is to be taken seriously. That does not diminish the arguments for changing the law. Foreign residency makes many expats eligible for the foreign earned income exclusion under IRC section 911. The exclusion is $108,700 for the 2021 tax year. Beyond that, foreign tax credits provide relief for foreign taxes already paid. Its unfortunate that expats must pay pricey tax advisers to determine they owe no U.S. tax. Americans abroad are not on equal footing with expats coming from countries with RBT systems. Bryan speaks of the need to be placed on taxation par with those other expats. RBT isnt about seeking special treatment, its about parity:  Democrats Abroad and the other organizations representing Americans abroad have had detailed discussions with Congress about a proposal to enact RBT and other reforms for Americans abroad that eliminate double taxation, remove barriers to banking, saving and investing and simplifying filing from abroad. . . . We will continue to advocate in support of an RBT model that provides relief to Americans abroad, prevents residency-based U.S. tax avoidance and is revenue neutral to the federal government. We believe the time will come when Congress embraces RBT.  This prioritizes the groups long-term objective. The phrasing conveys that the goal probably isnt attainable in the near term because of well-known political obstacle. Expats vote in U.S. elections, but nobody running for Congress naturally identifies them as a constituent group. Their footprint is too diverse. A footnote in Bryans letter references the organizations support for a version of RBT that includes a means-tested transition tax. Thats basically a one-time exit tax on the accrued wealth of high-net-worth U.S. individuals seeking nonresident status for income tax purposes. That status would be different from those who choose to relinquish U.S. citizenship, as permitted under current law. The latter group includes accidental Americans, who in addition to being nonresidents have no desire to retain U.S. citizenship. The former group would retain U.S. citizenship while establishing nonresident status  and be off the hook for U.S. income taxes under a residence-based regime (excluding the taxation of U.S.-source income, as mentioned at the outset above). Electing this status would come at no cost for most people. Only high-net-worth individuals would suffer the one-time exit tax. The explanation goes back to the concern about rich folks gaming the system. RBT risks losing some people (progressive Democrats like Warren) when the narrative turns to the superrich. Adding a wealth tax helps rebut that knee-jerk opposition. Trust me, its easier than rehashing the benefit principle only to get blank looks. WASHINGTON, DC - APRIL 27: U.S. Sen. Elizabeth Warren (D-MA) listens during a news conference ... [+] outside the U.S. Capitol April 27, 2021 in Washington, DC. Warren held the news conference to discuss the reintroduction of the "Universal Child Care and Early Learning Act." (Photo by Alex Wong/Getty Images) Getty Images  Lets say some private equity boss from Greenwich, Connecticut, acquired a Picasso 30 years ago, and the item has quintupled in value. Now the person wants to move to Mallorca and stay there forever  taking along appreciated capital assets. Once the taxpayer is permanently outside the U.S. tax net, the IRS may never have a second chance to tax the unrealized gain that occurred while they were a U.S. resident. The physical act of expatriation becomes a realization event. Fair question, but a typical answer is that we dont worry too much about hardship inflicted on people who collect museum pieces as a pastime. The exit tax may have a chilling effect on departures, but only for high-net-worth individuals  and only if the exit tax is sufficiently harsh. That raises questions about the nature of the exit tax. Democrats Abroad offers a list of four legislative priorities. The Filing Exemption  This would be an income tax filing exemption for Americans abroad who are compliant with financial account reporting requirements and owe zero U.S. tax. Expats would rely on the IRS substantial presence test to certify their offshore residence. They could use tax calculation worksheets (rather than actual returns) to demonstrate that they have zero U.S. tax liability. Otherwise, the exemption seems self-defeating, as youd need to prepare a return in order to determine you dont need to file it. High-net-worth individuals would be excluded from this form of relief, meaning they would always be required to file an annual return, even if their worksheet calculation demonstrated that they owed no U.S. tax, which might be the case if they had sufficient FTCs. The GILTI Exemption  This would be an exemption from the global intangible low-taxed income regime for Americans abroad earning less than $400,000 per year. Research shows that up to 20% of U.S. expats own and operate a small business. Actual examples include activities as diverse as commercial architects, information technology professionals, yoga instructors, and beekeepers. Many are being harmed by the GILTI rules, although the provision was intended to target large multinational corporations. Thats beyond the economic harm resulting from the Tax Cuts and Jobs Acts one-time repatriation tax, retroactively applied to post-1986 retained profits. Treasury has already provided some partial relief. Last year, regulations allowed individual shareholders to benefit from a discounted corporate tax rate (via the section 962 election) and a 50% reduction in the GILTI amount (via the section 250 deduction). This type of regulatory relief is unsatisfactory to many U.S. expats because double taxation isnt properly resolved. A GILTI exemption for expats would reconcile Treasurys desire to significantly toughen the regime with Bidens pledge to not increase taxes on individuals with incomes less than $400,000. Without