Offshore Thing

Go after the $300 billion in taxes that aren't collected each year

by Samuel Loewenberg

The American Prospect magazine, March 2004

George W. Bush seems to have the Democrats fiscally stymied. They can try to rescind most of his tax cuts, but as responsible fiscal stewards they would need that money to close his huge deficits-and could forget about addressing public needs. Alternatively, they could try to restore social outlay and take a lot of heat for being irresponsible about the deficit.

In fact, there's another, far better option that almost nobody mentions: collecting the hundreds of billions of dollars that the taxman leaves on the table. According to estimates from former Internal Revenue Service officials and independent tax experts, between $250 billion and $300 billion in owed taxes goes uncollected every year. Today, federal revenue is just 16.6 percent of the gross domestic product, the lowest ratio in 45 years. And corporate tax receipts are down to just 1.Z percent of the GDP, which is nearly half of what it was in 1998 and 1.2 percent less than it was in 1990 during the last recession. This revenue erosion is only partly due to Bush's tax cuts or the recent recession. In little-noticed moves over the last decade, Congress and the current administration have greatly eroded the ability of the federal government to collect taxes.

Going after this money wouldn't raise rates for law-abiding citizens. It would simply force tax cheats-in dollar terms, those are overwhelmingly corporations and the wealthy-to pay their fair share under existing tax laws. "The easiest way politically and substantively to address [policy] priorities should be more effectively enforcing the laws we now have against those who have been taking advantage of the system," Lawrence Summers, the former treasury secretary and current president of Harvard University, told me. While in government, Summers led a collaborative effort with the Europeans to crack down on offshore tax havens-an initiative that Bush appointees quickly killed. As Summers observes, a tax-enforcement strategy would give Democrats a way both to be fiscally responsible and to finance desperately needed social spending.

What happened to tax enforcement? It has been crippled by four overlapping assaults. In the 1990s, legitimate concern about a few overzealous prosecutions led Congress to create new "taxpayer rights" that hobbled legitimate tax collection. The Republican-led Congress underfunded the IRS, and the Bush administration has steered its audit efforts away from corporations and the wealthy. New loopholes written into the tax code made it easier for legitimate tax avoidance maneuvers to slide into illegal-but hard to uncover-tax evasion. And the use of foreign tax havens became ever more brazen.

According to recent congressional hearings, major accomplices in spreading illegal or barely legal tax-avoidance schemes are the very accounting firms, investment banks, and white-shoe law partnerships that are supposed to be the country's financial gatekeepers. One former Treasury Department official calls them "the arms merchants behind the tax-evasion arms race." In fact, many of the "financial products" they peddle are simply different versions of the fraudulent tax shelters devised by some of the same people for companies like Enron and Tyco.

These tax schemes, which proliferated during the late 1990s boom, depend on the premise that they will be too complicated for regulators to understand. They utilize a multilayered web of sham tax-free entities, including partnerships, nonprofit corporations, and trust funds. One scheme, dubbed "Slapshot" by its purveyors at J.P. Morgan, was designed to save Enron $120 million in taxes. The sleight of hand "was concealed within a mind-boggling array of loans, stock swaps, structured finance transactions," according to Senator Carl Levin, the ranking Democrat on the Senate investigations subcommittee of the Governmental Affairs Committee, who eventually uncovered the scheme.

Levin has been among a handful of legislators working to expose the institutionalization of tax scams. In November, he held hearings showing how the Big Four accounting firm KPMG made millions peddling abusive tax shelters. The hearing revealed the workings of one of the dodges marketed by the firm, dubbed "BLIPS". It started with a sham high-interest loan that was run through a paper partnership, which then formed a shell corporation, which then washed the money through rigged foreign-currency trades. The scam had the cooperation of both a merchant bank and the white-shoe law firm Sidley Austin Brown & Wood,which wrote dozens of certification letters-at a cost of more than $50,000 per letter- providing a legal basis for the scheme. In total, this one ploy cost taxpayers $1.4 billion in lost revenue.

