Release of the Pandora papers has focused attention South Dakota’ status as a domestic tax haven of sorts (along with Alaska, Delaware, Nevada, and probably other states). This results from South Dakota satisfying a legal trifecta:
- No state income tax
- No rule against perpetuities
- Favorable trust and banking laws
That combination allows high net worth families to create dynastic trusts that permanently avoid federal transfer taxes (gift, estate, and generation skipping) after paying one round and that round is often paid at a steep discount from the nominal rates when structured carefully. Daniel Hemel, a U of Chicago tax prof, details how all this works in a WaPo op-ed.
As Professor Hemel points out:
From a broad public policy perspective, all this is certifiably crazy. States such as South Dakota are helping out-of-state residents reduce federal and home-state tax liabilities so that in-state financial institutions can get a cut.
Daniel Hemel, South Dakota’s tax avoidance schemes represent federalism at its worst
The feds need to address this; individual states – at least small government types without a state income tax – have a natural incentive to compete for this business. Of course, economic theory says it is a losing competition. Just as pure competition reduces business firms’ margins to their marginal costs of production, the same is likely true for states competing against one another. Of course, real worlds markets are rarely so perfect, and those imperfections allow making nice profits. This competition among the states is often described as a “race to the bottom,” the idea being that states give away their tax bases in fruitless competition. Moreover, the economic benefits to states are hard to measure and often less than the costs.
In any case, South Dakota has attracted a surfeit of in trust investments, over $360 billion, according to WaPo stories on the Pandora Papers. But Howard Gleckman has a piece at Milken Institute Review (and cross posted at Forbes) that questions the premise, arguing South Dakota is getting little or nothing for its effort: “[T]here are few tax benefits for the state and little evidence that the trusts create jobs.” He concludes that South Dakota gets trivial state revenue from the activity and no jobs. Essentially, nada. He recognizes that they also suffer no revenue loss, since they don’t have an income or estate tax, making the feds and other states the losers. (“The only losers are the federal government and its taxpayers. Indeed, the states are little more than willing conduits to federal tax avoidance. All perfectly legal, but that is exactly the problem. While they may have nothing to lose, the rest of us do.”)
His conclusion on in-state economic benefits (“jobs” in his formulation) is debatable. It’s based on two data points, that South Dakota’s financial institutions jobs declined over the last decade and that although the number of South Dakota lawyers increased, they did so by less than the national average. (Why would out-of-state rich people switch to using South Dakota lawyers to set up these trusts anyway?) South Dakota has no income or corporate income tax, so the direct state revenue yield from trust assets is minimal. (Focusing exclusively on direct revenue is misleading. South Dakota relies heavily on a broad and high sales tax; 58% its sales tax revenue comes from taxing business purchase. So, increasing in-state business activity will inherently yield some state tax revenues, just to put a finer point on it.) Gleckman seemingly implies it is irrational for South Dakota (and, by implication, Alaska, Delaware, Nevada, et al) to compete for trust investments by allowing dynastic trusts. As an aside, Gleckman is a TPC blogger whose posts I regularly read, usually agree with, and often find insightful. In this case, I think he is a little too glib and quick.
What exactly motivates this type of political behavior and is it irrational? I have some thoughts – mainly that (at least for South Dakota) it may not be irrational. Even if it provides minimal benefits to the state, South Dakota’s political culture and its long running competition with my home state, Minnesota, dating back to governors long past, provides a natural, if not totally rational, explanation.
GDP data shows South Dakota has successfully attracted a lot of financial institution activity, compared with surrounding states. Gleckman’s piece rejects the idea that attracting trust investments is a successful economic development strategy based on the change in financial institution jobs over one decade. That is a thin reed to rely on. As he notes, South Dakota has been at this for a long time. South Dakota repealed the rule against perpetuities in 1983. But it was at busily attracting banking business before that by repealing its usury law to attract the credit card operations of national banks after the Supreme Court green lighted that strategy in a 1978 case, Marquette National Bank v. First Of Omaha Service Corp. That effort was successful with money center banks (Citibank initially) moving their credit card operations to South Dakota. Attracting trust administration business seems like natural agglomeration economics strategy, following on that – if the banks locate their credit card operations in South Dakota, adding trust operations is a natural fit.
GDP data suggests that South Dakota’s strategy has been successful – especially for a low population, prairie state without a major metropolitan area. Based on BEA data (4th quarter 2020), over 22% of its state GDP is derived from the finance and insurance sector. By contrast, its neighbors (North Dakota (7%), Nebraska (15%), Montana (6%), and Minnesota (11%)) derive much less and the national average is 10% for more general context. That is so, even though Minneapolis is the financial center for the Upper Great Plains region with national or regional headquarters for large banks like U.S. Bank and Wells Fargo, as well has having more large headquartered insurance companies than South Dakota. Sioux Falls has essentially become a veritable Zurich on the prairie. It’s hard for me to argue with South Dakota’s general strategy, contrary. Yes, financial sector employment in South Dakota may not have grown much in the last decade but that seems irrelevant for a long-running, mature strategy. South Dakota’s financial and insurance share of GDP is more than twice the national average.
