OK, I’m about to break my self-imposed rule again. The rule was, “One of the promises I made to myself when I started this blog was to avoid politics. I hate politics. In fact, I hate politics so much, I can honestly say that I would rather do my taxes, or go shopping, than get involved in politics.”
However, recent changes to U.S. tax laws affecting expatriates have put me in a tight spot, inasmuch as they have to do with both taxes and politics. That’s why I sat up and noticed a recent ed-op piece by Newt Gingrich and Ken Kies on the oddly-named “Tax Increase Prevention and Reconciliation Act” which became law in May 2006.
First, let me put forward my position on taxes as bluntly as I can. Taxes are a form of coercion; i.e. your government can force you to hand over money without necessarily providing anything in return. I don’t like being coerced to do anything, and I don’t know very many people who do, even among those of my friends who believe passionately in the principle that our government should be redistributing wealth by taxing the rich and giving money to the poor.
That said, I’m enough of a realist to know that government is necessary (even if those in power can rarely be trusted) and needs resources in order to function. I also realize that many of the benefits we get from being governed are impractical to fund through dedicated taxation. A good example is the system of laws and the judiciary in the United States that afford real protection of intellectual property (IP) rights, a benefit that far exceeds the sham protection that IP owners receive in most countries. If such protection means I don’t have to spend my own money to protect my IP, because would-be thieves are too afraid to mess with beneficiaries of the U.S. system, then I’m happy to have a reasonable amount of tax coerced from me to keep that system afloat. But I’ll demand transparency as to how the system functions as well as how my taxes are assessed, and (unlike my friends in the Mainland) I expect to be able to hold the responsible public servants accountable for their performance via the ballot box.
Gingrich and Kies have 3 key concerns:
- The section 911 rewrite is a “massive tax increase” that injures U.S. citizens working overseas because it is retroactive to the beginning of 2006.
- The resulting cost increases, borne either by U.S. expatriates or their employers, will hurt U.S. exports because there “will be fewer ‘Americans on the ground’” overseas who are in a position to specify or purchase U.S. goods and services. Further, U.S bidders on foreign projects may be placed at a disadvantage to the extent that they must employ U.S. citizens at higher cost.
- The impact of these costs increases will disproportionately hurt small- and medium-size U.S. businesses, which are “more likely than larger firms to use U.S. citizens when they first seek penetration of foreign markets.”
In response to these inequities, and to bolster U.S. competitiveness abroad, they recommend either the complete exemption of foreign earned income from taxation, or repealing the tax increase entirely and raising the “exemption” amount to $117,000.
Frankly, I expect more than this from two distinguished gentlemen, one a senior fellow at the American Enterprise Institute and the other a managing director of a consulting firm. There are plenty of reasons why the rules rewrite is bad tax law. Unfortunately, they’ve missed all of them.
Let’s start with how the U.S. taxes foreign earned income. Keep in mind that I’m a U.S. citizen who lives and works in Thailand, and who has also lived and worked in the United Kingdom and Malaysia, so I think that I actually know what I’m talking about. Unlike the U.S., which taxes its citizens and resident aliens on worldwide income, these countries have “territorial” tax systems, which sounds great until you look at their tax rates. In Malaysia, for instance, the rate is 27% against taxable income between about $26,700 and $62,000 per year. Thailand’s rate is 30% on taxable incomes between $26,000 and $104,000 per year. And in the U.K., it’s 20% against taxable incomes between $4,000 and $62,000 per year.
By comparison, the current U.S. tax rate for married people filing jointly is 15% on taxable incomes between $15,100 and $61,300 per year. If you are married, file jointly and have $60,000 in taxable income you’ll pay $8,245 per year as a U.S. citizen no matter where in the world you reside. Married or not, against the same taxable income you’ll pay $12,585 in foreign income tax if you reside and work in Malaysia all year; $12,725 in foreign income tax if you reside and work in the U.K. all year; and $13,325 in foreign tax if you reside and work in Thailand all year. And, when it comes to determining “taxable income,” you have to remember that personal and dependent exemptions, itemized deductions and standard deductions are usually far less generous outside of the U.S. For example, Thailand caps the total of all exemptions and deductions at about $32,500 per year (such a cap would apply to the absurd scenario of a married couple, both spouses over 65, with 3 dependent children in school and 4 dependent parents, making maximum contributions to available employee provident and long-term equity funds); the maximum home mortgage interest deduction is only $1,300 per year. The upshot is that you’d probably pay even more income tax in the U.K., Malaysia or Thailand than these figures suggest.
Because the U.S. taxes worldwide income, its tax laws have special provisions to prevent double-taxation of its citizens who work and reside in foreign countries. These comprise 4 so-called “benefits”: the foreign earned income exclusion (which Gingrich and Kies erroneously call an “exemption” in their closing argument), the foreign housing exclusion, the foreign tax deduction and the foreign tax credit. Before this year’s rewrite, all but the foreign tax credit came “off the top” of your income, no matter where you live, while the foreign tax credit came (and still comes) “off the bottom,” after you’ve figured your U.S. tax liability. What Gingrich and Kies don’t tell you is that you couldn’t (and still can’t) take the credit for any foreign taxes paid (or accrued) against the income you excluded or deducted. In other words, you can take the exclusions or deductions, or you can take the tax credit. But you can’t take both.