KPMG went ever further, mass marketing these tax scams using a full-scale telemarketing center based in Fort Wayne, Indiana. This boiler-room operation (which the firm called its "Tax Innovation Center") made hundreds of hard-sell cold calls pushing the firm's more than 500 tax shelters. The four schemes examined by Levin's staff earned the firm $1~4 million in fees between 1997 and 2001. KPMG's response? "All major accounting firms, including KPMG, as well as prominent law firms, investment advisers, and financial institutions offered tax advice, including these types of strategies, to clients," Philip Weisner, the partner in charge of the firm's Washington national practice, told the Senate panel. Among the banks that aided and abetted KPMG's schemes, Levin's subcommittee found, were NatWest, Deutsche Bank, and UBS.

According to New York Times tax correspondent David Cay Johnston, tax-exempt entities from Indian tribes to pension plans to Dutch banks with offices in the West Indies regularly "rent out" their tax-exempt status to tax cheats, for a relatively small fee and at virtually no risk to themselves. In his new book, Perfectly Legal, Johnston traces the tangled path of a typical scam, where the law, if not technically broken, was badly bent. In one dodge favored by the super rich, the vehicle is a small insurance company granted tax-free status to help it serve rural populations. While the company is only permitted to collect a few hundred thousand dollars in premiums, there is no limit on the amount of capital that can be invested in them and later pulled out, tax-free. Johnston found that one of Wall Street's richest players, Peter R. Kellogg, used just such a scheme to avoid more than $190 million in taxes.

Tax avoiders can feel secure that there is little chance their scams will ever be exposed: Only one in 400 partnerships is ever audited. In 2000 more than $5 trillion passed through some 7.5 million partnerships, many of them created solely to save taxes. The IRS audited less than 30,000 of them. Why? Tax officials have essentially thrown up their hands. "The IRS was no match for this kind of stuff," says Joseph Guttentag, who served as deputy assistant treasury secretary in the Clinton administration. Current and former officials blame the combination of funding cuts, congressional mandates, and the speed at which these scams reproduce and mutate. "Recognizing the IRS' diminished capacity, promoters and some tax professionals are selling a wide range of tax schemes and devices designed to improperly reduce taxes to taxpayers based on the simple premise they can get away with it," wrote former IRS Commissioner Charles Rossotti in his final report to the IRS Oversight Board at the end of 2002. Hardly a liberal, Rossotti is a Republican who was appointed by Bill Clinton and served during the first two years of the Bush administration before joining the Republican merchant bank The Carlyle Group. He estimated the loss in tax revenue to questionable partnerships alone to be $100 billion a year.

This laxness is, of course, no accident. Going easy on tax avoiders benefits what Johnston calls "the political donor class," whose members overwhelmingly support Republican candidates. Because investors were among those who suffered, Congress and the administration responded to the recent accounting frauds of Enron and others by passing sweeping reform legislation and increasing funding of the Securities and Exchange Commission. But when the IRS is cheated, it's only government that loses revenue.

Since the 1994 Republican takeover, Congress has consistently squeezed the IRS' budget. Consequently, in the last decade, the number of IRS employees has dropped by 19,000 overall. The agency was hit disproportionately hard among its compliance staff. Today it has 21,4Z1 employees, down 28 percent since l992, while tax avoidance schemes have expanded exponentially. There is, Rossotti wrote in his final report, "a huge gap between the number of taxpayers who are not filing, not reporting or not paying what they owe, and the IRS' capacity to require them to comply." Today only 1.1 percent of corporations are audited, down from 3 percent in 1992.

Things got even worse for the IRS' efforts in 1996, when the newly GOP-controlled Congress held hearings on abusive practices-not by tax cheats but by the IRS. Witnesses told tale after tale of abuse by rabid tax police. Ultimately much of the testimony turned out to be greatly exaggerated or even false. Still, the few bad eggs that were discovered were enough to give the GOP an excuse to crack down on the agency. The 1998 IRS Restructuring and Reform Act mandated that a complaint against an IRS employee would trigger an investigation that could lead to dismissal. "The employees felt if they made a tiny error they would be fired," said Rossotti. The chilling effect was almost immediate. In 1999, the year after the law took effect, property seizures dropped 98 percent, levies on bank accounts fell by three-fourths, and property liens dropped by two-thirds, according to Johnston.

