Is Residence-Based Taxation Compatible With Progressive Idealism?

Here I go again, harping on the United States’ stubborn adherence to citizenship-based taxation.¹ I have previously argued that residence-based taxation (RBT) is the superior model for how a government should tax individual income, which could explain why the doctrine is (almost) universally relied on outside the United States.²

The preference for RBT stems from the benefit principle, which reflects the common-sense notion that households should pay tax where they routinely consume public services. By choosing to live in a particular place, a person implicitly decides to purchase the bundle of public services associated with that geographic turf.

Citizenship-based taxation is problematic because it creates a potential mismatch between the place in which you live and the bundle of public services for which you’re charged. The mismatch is easily overlooked if you assume people are stationary objects. This column assumes human beings are a species of roamers.

Why should a U.S. citizen who establishes a long-term residence overseas be required to pay U.S. tax — barring some other factor that reasonably connects income to U.S. taxing claims? Other factors might include, for example, whether the taxpayer is living abroad while operating a U.S. trade or business. A source rule should (and does) catch that category of income. I’m not talking about taxation based on source principles. The case for RBT is best illustrated when we assume away source of income as a basis for the imposition of U.S. taxes.

The debate centers on whether it’s fair and just for U.S. expats (and accidental Americans) to be subject to U.S. tax on their foreign-source income. Citizenship-based taxation answers that question in the affirmative. RBT says no.

Here’s an odd thing I’ve noticed over the years: When presented with the same question, many people lean toward an indecisive response. They say the answer depends on the details — specifically, how wealthy the U.S. expat is and whether the person relocated to a country that imposes a normal level of taxation. Such a response is less than unfettered support for RBT; it’s a qualification. Lately I’ve been asking myself why these qualifications are necessary.

The quibbling puts the focus on the expat’s income or wealth status, as well as the adopted place of residence. Why should these factors influence our thoughts on the scope of national taxing rights? In other words, is there a sound basis for concluding that RBT should be permitted for most of us, but be off limits to the superrich? Or similarly, for concluding that RBT is acceptable if the expat settles in a high-tax country, but not in a tax haven?

These reservations are understandable. They reflect an instinctive concern about the stereotypical jet-setting U.S. expat who seeks to scam the system by playing fast and loose with the residency rules. I get that. The worry is that if you come down squarely on the side of RBT, without reservation, you could inadvertently acquiesce to the lax treatment of tax dodgers with passports. As a group, that is not a body of souls who merit special treatment via the tax code. Tax Notes has published some insightful commentary on that very point.³

While acknowledging the risk, I maintain that the circumstances of these rich folks should not become an obstacle to broader adoption of RBT. The policy should have nothing to do with going soft on scofflaws. Not to beat a dead horse, but every other country in the world (apart from Eritrea) has somehow managed to balance these concerns in a satisfactory manner and is no worse off for it. That’s despite the occasional example of a very rich person leaving the country, as happened with Sir James Ratcliffe, who was the wealthiest person in the United Kingdom until he expatriated to Monaco.⁴ Those who are skeptical about RBT will point to what happened with Ratcliffe and see a reason for caution.

My response is that RBT is not a mischievous plot to assist the rich. Nor is it a social science experiment perpetrated by libertarian think-tanks. It is the international norm for delineating the fiscal bond between the sovereign and the individual. Globally speaking, it is what normal taxation looks like.⁵ The accident of birth might be responsible for determining many aspects of modern life, but must it also preordain where a newborn child will pay tax for the duration of its existence — irrespective of choices made later in life?

But Rich People?

We live in an era in which discussions of income inequality hold much sway in terms of orienting economic policy. That’s a good thing. (Not the inequality, but the fact that policymakers have identified it and are prioritizing its mitigation.) It would be irresponsible for governments not to be actively thinking about how income inequality can be addressed.

These days, any tax proposal that seems reasonable — if not outright desirable — will be judged in terms of whether it helps shrink the income gap between the 1 percenters and the rest of us. That’s not to say that each new proposal must be developed with income redistribution being a foremost concern, but merely that we should expect that measures that are directionally indifferent will draw scrutiny. Someone is bound to ask whether the proposed measure will benefit the wealthy. If you’re not anticipating that kind of reaction, you should be.

That doesn’t mean each tax measure that flunks the progressivity test will be scrapped — far from it. The tax code is stuffed full of measures that disproportionately benefit the wealthy, often by design. Carried interest treatment is widely acknowledged to be a scandalous tax perk for the wealthy that’s devoid of substantive merit. Yet it survived eight years of the Obama administration and will likely survive the Biden years. There are many other examples; too many to name. Their presence in the tax code, and their resilience to change, reveals the practical limits of progressive liberalism.