Focusing just on jobs, state jobs in the finance insurance and real estate (FIRE) sector grew substantially faster than the national rate from 1977, just before it started trying to attract credit card operations of national banks, through 2001 – by 275% for South Dakota compared to 80% nationally. The graph shows South Dakota’s share of national FIRE jobs for the period. (Since 2001, finance and insurance job growth in South Dakota and nationally have been very similar.)
Most of the growth was surely due to credit card operations rather than trust administration since the former is much more labor intensive. So, this may say little about whether attracting trust assets was a good strategy, but it suggests the overall approach of luring banking operations is not obviously flawed. It is safe to conclude South Dakota’s economy would be worse off without its growth in financial services since the late 1970s – how much, if any, is due to becoming a tax haven for dynasty trusts is less clear. It certainly seems complementary to the overall strategy and hard to dismiss as providing no benefit.
As an aside, South Dakota’s attraction of trust assets sufficiently troubled Minnesota policymakers that the legislature in 1990s (based on a governor’s recommendation) modified Minnesota’s trust taxation to try and counter it. For many years, Minnesota had a robust trust administration business that was relentlessly being chipped away by South Dakota and other states without income taxes. The legislative changes made administrating a trust in Minnesota effectively irrelevant to whether the trust’s income was subject to Minnesota taxation, relying instead on the location of the settlor or beneficiaries. That would allow nonresidents to use Minnesota trust administration without paying Minnesota tax. No one (to my knowledge) seriously considered repealing the rule against perpetuities, so that proved to be a half measure that likely had little practical competitive benefit for the state. The change did make it more difficult to tax trust income (see Fielding v. Comm’r of Revenue).
South Dakota’s strategy is consistent with its dominant, anti-government political philosophy. South Dakota is a classic, deep red state with a political culture much like its neighbors to the west (Wyoming and Idaho, e.g.) with a strong libertarian flavor. A culture animated by deep antipathy for the federal government and indeed for government generally (gross over generalization, obviously, but reflecting more than a kernel of truth). Gleckman seems puzzled by why a state would enable nonresidents to avoid federal and state taxes for little or no economic payoff in state tax revenue or jobs. That is the wrong frame of reference. Accepting the (questionable) little-to-no-benefit premise, undercutting income taxation could well be perceived as an inherent good to the typical South Dakota pol. This is, after all, a state without income (individual or corporate) and estate taxes. If South Dakota controlled federal tax policy, I can’t imagine it would impose any of them. Undercutting federal transfer taxation likely, in its mind, is an altruist act. Rather than a perverse “race to bottom” (under the more conventional view) by undercutting other states’ taxes, they likely view it as helping to inch the country toward a libertarian utopia of lower taxes and minimal government.
Inertia makes it easy to just keep doing what you’re doing. States have always competed against one another for business investment and activity – both at a general level and by competing for specific projects. This competition becomes most intense when the states are neighbors and have widely different political philosophies, as is the case with Minnesota and South Dakota. Since the early 1970s, Minnesota has been a more liberal, big-government state, while South Dakota was a classic limited government, low-tax state. That naturally led to intense competition between the two states. (By contrast Wisconsin and Minnesota, two states with similar political philosophies (until the 2010 Wisconsin election changed that), engaged in spirited but more friendly competition.) That was compounded by a clash of personalities between two flamboyant former governors, Bill Janklow and Rudy Perpich, that added to the natural political and economic competition. Their personal clash was widely reported (e.g., NY Times), even in Janklow’s obits (MinnPost noting that the two ultimately became friends) and a ballad (MPR). Given this fuel, pursuing policies whose primary effect was to injure higher tax states, like Minnesota, even if the tangible benefits to South Dakota were minimal, is understandable. With a Hatfield v. McCoy element to the competition, reflexive striking-out, rather than careful cost-benefit assessments, typically govern. And, in any case, there is a tendency in politics to just keep doing what you’re doing. Inertia isn’t limited to physics.
Bottom line: it’s not at all clear that South Dakota’s strategy of luring trust assets was not a successful economic development strategy and even if the tangible economic benefits are modest to minimal, doing so is understandable as a psycho-political matter.
That said, I agree with Gleckman and Professor Hemel that Congress should fix the problem, because it undercuts federal transfer taxation and the ability of states to tax trust income (a complicated constitutional issue in itself). But Congress is unlikely to do anything about it. Despite abundant tax-the-rich rhetoric, the Dem-controlled Congress has no apparent appetite to put teeth in federal estate and gift taxation or to address the obvious ability of the ultrarich to shelter their income from taxation. Favorable capital gains rates and step-up in basis remain intact under the House’s tax bill; the Senates’ bill is unlikely to be materially different.
SALT Speak - Joel Michael's Blog 