At the same time, Congress has given the IRS funding since 1995 to target one class of potential tax cheats, the working poor, who the agency claimed were costing it more than $6.5 billion a year due to fraud and mistakes on Earned Income Tax Credit paperwork. By 2002, with its number of auditors reduced by one-fourth, the agency spent its precious resources auditing five times as many people receiving the Earned Income Tax Credit as the rich, according to Johnston. From a revenue-collecting standpoint, the move doesn't make much sense: The government can hope to regain only a few thousand dollars from the vast majority of these people, most of whom are guilty only of errors, not fraud, according to reports by the General Accounting Office and the IRS itself. Still, the penalties for the poor can be harsh: Congress gave the agency the power to withhold tax credits for between two and 1o years. That's a far more severe punishment than the penalties faced by the promoters of illegal tax shelters, who'd be assessed fines of $ 1,000 for individuals and $10,000 for corporations. As Senator Levin noted, for the professionals who bilk taxpayers out of billions of dollars, the deterrence value of those penalties is effectively zero.

Tax avoiders have another easy strategy for hiding their profits: booking them in offshore tax havens. By sheltering profits in tiny nations with no corporate taxes, such individuals and corporations can avoid being taxed in either Europe or the United States, costing governments billions of dollars in lost revenue. In the last two decades, the number of offshore companies, sham firms, or simply brassplate operations (companies with no business other than to hide profits) has exploded. In 1983 these offshore tax havens held $200 billion. Today that number has increased 2s-fold to $5 trillion. The Congressional Budget Office puts the annual loss to the U.S. Treasury from offshore tax cheating at $85 billion a year.

In this arena, too, the Bush administration has been complicit. In 1998, the Clinton administration reached an agreement with the European Union to crack down on foreign tax havens and collect hundreds of billions in taxes. The agreement would have required extensive reporting of transactions to authorities in the United States and European Union, effectively shutting down the most flagrant abuses. Almost immediately upon taking office, Bush officials gutted the program.

A common tax dodge among doctors and lawyers is to hide income in a tax haven and then access the bank account via credit card. This is virtually untraceable because the tax haven's authorities don't report transactions (that's what makes it a tax haven). IRS subpoenas from MasterCard and Visa found that between 1 million and 2 million Americans held credit cards issued by offshore banks. And yet the agency has had the resources to prosecute only a handful of these cases.

Another dodge is a corporation's fictitious move offshore. This is legal under existing law, although one of the country's most respected regulators called it "morally appalling." The scheme is known in tax jargon as an "inversion" because it creates a shell company in the offshore jurisdiction while turning the U.S. company (where the actual headquarters are located) into a subsidiary. Then the company reaps its profits in the tax-free jurisdiction while keeping losses in the U.S. subsidiary. Inversions date back to the 19805, but they became really popular after Tyco used one in 1997. By 2001, Tyco claimed that "moving" to Bermuda had saved it $400 million in tax payments. At the time, Tyco was seen as an innovator, and the firm's stock price shot through the roof, according to Reuven Avi-Yonah, an expert on international tax policy at the University of Michigan Law School. (Of course, the industrial conglomerate has since come unraveled after a major criminal fraud investigation.) This dodge was so appealing that a partner at the accounting firm Ernst & Young wrote in a post-September 1l online sales pitch, "The improvement on earnings is powerful enough to say that maybe the patriotism should take a back seat."

