Sunday, October 17, 2010

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.


  1. The problem with taxing capital gains is that a) it discourages saving and investment and b) it's double taxation, as the interest derives from previous income that has already been taxed. Taxing capital gains is basically taxing people in the future to finance consumption by people in the present.

  2. Bullsqueeze.

    First: those making higher incomes are not necessarily harder working. In my career, the time period when I made the most, my work was the easiest and by far the most rewarding. I have known several nepotists where the kids had the nice cushy "job" that they never showed up for. And, having worked with drillers and construction workers, I can say without doubt that some of the worst paid people work the hardest.

    Second: The people are taxed the same. The money is taxed differently. Warren Buffet pays the same taxes on the first $80,000 as the guy who only makes $80,000. No matter who you are, you face the same tax laws. Its progressive taxation of income, not of people.

    Third: As to disincentivizing people: WANH. If you are worried about the marginal tax rate in going from $240k to $270k, then wanh. You have more than enough money to clothe, feed, house, insure, and entertain yourself and a family. There are many people working their asses off who aren't to that point. You are working to win a game, to compensate for a small penis or something. And I'm all out of giveashits for you whiny punks.

  3. Andrew - I have heard those arguments before, but I think that if you implement a structure with 0% tax on the first $50K in capital gains, then it will not discourage savings and investment for 99.9% of Americans. Also, the "double taxation" aspect seems very lacking in the cases that I identified above with no taxes on munis or sheltered real estate.

    As for your last statement that taxing capital gains is taxing people in the future to support consumption today, that seems like it would be more appropriate to apply to debt taken out by the government. Otherwise, how is a capital gains tax today taxing people in the future?

  4. 7:27 -
    Sure, there are some people who get their high income through nepotism or some other un-worked-for way. However, in my experience, those situations rarely last. In general, people who work hard and invest in themselves in a smart way (which is really just leveraging past hard work) usually end up making more in the long run.

    Second, it's true that you face the same tax laws, but what if the tax laws caped income made by lawyers at 15% while others had to pay up to 35%? That would not seem equitable. My point above is that the "rich" earn their money in a way that is taxed at most at 15% - while you are taxed much more. That does not seem fair.

    Third, I feel your apathy. Why should we be concerned? Personally, I feel like we should have some interest in how the country works and how we want to go in the future. The tax code does indeed shape public behavior. Changes in home ownership, charitable donation, real estate ownership, etc., are all influenced by the tax code. I think that we should be concerned about what kind of message we are sending.

    I also am an "emperor's got no clothes" kind of guy. Consequently, when I see a policy that does not fulfill the purpose that it was supposedly written for (raising taxes on the "rich") it makes me want to address it and question whether it should be re-adusted to be more in line with our supposed motiviation. I think that it is a little sad that many people in America do not question - that they mindlessly accept as sheep whatever is imposed in them. Even more offensively, when people dare to question the status quo, some feel like they should be smacked down with ad hominem attacks - and by speculating as to the size of their genitals no less (a true giveaway as to their mental level.)

    The Baby Boomers that epitomized the "don't question government" and "you have enough, just shut up and let government do whatever it wants, even if the reason it give is false" have left our contry in a terrible, terrible mess. Too many years of unsupervised government doing whatever it wants to spend taxpayer dollars - and take on new debt - to keep themselves in office. Too many years of programs and expenses advanced under false premises. Enough of the lies. Question - and question again. When a tax policy is not doing what it says it should be doing - it should be questioned. Stand up for our country - or I guess you could just go back to talking about genitalia. Your choice.

  5. Managing Partner:

    1) I wasn't arguing that income is never earned. I was arguing that income (wealth as well) is not always earned. I might have also used the examples of Hollywood starlets who won a genetic lottery versus police officers who actually contribute to society, or professional athletes versus engineers. My point is that wealth or income is not equivalent nor even corollary to merit, which is an underlying sentiment in the "please don't tax us rich people" argument.

    2) I personally agree with you that investment income should be taxed like any other income, perhaps even moreso as I don't feel like investing is an "earning" profession.

    3) I am concerned about our society. I am concerned about the growing income and wealth disparities as well as the outsourcing done solely to benefit the owner class and how these factors will adversely affect the rest of us. I simply have no sympathy left for people like Ben Stein with all of his poor me whining.

    4) I think your "emperor has no clothes" argument fails in that, prior to Reagan, high tax rates on higher income (rates that approached 90% after WWII) still allowed for the US to boom through the 50s, to pay for the space and the arms races in the 60s and 70s, and for our government's debt to be less than $1 trillion at the end of the Carter administration. Cutting taxes on the wealthy under Reagan cut tax receipts by a massive amount, such that the debt doubled in 8 years. And what did we get for our "hey, we'll take out a big government loan if you guys will invest in the economy and make it grow" deal? Hundreds of thousands of jobs shipped to Thailand, Taiwan, Indonesia, etc. They took the big chunk of tax relief and used it to fund the destruction of the American manufacturing base and middle class. There's your naked emperor.

    5) I think you are largely right, but not quite, regarding the baby boomers. More than lack of questioning, I think lack of responsibility has led us to where we are. We are being run by a generation that thinks you can get something for nothing. As long as they think that their taxes are low, lots of people won't care what the government is doing. And of course there is the whole "oooh, we gotta bomb (insert mustachioed or pineapple faced bad guy name), or else he'll KEEEEEELLLL you" meme expoited so well by a large part of our political class.

