When it comes to tax avoidance, how much is too much?
The answer depends on whether you're running for president. Ever since someone leaked portions of Republican presidential nominee Donald Trump's 20-year-old state tax returns, the world has been obsessed with speculation that he may have avoided paying federal income taxes for nearly two decades.
The possibility that Trump was part of Mitt Romney's famous "47 percent" is hardly news; people have been suggesting for months that his annual tax payments might be low or even nonexistent. But the leak gave substance to that speculation and ignited a political firestorm.
Tax avoidance has been a volatile issue in American politics for more than a century, ever since the income tax put a premium on tax planning. But the moral status of avoidance has been hotly contested by legal and political luminaries. Some have insisted on the taxpayer's legal right to minimize tax liabilities. Others have invoked a supra-legal moral responsibility to pay a vaguely defined "fair share," even in the absence of legal compulsion.
But one fact is clear from this long-running debate: In politics, if not in law, the moral status of tax avoidance varies with the avoider's effective tax rate. More specifically, zero is a hard number to defend. And it's also a trigger for legislative action.
The contested morality of tax avoidance was on full display during the 2012 presidential election, thanks to Romney. On the one hand, his personal tax returns revealed a 14 percent effective tax rate -- too low for such a rich man, at least according to Democratic critics.
The political fallout from Romney's tax disclosure was significant, but it was nothing compared with the blowback from his infamous comments about the "47 percent." "These are people who pay no income tax," he told a group of donors in the midst of his campaign. "Forty-seven percent of Americans pay no income tax. So our message of low taxes doesn't connect."
The 47 percent comment was a disaster, and the 14 percent rate was certainly no help. But here's the thing about Romney's numbers: Both were defensible in the context of U.S. political history.
Romney's complaints about the 47 percent were well within the bounds of American political discourse over taxation and civic responsibility. Over the years, leaders of both parties have been known to decry the nonpayer phenomenon, and poll results have confirmed that many Americans consider taxpaying -- perhaps better described as tax participation -- to be a moral responsibility.
(The real problem with Romney's 47 percent wasn't his concern about nonpayers, but the scorn he directed their way. "My job is not to worry about those people," he said. "I'll never convince them they should take personal responsibility and care for their lives.")
Similarly, Romney's tax rate disclosure was survivable. Over the decades, Americans have shown a willingness to tolerate tax avoidance, even among the rich and famous; 14 percent was low, but it probably wasn't deadly, even for a wealthy candidate.
Decades of Debate
In general, Americans have been arguing about tax avoidance for decades, and not just when it concerned their political candidates. The debate is best encapsulated in three remarks, all of them offered up in the politically charged decades of the 1930s and 1940s. On the one side is Judge Learned Hand, who famously defended tax avoidance. "Any one may so arrange his affairs that his taxes shall be as low as possible," he wrote in Helvering v. Gregory in 1934. "He is not bound to choose that pattern which will best pay the Treasury; there is not even a patriotic duty to increase one's taxes."
Also on point, however, is one of Hand's less quoted observations from more than a decade later. "Over and over again courts have said that there is nothing sinister in so arranging one's affairs as to keep taxes as low as possible," he wrote in his dissent in Commissioner v. Newman. "Everybody does so, rich or poor; and all do right, for nobody owes any public duty to pay more than the law demands: Taxes are enforced exactions, not voluntary contributions. To demand more in the name of morals is mere cant."
If Hand's defense of tax avoidance is powerful, so were the indictments of aggressive tax minimization offered up by his contemporary, Treasury Secretary Henry Morgenthau Jr. "We still have too many cases of what I may call moral fraud," Morgenthau told President Franklin D. Roosevelt in a memo later made public by the White House. "That is, the defeat of taxes through doubtful legal devices which have no real business utility, and to which a downright honest man would not resort to reduce his taxes."
FDR shared Morgenthau's moralized view of tax avoidance. "When our legitimate revenues are attacked, the whole structure of our government is attacked," he told Congress in a special message. "Clever little schemes are not admirable when they undermine the foundations of society."
If Hand and the New Dealers saw tax evasion differently, so did many other political leaders. In general, tax avoidance has spawned a lot of overheated rhetoric and vibrant political theater, including various legislative drives to close loopholes. In fact, antiavoidance debate is something of a set piece in American politics, often set in motion by Democrats trying to mobilize political support on the left.
The Zero Bound
Antiavoidance campaigns have sometimes produced meaningful and enduring change. The Tax Reform Act of 1986 is one obvious example, although its success hinged at least as much on calls for simplification as it did on complaints about avoidance.
But there's a particular sort of antiavoidance campaign that tends to bring forth a powerful, if not always ideal, legislative response. These are campaigns rooted in a specific sort of tax minimization: the kind that zeroes out tax liability, especially among the wealthy.
At several pivotal moments, Americans have been transfixed and outraged by revelations that some members of the nation's economic elite have managed to incur no tax liability. These well-heeled lucky ducks have presented an irresistible target to the kind of politician that traffics in populist outrage.
One famous example occurred in January 1969, when acting Treasury Secretary Joseph W. Barr told Congress that 155 taxpayers with adjusted gross incomes greater than $200,000 (and 21 earning more than $1 million) had paid no income tax the year before. The resulting outcry prompted Congress to develop the nation's first alternative minimum tax.