Many people will privately admit to discomfort with citizenship-based taxation, especially when discussion turns to the Foreign Account Tax Compliance Act. They even concede that residence is the more enlightened taxing concept, offering a nod of approval to the benefit principle. But tax reforms are seen through a political prism, and for many Democratic voters, that implies a reluctance to deviate from the Biden administration’s stated goal of extracting a bit more income tax from those at the top end of the income strata — more precisely, the pledge to not increase income taxes on those earning less than $400,000 per year.

That brings us to the pivotal inquiry for this week: Can you be a self-respecting progressive liberal and still support the elimination of citizenship-based taxation? I propose the answer is yes, but readers are welcome to disagree. I suspect many of them will for the reasons discussed below.

To further explore this issue, I’ll examine the recent submission by Democrats Abroad to the Senate Finance Committee. As you can detect from the group’s name, they represent the interests of U.S. expats with the added twist that they happen to be loyal Democrats. It follows that the group’s membership would have no desire to oppose the things President Biden is trying to accomplish, including his proposed changes to the tax code.

Why not also analyze the preferences of Republicans abroad, whose opinions of RBT are equally relevant? That’s simple. As a source of thematic material, the view from the political right lacks the same internal tension. As the purpose here is to explore the RBT debate as a manifestation of cognitive dissonance, we must look at the Democrats. That explains this week’s headline.

Exit Tax as Wealth Tax?

The document we’re scrutinizing is a May 7 correspondence from Julia Bryan, global chair for Democrats Abroad, to the Senate Finance Committee.⁶ It comments on matters covered during an April 27 hearing of the Fiscal Responsibility and Economic Growth Subcommittee. The subcommittee is chaired by Sen. Elizabeth Warren, D-Mass., who famously supports increased taxes on corporations and a wealth tax. The ranking minority member is Sen. Bill Cassidy, R-La., who opposes increased taxation generally.

Bryan begins the letter by outlining the circumstances of the 9 million U.S. citizens who live outside the country. That number excludes military personnel stationed at overseas installations, as well as those studying abroad or otherwise engaged in short-term or transitory foreign living arrangements. The clear theme is that U.S. tax law falsely portrays these individuals as “high rollers.” Bryan cites research, published at the urging of congressional staff, showing the primary reasons why these people ended up living abroad. The most common reasons are personal relationships (love, marriage, and raising a family) or the pursuit of employment and educational opportunities. A set of statistics fill in the picture of who these expats are:

• 32 percent moved overseas for marriage or a relationship;

• 25 percent moved overseas for employment;

• 61 percent have household income under $100,000;

• 64 percent have no plans to return to the United States; and

• 71 percent are married to non-U.S. spouses.⁷

Bryan further describes U.S. expats as follows:

The vast majority of us are middle-class Americans, working, raising families, and retiring in countries with a higher overall tax-burden than the U.S. The tax policies and regulations that affect Americans abroad do not reflect this reality, but instead penalize millions of us ordinary American citizens in attempts to foil a few bad actors. Filing taxes from abroad and navigating the convergence of the U.S. and a non-U.S. tax system is stunningly complex. Research has found most seek the services of expensive tax return preparers to produce filings that commonly show that we owe no U.S. tax.⁸

The point about most expats not owing any U.S. tax is to be taken seriously. That does not diminish the arguments for changing the law. Foreign residency makes many expats eligible for the foreign earned income exclusion under IRC section 911. The exclusion is $108,700 for the 2021 tax year. Beyond that, foreign tax credits provide relief for foreign taxes already paid. It’s unfortunate that expats must pay pricey tax advisers to determine they owe no U.S. tax.

Americans abroad are not on equal footing with expats coming from countries with RBT systems. Bryan speaks of the need to be placed on “taxation par” with those other expats. RBT isn’t about seeking special treatment, it’s about parity:

Democrats Abroad and the other organizations representing Americans abroad have had detailed discussions with Congress about a proposal to enact RBT and other reforms for Americans abroad that eliminate double taxation, remove barriers to banking, saving and investing and simplifying filing from abroad. . . . We will continue to advocate in support of an RBT model that provides relief to Americans abroad, prevents residency-based U.S. tax avoidance and is revenue neutral to the federal government. We believe the time will come when Congress embraces RBT.⁹

This prioritizes the group’s long-term objective. The phrasing conveys that the goal probably isn’t attainable in the near term because of well-known political obstacle. Expats vote in U.S. elections, but nobody running for Congress naturally identifies them as a constituent group. Their footprint is too diverse.