The first serious attempt to crack down on tax havens did not come until the late 1990S, when the problem of hiding profits offshore had grown out of control. According a 2001 article in the journal Accounting Today, the U.S. government received only 340 reports about U.S. accounts in Panama, despite the fact that most of the 370,000 offshore corporations there are controlled by U.S. citizens. From the Netherlands Antilles, which houses 21,000 offshore corporations, the IRS received only 200 reports. "lt started out as flea bites and became the economic equivalent of smallpox," said Jonathan M. Winer, former Clinton deputy assistant secretary of state for international law enforcement. "It's economic and tax piracy."

Recognizing that hundreds of billions of dollars were being drained from the Treasury Department, the Clinton administration joined with France, Germany, and Japan in 1998 to create an ambitious program to crack down on abusive offshore tax shelters. The effort was made through the Organization for Economic Cooperation and Development (OECD), a group of 30 developed nations that tries to promote joint policy through consensus. The project aimed to stop countries with no real economies, and with extremely low or zero taxes, from providing havens for multinationals and rich individuals looking to hide their incomes in purely sham transactions. As a recent report on tax avoidance issued by the Friedrich Ebert Foundation, the German Social Democratic think tank, noted, "Markets have globalized, yet tax structures have remained largely national.... [T]ax havens allow financial institutions to outflank the regulation of financial markets in their home countries."

The OECD project proposed to clamp down on tax havens by pressuring them to end particularly egregious tax breaks and forcing them to report financial data. Identifying 35 nations with particularly abusive tax practices, the OECD wanted to force them to start sharing data on foreign account holders, to stop permitting paper companies with no economic substance, to cease giving special tax breaks to foreigners that were not available to their own citizens, and to desist from cutting secret deals with individual taxpayers.

The tax havens were understandably resistant, as such moves would have effectively taken away much of their appeal. Still, the pressure was so great that some of the most well-established tax havens, including Barbados and the Cayman Islands, initially agreed to many of the provisions. The Bush administration then brought the OECD project to a grinding halt. The prime mover behind the administration's retreat was a Washington group called The Center for Freedom and Prosperity, which has held pro-tax haven rallies around the world, including in Barbados and Ottawa during the last OECD meeting. Critics call it "the tax cheats lobby." The group won't reveal its funders, but it's associated with The Heritage Foundation, the right-wing think tank that was another major force behind the administration's decision. (One of the center's founders comes from Heritage, and the two organizations work in concert with one another on this issue.)

The groups have powerful friends in Congress, including Assistant Senate Majority Leader Don Nickles, who sent a hand-signed letter to Treasury Secretary Paul O'Neill in February 2001 asking him to drop the project. (The letter was reportedly written by The Center for Freedom and Prosperity.) House Majority Leader Dick Armey said that the o E c D project was the work of the "global tax police." The anti-OECD forces also met with top Bush economic advisers Glenn Hubbard and Lawrence Lindsey, as well as Cesar Conda, domestic-policy adviser to Vice President Dick Cheney, in the spring of 2001. In March of that same year, they even got the Congressional Black Caucus to weigh in with a letter to the administration claiming the project would hurt developing countries.

By May 2001, Secretary O'Neill announced that the administration was pulling back from the OECD. He was concerned, he said, "by the notion that lower taxes are naturally questionable and that one country or a group of countries could interfere in another country's decision to organize its own tax system." Without the support of the United States the project has been floundering. The OECD has dropped most of the requirements for changing tax practices, leaving only a voluntary information-sharing component. The project's teeth, which included cutting off noncompliant tax havens from access to U.S. banks, are gone.

A bipartisan group of former IRS commissioners wrote in June 2001 to the administration, begging it to change its stance. Their appeal fell on deaf ears. Legal or not, Republicans seem plenty happy with the current state of affairs, as long as it shrinks government. But for Democrats who believe government has a responsibility to society, the tax-collection issue is vitally important. Without revenue, there can be no social spending, no deficit reduction, and no dealing with the crises in health care, the environment, and education. Republicans seem to have figured this out. Most Democrats haven't connected the dots.

SAMUEL LOEWENBERG has written for The Economist, The New York Times, Fortune, Time, and The American Prospect. He lives in Madrid, Spain.

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