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Reading through the House Ways and Means Committee’s tax proposals this week, a realization hit me: These cats don’t understand a basic rule of taxation—the more you tax something, the less of it you get. How else to explain their apparent belief they would actually raise money for Uncle Sam by slapping a 3% surtax on incomes exceeding $5 million annually? After all, if there is any group good at reducing their income on a moment’s notice to ease their tax burdens, it is society’s most highly paid individuals. Thinking through the finer points of this is, in my view, key to understanding why this tax plan is more bark than bite—unlikely to suck mountains of money out of the productive economy (or markets).
From a normal person’s perspective, the tools available to reduce adjusted gross income are generally simple and limited. We can contribute to retirement accounts, pay mortgage interest,[i] donate to charity and realize losses on our investments. (We used to be able to include “pay high state income taxes” on that list, but alas, that is now limited.) There are some other tricks too, but those traditional deductions are the biggies regular people use. If the rates on the lower tax bands were higher, we would probably figure out more ways to reduce our income in order to keep more of our hard-earned cash—that is just human nature. Necessity is the mother of invention.[ii]
For people making significantly more than the rest of us—say, people with annual incomes in the high seven or eight figures—the incentive to reduce taxable income is much greater. This year, a single Californian with an adjusted gross income of $150,000 would pay a little over $41,000 in federal and state income taxes. That is not chump change, but it doesn’t take such a huge bite that it makes one wonder why they even bother working and earning at all. But compare that to San Diego Padres third baseman Manny Machado, scheduled to make $34 million this season—the most highly paid baseball player in California. Presuming no tax planning magic, he would fork over half his income to DC and Sacramento—about $17 million. The House’s two main high-income tax hikes would tack more than $1.4 million on to that. I am no tax-strategy expert, but that kinda seems like incentive to find creative ways to reduce income?
I don’t know what Machado’s tax strategy is, but if this House plan passes, we might see more pro athletes and movie stars following the lead of baseball great Bobby Bonilla. Every July 1, the New York Mets deposit over $1 million into his account, even though he hasn’t played for the team since 2000. In a decision that potentially makes him the wisest baseball player ever, when he accepted a buyout of his contract, instead of taking a $5.9 million lump sum, he negotiated annual payments of $1.2 million at 8% interest for 25 years beginning in 2011. That is perhaps the most extreme example of deferred compensation in sports, but several other players have deferred big chunks of money over time. It is kind of a win-win. The player gets a smaller tax bill, and the team gets more payroll flexibility. Expect more of it if the top marginal tax rates go higher.
Now, these moves aren’t expressly tax-related. But recent history is rife with examples of big earners responding to tax changes. When Ireland capped tax breaks for artists earning income from royalty payments in 2006, U2[iii] responded by moving their tax entity to the Netherlands, which had a much friendlier system. In its effort to tax royalty payments more, Ireland got less of them. Thirty-five years earlier, the Rolling Stones[iv] moved to France to avoid Britain’s insane 93% tax on high incomes. The world got Exile on Main Street. Her Majesty’s Treasury got nothing. Later in the 1970s, David Bowie[v] (Switzerland), Ringo Starr[vi] (Monte Carlo) and others also became British tax refugees. Even when the Brits cut taxes in the 1980s, a lot of rockers maintained their avoidance strategies. Bowie spent much of his later years in Bermuda. Like U2, the Stones have funneled most of their royalties through the Netherlands for decades, and Mick and Keith spend minimal time in the UK. As Keith famously quipped to the New Yorker: “We left, and they lost out. No taxes at all.”
None of that is to say that America’s highest earners will leave for greener pastures if the tax plan passes. Heck, doing so wouldn’t even help unless they revoked citizenship, as Uncle Sam is rather aggressive when it comes to taxing Americans earning income abroad. But expect more complex tax shelters, deductible interest and other similar arrangements. It seems like it would be a huge boon for tax planners and attorneys. But probably much less so for the IRS.
Low-ish tax rates for the rich might not be a great look, but basic laws of incentives dictate they will probably raise a lot more revenue than punitive rates. You needn’t subscribe to the Laffer Curve to believe that—it is a matter of common sense. “Tax the rich” may grab eyeballs when stitched onto a Congresswoman’s dress at the Met Gala, but slogans aren’t reality. Just remember that the more complicated and convoluted the tax code, the more the opportunities for those of means and so inclined to game it—especially when lawmakers target them. That seems like a way to ensure the law of unintended consequences rears its head once again.
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*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.