Part 1: History of citizenship-based taxation
Citizenship-based taxation has been an issue throughout the 150-year history of the US income tax.
Interestingly, the United States started with a residence-based tax system. The first income tax enacted by Congress, passed in 1861 to help fund Civil War efforts, Rep. Justin Morrill, proponent of Revenue Act of 1861only taxed citizens abroad on their income from US investments; overseas income was specifically excluded.
In 1864, Congress moved to citizenship-based taxation and passed a new law which taxed non-resident citizens on their non-US income as well. The tax, both for residents and non-residents, was only in effect until 1872.
Congress introduced an income tax law in 1894 which included taxation on all income of non-resident citizens. The law was ruled unconstitutional by the Supreme Court the following year (for reasons unrelated to non-resident taxation).
14 years later, the 16th Amendment to the Constitution was passed to overturn this Supreme Court decision, and the modern federal income tax was begun.
The new income tax regime forming the basis of the modern system of US taxation, created in 1913 and revised in 1916, applied to “every citizen of the United States, whether residing at home or abroad.”
The provision of the new law taxing non-resident citizens on their global income was immediately controversial. Already by 1914, US citizens in London had begun to renounce citizenship in order to escape double taxation, and American Abroad groups challenged the legality of the new provision. The challenges reached their climax in 1924 when the Supreme Court ruled in a case brought by a US citizen living in Mexico that taxing non-resident citizens on their global income was indeed constitutional.
Debate about if – and how – to avoid double-taxation of Americans abroad
Since the 1924 Supreme Court decision, there has been no serious attempt by lawmakers to end the taxation of citizens who do not reside in the USInstead, the focus of the debate has generally been on the extent to which the earnings of Americans working overseas should be taxed by both the country of work/residency and the United States.
A 1918 provision in the tax law allowed Americans to take a credit for taxes paid to a foreign government.
In 1926, Congress created the foreign earned income exclusion, which allowed taxpayers to shield an unlimited amount of foreign income from US taxes. In 1962, Congress put a limit on how much foreign income could be excluded from US taxes.
There have been numerous attempts to rescind the foreign-earned income exclusion completely, so that all income earned outside the United States would be subject to US taxes. The exclusion was replaced by an alternate structure from 1978 to 1981, but was reinstated and is still in effect today.
The foreign-earned income exclusion was set at $75,000 in 1981 (equivalent to $220,000 in 2020 dollars). Above that amount, foreign earnings are taxed both in the US as well as in the source country and/or country of residence.Note that for income levels above the exclusion amount, pre- and post-2006 systems are not directly comparable due to the introduction of the ‘stacking procedure’.
Legislation was enacted to raise the limit by 1986 to $95,000 (equivalent to $223,000 in 2020 dollars). However, in several subsequent “revenue enhancement” sessions, Congress opted to leave the amount virtually unchanged for the next two decades, thereby effectively – and stealthily – letting inflation cut away the real value of the benefit.
By 2020, the foreign earned-income exclusion had increased slightly in nominal terms to $107,600. In real inflation-adjusted dollars, this represents a massive fall in value in the nearly 40 years since the passage of the 1981 law.
2005 Law significantly increases taxes of Americans abroad
New legislation in 2005 tied the foreign-earned income exclusion to inflation. The foreign-earned income exclusion is now $107,600 (2020 adjusted) after a number of years of inflationary adjustments.
However, the same legislation significantly reduced the benefit through two changes. First, a “stacking procedure” was introduced where the rate used to calculate tax is what would have applied if the exclusion was not used. Because of the progressivity of tax rates, the taxpayer is forced to pay higher marginal rates on any amount above the foreign-earned income exclusion because he loses the benefits of the lower marginal rates for lower income amounts. The difference was significant and effectively reduced the net benefit of the foreign earned-income exclusion despite the apparent increase. Secondly, a new cap of $11,536 for housing exclusions for citizens living overseas was introduced.
The net change caused by the 2005 legislation significantly increased the taxes of Americans working overseas.
There was a storm of protests from groups representing Americans working abroad and numerous attempts to reinstate the previous laws, but little has changed since. If anything, the political climate since seems to favor further reducing the tax benefits given to Americans abroad.
Note that investment earnings have never received any benefit and are subject to US taxation in addition to taxation from the taxpayer’s country of residence.
Also important to note is that many tax benefits allowed to US residents are not available to citizens overseas. For example, donations to charities outside the US are not tax deductible, property cannot be transferred tax-free to spouses who are not US citizens, Medicare benefits cannot be received.
While there have been debates about how much foreign-earned income should be excludable and to whom the provisions should apply, Congress has been very clear throughout 150 years that all global income of any American citizen, living inside or outside the US, is subject to US tax.
In a century since introduction of the modern income tax system, no law to tax based on residency rather than citizenship has ever passed Congress. As far as we are aware, no such legislation has even been introduced and voted upon.
There have been proposals by academics and interest groups representing overseas Americans to introduce a residence-based tax system similar to every other country in the world, but they have not received widespread attention. As the 150 years of lawmakers’ quotes in the next section below show, the political reality of scrapping a citizenship-based tax system is essentially zero.
