Perfectly Legal

posted in: Socioeconomics | 0

David Cay Johnston has the ability to write books that are like watching a train wreck in slow motion; except the train wreck involves everyone you’ve ever known, so you keep watching out of a combination of morbid interest and the faint hope that maybe things will come out okay.dbfa225b9da0eb81e64c5110.L

I have previously reviewed another of his books, Free Lunch, and expressed similar sentiments.

Make no mistake, he is a very skilled writer, weaves a very tight narrative, and the subject matter is of utmost importance, particularly in today’s charged dialogue concerning taxes, classism, and corporate personhood.

The books central drive is this:

  1. Most of us are not rich: There is an aggravated disparity in the distribution of wealth in this country, particularly in the top 1/10th of the top 1% (the top 0.001th overall), and this disparity has grown over the past 30 years.
  2. The rich know how to cheat at our expense: The wealthiest individuals in this country (which Johnston refers to as the “political donor class”) are have the time and financial resources to find and exploit various loopholes and legal-fu to further expand (or protect) their wealth, often at the expense of the the common taxpayers (since the money for governmental programs has to come from somewhere)
  3. This cheating is subsisted by you and I: While some of the wealthy do pay some of their taxes, and that sum is a significant amount of the total taxes paid (though not a proportional amount, given how much wealth they wield), the difference between what they should pay and what they do pay is comes from either the tax dollars of the average taxpayer or from additional debt — either way, we foot the bill.
  4. The rich can sustain and protect their cheating: The “political donor class” also uses their influence and wealth to sway legislation and judgements in favor of their existing exploitations, or to generate new exploits.

It makes me hopeful to see the Occupy Wallstreet protests, which are essentially all about these issues, happening as I am reading this book. It always catches me by surprise when I encounter someone who doesn’t understand how much wealth disparity there is, or who thinks that a six figure salary is “rich.”

I highly recommend this book for everyone to read, especially right now. “Nickel & Dimed“, and “Free Lunch” are both also good reads that are appropriate for the present as well.

There is so much injustice, so much complexity, that I would have to recap the entire book to cover it all, but for the sake of illustration, here are some examples of the premises mentioned above.

Most of us are not rich

While this seems like it goes without saying, most of us are not wealthy. (For the purposes of this post, I am defining “wealthy” as “possessing enough income / positive cash flow to where cost of living is inconsequential”) What’s worse, though, is that Americans don’t quite know how quite disproportionate things are (see page 11). In fact, Americans polled in that survey prefer a more egalitarian distribution (more similar to Sweden).

But exactly how bad is it?

Johnston pulls data from Pikity & Saez and constructs a visualization displaying the wealth distribution as a “ladder” of 100 rungs, where each rung is a percentile. (So if you are in the 50th percentile, then you earn more money than 49% of the population).

These images show the amount of income growth each percentile received, in inflation-adjusted dollars, between 1970 and 2000. (Used with permission from the author)

This first image shows the big picture — the bottom 90% of us experienced a 0.1% decrease p33-150x150in average income over that time period. For reference, the 90th percentile is ~$220,000 in the year 2000.

The top 10% saw a nominal increase of 86% in that 30 year period.

The tiny bar graphs on the right side represent the “income share” change fro 1970 to 2000. For the top 10%, their share of income grew from 33% to 48%. (So the top 10% earned roughly 1/2 of all income in 2000). The bottom 90% dropped from 67% to 52%.

But using averages, particularly for the upper tier, is not specific enough.

This second visualization focuses in more specifically on that top 10%. This is where it p36-150x150becomes clear how much the money is flowing upwards.

  • The 90th to 95th percentiles (average $103,000) experienced +29.6% nominal income growth
  • The 95th to 99th percentile (average $178,000) had +54.2% nominal income growth

Pausing there for a moment — the Occupy Wallstreet movement refers to the “99%”. If you earn under ~$250k you are part of the 99%, like it or not. The topmost portion of this graph is the 1%, the people mentioned by Occupy  Wallstreet. Johnston splits this percentile in half:

  • The 99.0th to 99.5th percentile (average $384,000) had +89.5%
  • The 99.5th to 100th percentile (average $777,000) had +144.8%

Already we’re starting to see that the “86%” income increase that the top 10% experienced is heavily weighted to the topmost earners. The top 1% are the only people that even earned the “average” of that entire decile. Let’s dig even a little further.