A footnote in Bryan’s letter references the organization’s support for a version of RBT that includes a means-tested transition tax.¹⁰ That’s basically a one-time exit tax on the accrued wealth of high-net-worth U.S. individuals seeking nonresident status for income tax purposes. That status would be different from those who choose to relinquish U.S. citizenship, as permitted under current law. The latter group includes accidental Americans, who in addition to being nonresidents have no desire to retain U.S. citizenship. The former group, mentioned in the footnote, would retain U.S. citizenship while establishing nonresident status — and be off the hook for U.S. income taxes under a residence-based regime (excluding the taxation of U.S.-source income, as mentioned at the outset above). Electing this status would come at no cost for most people. Only high-net-worth individuals would suffer the one-time exit tax.

The footnote adds that “RBT is not incompatible with a wealth tax.” It made sense to include that comment; the Senate subcommittee is chaired by Sen. Warren, after all. Every good advocate plays to their audience.

Why make entitlement to RBT contingent on an exit tax, outwardly portrayed as a type of wealth taxation? The explanation goes back to the concern about rich folks gaming the system. RBT risks losing some people (progressive Democrats like Warren) when the narrative turns to the superrich. Adding a wealth tax helps rebut that knee-jerk opposition. Trust me, it’s easier than rehashing the benefit principle only to get blank looks.

Let’s say some private equity boss from Greenwich, Connecticut, acquired a Picasso 30 years ago, and the item has quintupled in value. Now the person wants to move to Mallorca and stay there forever — taking along appreciated capital assets. Once the taxpayer is permanently outside the U.S. tax net, the IRS may never have a second chance to tax the unrealized gain that occurred while they were a U.S. resident. The physical act of expatriation becomes a realization event.

Is liquidity a problem? Will expats be forced to sell their treasured assets to pay the exit tax incurred on their way out the door? Fair question, but a typical answer is that we don’t worry too much about hardship inflicted on people who collect museum pieces as a pastime.

The exit tax may have a chilling effect on departures, but only for high-net-worth individuals — and only if the exit tax is sufficiently harsh. That raises questions about the nature of the exit tax. Is its primary purpose to deter expatriation (preventing episodes like the one involving Ratcliffe), or to seek equivalence to the capital gain outcome that would have occurred if an actual sale took place the day before the person left the country?

Four Easy Pieces

If a full transition to RBT is not yet in the cards, what useful half-steps might Congress consider in the meantime? Democrats Abroad offers a list of four legislative priorities.

The Filing Exemption

This would be an income tax filing exemption for Americans abroad who are compliant with financial account reporting requirements and owe zero U.S. tax. Expats would rely on the IRS substantial presence test to certify their offshore residence. They could use tax calculation worksheets (rather than actual returns) to demonstrate that they have zero U.S. tax liability. Otherwise, the exemption seems self-defeating, as you’d need to prepare a return in order to determine you don’t need to file it.

High-net-worth individuals would be excluded from this form of relief, meaning they would always be required to file an annual return, even if their worksheet calculation demonstrated that they owed no U.S. tax, which might be the case if they had sufficient FTCs.

The GILTI Exemption

This would be an exemption from the global intangible low-taxed income regime for Americans abroad earning less than $400,000 per year. Research shows that up to 20 percent of U.S. expats own and operate a small business. Actual examples include activities as diverse as commercial architects, information technology professionals, yoga instructors, and beekeepers. Many are being harmed by the GILTI rules, although the provision was intended to target large multinational corporations. That’s beyond the economic harm resulting from the Tax Cuts and Jobs Act’s one-time repatriation tax, retroactively applied to post-1986 retained profits.¹¹

Treasury has already provided some partial relief. Last year, regulations allowed individual shareholders to benefit from a discounted corporate tax rate (via the section 962 election) and a 50 percent reduction in the GILTI amount (via the section 250 deduction). This type of regulatory relief is unsatisfactory to many U.S. expats because double taxation isn’t properly resolved.

A GILTI exemption for expats would reconcile Treasury’s desire to significantly toughen the regime with Biden’s pledge to not increase taxes on individuals with incomes less than $400,000. Without such an exemption, the prospect of a beefier GILTI regime (both as to the increased rate of 21 percent and elimination of the qualified business asset investment exclusion) could spell more bad news for expats who are business owners.