Americans working overseas and the income they earn soars in last 20 years
While the US tax system remains fixed to citizenship-based taxation, US workers have become increasingly mobile. As the economies of the world become more connected and barriers to working abroad fall, the foreign earnings of US citizens have grown much more rapidly in the last few decades than domestic earnings:
From 1987 to 2001, IRS data shows that while overall income by US citizens grew by 43% in real terms, foreign-source income more than quadrupled.
The number of US citizens affected by foreign tax issues has also expanded dramatically even more recently:
In 1991, 220,165 individuals reported foreign earnings to the IRS. In 2006, it had grown by 52% to 334,851. This represents an increase of 114,686 more Americans working overseas in just 15 years.
Part 2: Background on Non-residency, expatriation and tax
The income of citizens abroad can come from two sources: US or foreign. The cases and controversies about citizenship-based taxation and expatriation have arisen because of both sources.
The first 19th-century tax laws aimed at non-resident citizens were intended to prevent Americans living abroad from earning income from US investments while not paying taxes:
“If a man draws his income from our public debt, or from property here, and resides in Paris, skulking away from contributing his personal support to the Government in this day of its extremity, he ought to pay a higher income tax.”
– Senator Jacob Collamer (Rep., Vt.), 1862
Although eventually struck down by the Supreme Court, the tax law that Congress passed at the end of the 19th century was similarly aimed:
“[The point of citizenship-based taxation is so that] if an American citizen went abroad and carried the protection of his country, of his citizenship with him, he did not escape its burdens… There are a great many people, I am sorry to say, who go abroad for that very purpose, and some of them went abroad during the late [Civil W]ar. They lived in luxury, at the same time at less cost, in a foreign capital; they had none of the voluntary obligations which rest upon citizens, of charity, or contributions, or supporting churches, or anything of that sort, and they escaped taxation.”
– Senator George Hoar (Rep., Mass.) , 1894
The intent of citizenship-based taxation at the start of the modern tax regime in 1913 was similarly clear:
“You know who they [the US Government] are really after – the idle rich, who come here [to London] to buy property and spend here incomes drawn from the United States.”
– An “influential member of the American Society” in London, as quoted in NY Times, March 6, 1914
Despite the political focus on US-sourced earnings, the Supreme Court, in its first decision on citizenship-based taxation, focused on foreign-source income. In the case of Cook v. Tait in 1924, it ruled that taxation of the foreign-source income of non-resident citizens is legal.
Congress makes US a tax haven for foreigners’ investments in 1966
A significant alteration in the tax code in 1966 designed to encourage foreign investment in the US marked the start of a new regime for individuals who renounce their citizenship.
Until then, non-resident non-citizens who earned income from US sources were taxed at the same rates as US residents.
To encourage foreign investment in the US, Congress passed in 1966 a law (the Foreign Investors Tax Act) which gave significant tax advantages to non-resident non-citizens. For them, interest on bank deposits, coupon payments from US government debt, and portfolio interest paid by US domestic corporations became tax-free, and other investments enjoyed other tax benefits. The US became a de facto tax haven for foreign investors.
These benefits were limited to non-citizens living outside the US. Citizens outside the US continued to be taxed in the same manner as citizens resident in the country.
Congress tries to counter the incentive to expatriate
Lawmakers recognized that the new difference in tax between citizens and non-resident non-citizens caused by this tax-haven legislation significantly increased the financial incentive to renounce citizenship.
To combat the incentive to expatriate caused by the favorable tax-status they gave to foreigners’ investments in the US in 1966, Congress enacted the first tax aimed directly at individuals who renounce citizenship.
The 1966 law applied a 10-year tax on US-source income of individuals whose main motive for expatriation was tax avoidance. In practice, though, the legislation was ineffective at reducing the tax benefit of expatriation: the IRS was not informed of expatriations, determining the “tax avoidance” motive was difficult, individuals could fairly easily restructure many of their assets to escape the tax, and enforcing a 10-year tax regime on foreign citizens living outside the US was impossible.
Politicians enraged in 1990s by expatriation of wealthy Americans
In the mid-1990s, the expatriation of several wealthy US citizens drew enormous media attention and massive Congressional scrutiny. President Clinton himself supposedly read an article in Forbes and demanded action (see here for link to the article that started the fury).
The political debate was emotionally charged. Lawmakers from both parties in Congress and officials in the White House were in unison:
“[These are] Benedict Arnolds who would sell out their citizenship, sell out their country in order to maintain their wealth. Jet setters who are able to… enjoy the full benefits of all the wealth that they have accumulated in the United States of America as citizens, and renounce.”
– Rep. Neil Abercrombie (Dem, Haw.), 1995
“[T]hese [are] wealthy individuals [who] have engaged in the despicable act of renouncing their allegiance to the United States [due to the supposedly] punitive levels of taxation in this country… Their argument that our taxes are at punitive levels is totally false. The United States has one of the lowest tax burdens of all industrialized nations in the world. It is true that our rates exceed those provided by the tax havens to which these wealthy people are fleeing. However, those individuals can reside safely in those havens only by reason of the defense expenditures of this country which enable wealthy expatriates to live safely anywhere in the world… They condemn as class warfare our attempt to make a handful or two of the wealthiest of the wealthy bear the same burden of tax as all the rest of us.”
