This recent YouTube presentation by Steve Ballmer is a primer of sorts on taxation in the U.S. Ballmer, the 8th wealthiest American, whose wealth, depending on the day, is around $150 billion. He covers a lot of ground in the video, but focuses most on the federal income tax.
His takeaway point on the federal income tax is that American taxpayers with incomes of $54,611 have an effective tax rate of 5%, whereas those Americans with incomes sufficient to place them in the top 1 percent of all taxpayers, with an average income of $2.2 million, have an effective tax rate of 27%.
By all appearances, everything Ballmer says in the video is accurate. And likely well-intended.
Accurate and well-intended, yet meaningless. That’s because all of it is premised—falsely—on one data point. And the failure to recognize that false premise distorts the understanding millions of Americans have of our income tax system as it applies to the ultrarich.
The False Premise: “Adjusted Gross Income” Measures the Income of the Ultrarich
The problem with Ballmer’s presentation and countless other misleading analyses of America’s federal income tax, is that our federal income tax is based not on a person’s economic income, but on an arbitrary definition of income that exists only for federal income tax purposes. That definition is embodied in the term “adjusted gross income” or AGI for short. When you see a mention of someone’s or some group’s “effective federal income tax rate” that refers to the ratio that their income tax payments bear to their AGI.
For those whose incomes consist almost entirely of wages from their jobs, “adjusted gross income” is very close to their income in an economic sense. It leaves out the value of health insurance provided by their employer and the increase in the value of their residence and investments, but those items typically are modest in comparison to a working class American’s wages.
As we move up the economic ladder, however, a person’s AGI has increasingly less connection to her economic income. And when we get to the billionaire class, there’s practically no connection at all. Jeff Bezos, for example, according to reporting by ProPublica, had under $50 million of AGI in 2007, a year his Amazon fortune increased by $3.8 billion. Elon Musk had little or no AGI in 2018, when his wealth increased by several billion. The meaninglessness of adjusted gross income as a measure of income is so extreme at the billionaire level, as I recently explained in an article for Mother Jones, that even if our top billionaires paid 100 percent of their adjusted gross income in tax, they still would be growing their wealth at a faster rate than the rest of us.
A study performed for the IRS by four University of California, Berkeley economists, found that between 2018 and 2020, the wealthiest 380 Americans (basically, the Forbes 400), a group whose wealth, before income tax but after consumption expenditures, has been increasing at an average rate of about 10 percent per year, had adjusted gross incomes averaging under 2.2 percent of their wealth in the years 2018, 2019 and 2020. Obviously, the bulk of their economic income isn’t showing up on their tax returns.
Last September, I testified before the Senate Finance Committee at a hearing on tax avoidance by the ultrarich. My written testimony identified many of the ways the ultra-rich structure their financial affairs to avoid tax. The essence of the great majority of the income tax avoidance strategies I discussed was simple: avoid having economic income show up on the tax return as adjusted gross income.
For those interested in more expansive coverage of tax avoidance by the utrarich, click on the link and read the testimony in its entirety. Following is a more focused look at the parts of my testimony that relate to the false premise of adjusted gross income.
Fictions and Loopholes
The disconnect between adjusted gross income and real economic income for the ultrarich stems from various fictions and loopholes in the tax law. Identifying all of them would require a book, or at least a lengthy article. But focusing on just two of the fictions and two of the loopholes—and the synergy in the operation of those fictions and loopholes—gives us a pretty good picture of how miserably adjusted gross income fails to capture the true income of the ultrarich.
Fiction Number 1: The Realization Requirement
Under the income tax code, investment gains are not treated as income until investments are sold. That’s the so-called “realization requirement”. It sounds simple enough. When a taxpayer has the cash proceeds from selling an investment, the income tax on the gain must be paid, but not before then. It’s super convenient, as it obviates having to estimate values of assets each year. But basing taxation of income on an event—sale—that is entirely controlled by wealthy taxpayers doesn’t work in the real world. It causes their adjusted gross income each year to be a meaningless number.
Consider Jeff Bezos. He currently holds $200 billion or so of Amazon stock, which he purchased in 1994 when he founded the company. His cost for that stock is about $200,000, 0.0001 percent of its current value. That’s $199.9998 billion of gain. He could turn those Amazon shares into cash practically immediately, by selling his shares. And he could have done so every year since 1994.