such an exemption, the prospect of a beefier GILTI regime (both as to the increased rate of 21% and elimination of the qualified business asset investment exclusion) could spell more bad news for expats who are business owners. Again, the group proposes that high-net-worth individuals be excluded from the described GILTI relief. You might think that goes without saying, because the recommended income threshold of $400,000 leaves a lot of space between middle-income taxpayers and the high-net-worth crowd. But recall that income and wealth are distinct economic concepts. An income statement tells you nothing about a persons balance sheet. Foreign Bank Account Report Updates  This would be a series of updates to the foreign bank account reporting regime. It includes the elimination of FBAR and FATCA duplication, the creation of a dedicated FBAR filing threshold for Americans abroad thats five times the conventional FBAR threshold, and reform of the disproportionate FBAR penalty regime for willful neglect. As previously reported, the FBAR penalty structure is a mess that requires congressional intervention. Additional relief includes the ability to submit paper FBAR filings, which in some cases is preferred to online filings. FATCA Relief  This would be a same-country exemption for FATCA reporting, along the lines of whats included in the proposed Overseas Americans Financial Access Act  that is, if the U.S. expat owns or maintains a beneficial interest in a foreign bank account and lives in the same jurisdiction. The risk of tax evasion that FATCA is targeting is notably diminished when the U.S. citizen in question holds a foreign financial account and lives in the same jurisdiction. For example, having a Swiss bank account is perfectly normal if you happen to reside in Switzerland. The point of the Overseas Americans Financial Access Act is to make it easier for U.S. expats to have access to banking and financial services. Bryan argues that each proposal is consistent with the vision of Bidens American Families Plan. That may literally be so. The better question to ask, however, is whether RBT is consistent with the preferences of Sen. Warren, who not only chairs the subcommittee in question but is often regarded as representing the progressive wing of the Democratic Party. We might ask the same of Sen. Bernie Sanders, I-Vt., another influencer among progressives. WASHINGTON, DC - FEBRUARY 25: Senate Budget Committee Chairman Sen. Bernie Sanders, I-Vt., speaks ... [+] during a hearing on Capitol Hill examining wages at large profitable corporations February 25, 2021 in Washington, DC. The committee is looking at why many low-wage workers in America qualify for public benefits even though thousands of them are employees of large corporations. We can ask that question repeatedly, and the thought process always leads to matters of perception. Democratic tax policy is wedded to an understanding of progressivity that doesnt bode well for Americans abroad. A dozen years ago, President Obama famously promised not to increase taxes on people earning under $250,000. In doing so, he established an informal standard for people who might not qualify as superrich but are wealthy enough that they shouldnt be sheltered from the possibility of future tax increases during his term in office. Biden has repeated that exercise, having upped the standard to $400,000. For advocates of RBT, theres an awkwardness with this practice of quantitatively defining a group of taxpayers who deserve protection against future tax hikes. By implication, the practice instructs us that taxpayers on the wrong side of that dividing line arent deserving of consideration. A reform proposal that helps even a few members of that unprotected group is bound to be criticized as poorly targeted. Im not suggesting that the Warrens and Sanderses of the world are horribly mistaken in their orientation about whats fair and just taxation. But their perspective isnt conducive to easing burdens on a category of people who  despite being predominantly middle income  arent defined by reference to their income or wealth. They are defined by geography (place of residence), which does not render them members of a protected class. Its as if progressive liberalism suffers from tunnel vision when it comes to perceptions of need. You can point out that expats, as a group, are being unfairly treated under current law. The response from progressives is to fixate on income level or wealth status. You can try to explain that economic status is irrelevant to the source (foreign residency) of their disparate treatment, and thats where you lose them. Consider the statistics referenced in the letter from Democrats Abroad. It claims that 61% of U.S. expats earn less than $100,000 per year. That informs us that a preponderance of the group is middle income or reasonably close to it. Lets agree that their numbers comprise a small percentage of the whole expat community, which I firmly believe to be true. When spread over a pool of 9 million expats, that translates to a number of rich folks who could conceivably benefit from RBT. As long as their number is something other than zero, their presence becomes a disqualifier. The applicable paradigm for determining acceptability relies solely on measures of income or other gauges of private wealth. Thats a highly restrictive view of who can benefit from changes to the tax code. This explains why the reform recommendations floated by Democrats Abroad include carveouts for high-net-worth individuals. Those provisions arent there by accident; they reflect what is expected by progressive ideals. To think about income and wealth in these ways is not necessarily a flawed concept, but its a poor fit for what residence-based taxation seeks to accomplish. Theres your conclusion. RBT is not incompatible with progressive ideals, but good luck convincing people of that.