– Rep. Sam Gibbons (Dem., Fl.), 1995
“If you’ve gotten your riches from America, you should pay your fair share of taxes. These expatriates are really like economic Benedict Arnolds.”
– Leslie Samuels, Assistant Secretary for tax policy, US Department of the Treasury, 1995
The rallying cry in Congressional debate was “to close the billionaires’ loophole”. As Rep. Peter DeFazio (Dem, Or.) stated, Congress’ goal was to stop the “billionaires and centi-millionaires” from “escaping” from the US tax system.
A few voices were raised that “billionaires and centi-millionaires” were at most a handful of the thousands of expatriation cases. Others mentioned the irony that while moving abroad and reducing taxes was considered by US lawmakers to be “escape”, “illegal action”, and the act of “taking advantage of a loophole that scoundrels have now begun to exploit”, it was in fact completely legal and standard in every other country of the world. Or that, as Rep. Nancy Johnson (Rep., Conn.) pointed out, “when a nation makes the decision to oppose a unique and extraordinarily broadly burdensome tax, even if it is on a small group, it sends a message to all those choosing to invest that investing in America could be hazardous to their interests.”
But pointing out these inconvenient facts was politically untenable in the face of the “unpatriotic billionaire” meme. Lawmakers of all political stripes were unified in their disgust at expatriation and political action was guaranteed.
1996 law against “taxpatriation”: strict and onerous intent, unworkable result
With such unified political will, Congress in 1996 enacted new legislation to stiffen penalties against expatriation. For legal and practical reasons, legislators only revised the 1966 law and did not enact as onerous a burden as many wanted:
“This proposal is not designed to prevent Americans from shifting their assets and citizenship to another country. If it was my instruction, it would. Why should I give two hoots about somebody that wants to give up their US citizenship and shift their income to another country…?
It has been brought up about double taxation. I say, ‘You can triple or quadruple tax them as far as I’m concerned, run it up to a hundred percent if they want to give up their citizenship because they don’t want to pay their taxes.’
How can you say that we should all do our share in America, including making all the kids, and the elderly people, and everybody else, have to contribute to the deficit, to bring it down, and at the same time allow these sleazy bums, who don’t want to pay their taxes, to leave this country, and renounce their citizenship, and expect me to have one iota of sympathy for them.”
–Rep. Neil Abercrombie (Dem, Haw.), 1995
In essence, the new law retained most of the 1966 law’s features, including the 10-year post-renunciation tax, but attempted to correct the practical problems. In particular, the 1996 law created the assumption that tax avoidance was the principal motivation for expatriation for any individual whose net worth was at least $500,000 or whose average income tax in the 5 years prior to expatriation was over $100,000. The law also provided that an individual who renounced citizenship would still remain subject to US taxation on his global income until he officially informed the IRS of his expatriation.
Another provision was added ordering the IRS to make public the names of all individuals who renounce citizenship (see here for summary and analysis of the data resulting from this provision). The intent behind this so-called “name-and-shame” statute was described by one legislator:
“I hope that one day we will just publish the names of people that America has given so much to and that they care so little about that citizenship that they would flee in order to avoid taxes.”
– Rep. Charles Rangel (Dem., NY), 1995
Congress inserted another provision, the so-called Reed Amendment, barring entry to the US to any individual whose motivation for expatriation was tax avoidance.
There were several challenges to the 1996 law on both legal and practical terms. Legally, the expatriation tax regime existed on shaky constitutional footing.
In essence, the law created a separate class of citizen who had no benefits of citizenship – the right to live and work in the US, the right to vote, the right to protection of the US, etc – but who still had the tax obligation of citizenship. Numerous legal scholars noted the problems, but no case was brought to challenge this issue.
Separately, individuals contested the assumption that the principal motivation for renouncing for anyone meeting the economic thresholds was tax avoidance. In the first five years after the law was passed, 270 people applied to the IRS for a ruling that they had expatriated for non-tax reasons. Of them, half received favorable rulings, 11 were rejected, and the rest received “neutral” rulings (which apparently allowed them to ignore the law pending a specific request for review by the IRS).
Enraged that so many individuals were deemed to have expatriated for reasons other than tax avoidance, Congress strengthened the presumption in 2004. The changed regulation stipulated that all individuals who met the economic thresholds by definition expatriated solely to avoid taxes, and no argument to the contrary was acceptable.
From the IRS’s view, the 1996 legislation still suffered from the same difficulty of enforcing a tax regime for 10-years against foreign citizens living in a foreign country. Administration of the law was difficult, and verification virtually impossible.
And the Reed Amendment barring entry to the US was unworkable and never enforced.
2008 law introduces first exit-tax in US history
Renunciation tax law was given a major overhaul in 2008. The 10-year tax regime was replaced with an exit tax on the expatriating citizen. The exit tax also includes a covered gift and covered bequest rule which applies the US estate and gift tax to US tax residents who receive transfers from a ‘covered expatriate.’