James Joyner points the way this afternoon to this piece by Ben Stein discussing a recent conversation he had with Warren Buffett on how the rich pay taxes. The meaty quote:
Mr. Buffett compiled a data sheet of the men and women who work in his office. He had each of them make a fraction; the numerator was how much they paid in federal income tax and in payroll taxes for Social Security and Medicare, and the denominator was their taxable income. The people in his office were mostly secretaries and clerks, though not all.
It turned out that Mr. Buffett, with immense income from dividends and capital gains, paid far, far less as a fraction of his income than the secretaries or the clerks or anyone else in his office. Further, in conversation it came up that Mr. Buffett doesn’t use any tax planning at all. He just pays as the Internal Revenue Code requires. “How can this be fair?” he asked of how little he pays relative to his employees. “How can this be right?”
The timing turns out to be pretty good on my end. I'm getting ready to go back into business again (some people just never learn :D ), and as part of that, I've brushed up on a lot of stuff related to tax laws. And as I've delved into it, I've learned something: Mr. Buffett is absolutely correct. Our tax code is tremendously rigged to favor the wealthy, especially the very wealthy and the very large corporations. In comments on Mr. Joyner's blog there has been some healthy skepticism of Mr. Buffett's claim not to use any tax planning. However, knowing what I know of the tax code, I can believe it. He really wouldn't have to do any to still pay a much smaller percentage of taxes than his salaried employees.
It all comes down to one simple fact when dealing with the US tax code:
NOT ALL INCOME IS THE SAME
The typical US taxpayer earns most of his income from salary, wages, and tips. It's what the IRS calls "earned income" - the income you get from actually having a job and doing the stuff that job requires, or earning it the old fashioned way. This is how most middle class, and even upper middle class, families earn their income. It's also the highest taxed form of income. I'll give a specific example at the end of this post, but for now just trust me that it's true.
The typical "rich" person, on the other hand, receives mostly "unearned income". This is basically any income that you don't have to work for: interest, capital gains, dividends, rent paid on real estate, etc. I don't do anything for the interest my savings account earns - I get money just for having the money sitting there, hence it is "unearned." However, all of these different types of income are taxed very differently.
Interest is taxed basically the same as earned income. It kind of stinks for the average saver, because your typical bank account interest rate is fairly low anyway, and it gets taxed the same as normal income.
Capital Gains and Dividends, on the other hand, get classified entirely separately on your tax return, and get taxed at entirely different - and much lower - rates than your normal income. (Again, details to follow in a specific example). There are also a number of ways in which you can make a *lot* of money in capital gains without paying any taxes at all.
Best of all (from a tax perspective) is real estate. Theoretically, it's taxed as capital gains. But you can make a lot of profit on real estate and pay almost no taxes at all, if you're smart about what you're doing.
Furthermore, corporations themselves are taxed in a totally different way than individuals, making it possible for business owners to give themselves all kinds of incredible perks tax free (or nearly so).
Here's a breakdown of how different kinds of income are taxed on an individual:
The first $7550 is taxed at 10%.
Every dollar from $7551 to $30,650 is taxed at 15%.
From $30,651 to $74,200 is taxed at 25%.
From $74,201 to $154,800 is taxed at 28%.
From $154,801 to $336,550 is taxed at 33%.
Everything above that is taxed at 35%.
It looks nice, and fairly progressive - the rich pay more, right? Except that most of the income the rich get doesn't come fit on that table. Also, keep in mind that this doesn't even cover all of the taxes you have to pay because you also have to pay the so called "payroll taxes" (Social Security and Medicare) on earned income (up to $94,200). That's another 6.2% for Social Security and another 2.9% for Medicare. That's 9.1% on top of what I already listed.
The rich mostly earn their income from Capital Gains (buying stuff - such as stock or real estate - and then selling it at a higher price). There are two rates for capital gains income: long term and short term. Which income falls into which category can get confusing, but it mostly relates to how long you hold onto an asset before you sell it. If you hold onto it long term (usually more than one year), you get a major break:
The first $7550 is taxed at 5%.
Every dollar from $7551 to $30,650 is taxed at 5%.
From $30,651 to $74,200 is taxed at 15%.
From $74,201 to $154,800 is taxed at 15%.
From $154,801 to $336,550 is taxed at 15%.
Everything above that is taxed at 15%.
Let's turn this into a few examples.
