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April 2005

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The Political Economy Of Taxes

By Edward Herman
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R obert Cay Johnston’s book Perfectly Legal (Portfolio, 2003) discloses its main theme in its subtitle: The Covert Campaign To Rig Our Tax System To Benefit The Super Rich—And Cheat Everybody Else . This might seem surprising coming from a business reporter at the New York Times , but he has been one of their better journalists. Some, but by no means all, of his facts and arguments presented in Perfectly Legal could have been read there. Still, it is interesting that his book goes well beyond his efforts in the paper. In fact, Johnston often sounds here like Ralph Nader or somebody still further left, with statements such as: “that a tax designed to catch aggressive rich tax avoiders [the minimum alternative tax] is being applied to middle income families to finance tax cuts for the super rich shows how both parties in Washington have become two wings of the same party. The party of money.” 

 Not being a practical manual on taxes, Perfectly Legal is of necessity a work in political economy, and Johnston features the flow of power from the super rich—which he sardonically labels “the political donor class”—through legislatures passing tax laws that have increasingly served the political donor class to the tax collection agency, the Internal Revenue Service (IRS). The IRS’s activities are sharply limited and directed by those donor-friendly laws and the pressures and threats from politicians and from donors who can activate the politicians to bully the IRS. To this structure we can add a subdivision under the donor class, which we may call the “tax cheat advisory service,” consisting of bankers, security firms, tax specialists, and others who have rushed to sell to the donor class accounting or legal tricks by which their taxes can be reduced or eliminated. It is a very good illustration of how well the market works to service any money demand; here a demand for tax evasion services, with the market producing a plentiful supply of talent for this constructive effort. 

One other element in this political economy structure is the media. While Johnston doesn’t offer any systematic treatment of the media role, time and again he refers to important tax developments to which the public should have been alerted that were ignored by the media. This helps make this campaign of downward redistribution of the tax burden “covert” and outside the sphere of public debate. 

Johnston’s political donor class is only a few thousand very rich people. Sometimes he focuses on the 400 top taxpayers ($174 million in average income in 2000), whose 1.1 percent of all income in 2000 was double their 0.5 percent in 1992. Their federal tax income burden fell 16 percent between those dates, whereas overall federal tax rates increased 18 percent (recall that this was the Clinton years). This understates the case as the political donor class does not report all its income. Johnston estimates that fully half of donor class income is unreported and his book is focused on the upswing of upper class tax evasion. Johnston notes the interaction between the increased income and wealth of the donor class and their political muscle and ability to subvert the tax system, which provides a pretty feedback system that further enhances their wealth and ability to make the tax system serve their needs. 

He also repeatedly points out how much the Democrats have contributed to subversion of the tax system, even if the Republicans out-do them in this race to the equity bottom. He refers several times to the importance of the great increase in Social Security tax rates in 1983, enacted by a Democratic Congress, which as he says was “used to pay the ordinary bills of the government, making up for the taxes that were no longer being paid by the rich because of the 1981 income tax cuts.” He quotes Senator Moynihan calling this tax increase “thievery,” taking from the poor to pay for the tax cuts for the rich. (George W. Bush is offering a variant of this earlier thievery: he is using even more brazen tax cuts for the rich that produce deficits and an escalating debt that may imperil the future of Social Security and calls this a “Social Security crisis” when it is a Bush “borrow-and-spend crisis.”)

Two additional major crimes in tax regression occurred in the Clinton years. One was the agreement to give the IRS over $100 million a year to audit applicants for the earned income tax credit (EITC) to control fraud by the working poor. Under this program the IRS in 2001 audited 397,000 working class applicants, 8 times as many audits as it carried out for individuals with incomes of $100,000 or more. Johnston provides a case study of an IRS court proceeding against Maritza Reyes, a domestic who worked hard to make $7,000 a year, with a $7,000 tax savings at stake. Johnston shows that the IRS had no case, no witnesses, and no documents, just suspicions based on an address that would have been cleared up by talking with Reyes. Instead they forced her to trial and lost. He stresses that the poor are easy targets, with few resources with which to defend themselves, helping give the IRS a good “win” record. Also, this is what the powerful Republican right wing, with some Democratic allies, presses for—the same folks who aggressively support tax cuts for the rich and IRS restraint in dealing with the donor class. 

The other Clinton era service to tax regression was the IRS Reform and Restructuring Act of 1998, signed into law by Clinton despite its major effect being “handcuffing the tax police.” This legislation followed well-publicized and hugely biased hearings organized by right wing Senator William Roth that made out IRS personnel to be “jack-booted thugs” threatening taxpayers with guns, using subpoenas to embarrass people, making people pay taxes they did not owe, etc. As Johnston says about this testimony, “Most of it wasn’t true.” Some of it was true—he mentions six IRS agents and a few outside experts who described not a rogue agency, but one with problems created by Congress, namely, insufficient resources; pressure to go after the weak to generate success numbers; inability or unwillingness to pursue those with money to fight back. But the media picked up on the “jack-booted thugs” claims and gave “passing mention” to the serious internal complaints about the effects of Congressional intervention and policy. Subsequently, also, a report by William Webster on behalf of the General Accounting Office exonerated the IRS from the jackboot accusation and found that IRS cases were based on reasonable evidence. But the damage had been done and a law passed that made it dangerous for IRS personnel to pursue tax delinquents, who were provided with numerous bases of complaint, the mere filing of which could mean a grueling round of inquiries. The act was a windfall for tax cheats. Property seizures and other forms of collection for tax non-payment plummeted. Low-level IRS man- agers complained that the new message to them was “don’t aggravate taxpayers,” excepting people like Maritza Reyes. 