The bottom line is that most U.S. expatriates in Thailand, the U.K. and Malaysia won’t pay a single cent more in U.S. taxes than before. Why? Well, even if the foreign earned income and housing exclusions were completely wiped off the books (and I admit this is a gross oversimplification, owing to the bizarre complexity of the U.S. tax system), the typical expatriate would simply deduct their foreign taxes (anywhere from $12,585 to $13,325 in the examples given above) from their U.S. tax liability ($8,245, from above) and would owe nothing to the U.S., because the foreign tax exceeds the U.S. tax. For these people or their employers, it’s not a “massive tax increase,” it’s a big nothing.
Let’s see. Big nothing equals no extra cost which, to follow Gingrich’s and Kies’s logic to its ultimate conclusion, equals no loss of exports and no harm to small- and medium-size business. Poof!
Why would two distinguished gentlemen, one a senior fellow at the American Enterprise Institute and the other a managing director of a consulting firm, make so much ado about nothing? Well, let’s consider what might happen if you live and work in a country with lower tax rates than the U.S. In 1998, I had the good fortune to be living in Malaysia when its government, struggling to recover from the 1997 Asian meltdown, suddenly abated all income taxes, which meant that I could not take any foreign tax credit on my U.S. return. But I was still able to take the foreign earned income and housing exclusions, because those provisions were valid (and remain valid, even after the 2006 rewrite) no matter what you pay in foreign taxes.
By taxing foreign earned income above the exclusion cap at higher rates than before, and limiting the foreign housing exclusion, the U.S. is certainly reducing the potential “benefit” to taxpayers, but only U.S. citizens living and working in low-tax or no-tax countries would actually see a “tax increase.” Let’s examine a Singapore scenario to see how “massive” such an increase would be. I chose Singapore because its highest marginal tax rate is 22%, which is considerably lower than most other countries.
Suppose you are a married U.S. citizen with 2 children, live and work in Singapore all year, earn $200,000 per year, don’t own any homes anywhere, and spend $4,800 per month on rented housing in Singapore. Under current Singapore tax laws, your Singapore income tax would be about $34,300 per year. Under the old U.S. rules, you would have owed no U.S. tax after taking the foreign tax credit, so your total annual tax bite would have been $34,300. Under the new rules, the least you will owe the U.S. government after taking the foreign tax credit is about $4,900 per year (incidentally, under the new rules it would be cheapest to avoid the foreign earned income and housing exclusions altogether), which increases your total tax bite about 14% to $39,200. Is this a tax increase? Sure. Is it “massive?” Well, “massive” is a subjective term, but it’s nowhere near the “tens of thousands of dollars” quoted by Gingrich and Kies (you never know; however, maybe they meant Hong Kong dollars and conveniently forgot to point that out). Would it cause me to “move back to the U.S. on a week’s notice”? Of course not!
What irks me about the new tax law is its retroactivity. I benefited from this a few years back, when a fattened child tax credit was not only made retroactive but also paid out to taxpayers in advance. I thought it was bad tax law then and I think no less now. It all goes back to what I demand: transparency as to how the system functions.
If I were a U.S. expatriate in Singapore, you bet I’d be unhappy about having to pay $4,900 more than I planned in taxes for 2006. I’d be just as unhappy if I were a U.S. business that offered its expatriate employees so-called “totalization” agreements under which the employee pays exactly what he or she would have paid if working in the U.S., while their employer absorbs (or benefits from) the cost differential. Or, more to the point, I’d be unhappy in quantum to the extent that my company (keep in mind, I own a global business) has highly-paid Americans working overseas. Which of course is the whole reason Gingrich and Kies wrote their blatantly partisan, lobbyist-motivated article.
But I am a U.S. expatriate in Thailand, happily immune to all this. As they say, “no amount of planning will ever replace dumb luck.” And as luck would have it, this was the year I chose to acquire and operate my own business, and buy my own home in Thailand.
For starters, the foreign housing exclusion only applies to rental property. Under the old rules, I couldn’t exclude anything for housing because I own my house here. I assume the new rules have similar restrictions. If so, for me, reducing the foreign housing exclusion means zip, nada, big nothing.
Second, as at the start of the year I owned a business that’s incorporated in Thailand. I can take dividends out of the business in lieu of salary, anytime I wish. This is highly advantageous in Thailand because dividends attract a far lower tax rate than salaries (though they don’t qualify as “foreign earned income,” I’m afraid). To the extent that the earnings remain in Thailand (where I can use them to run my business), and not distributed to me (where my wife could plunder them to her heart’s content), they are completely exempt from U.S. tax.
LInk: Our Taxed Expats (by Newt Gingrich and Ken Kies, June 28th, 2006)
“… The larger issue is that [the rules under section 911 that limit U.S. taxation of American citizens working abroad] are of great importance for American competitiveness, which is why Congress needs to revisit the new law’s changes as soon as possible.”