Example 1:
Joe Schmoe has a pretty good job as a software developer. He makes about $80,000 a year. So his taxes look like this:
[keep in mind that this is a simplified example that includes no deductions - neither will any of the other examples]
$4960 for Social Security
$2320 for Medicare
$755 for the first $7550 of his income
$3465 for the next $23,100 of his income
$10,887 for the next $43,550 of his income
$1624 for the last $5800 of his income
Grand total: $24,011 in taxes, or 30% of his income.
Now, let's consider somebody like Warren Buffet (only less wealthy) who made most of his money by investing in the stock market. Let's assume that Richie Rich made $1 million in the same tax period. We'll even be generous and assume that a good chunk of that came from a high paying day job: say, $150,000 a year. Let's assume that another $300,000 came from short term capital gains (which, again, is taxed like earned income). The remaining $550,000 came from long term capital gains - he bought stock or real estate, held onto it for 12 months or more, then sold it.
On his earned income and short term gains, his tax bill would look like this:
$5840.4 for Social Security (remember, only the first $94,200 is taxable here)
$2731.8 for Medicare (again, only the first $94,200 is taxable here)
$755 for the first $7550 of his income
$3465 for the next $23,100 of his income
$10,887 for the next $43,550 of his income
$22,568 for the next $80,600 of his income
$59,977.50 for the next $181,750 of his income
$39,707.50 for the last $113,450 of this income type
Total Earned Income/Short Term Gains taxes (the first $450,000 of income): $145,932.20
However, the last $550,000 of his income is long term capital gains, so it's only taxed at 15%, for a total of $82,500.
Stop right there before I even compute the total. The first $450,000 of his income cost him almost $150,000 in taxes. The last $550,000 cost him less than $85,000 in taxes. The second group was 22% more income, yet cost him 43% less in taxes.
Add the totals together and you get $228,432.20 in total taxes - a hefty tax bill, to be sure. But it's only 22.8% of his total income - dramatically less than poor Joe Schmoe above.
Again, all of these examples are before any deductions at all - deductions that are a lot easier for rich people and large corporations to take, because they involve ways that many of these people are moving money around already that less rich people can't afford to do.
I'm a pretty conservative guy. I'm absolutely not in favor of taxing the rich at ridiculously high rates. But I also think it's absurd that Richie Rich making a cool million pays a smaller percentage of taxes than Joe Schmoe, especially when the difference in the percentage is so huge.
Granted, there are a whole host of crazy tax rules that adjust these numbers. In addition to deductions, there's also the AMT to consider, which is going to raise Richie Rich's percentage paid in income taxes. But even the AMT is rigged in such a way that it really screws the upper middle class guy making about $100-$200K per year while resulting in a lower tax burden for Richie Rich making $1 million or more. Again, it mostly comes down to how you earn your income. Those long term capital gains are still only taxed at 15% under the AMT.
Unfortunately, this entirely too long blog entry doesn't even scratch the surface of the methods available to rich Americans to shield their money from taxes. It's a sore subject to me because I'm currently just entering the core income bracket that gets royally screwed on taxes - and believe me, it makes a difference. And that doesn't even include all the ridiculous ways that I see our government spending my hard earned money every day.
The worst part of all, however, is that Democrats and Republicans both are equally culpable for this intolerable arrangement. It's all a shell game that gets the middle class to look away from the tax breaks the rich get by fooling us into thinking our tax code is truly progressive. Look at this advancement of tax rates, they say, hoping that we won't notice that the truly rich are playing under an entirely different set of rules.
I have to admit that there are good reasons (even very good reasons) to keep taxes low on investment. Investment really does stimulate the economy and create wealth. However, it's kind of ridiculous to give the Walton family or Paris Hilton a huge discount on taxes just because their daddy created a big company. The true growth and creation of wealth comes from the creation and growth of small businesses, something that has, unfortunately, only seems to get harder and harder (as if it weren't hard enough to begin with).
Our current tax code is broken - at least as broken as it was before Reagan's tax simplification (an amazing and unambiguously good accomplishment, even if you have a lot of other problems with the man's presidency). At the very minimum, it's badly in need of another round of simplification. The current president was hinting at such a thing shortly after his reelection. If he'd pressed forward with it, his party might have had much better results in the recent midterm elections. Alas, the system is largely in the hands of big businesses right now, and is unlikely to change soon.
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