Here in this last graph, Johnston takes that top 1/2 of the top 1% and breaks it down even p38-150x150more.

  • From the 99.5th to the 99.9th percentile (average $777,000), or +144.8%
  • The 99.90th to the 99.99th percentile (average $3,000,000), had +322% increase

Each 1/10th of 1% is 134,000 households. So the 99.5-99.9% range is 528,000 households. The 99.90-99.99% range is 120,600 households. And the top 13,400 households, or the top 0.01%…

  • The top 0.01th percentile, averaging $23.9 million, had +558.3% increase in income over that 30 year period. Back in 1970, they earned $3.6 million. (Both numbers adjusted for inflation already!)

Many figures I’ve seen typically just use “average” numbers, like those early charts, and the true horror of the inequality (shown in that last chart) only comes through when you go down that rabbit hole. But how do they get to that point? How did they become so disproportionately wealthy?

The rich know how to cheat at our expense

I recently had someone tell me that the super-rich are “not mad scientists, conspiring for world domination” with regard to their ability to exploit tax law and the IRS. While I agree with that statement in the most literal sense, the super-rich are probably by-and-large not quite knowledgeable enough about the esotericities of the tax code and financial ju-jitsu necessary to become even more rich.

Those people do exist, however, and for a comparatively small fee (for some of the larger values of “small”), they will ply their trade and make tax liabilities vanish like some kind of bourgeois street magician.

Jonathan Blattmachr

One such wizard is lawyer named Jonathan Blattmachr (“BLOT-mach-ur”). Says Johnston:

Over the years Blattmachr has found dozens of ways to navigate huge sums of money around government’s many levies. He knows how to make a man who appears as a Midas before his bankers look like a pauper to the tax man. (8)

His clientele have included Bill Gates, the Gettys, the Rockefellers and many others that probably appear on the Forbes 400 list. His services often include clever tricks for avoiding tax liability entirely or by constructing obtuse financial models and investments whose primary purpose is to circumvent Caesar’s rent.

The trick was in manipulating charitable trusts, a common enough device used by generous people who own an asset, such as stock or a building that has appreciated in value. Instead of selling the asset and investing the after-tax proceeds, an individual or a married couple can donate the asset to a charitable trust they control. The trust sells the asset tax-free and invests the proceeds, giving the donating individual or couple a lifetime income, typically 6 percent per year. When the donors die, what remains in the trust, typically half its value, goes to charity.

This is pretty straightforward. It’s also not all that devious. It’s also not what Blattmachr actually does. For Bill Gates, who with his spouse founded the Bill and Melinda Gates Foundation, there was something even more clever. Johnston continues:

Blattmachr’s plan was to take back not 6 percent annually for life, but 80 percent per year for two years. Gates could have pocketed at least $192 million without paying any tax. Then the trust would fold and a charity would get the remaining sum, less than $8 million. Under the plan Gates could have converted into cash more than 96 percent of gains on the Microsoft shares he donated, not the 72 percent he was entitled to after federal capital gains taxes. The charity would get less than four cents on each donated dollar. The government [and by extension, the rest of we taxpayers] would collect nothing.

The scheme even created a tax deduction that was enough to reduce Gates’ income by about $2 million. (9)

Johnston points out that it is unknown whether or not Gates actually went forward with this plan, but that if he had chosen to, it would have been essentially legal to do so.

