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Tax History: High Rates and Hollywood: A Short History of Tinseltown Tax Avoidance

Posted on Jan. 28, 2019

Should Americans earning more than $10 million face a 70 percent marginal tax rate? Rep. Alexandria Ocasio-Cortez, D-N.Y., thinks so, and according to one recent poll, nearly 60 percent of Americans are inclined to agree.

Fans of the Ocasio-Cortez superbracket tend to emphasize the additional revenue it would produce, making it easier to finance desirable spending initiatives. They also welcome any tax reform that promises to curb growing income and wealth inequalities.

Critics, however, have warned that both revenue and redistribution are likely to fall short of liberal expectations. First, high rates will slow economic growth, they contend, depressing tax revenue across the board. Second, those same high rates will encourage aggressive tax avoidance, thereby distorting incentives, reducing efficiency, and undermining the very redistributive effect that liberals say they want.

Hollywood’s history of tax avoidance makes that second worry seem plausible.

High Rate History

Much of the debate over taxing the rich has been explicitly historical, with both proponents and critics ransacking the past in search of useful precedent. The middle decades of the 20th century have gotten special attention, thanks to the high marginal rates enacted by Democrats during the twin emergencies of the Great Depression and World War II, as well as the tenacious survival of these rates through the prosperous (and sometimes Republican) years of the 1950s.

For liberals, the persistence of high rates after World War II is a sure sign that they are no barrier to growth and prosperity. Conservatives, on the other hand, caution that while marginal rates were high, average rates were much lower. In fact, according to one 2017 estimate from the Tax Foundation, while the top marginal rate in the Eisenhower years remained above 90 percent, “the top 1 percent of taxpayers paid an average effective rate of only 16.9 percent in income taxes during the 1950s.”

No one disputes the wide gap between marginal and average income tax rates, part of which is simply a mathematical result of using a progressive rate structure. But there is plenty of disagreement over the size of the divergence at various points in time. For instance, W. Elliot Brownlee, a historian at the University of California, Santa Barbara, estimates that the top 1 percent of earners paid an average rate of 32 percent in 1952. That’s a long way from the Tax Foundation’s 16.9 percent.

While smaller, however, even Brownlee’s estimate suggests the existence of some active tax avoidance among the nation’s economic elite. In a recent article for The Wall Street Journal, Laura Saunders explored some of the myriad ways in which wealthy taxpayers worked feverishly to minimize their tax bill when marginal rates were at their highest. In doing so, Saunders also illuminated another key fact: Some of the most aggressive tax minimization occurred in Hollywood.

The leading historian of Hollywood tax avoidance is Eric Hoyt, an associate professor of media and cultural studies at the University of Wisconsin-Madison. In a 2010 article for the journal Film History, and again in a 2017 edited volume Hollywood and the Law, Hoyt described some of the more vigorous and creative tax reduction techniques in use by Hollywood film stars during the 1930s, 1940s, and 1950s.

Creative Deductions

Not surprisingly, expense deductions were at the heart of many Hollywood avoidance strategies. “The distinction between a deductible business expense and a non-deductible personal expense was often vague, especially in the minds of highly paid talent who were willing to push the envelope in order to claim more deductions and fall into a lower tax bracket,” Hoyt wrote in 2010. Entertainment deductions were a key point of conflict between moviemakers and the Bureau of Internal Revenue (BIR). The director George Cukor, for instance, got this note from his financial manager:

I had a heavy session with the Income Tax Man — all day yesterday — they are reviewing and pulling apart your 1940 and 1941 income tax deductions. They are not going to allow all the entertainment you did in 1941. That year you had the Tallulah Bankhead party which came close to $1,000.00 and he said by no stretch of the imagination could a party like that be called and [sic] necessary entertainment expense for business purposes.

Similarly, the 1935 and 1936 returns filed by actor and comedian W.C. Fields ran afoul of BIR auditors, who questioned his deductions for payments to his brother and sister, ostensibly for help with “story preparation”; the BIR decided they were gifts.

Extraordinary wardrobe deductions were also popular with actors and actresses. “Appearing before an adoring public wearing chic, fashionable clothing was essential to maintaining a star’s image and earning power, or so the argument went,” Hoyt wrote. Dinner at Eight actress Madge Evans, for instance, tried to deduct $2,350 for a mink coat worn during a 1934 trip to New York. BIR auditors disallowed it, as well as other expenses associated with the trip, arguing that “the trip was fundamentally a vacation, not a business trip; and the mink was a warm coat, not a necessary business expense.”

Questionable deductions were just the tip of the avoidance iceberg. More problematic were the various ways in which actors and directors organized their professional activities to minimize taxes. Many stars, for instance, limited themselves to just one or two movies a year, reasoning that marginal tax rates on the income from a third film made it hard to justify the additional effort.

Ronald Reagan was fond of making this point when referring to his own acting career. As his Treasury secretary and chief of staff, Donald Regan, later recalled (as reported in Reagan: The Man and His Presidency by Deborah Hart Strober and Gerald Strober):

When he was in Hollywood he would make about three or four hundred thousand dollars per picture. Reagan would work for three months and loaf for three months, so he was making between six and seven hundred thousand dollars per year. Between Uncle Sam and the state of California, over 91 percent of that was going to taxes. His question, asked rhetorically, was this: “Why should I have done a third picture, even if it was Gone with the Wind? What good would it have done me?”