Again, the group proposes that high-net-worth individuals be excluded from the described GILTI relief. You might think that goes without saying, because the recommended income threshold of $400,000 leaves a lot of space between middle-income taxpayers and the high-net-worth crowd. But recall that income and wealth are distinct economic concepts. An income statement tells you nothing about a person’s balance sheet.

Foreign Bank Account Report Updates

This would be a series of updates to the foreign bank account reporting regime. It includes the elimination of FBAR and FATCA duplication, the creation of a dedicated FBAR filing threshold for Americans abroad that’s five times the conventional FBAR threshold, and reform of the disproportionate FBAR penalty regime for willful neglect. As previously reported, the FBAR penalty structure is a mess that requires congressional intervention.¹² Additional relief includes the ability to submit paper FBAR filings, which in some cases is preferred to online filings.

FATCA Relief

This would be a same-country exemption for FATCA reporting, along the lines of what’s included in the proposed Overseas Americans Financial Access Act — that is, if the U.S. expat owns or maintains a beneficial interest in a foreign bank account and lives in the same jurisdiction. The risk of tax evasion that FATCA is targeting is notably diminished when the U.S. citizen in question holds a foreign financial account and lives in the same jurisdiction. For example, having a Swiss bank account is perfectly normal if you happen to reside in Switzerland. The point of the Overseas Americans Financial Access Act is to make it easier for U.S. expats to have access to banking and financial services. I couldn’t get by without a local bank account, could you?

Are They Listening?

Bryan argues that each proposal is consistent with “the vision” of Biden’s American Families Plan. That may literally be so. The better question to ask, however, is whether RBT is consistent with the preferences of Sen. Warren, who not only chairs the subcommittee in question but is often regarded as representing the progressive wing of the Democratic Party. We might ask the same of Sen. Bernie Sanders, I-Vt., another influencer among progressives. For that matter, what is holding up the Democratic Party as a whole from rallying behind RBT? We can ask that question repeatedly, and the thought process always leads to matters of perception.

Democratic tax policy is wedded to an understanding of progressivity that doesn’t bode well for Americans abroad. A dozen years ago, President Obama famously promised not to increase taxes on people earning under $250,000. In doing so, he established an informal standard for people who might not qualify as superrich but are wealthy enough that they shouldn’t be sheltered from the possibility of future tax increases during his term in office. Biden has repeated that exercise, having upped the standard to $400,000.

For advocates of RBT, there’s an awkwardness with this practice of quantitatively defining a group of taxpayers who deserve protection against future tax hikes. By implication, the practice instructs us that taxpayers on the wrong side of that dividing line aren’t deserving of consideration. A reform proposal that helps even a few members of that unprotected group is bound to be criticized as poorly targeted.

I’m not suggesting that the Warrens and Sanderses of the world are horribly mistaken in their orientation about what’s fair and just taxation. But their perspective isn’t conducive to easing burdens on a category of people who — despite being predominantly middle income — aren’t defined by reference to their income or wealth. They are defined by geography (place of residence), which does not render them members of a protected class.

It’s as if progressive liberalism suffers from tunnel vision when it comes to perceptions of need. You can point out that expats, as a group, are being unfairly treated under current law. The response from progressives is to fixate on income level or wealth status. You can try to explain that economic status is irrelevant to the source (foreign residency) of their disparate treatment, and that’s where you lose them.

Consider the statistics referenced in the letter from Democrats Abroad. It claims that 61 percent of U.S. expats earn less than $100,000 per year. That informs us that a preponderance of the group is middle income or reasonably close to it. What about the other 39 percent who earn more than $100,000 per year? How many of them might be considered affluent or flat-out rich?

Let’s agree that their numbers comprise a small percentage of the whole expat community, which I firmly believe to be true. When spread over a pool of 9 million expats, that translates to a number of rich folks who could conceivably benefit from RBT. As long as their number is something other than zero, their presence becomes a disqualifier. The applicable paradigm for determining acceptability relies solely on measures of income or other gauges of private wealth. That’s a highly restrictive view of who can benefit from changes to the tax code.

This explains why the reform recommendations floated by Democrats Abroad include carveouts for high-net-worth individuals. Those provisions aren’t there by accident; they reflect what is expected by progressive ideals.

To think about income and wealth in these ways is not necessarily a flawed concept, but it’s a poor fit for what residence-based taxation seeks to accomplish.

There’s your conclusion. RBT is not incompatible with progressive ideals, but good luck convincing people of that.