High Income, No Taxes: How Big Money Beats the IRS
Life + Money

High Income, No Taxes: How Big Money Beats the IRS

TFT Staff

No wonder President Obama is calling for tax reform. More than 10,000 Americans who earned more than $200,000 during 2007 paid no income taxes to the U.S. government. And it’s perfectly legal.

These high earners, among the estimated 47 percent of all Americans who pay no federal income tax, benefited from numerous popular, time-honored provisions in the tax laws that aren't likely to go away anytime soon. And the group, while accounting for a tiny sliver of the 143 million income-tax returns filed for 2007, has grown rapidly in recent years.

How can they do it?

  • Losses from partnerships or S Corporations, typically small businesses whose income and losses flow through to the owners.
  • Investments in nontaxable municipal bonds.
  • Extraordinary medical or dental expenses.
  • A combination of these factors and others.

"Some of these are fairly uncontroversial deductions needed to measure net income correctly, such as casualty or theft loss deductions or medical expense deductions," says Joel Slemrod, a professor of economics at the University of Michigan in Ann Arbor. "Others are conscious, but debatable, policy choices, such as the exemption of state and local bond interest and charitable deductions."

For 2007, the most recent data available, there were about 4.5 million individual income-tax returns reporting adjusted gross income of $200,000 or more, about 3 percent of the 143 million tax returns filed for that year, according to an article in an IRS publication by Justin Bryan, an economist. Of these "high-income" returns, a record 10,465 showed no U.S. income-tax liability, about a quarter of one percent of the group, the IRS said. That was up from 8,252 the prior year, a smaller percentage of the group. As recently as 2004, there were only 2,833 high-income returns showing no tax liability.

The number of nontaxpayers may diminish if Congress ever agrees to overhaul the bewilderingly complex U.S. income-tax system, as President Obama has said he wants to do. But while Fed Chairman Ben S. Bernanke and the president’s fiscal commission also have called for changes, including eliminating certain deductions and reducing tax rates for everyone, there doesn’t appear to be a consensus on what to do. Meanwhile, the Senate on Monday moved toward approval of the compromise on extending the Bush-era tax cuts for everyone including the middle class, which would add nearly $857 billion to the federal debt over 10 years. The House is expected to vote later this week.

During the Bush Administration, an internal Treasury Department memo neatly summarized why a major overhaul of the tax system carried grave political risks. The memo, written by Pam Olson, then a senior Treasury tax policy official, warned: "Any reform is likely to have vocal losers and largely silent winners."

Because of the write-offs, these non-taxpayers also avoid the dreaded Alternative Minimum Tax, or AMT, which was originally intended to ensure high earners pay their share of income taxes. The AMT’s origins date back to the late 1960s, when the Treasury Department touched off an uproar after reporting to Congress that about 150 Americans who had earned $200,000 or more (more than $1 million in today’s dollars) had paid no taxes through legitimate means. About 4 million returns last year were subject to the AMT – including many from residents in high-tax areas who earned between $100,000 and $500,000. It could ensnare as many as 25 million more middle-income taxpayers if the tax compromise isn’t passed by Congress.

Many in this nontaxpaying group own state and local government bonds, known as "municipals," that pay tax-exempt interest. These have long been a popular investment among high-income Americans, especially in high-tax areas such as New York City, New Jersey, California and Massachusetts.

A separate IRS report shows that about 6.5 million individual income-tax returns reported tax-exempt interest for 2008. The dollar amount of tax-exempt interest totaled nearly $80 billion. But not all municipal bonds are tax-exempt. Some bond holders pay fully taxable interest and others pay interest that isn’t taxable under the regular system but is subject to the AMT.

Some high-income earners also benefit from foreign tax credits and other types of credits. Large charitable donations can reduce taxable income, as do casualty and theft losses.

Why does the IRS publish these numbers? The Tax Reform Act of 1976 required annual publication of data on individual income-tax returns of $200,000 or more, including how many reported no income-tax liability and the importance of various tax provisions in making those returns nontaxable.

Says Slemrod: "I am more concerned about high-income folks who illegally evade taxes, and therefore do not show up in these statistics."

He has a point. Cheating and other forms of noncompliance clearly are a much bigger problem across all income groups. IRS officials have estimated the nation’s "tax gap," or the difference between what it collects each year and what officials estimate should be collected, is about $290 billion.