“Non-profit” Insurance Companies

Another such loophole that could only be exploited by someone very wealthy is related to non-profit organizations, organizations with filings for Section 501(c)(3) status. The laws associated with that status “authorizes people and companies to deduct gifts made to charities,” containing a particularly subsection, number 15, that “authorizes tax-exempt insurance companies.” (188)

While there are a lot of details to how this works, discussed in the book, in a general sense this is how it works:

  • A “non-profit” insurance company is tax-exempt, so they pay no taxes on their revenue
  • A 1986 tax reform law changed things so that investors could now own these insurance companies
  • That same law also contained a clause that removed the cap on how much capital could be invested into these companies
  • The companies collect next to nothing in annual premiums (typically less than $10,000 in the examples given)
  • The money in the insurance company can be used as capital for investing in any number of things, making the wealth grow enormously
  • When the investors have had enough, they can liquidate it, only paying taxes on the growth but not any of the initial investments. (So if you had invested $100M and the company accrued $100M in profits from investments, you would only pay taxes on that second $100M, but get your initial $100M back untouched…and untaxed)

One particular investor, exploiting this loophole, Peter R. Kellogg, saved him $189 million dollars in income taxes from 1996-2001 through two of his non-profit insurance companies, by dumping an exorbitant amount of capital into them.

Johnston also mentions in passing that this particular financial instrument has been used over the years by vendors of electronics, automobiles, and other manufactured goods as “warranties.” The premiums that you may or may not pay into those policies are basically all bonus, as the primary drive of that insurance company would be to exploit its tax-exempt status. (NB I am not saying that all, or even most, of those policies are done like this, but if you are considering purchasing a warranty or insurance policy, you might inquire whether or not the insurance provider is a non-profit company).

Legal(?) Tax Evasion

Johnston spends 5 chapters (14,15,17, 18, 19) talking about using off-shore investments for tax evasion. There is far too much information to cover here.

In a nutshell, Johnston provides a myriad of examples of how the super-rich use off-shore investments in the Caymans, Bermuda, and other countries with miniscule tax rates to hide their money from our government. Seminars and industry experts consult with these wealthy individuals to show them the latest bleeding-edge tricks to eschew their tax liabilities. In Johnston’s opinion, when those tricks become common knowledge (or even known to exist by the government), the insiders are already leaps and bounds ahead of that.

The information on this topic is maddeningly good, but like I said there’s just too much to cover.

The cheating is subsisted by you and I

Chapter 16, “Profiting off taxes,” is by far the most bizarre and simultaneously clever example of tax evasion I’ve ever read. I had to read this chapter 3 times to really grasp fully what happened here. First, there are the key players:

  • Robert Gordon, an Australian who owns Twenty-First Securities (basically: a consultant)
  • Royal Dutch Shell, a publicly traded oil company
  • The insurance company of Arthur J. Gallagher & Co., a publicly traded Chicago-based company
  • Compaq Computer Corporation, a US based computer manufacturer, popular in the 1990s
  • The governments of Holland and the US

The entire transaction occurred in a matter of seconds, and the end result was that Compaq shaved $3 million off its tax liability to the US.

Here is the breakdown of what occurred:

  1. The Gallagher Co. borrowed 10 million (worth $890 million) shares of the Royal Dutch Shell company from various owners via a pension fund, which are exempt from US taxes but not Dutch taxes.
  2. Gallagher Co., in 23 separate transactions, sold “short” and bought back all 10 million shares – the recipient of the shares in the transaction was Compaq. (Gallagher Co. earned a $1,000 fee for each transaction, $23,000 in total)
  3. Each share was sold to compaq for $1.92 than its market value, so on paper Compaq loses money in the trade, overall.
  4. Owning those shares on this particular day for even a few seconds entitled Compaq to both quarterly dividends ($2.25 per share) as well as a tax liability to the Dutch government of $0.33 per share. (meaning Compaq earns $1.92 per share from dividends)
  5. The Dutch and US governments have a treaty that allows US citizens / companies that pay taxes to the Dutch government to deduct, dollar for dollar, that amount from their tax liability to the US. (“foreign tax credit”)
  6. Compaq, who paid $3.3 million in taxes to the Dutch government at no actual cost to them (the payment was absorbed in the transaction and by the dividends), now has a $3.3M tax credit with the US — “enough to wipe out the federal corporate income taxes on more than $8.5 million in profit.” (224)
  7. Gordon’s firm collected over $1M in fees.