How much has Bezos’ Amazon fortune increased on an average yearly basis? A stunning 56.15 percent. But year after year none of those gains have shown up on his annual tax returns, unless he happened to sell shares in a given year. If he sold all those shares this year and paid the federal income tax of 23.8 percent, he’d be left with $152.4 billion. Remember that number. When you do the math, Bezos’ after-tax average annual rate of wealth growth on those shares would be 54.79 percent. Remember that number as well.
How does Bezos compare to a different investor, who also had gains of 56.15 percent year in and year out for the past 31 years, but who sold his investments each year and paid that 23.8 percent tax? That investor’s after tax annual rate of wealth growth would be a still stratospheric 42.79 percent, but noticeably less than Bezos’ after-tax return if he sold out this year. And that champion investor’s wealth? Slightly under $12.5 billion. Still a huge fortune, but less than one-twelfth the current after-tax value—$152.4 billion, remember?—of Bezos’ Amazon shares.
Although they’re not in a position as extreme as Bezos’s, the great majority of America’s billionaires have held valuable investments for long periods, during which those investments have increased dramatically in value. Had their adjusted gross incomes included their annual investment gains, their fortunes would be a fraction of their current size.
Fiction Number 2: Declining Asset Values
Truth is, in discussing the false premise of AGI, everything else pales in comparison to the fiction created by the realization requirement: that investment gains are not income until investments are sold. But other items still translate into billions of dollars in the case of many of the ultrarich, so they’re worth noting. The next most significant fiction, I’d say, is the declining asset values fiction.
The tax code allows owners to claim deductions, which reduce AGI, for the supposed decline in value of property used in their businesses, regardless of whether that property really is declining in value. This translates into massive understatements of income related to two asset types: real estate and closely held businesses, particularly sports teams. A real estate mogul can buy an apartment project for, say, $100 million, and claim the bulk of that purchase price as depreciation deductions over the succeeding years, even though the value of the apartment project is rising. That causes the real estate mogul’s adjusted gross income to be understated by tens of millions of dollars–on just one property. Multiply that by a couple dozen properties and we’re talking serious money.
Similarly, when a billionaire buys a sports team, most of the purchase price typically is allocated to intangible assets, like goodwill and player contracts. Those “intangibles” can be amortized over a 15-year period, even though the value of the team typically is rising during that period. The effect of those amortization deductions is to artificially deflate the billionaire’s AGI by sometimes billions of dollars over that 15-year period.
Okay, enough about fictions for now. We’ll get back to them in connection with stepped-up basis. On to the loopholes.
Loophole Number 1: The Like-Kind Exchange Rules
Section 1031 of the Tax Code allows taxpayers to avoid tax on gains from “like-kind exchanges” of real property. On the surface, that doesn’t sound like much of a benefit. How often do people swap interests in real estate? Not very.
But long ago, tax avoidance planners figured out how to make the sale of a property and reinvestment of the proceeds qualify as a like-kind exchange, and Congress incorporated that strategy into the tax code. Basically, when a seller of real estate who wants to reinvest the proceeds from the sale finds a buyer, he enters into an agreement with a third-party, known as an “accommodator,” to swap his property for another property to be named later. The accommodator then sells to the buyer and, at the direction of the seller, buys the “replacement property” identified by the seller, then delivers it to the seller. On paper, then, the seller and the accommodator have entered into a like-kind exchange.
Here’s how I described in my Senate Finance Committee testimony the tax avoidance planning that the like-kind exchange rules make possible, enabling a strategy commonly referred to as “swap til you drop”:
John Rich buys a small office building for $10 million, paying $2.5 million in cash and paying the remainder of the purchase price with the proceeds of a $7.5 million loan. Five years later, John sells the small office building for $20 million and uses the net proceeds (after repayment of the loan), along with the proceeds of a new $37.5 million loan, to purchase a shopping center for $50 million. He avoids taxation of his $12 million gain (which includes recapture of $2 million of depreciation deductions claimed by John to offset rental income from the building) by structuring the transactions as a like-kind exchange. After seeing the shopping center double in value to $100 million, John sells it and uses the net proceeds, along with the proceeds of a new $187.5 million loan, to buy an office complex for $250 million. He avoids taxation on his $65 million gain (which includes the recapture of additional depreciation deductions) by structuring the transactions as a like-kind exchange. John continues to buy and sell real property in this fashion throughout his life. John continues to buy and sell real property in this fashion throughout his life.
What happens when John dies? That brings us to the stepped-up basis loophole.
Loophole Number 2: Stepped-Up Basis
There’s one giant loophole that fits hand in glove with the giant fiction known as the realization requirement: stepped-up basis. That’s a fancy tax term for the elimination of previously untaxed gains upon a taxpayer’s death. When inheritors sell inherited assets, they’re generally treated as if they paid fair market value for those assets on the date of death of the decedent from whom they inherited. The cost basis in the assets is “stepped-up” to fair market value.