The mistreatment of the poor by the IRS is further reflected in the fact that in two-thirds of the audited cases against the poor they get refunds, whereas overall statistics show that two-thirds of audited cases result in more taxes being owed. The IRS is also free to deny credit for two years or longer to EITC taxpayers, if they deem an error on the return significant, and the IRS uses this power. This is in spectacular contrast to the IRS’s treatment of errors, fraud, and failure to file a return by the affluent. “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.”  

Johnston’s book is an extended recital of evidence of rich tax evaders getting away with murder. He has an entire chapter on people—most importantly business leaders and the wealthy—who refuse to file tax returns (Chapter 14, “Mass Market Tax Evasion”). Some of them brag openly about non-payment and many of them aren’t even bothered by the IRS, which focuses on errors in the details of returns, whereas claiming a zero income is not an error. Until 2000 the IRS didn’t even try to identify and check out those who had filed zero income claims. In dealing with a widespread business refusal to collect and send in withheld tax income, the IRS not only dragged its feet in taking any action, in one case, while failing to act against the employer, it sent letters to the workers telling them that they were still responsible for those taxes the employer was refusing to withhold. 

Johnston describes case after case of gross abuse where the IRS did nothing or started to investigate, but where the auditors were called off by the higher authorities in the IRS because of their own bias or because of political pressure from without. The investigation of Enron was terminated in this manner in 1999, although Senator John Breaux had noted, “Instead of drilling for gas and oil, Enron was drilling the tax code, looking for ways to find more and more tax shelters.” An audit of Unocal was called off by higher-ups in the IRS, a point now known because one of the auditors was so outraged he sued the IRS. In another major case involving Chevron the IRS took the company to court, “briefly, until the auditors were shut down on orders from the IRS national office.” 

Mostly, the tax cheats and evaders are not confronted at all, partly because of fear of political repercussions, but also because of lack of resources to deal with complex cases. Congress doesn’t allocate $100 million to go after Chevron et al., as they did for Maritza Reyes. Johnston cites case after case where money needed to investigate major cheating avenues was not forthcoming. Thus, while some Senators were allegedly appalled to learn that cheating was rampant among partnership investors, “there were no hearings on national television to expose the cheats and no extra funding was allotted to hire and train auditors to hunt for these cheats.” Rich folks who have shifted their citizenship to Belize or the Cayman Islands—in tax-speak, “expatriation”—were still required by law to pay U.S. taxes for the subsequent decade, but Johnston points out that Congress provided no money to check on these payments and the IRS has generally “ceased all compliance” efforts checking up on this group that has not displayed much patriotic ardor (Johnston’s chapter is entitled “Profits Trump Patriotism”). 

As IRS responsibilities have grown its resources have shrunk, illustrated by a 30 percent drop in the  number of auditors between 1988 and 2002. Johnston provides a table on “Tax Cheats and Debtors Get Away Without Paying” that shows, for example, that 79 percent of the cases of offshore tax evasion are not pursued, along with 75 percent of those who failed to file returns. As late as 2003 the IRS had never audited any of the 1,400 insurance companies that operate free of tax. 

The IRS’s inability or unwillingness to pursue those with money and political muscle has had wide consequences in the expansion of tax evasion over the past decade. Johnston describes many modes of evasion and implicit discrimination: (1) The ability of executives to escape taxes through expenses, exchange funds, and the right to virtually unlimited tax free pension savings, whereas a sharp ceiling is placed on 401(k) savings by ordinary workers; (2) The use of offshore business units to take income in low- or zero-tax locales; (3) The proliferation of tax shelters and use of complex organizational structures, including multiple partnerships, to inflate income and hide expenses. These are often accompanied by “opinion letters” from law firms explaining why the tricks employed are legal; letters costing the tax evader up to a million dollars, but giving them legal cover in case of IRS challenge. It is not surprising that estimates of the “tax gap,” i.e., the difference between taxes paid and tax obligations, now run to $300 billion and even higher. 

Perfectly Legal is a text-book study of how a government agency can be made incapable of properly carrying out its designated function, forced to discriminate against the weak and allow serious abuses by the donor class and others who benefit from their debilitating impact on the agency. The mechanisms are simple and some of them are features of a long-standing process by which regulators are brought to heel and made serviceable to the interests of the regulated. Here, with the IRS: defund to the degree necessary to prevent adequate resources being devoted to big abusers; provide specific enforcement funding only for tasks like going after Maritza Reyes; get loopholes opened for abuses by legislation and have them kept open by donor class-friendly legislators; fail to respond to new forms of abuse with legislation or funding for study and enforcement; make the IRS sensitive to donor class ability to get political assistance when the IRS gets uppity; and use the revolving door with IRS officials to help lobby the organization and make them think of the possibility of a more prosperous post-IRS future.  

Also in the background must be a media sufficiently responsive to the donor class to make sure that the IRS’s failures—the bias favoring the rich and detrimental to the poor and ordinary citizens, the huge and growing loss of tax revenue following from these failures—are not reported and editorialized on to an extent that will make them live public issues. That the media have met this standard is evident even in Johnston’s references to the media, but even more in the numerous cases and issues he discusses that are somehow not news- or editorial-worthy. The system works beautifully for the donor class and others, in the short-run grab-and-run mode, and as an important element in the donor class’s accelerating class warfare.

Edward S. Herman is an economist, media critic, and author. 
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