In the end, Gallagher earned $23,000, the pension fund earned a tiny fee for loaning its shares for short-selling, the Dutch government earned its $0.33 per share it would have gotten either way, Compaq ended up with over $2 million (money that it would have otherwise had to have paid to the US government for taxes).

The US government lost out on $3 million, which was paid to the Dutch government instead. Think about that for a moment.

All of this elaborate planning and financial acrobatics just to screw the US government out of $3 million. That is tax dollars that you and I will ultimately have to cover.

There’s no free lunch in all of this. Every tax dollar that a company or person (wealthy or not!) cheats the government out of has to be paid by someone. I have heard many people complain about the poor that “cheat the system” by milking welfare, disability, or food stamps — this is chump change compared to deals like the one with Compaq, above. They’re both wrong, but in the same way that saying that robbing a convenience store is the same as robbing Fort Knox.

The rich can sustain and protect their cheating

There are two components to this: the sustenance and the protection.

Cheating is easy, it’s the oversight, the risk of getting caught, that complicates things. Hampering that oversight is accomplished by both inhibiting the law enforcement (typically the IRS) and having laws changed or twisted to better suit them.

While there was a chapter entirely devoted to this topic (“Handcuffing the Tax Police”), it’s difficult to pick out any one snippet or factoid that clearly illustrates how systemic this problem has become; but it’s a theme that arises constantly. A few choice quotes:

In Nashville, a revenue agent said anyone there could get a tax case resolved favorably if the taxpayer had enough influence to get a senator or congressperson to complain to the IRS. “We just collapse,” the 14-year veteran said. (154)

Except for one category, audits fell off sharply for every kind of taxpayer. The audit rate for people making more than $100,000 plummeted further from the low rate when [IRS Commissioner Rossotti]’s own returns were examined in 1997. By 2000, it was down to one in 145.
Audits of the largest corporations , which pay about 85% of the corporate income tax, fell too. In the late 1980s, two out of three large companies were audited. By the time Rossotti was hired, only half of the big companies were being audited. That rapidly fell to one in there. (166)

The real injustice, though, is that audits were not uniformly decreasing. The poorer taxpayers, particularly those filing Earned Income Credit, are disproportionately filing.

Looked at another way, one in 47 of the working poor had their returns audited, compared to one in 145 of the affluent and one in 400 returns filed by partnerships, which are used mostly by the wealthy. (137)

Congress also lets the IRS deny the [Earned Income Credit] for 2 years or even 10 years. The rich are treated gently. Penalties for errors are rare and those for cheating are often waived when the IRS deals with the highest income Americans and the biggest companies. In 2002 the IRS assessed just 22 negligence penalties against 2.5 million corporations, a decline of more than 99 percent from 1993 when nearly 2,400 penalties were imposed. … In some cases it let the companies keep a fifth of their ill-gotten tax savings. (141)

There are at least 3 chapters spent on this topic of tax exploitation.

As far as sustaining this advantage, Johnston has this to say:

But what [political campaign donations] did buy, every politician acknowledged, was access. That access meant that every senator and representative was listening primarily to the concerns and ideas of the super rich, of the political donor class.  (44)

And with their campaign contributions, they wielded enormous influence. In the 2000 elections for Congress, the nonpartisan Center for Responsive Politics found that more than 80 percent of identifiable political contributions came from just one in 625 Americans. By the 2002 elections, the ratio was down to just one in 833, roughly equaling the top tenth of 1 percent. (46)


Much like Free Lunch, there is so much information in these pages that even with all of the spoilers above I have barely scraped the surface. Johnston earned his keep working the tax beat for the NY Times for many years (he now writes a blog for Reuters, in a similar vein of topics), and his diligence for research is still sharp as ever. This, and Free Lunch, will pull back the comfortable wool of our delusions about the American classes and reveal the ghastly beast within.