Reagan was outraged by high rates in general, but he also insisted that the tax system was unfair to Hollywood celebrities in particular. As he wrote in his 1990 autobiography, An American Life:

I’d always thought there was something inherently unfair toward actors in the tax system. I’d seen careers take off like a comet, shine briefly, then burn out almost overnight, but during their brief period of stardom, taxes would have eaten up most of their income and they’d have little left afterward.

Similar logic motivated Los Angeles attorney Roger Marchetti when he tried to convince Congress that actors needed some sort of depletion allowance to account for their fleeting fame (and earning power). “Marchetti found his inspiration in the form of a 1926 income tax provision granted for the oil industry,” Hoyt recounted. “Because oil wells made large sums of money in their early years but eventually ran dry, oil companies were given a 27½ percent depletion allowance for oil wells. Marchetti wanted movie stars to receive the same treatment.”

Lawmakers were unimpressed by this analogy. “Oil companies purchase land for drilling and capitalize the land as an asset, deducting the value of the asset during its life,” Hoyt explained. “Movie stars, on the other hand, do not purchase themselves. They are not capitalized assets. A 27½ cent depletion deduction of a zero dollar purchase is zero dollars. Congress had little sympathy for the complaints of the Hollywood nouveau riche.”

Other tax minimization schemes were more successful, especially the use of personal service corporations. This technique was pioneered by the British actor Charles Laughton, who ran afoul of U.S. tax officials when he established a U.K. corporation in 1934 and funneled most of his personal income through it. The company paid Laughton a modest salary while retaining most of the fees he received from Hollywood studios. That retained income was then taxed at relatively low corporate, rather than individual, rates.

The BIR challenged this arrangement, and initially Laughton lost his case in court. On appeal, however, the actor and his attorneys argued successfully that the corporate arrangement was consistent with broader, more common business practices. As Hoyt explained: “Previous tax appeals centered on the unique circumstances of Hollywood — the way the industry compounded business and personal matters, the boom and bust nature of stardom — had failed. But courts were receptive to a corporate logic, one acknowledging the unique circumstances of how motion picture corporations frequently loaned contracted talent to one another.”

Stars were also working hard to take advantage of the rate preference for capital gains — then, as now, a fixture of creative tax planning. Collapsible corporations were especially popular, as Yale law professor Boris Bittker explained in 1967:

A producer, director, and leading actors would organize a corporation to produce a single motion picture. They would invest small amounts of cash and agree to work for modest salaries, and the corporation would finance the production with borrowed funds. When the motion picture was completed, but before it was released for public exhibition, the corporation would be liquidated. The stockholders would report the difference between the cost of their stock and the value of their proportionate shares in the completed film (established on the basis of previews) as long-term capital gain.

Collapsible corporations proliferated during World War II, but Treasury Secretary Henry Morgenthau Jr. — grateful for Hollywood’s assistance in managing wartime propaganda — instructed his minions to ignore the issue, according to Hoyt. In 1945, with Morgenthau gone from Treasury, BIR officials warned studios and celebrities that the proverbial jig was up. Five years later, Congress enacted a legislative fix to eliminate the problem more completely.

“In examining the history of the capital gains tax shelter, we can see a certain back and forth relationship between the government and the motion picture industry,” Hoyt observed. “The income tax’s high marginal rates frustrated Hollywood independent producers, who innovated the capital gains tax shelter to retain a greater portion of their profits, later causing the government to amend the tax code.”

This relationship was not simply a game of cat and mouse, with government taxing and movie stars avoiding. “The important point we must remember is that the relationship was dynamic,” Hoyt wrote, “not simply causal from the direction of the government to Hollywood and not operating in isolation (creative control, studio conditions, and the cultural context were all significant factors).” Tax avoidance, in other words, was embedded in the social and economic structures of the time as well as the specific business practices of the entertainment industry.

Just Like Us

By its very nature, Hollywood tax avoidance is a curiosity. Americans buy Us Weekly to be reassured that stars are “just like us,” shopping at Target and juggling footlong receipts from CVS. But we also greedily devour news stories about the tax problems of the rich and famous, from Mike “The Situation” Sorrentino to the rapper DMX to skier Lindsey Vonn.

The popular penchant for tax schadenfreude is not new. Tinseltown tax avoiders in the mid-20th century faced similar scrutiny. “As Laughton and other top tier Hollywood talent negotiated the rocky waters of rising income tax rates, they did so largely in the public view,” Hoyt wrote. “Newspapers of the 1930s repeatedly published reports about movie stars with tax deficiencies and liens against their property.”

The voyeuristic quality of such coverage — then as now — is undeniable. But it still serves as a useful reminder that high marginal rates are a nearly irresistible inducement to aggressive tax avoidance. Skeptics will object, correctly, that wealthy taxpayers will often work hard to avoid low and moderate rates, too. But that doesn’t mean higher rates — especially much higher rates — won’t make the problem even worse.

The history of Hollywood tax avoidance is not an argument against any marginal rate hike — or even an argument against large ones. But it is a cautionary tale: High rates are not unproblematic. Or unavoidable.

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