Which means if Jeff Bezos dies leaving his $200 billion or so of Amazon shares to his wife and kids, they could sell those shares without any of the gain winding up in their adjusted gross incomes. That exemplifies the strategy known as “buy-borrow-die,” which causes the appearance of investment gains as adjusted gross income not simply to be delayed, but to never take place at all. For federal income tax purposes, those gains simply vanish.
So, when John Rich died leaving his real estate empire to his children, those lucky kids could sell all the properties without having to pay any income tax on the gains John deferred throughout his lifetime. Those gains would include not only the increase in the value of his properties above their purchase price, but all the depreciation deductions that were claimed based on the fiction that the properties were declining in value when in reality they are increasing in value. This is the closing act in the “swap til you drop” strategy.
And for those billionaire sports team owners and their families, there’s what I call the everlasting tax shelter. Here’s how it works: A billionaire purchases a sports team for $1 billion. Over the following 15 years, the billionaire claims amortization deductions for $900 million of the purchase price, reducing his AGI by that amount. The billionaire then dies, leaving ownership of the team to his spouse, at a time the team is valued at $2 billion. That causes $1.9 billion of gain ($1 billion of actual gain plus $900,000 of amortization deductions) to permanently escape inclusion in adjusted gross income. The billionaire’s spouse then claims amortization deductions over the following 15 years totaling $1.8 billion, reducing her AGI by that amount. The billionaire’s spouse then dies, leaving ownership of the team to the billionaire’s children when the team is valued at $3 billion. Over the following 15 years the billionaire’s children claim amortization deductions totaling $2.7 billion, reducing their AGI by that amount. Over the course of the family’s ownership, the income tax benefits total over twice the billionaire’s original investment in the team. If the billionaire’s children retain ownership of the team until their deaths, the appreciation in value of the team over the course of the family members’ lives will escape inclusion in adjusted gross income entirely.
The Way Forward
The damage wrought by the false premise of adjusted gross income cannot be overstated. For close to half a century, as the country’s economic inequality crept towards the oligarchy we now face, apologists for the rich invoked concocted reports to claim the rich were paying their “fair share.” Without exception, those reports all were based on the false premise that adjusted gross income is a reflection of a person’s economic income, when the reality is anything but.
Where must we go from here? We have no realistic alternative other than confronting the false premise of adjusted gross income and reforming our income tax system to tax, at appropriate levels, true economic income.
Theoretically, there are two pathways other than taxing true economic income to arrest, then reverse, the extreme concentration of American wealth: taxing extreme wealth or taxing the intergenerational transfer of extreme wealth. As a practical matter, both those pathways are not available. The Supreme Court has made it quite clear that it would hold a federal wealth tax unconstitutional. Yes, the composition of the Supreme Court could change, but the prospects of that taking place in the timeframe needed are remote.
We already have a system to tax the intergenerational transfer of extreme wealth. But that system is so loophole ridden that vast amounts of dynastic—and oligarchic— wealth have been moved beyond the reach of that system. Even if the loopholes were plugged immediately, it would take at least a generation, and likely more, before the system reliably limited the size of fortunes passing from one generation to the next. And even putting that constraint aside, the rate at which extreme wealth now accumulates in America is so high that the process of constraining it must take place within a generation, not between generations. Mark Zuckerberg’s wealth, for example, is likely to exceed $1 trillion before it passes to his descendants.
That leaves us with only one realistic path forward: a tax on the growth of extreme wealth—that is, true economic income—at a level sufficient to prevent its further expansion. That means reforming the income tax code to align “adjusted gross income” with the one metric it supposedly was designed to measure: income.
There are legislative proposals to do just that. Sen. Wyden’s Billionaires Income Tax would include the growth of investment values in the adjusted gross income of billionaires. In 2022, Reps. Jamaal Bowman and Susan Wild introduced another measure, their Babies Over Billionaires Act, that also would have included investment gains in the income of the ultrarich before the sale of the investments.
It will require a monumental effort to make the necessary changes happen. Which brings us back to adjusted gross income. The first step in the right direction is to call out those who invoke the false premise of adjusted gross income, whether Steve Ballmer, the Tax Foundation, the Manhattan Institute, or others. Unless and until it is widely understood that adjusted gross income has nothing to do with the actual income of an ultrarich person, the battle we must win will be a battle we can’t win. Let’s not let that happen.