Is it smart to avoid paying taxes?
Donald Trump certainly thinks it is: in the first debate, he famously said that not paying taxes “makes me smart." In the second debate, he doubled down on that assertion: “Many of her friends took bigger deductions,” he said of Clinton. “Warren Buffett took a massive deduction.”
This, it turns out, was a lie.
— Carl Quintanilla (@carlquintanilla) October 10, 2016
Warren Buffett does not have a lot of income, by billionaire standards: most of his wealth is in Berkshire Hathaway stock, which doesn’t pay a dividend.* As a result he had $11.56 million of taxable income in 2015, on which he paid $1.97 million in state income taxes and $1.85 million in federal income taxes. That’s $3.82 million overall, which amounts to a tax rate of 33%.
The only substantial deduction that Buffett took, beyond the standard deduction of his state income taxes, was a $3.47 million deduction for charitable contributions. That’s 30% of his taxable income, the maximum allowed under tax law. This didn’t stop Buffett from giving much, much more than $3.47 million to charity. In fact, he gave more than 800 times that amount – $2.86 billion, most of which was donated to the Gates Foundation, and almost none of which was tax-deductible.
Or to put it another way, Buffett gave 24,715% of his annual income to charity last year, which was a pretty typical year for him, even though the tax benefits of giving to charity top out at the 30% level.
Warren Buffett is rightly proud of having paid federal income tax for 72 consecutive years, since he first remitted $7 to the government in 1944. Indeed, he’s on the record as saying that he wants to pay more tax, not less.
This is the question, then: Is Warren Buffett smart? Is it smart to pay taxes for 72 straight years? Is it smart to give money to charity even if you don’t get a tax deduction for it? Is it smart to simply live your life as you want to live it, and then pay taxes that you owe, instead of organizing your life in such a way as to pay as few taxes as possible?
The answer is, clearly, yes.
It’s smart not only because the costs of running the country should be borne by those who can most easily afford them. It’s smart also because once you adopt an aggressive strategy aimed at minimizing your tax payments, you start to see the government as the enemy in a zero-sum game: the more you pay them, the less money you have for yourself. Far from your interests being aligned with those of your government, you start to think of your interests (paying as little tax as possible) as being diametrically opposed to what the government needs (tax revenues).**
Consider high-profile Trump supporter Anthony Scaramucci, who says that people “should pay what they are legally obligated to pay and not a penny more." The fact is, however, that the amount at the bottom of your tax return is highly dependent on what you’ve done further up, and individuals, especially if they're property developers, have a lot of choices about what to do on their returns.
For example: in Sunday’s debate, Trump said that depreciation “is a wonderful charge” which was behind a lot of the write-offs on his tax returns.
“I love depreciation,” he added, helpfully.
What he’s talking about is a loophole which allows property developers like himself to treat buildings as though they were more akin to computers, or cars, or other things which generally fall in value over time. Even if the real estate market is soaring, Trump can claim that his buildings are “depreciating."
The result is that while he’s making money in the real world, from rental income, he’s barely breaking even in the fictional world of tax returns, where the amount that his buildings depreciate in value every year is just a tiny bit larger than the amount they throw off in income. Offset the one against the other, and you have no net income—and no tax liability.
For the rest of us, this isn’t possible. If you have a house worth $350,000 and a $50,000 income, you can’t simply declare that your house has depreciated by $50,000 and that therefore you have no net income and owe no taxes. Or, at least, if you attempted to do that, the IRS would probably have a pretty good belly laugh before hitting you with substantial fines, and even a possible criminal prosecution for tax fraud.
It comes as little surprise, then, to learn that a majority of Americans consider not paying taxes to be “selfish” and “unpatriotic”, even if half of them still think that it is “smart”.
What’s less obvious, but far more important, is that tax avoidance, for the vast majority of Americans, is a very high-risk strategy, where the downside is much bigger than the upside.
The problem is that the question is being skewed by Donald Trump, who’s an outlier not only in terms of his wealth but also because he’s a real-estate developer. If your entire industry is built on tax breaks, then taking advantage of those tax breaks is not particularly smart or stupid—it's just table stakes.
But for 99% of Americans, up to and including Warren Buffett, a relatively simple approach to taxes—one which doesn’t involve aggressive tax avoidance—is likely the more sensible approach.
That’s partly because, contra Anthony Scaramucci, there is no single amount which is the sum you are “legally obligated to pay” in taxes each year. Instead, there is a highly complex tax code, interpreted by a battalion of accountants, all of whom spend their careers trying to discern the fine line between what is permissible and what is fraud.
Let’s say you’re a freelance journalist who works at home. What proportion of your rent constitutes a legitimate business expense? How many of your lunches are professional rather than personal? If you buy a movie ticket or subscribe to a magazine, is that professional research?
These are not questions with cut-and-dried answers. Instead, it’s up to the individual to decide how aggressive they want to be. The upside to aggression is that you pay less in tax; the downside is that you have a higher chance of getting a highly unpleasant audit.
Here’s the good news: if you’re an employee making less than $100,000 per year, and you’re not claiming any dependents, then there’s a very good chance that you can file your taxes easily using the 1040EZ form. It’s just two pages long, it allows you the full standard deduction, and it has essentially zero grey areas. You file the form, you get your refund, you have essentially nothing to worry about, and you can get on with all the fun bits of your life—you know, the bits which don’t involve tax returns.
There are Americans who spend a huge amount of time and effort trying to jump through hoops to minimize their taxes, and contribute as little as they can to the public coffers. Those people, frankly, need to get their priorities straight.
Paying taxes is never pleasant, but it’s necessary: it’s what makes the country run. The trick is just to get it over with quickly and move on, instead of dragging it out onto interminable schedules and deductions. Keeping your taxes simple is, ultimately, the smartest move you can make.
*This is a reason Buffett prefers stock buybacks to dividends, and is also a reason to tax wealth rather than income. But it's not Buffett's fault that the US fiscal system is based on income taxes rather than wealth taxes.
**This is also why there is no "fiduciary obligation" to avoid paying taxes, not even for corporations. Companies have no more obligation to minimize their taxes than individuals do, and while shareholders can certainly smile on companies which are good at tax avoidance, they would never win a court case complaining that a company was paying too much in taxes. The courts are part of the government, after all: they know which side they're on.