Taxing the "Rich"

In previous posts, I described our federal taxes as taxing the "hardest workers more".  It seems that some people disagree and prefer to characterize the increasing federal income tax rates as higher taxes on the "rich".  However, that's not right by a long shot.  It seems like there is a fundamental misunderstanding of both what constitutes "rich" and how the tax code works to tax income from people that are "rich."  As I will show below, the federal income tax really hits hardest on those with high salary incomes (the hardest workers) rather than the rich (those with high assets).

1) "Rich" refers to net assets, not income
First, "rich" is a measure of total assets (also known as wealth or net worth), not of income.  However, our tax code taxes INCOME, not WEALTH.  For example, if someone has $100 million in assets, but has no taxable income, then they pay zero tax (this actually happens pretty frequently - see below).  Our tax rates do not even take wealth into account, so saying that the higher tax rates "tax the rich more" makes no sense.

In a larger sense, what is "rich"?  People have many different ideas of what number constitutes "rich" - ranging from $1M to $10M.  However, a compromise definition would be that you are "rich" when you have sufficient assets so that the return on the assets is enough to provide for your lifestyle without having to work.  In practice, this number would be between $2M-$4M in most parts of the country.  That's enough to produce $80-$160K/year in income from investments.  (However, many people probably would not consider them as "rich" unless their investments could produce $1M/year - which would require about $25M in assets.)

2) The "rich" pay capital gains, not ordinary income
Consequently, I would respectfully submit that most people who are "rich" make the bulk of their income through investments rather than salary.  Whether the money made by the "rich" is made as salary or investment income is very important because our tax code treats it very differently.  For example, in 2010, the top long-term capital gains rate was 15% while the top earned income rate was 35%.

That means that if you have an attorney billing 80 hours/week for a year, then their salary based on their work may be taxed up to 35%.  However, if you have a "rich" multi-millionaire making $10M in the stock market, then their earning is only taxed up to 15%.  To put it another way, the tax on earned income is more than double the tax on capitol gains, which is the predominant way that "rich" people earn their income.  Consequently, raising the ordinary income tax rates to "tax the rich more" makes no sense because the rich typically don't earn the bulk of their money that way.

To put it another way, the $10M in capital gains is taxed at the same rate (15%) as a single person making $8,351– $33,950.  That rate does not increase as the person making the $10M gets "richer".  However, the rate that that single person gets taxed with for his income is certainly going to go up if he starts working harder by any of  a) working overtime, b) getting increased training to provide additional value, c) getting a second job, etc.

That is, our tax structure is going to tax him more for working harder - it is not going to tax the "rich" person any more, regardless of how much more the rich person earns!  We tax harder workers more, instead of taxing the "rich" more.

3) Interest On Municipal Bonds
It gets even better - interest on qualifying municipal bonds is not taxed at the federal level.  That means that a rich person can have $10M in earned interest from municipal bonds in a single year and they will not have to pay any federal income taxes.  None.  Zip.  Zero.  On the other hand, all income from working people will be taxed - and the tax will be higher as working income increases with additional work.

4) Income From Real Estate Sheltered By Depreciation
Here's another one - when you buy real estate, our tax code allows you to depreciate the real estate over 27.5 years for residential and 40 years for commercial.  What that means is that if you buy a $1M apartment building which has a land value of $200K and a building value of $800K, then every year you can take $29K in untaxed income out of the apartment building ($800K/27.5).  That's after all expenses are paid.  As a more detailed example, suppose that your total rents are $100K/year and the mortgage and all other expenses associated with the property at $70K for the year.  Of the remaining $30K, $29K would be sheltered by depreciation and you would only have to pay taxes on the $1K.  Seriously.

Many people who are rich know that they can control their total taxes by buying additional properties or by re-mortgaging.  For example, if you are starting to pay down the mortgage such that the cash from the initial property is starting to exceed the depreciation, then you can do either of two things.  First, take a second mortgage on the first property - for example, take out another $200K.  That will increase your mortgage expense so that your free cash no longer exceeds the depreciation.  The $200K can either be used to live on or to buy more property.  Alternatively, the person could just buy another property outright.

Thus, between the 0% tax rate on municipal bonds, the frequently 0% tax rate on real estate, and the "worst case scenario" tax rate of 15% on capitol gains, the "rich" who live primarily on investment income pay far, far less in taxes than the hardest workers - those who have a high salary income which is subject to 33% or 35% taxation.  (This is all without doing anything fancy like foreign corporations with retained earnings and is completely above board.) Additionally, raising the marginal tax rates on salary income completely misses the objective of "taxing the rich more".  If someone really wanted to "tax the rich more", then they should look at muni's, real estate and capital gains.

For example, one might believe that everyone's labor should be taxed the same and that we should not disincentivize people from working harder.  Consequently, one might be in favor of a flat tax on income.  However, one might recognize that the "rich" who live on investment income typically do not have the bulk of their income as salary.  Consequently, one might wish to implement a progressive taxation of investment income.  For example, the first $25K of investment income is at a capital gains rate of 15%, then the tax level rises at higher earning levels.  If one really wanted to sock it to the rich, then taxing investment income over $500K/year at a 50% rate would really do it.  That's how you really raise taxes on the rich - and it's a huge up from the current rate of 15% (if that).

Additionally, one would have to take a look at the lack of muni taxation and maybe give the first $50K/year the 0% rate, but after that include muni earnings as capital gains.  Similarly with depreciation from real estate - $50K/year in free cash flow and the remainder as capital gains.  That would close off those avenues as significant sources of tax planning for the "rich" while still allowing them for most investors.

I hope that it is now apparent that our current tax structure is laughably mis-focused.  They say that they want to tax the "rich", but instead they are only shooting themselves in the foot by really taxing work at top rates and disincentivizing workers from working more.  It's kind of ironic how the "rich" who make the bulk of their income from investments offered up the hardest working people (who make the bulk of their income from work) as targets for rage against the "rich".  Our current federal income taxes tax the hardest workers - not the rich - the most.