There is so much heat and so little light in the debate over how to avoid the “fiscal cliff.” I recently watched a Sunday morning news show in which the anchor played footage showing Speaker Boehner saying that tax rates should not be raised, and then watched her pose the non sequitur to her panelists, “Why is it do you think that the Republicans are so opposed to raising revenues?” Nobody batted an eye. (Hint: For those of you skimming this, marginal tax rates are not taxes and taxes are not marginal tax rates.)
Some Tea Party congressmen reiterate their pledge to not raise taxes, yet talk about broadening the tax code, which would … raise taxes. On another front, economist turned leftist political journalist Paul Krugman agrees with the CBO that failure of Congress to prevent the pending tax increase and spending cuts scheduled to happen January 1, 2013, will change GDP growth of 2.5% next year to a 2.3% shrinkage, yet blithely juxtaposes his assertion that a sizeable tax increase on only those with an AGI of $250k or more will have no effect. How is that possible when this group represents 1.9% of all tax returns filed – yet represents 22.9% of all AGI and pays 45.6% of all income taxes today?
Finally, let me shine some light on just a little piece of this debate. I spent a recent weekend pushing through the tax code to examine an assertion made popular last spring, and culminating in the “Buffet discussion,” that the “rich” don’t pay their fair share of taxes because too much of their income comes from dividends and capital gains, which are taxed at rates (15%) that are currently much lower than wages.
Given:
- The fiscal gap should be closed with some revenue increase from taxes.
- The upcoming automatic reversion to pre-2003 tax rates would increase taxes and, according to all estimates, put the U.S. into a recession.
- A good strategy is to raise taxes only on the wealthy (actually high income earners, possibly $250k of “income”), because this group has not paid its “fair share,” especially the Buffet-like taxpayers who benefit from low 15% long-term capital gain and dividend marginal tax rates. There will supposedly be no economic effect because they will not spend less and their decreased savings will have no impact on investments or the economy.
The issue has had mountains of words written and spoken on it. We peer over the “fiscal cliff” and the possibility that our legislators and President will actually address the problem at least temporarily and surely with band-aids, since there is no time to rewrite and agree to a change in our entire tax code. I’d like to address, from the point of an informed economics and tax layperson, the fairness and economic impact of the pending change in capital gains and dividend tax rates compared to wages. I’d like to share fact, rather than bluster, emotion and illogical reasoning.
First, the let’s look at the 2012 tax structure from the perspective of Wally Wage Earner and Isabelle Investor. Wally makes $40k a year in wages and his family has the average 2010 IRS statistical proportion of deductions and credits. After payroll ($2,260) and federal income taxes ($2,410), he spends it all and can save nothing. I’m ignoring state income taxes. Corporations pay income taxes in the U.S. Most of what he spends is produced and provided by corporations with average before-tax profits of 7% and 20% average tax rates on profits. That results in an implicit tax of 1.42% ($502) buried in his purchases. What is the real total federal tax rate on his income? Ignoring Social Security – which is supposed to be a government-sponsored, participant-funded pension, not an entitlement or income redistribution program – his real total federal tax rate is the sum of those ($2,912) divided by his wages plus the invisible corporate taxes buried in his purchases and would otherwise be in his pocket via cheaper purchases ($40,502, or 7.2%). If you don’t like assumption on payroll tax and view your retirement as a universal entitlement which should be progressively financed according to ability to pay, like welfare programs, defense spending, and other general welfare items, then the total rate is $8,232/$43,562 or 18.9%. This accounts for both the employee AND the employer contribution to FICA, which arguably Wally is earning and would have in cash were the employer not required to contribute, hence a hidden tax of $3,060.
Isabelle is one of the many individuals who have supposedly not been paying their fair share because of low marginal investment income rates. She reaps $1 million a year in long-term capital gains and dividend income, with no wages and therefore no Social Security FICA. Nevertheless, those alone generate a $127,500 FIT bill under current law. There would be no AMT. Still that’s only a 12.75% tax rate, correct? No.
All of Isabelle’s dividends and long-term gains (LTG) come from after-tax profits of corporations which pay taxes at the highest marginal rate in the developed world. The actual rate paid by U.S. corporations averages about 20% currently, which equates to a 25% tax on the average for every dividend and long-term gain ($1.25 pretax corporate profits times 20% tax rate = $.25, leaving $1 to distribute). In other words, the income is taxed twice, once at the corporate level and once at the individual level. That’s an extra $250k of buried taxes on her investments, which otherwise would flow to her. Assume she spends $400k per year and saves the rest, so she also has the hidden tax in her spending ($5,680) for a total of $383,180 against wages, and invisible taxes of $1,255,690. This leaves her with an effective tax rate of 30.5%, more than four times the rate Wally is paying without FICA and 11.6% more than Wally is paying with FICA.