But the 1969 episode was not the first. More than three decades earlier, a similar disclosure about millionaire nonpayers prompted Congress to revamp the tax treatment of losses -- an issue of non-trivial interest in our current political environment.
In May 1933 Congress was transfixed by the public hearings of the Pecora Commission, an investigating panel convened by the Senate Banking Committee and led by former New York prosecutor Ferdinand Pecora. Charged with uncovering the causes of the 1929 stock market crash, Pecora hauled a string of Wall Street titans into his congressional hearing room, including the most famous of them all, J.P. Morgan Jr.
"Morgan Paid No Income Tax for 1931 or 1932," reported The New York Times breathlessly on May 24, 1933. The resulting outrage was immediate and overwhelming. "What has rankled most in the hearts of the vocal public, is that when millions of persons with small incomes were straining every nerve to meet their income taxes, these princes of wealth, who personally enjoyed luxuries denied to almost everyone else, did not pay any income tax at all," declared The New Republic in a typical press comment.
As it turned out, Morgan's lack of tax liability was "perfectly legal," to use a phrase that was popular then, as it is now. Morgan and the partners in his trading company had taken huge losses during the market crash, wiping out their income from other sources. Back then, those losses were fully deductible against any form of income, not just capital gains.
Morgan was quick to point out that his losses were hardly good news, even if they helped him avoid taxes. "I am not responsible for these figures," he insisted archly. "I viewed them with great regret when they appeared."
Morgan's defenders -- and there were a few -- emphasized that loss deductions were entirely reasonable and proper. "He knew, as virtually everyone in banking circles who had given a moment's thought to it did, that if the Morgans had not written off enough losses to prevent income tax payments in the years just past, they were just foolish," explained Businessweek. "Any individual who pays unnecessary taxes is merely stupid. Among all the charges and innuendoes that have been flung about, not one yet accuses the Morgan outfit of stupidity."
But if Morgan had the law on his side, he had politics against him. As one writer at The Nation summed up the extralegal indictment of Morgan and his partners:
For them to seize upon the 'capital losses' provision of the existing law for the purpose of withholding contributions to the support of the government under which they have prospered so greatly, was as natural as for a hog to snap up an ear of corn.
Lawmakers were inclined to agree, and they moved quickly to limit loss deductions; rich people would remain taxpayers even when they were losing money in the stock market. Both the National Industrial Recovery Act and the Revenue Act of 1934 included new limits on the deductibility of capital losses, much to the delight of Democratic political leaders. But tax experts of almost every political stripe were unimpressed by the loss limitations. As New Deal economist George Haas told his bosses at Treasury:
The widespread sense of injustice flowing out of this treatment impairs cooperation between taxpayers and the government in the administration of the income tax. In the minds of many, the present treatment is so patently unjust as to be repugnant to all sense of fair play.
Haas was probably right about the views of affected taxpayers, but the public seemed to take a broader view of what constituted fair play. Judging by press comment, political rhetoric, and congressional action, Americans thought the new loss limitations served the imperatives of social justice and civic responsibility.
Provisions could be technically legal yet morally repugnant, according to many critics of the era. "The country, in 1933, was in no mood for nice distinctions between tax 'evasion' and tax 'avoidance,'" Pecora recalled in his memoirs. "Approved by the existing tax authorities or not, the public could not see the justice or equity of financial giants paying nothing, while Tom, Dick, and Harry scraped the bottom of their modest purses to meet their tax obligations to the government."
The Power of Zero
The Pecora episode illuminates the complexity of tax avoidance debates in U.S. politics. For the most part, Americans have accepted, if only grudgingly, the proposition that legal tax minimization is tolerable, even among the rich. But they have a hard time accepting minimization when it reduces liabilities to zero.
And it's important to recognize that popular discomfort with nonpayers is not entirely a class issue. Yes, it has been most potent when the taxpayers in question have been wealthy. But as Romney understood when talking about the 47 percent (now reduced to 44 percent, according to estimates from the Tax Policy Center), Americans are uncomfortable with any class of nonpayers.
Treasury Secretary Andrew Mellon, who served every Republican president of the 1920s, understood that fact. "Nothing brings home to a man the feeling that he personally has an interest in seeing that government revenues are not squandered, but intelligently expended, as the fact that he contributes individually a direct tax, no matter how small, to his government," he told Congress.
Of course, Mellon was famously conservative. But even some liberals have agreed with his sentiment about keeping the tax base sufficiently broad. As Rep. Cordell Hull, a Tennessee Democrat and legislative father of the 1913 income tax, once observed, "A tax system as vitally important as is the income tax should apply to a respectable number of persons."
History does not record whether Hull regarded 53 percent -- or any other number -- as adequately respectable.
All of which brings us back to the current agony of Trump, caught as he is between privacy and the popular inclination to speculate about his tax behavior. It's not a happy spot for any political candidate, even if the situation is ultimately of his own making.
But for the rest of us, the Trump leak gives us a chance to contemplate the moral status of tax avoidance generally, and nonpayers in particular. It also raises the specter of a legislative response. In the past, nonpayer scandals, especially among the rich, have been a catalyst for action.
And not always the kind of action that tax experts like.