Is that a fair share or not? It’s up to your judgment, but the point is that the assertion wealthy investors are not paying their proportionate share or that their total income tax rate is lower than the low wage earner is flatly false. Now, if some of the long-term gain does not come from a corporation or a taxable entity (real estate, etc.), would that lower the effective rate for Isabelle? Sure, but the result would typically still be the same. The bottom line is that a 15% rate for LTG and dividends does a pretty efficient job of equalizing wage earners and investor marginal rates. Suppose Isabelle were Wage Earner Isabelle or Interest Income Isabelle. Her effective FIT rate alone would be 31.8%. Compare that to Isabelle Investor’s FIT plus hidden Investment income and dividend tax rate of ($127,500 + $250,000) divided by $1,250,000 (27%). What tax rate on dividends and LTG would get the total effective rate to 31.8%? About 2.3% higher than the current 15%, or 17.3%.
Isabelle is one of the many individuals who have supposedly not been paying their fair share because of low marginal investment income rates. She reaps $1 million a year in long-term capital gains and dividend income, with no wages and therefore no Social Security FICA. Nevertheless, those alone generate a $127,500 FIT bill under current law. There would be no AMT. Still that’s only a 12.75% tax rate, correct? No.
All of Isabelle’s dividends and long-term gains (LTG) come from after-tax profits of corporations which pay taxes at the highest marginal rate in the developed world. The actual rate paid by U.S. corporations averages about 20% currently, which equates to a 25% tax on the average for every dividend and long-term gain ($1.25 pretax corporate profits times 20% tax rate = $.25, leaving $1 to distribute). In other words, the income is taxed twice, once at the corporate level and once at the individual level. That’s an extra $250k of buried taxes on her investments, which otherwise would flow to her. Assume she spends $400k per year and saves the rest, so she also has the hidden tax in her spending ($5,680) for a total of $383,180 against wages, and invisible taxes of $1,255,690. This leaves her with an effective tax rate of 30.5%, more than four times the rate Wally is paying without FICA and 11.6% more than Wally is paying with FICA.
Is that a fair share or not? It’s up to your judgment, but the point is that the assertion wealthy investors are not paying their proportionate share or that their total income tax rate is lower than the low wage earner is flatly false. Now, if some of the long-term gain does not come from a corporation or a taxable entity (real estate, etc.), would that lower the effective rate for Isabelle? Sure, but the result would typically still be the same. The bottom line is that a 15% rate for LTG and dividends does a pretty efficient job of equalizing wage earners and investor marginal rates. Suppose Isabelle were Wage Earner Isabelle or Interest Income Isabelle. Her effective FIT rate alone would be 31.8%. Compare that to Isabelle Investor’s FIT plus hidden Investment income and dividend tax rate of ($127,500 + $250,000) divided by $1,250,000 (27%). What tax rate on dividends and LTG would get the total effective rate to 31.8%? About 2.3% higher than the current 15%, or 17.3%.
Absent action from Congress, tax rates rocket up in January of 2013. Wally is not exempt from the effects. Payroll taxes rise $800 to $3,060 and his federal income taxes rise $870 to $3,280, thanks to a rise in the very lowest tax bracket rate from 10% to 15%. Wally will have $1,670 less to spend, so his hidden tax in purchases will decline by $24. His real total federal tax rate leaving out FICA rises 2.1% to 9.3%. With FICA it rises 3.8% to 22.7%. The effect on the economy from Wally’s vanished spending? Minus 4.7% times whatever economic multiplier occurs throughout the economy. That’s pretty deflating to GDP.
Isabelle gets the hammer January 1. Her FIT rises $126,063 to $253,563. This comes from three sources: higher marginal rates in the first tier and the last tier (above $388,350 goes from 35% to 39.6%), her deductions get a $20,020 haircut, dividends get taxed at these ordinary income rates instead of 15%, LTG rises from 15% to 20%, and a new Obamacare surtax on income earners above $250k goes into effect ($28,500). Her hidden tax in her investment income at the corporate level stays the same, ignoring the short-term damage done to corporate profits and dividends. Assume her spending and savings each reduce proportionately (14.45%). Due to the spending drop, the hidden tax in purchases drops $821. Total taxes are $508,422 against wages, and invisible taxes of $1,254,859 – an increase in the effective tax of 10% to 40.5%. It’s hard to imagine this 14.45% drop in spending and also in private investment would not impact the economy negatively.
Is the “real” tax rate fair? Should it be made more progressive? Should we just let the cliff occur (CBO now says that despite short-term recession and more unemployment, we would be better off long term because of the tax increases and spending reductions)? Should we reform the whole tax system? These are the issues that face the American people. Perhaps with this information you’ll feel more informed in dealing with your clients and more understanding of their situations. Good luck.