    6) As to the government "doing whatever it wants to spend taxpayer dollars - and take on new debt - to keep themselves in office" - which part bothers you the most? Is it the part where the government gives money to keep children fed, to provide a minimalist basic education, to provide some basic healthcare in order to buy votes? Or is it the part where the politicians give money to corporations and contractors to build things that go boom and to provide thugs to bully Iraqis to the point that they get thrown out of the country by a 5th rate "government"?

  6. Hi 12:43!
    1) I agree - not all income is always earned. However, it seems like you are saying that income has no correlation to work - which I have to disagree with. The correlation is not exact, but generally people that work harder make more. I agree that it's sometimes tough to tell this on the border cases like actors. However, if you have two police officers and one works overtime, then that one will likely earn more. If you have two office workers and one works harder, then that one is more likely to get the promotion. In our career, the equation is very direct. If we bill more hours, then we are compensated more.

    2) Cool. However, just to be clear, I proposed the taxation of capital gains so that the statements about "raising the taxes on the rich" would be more accurate. There have been many economists and people of both political parties that have found that a consumption-based taxed is more growth-friendly than our current income-based tax. I think that should at least be explored.

    3) I'm glad to hear it! I'm concerned about income disparity, too, but I think that it is a symptom of an even larger problem. Accumulation of wealth seems like it is based more on personal choices.

    4) It seems like you missed my point - those high tax rates were not really being paid by the "rich". Instead, the rich were earning their income from investments - mostly real estate. They paid capital gains, not ordinary income. IN fact, if you actually look at what Regan did with the 1986 tax reform act, he really socked it to the rich!

    He went after real-estate sheltering big time. Did you know that pre-1986 you could shelter earned income directly with real estate depreciation? Thus, if you have a high salary, you just bought real estate until you have enough depreciation that you pay zero taxes. Regan ended that - in fact, he ended it so harshly that it brought on the S&L crisis as everyone wanted to sell their real estate.

    Again, this is my primary point - you have to stop looking at ordinary income and thinking that those rates apply to the "rich" - the "rich simply don't generate income that is taxed under that part of the tax code.

    5) Amen.

    6) Good, but broad, question. Really three questions rolled into one. First, should we take on debt to pay for current, recurring spending - I don't think that we should. We have an obligation to pass to our children an economy and country that are at least as fiscally healthy as we got them. Second, should any taxpayer dollars be spent to keep politicians in office - absolutely not. It disgusts me that both political parties take hundreds of millions of taxpayer dollars to fund their candidates and conventions. Third, what should we spend our taxpayer dollars on? What would you eliminate? That's a big, complicated question, and I have a lot to say - too much for here. However, I think that there are very significant cutting and restructuring possibilities without significnatly impacting our delivery of our core services. Unfortunately, it's difficult to even have this conversation in today's politically charged world- where politicians are more interested in the next sound bite and keeping themselves in office as opposed to doing what is best for the country. Personally, I applaud Jon Stewart's Rally To Restore Sanity - I wish I could make it!

  7. 1) No, I am not saying that there is no correlation, just that the CEO of Goldman Sachs, the VP for public affairs of WB, etc. don't work that much harder than I do nor many people that I know. And yet, in our system, these people are paid more in a day than most Americans are paid in a year. I'm not saying that there isn't a correlation to work, I'm saying that the system is skewed and rigged.

    2) Again, I agree with raising capital gains taxes. I am hesitant regarding consumption taxes. To be perfectly honest, the comparison is beyond my knowledge of economics, so I have to fall back on other analyses. Primarily, I know a local radio talk show host who is a major backer and fan of the fairtax. I know that this guy is working against my interests most of the time, so I assume he is doing so here as well.

    3) Accumulation of wealth is a result of personal choices . . . . to a point. What personal choices did Paris Hilton make that helped her accumulate her wealth? Sam Walton's kids? Elizabeth Hurley? Shaquille O'Niell? Which of these folks made personal decisions which had more to do with their accumulation of wealth than did winning the genetic lottery? My argument is that the truth lies somewhere in the middle, perhaps leaning a bit to luck.

    4) I'd have to go back and check, but didn't Reagan also lower capital gains taxes? As above, I understand your point about taxing wealth and am in favor of it and of restoring the estate tax to 1970s levels.

    5 and 6) I wish I could make it there, too. I'll raise a beer for you.

  8. Hi 2:05

    1) Yes, there is certainly some skew and there are extreme cases, but there is a substantial correlation for most people that working harder leads to higher income.

    2) OK.

    3) Sam Walton's kids did not accumulate the wealth - they just had it bestowed on them. Also, these are extreme cases. I'm thinking more along the lines that the person that chooses not to buy the big expensive TV and cell phone plan is going to accumulate more wealth than the guy in the cubicle next door who does buy them. Sure, there are people that make so little that accumulation of wealth is impossible, but for the average household income, the accumulation of wealth represents a decision to save rather than a decision to spend.

    4) Capitol gains taxes went from 28% under Carter to 20% during Reagan's first term, but were then raised back to 28% during his second term.

    5) and 6) Thanks!

  9. Here's an example of a problem with the capital gains tax. Suppose you bought a stock in 1960 for $100 and sold it in 2010 for $150. The taxman would say you had a $50 capital gain. However, considering inflation you actually lost a bundle of money in real terms. So you can be taxed on essentially non-existant income.

  10. To anonymous:

    No one said that investing was a win/win proposition. It's a risk you take, according to the people who manage my 401k.

  11. 11:43 - I agree that in your example the investment has not kept up with inflation and consequently has "lost money." However, I will compare your example with the situation where someone puts $100 away in a drawer in 1960 and takes it out in 2010. That person has gotten zero gain and has "lost" a lot more money due to inflation. Compared to the $100 in the drawer, your $150 has indeed experienced a "gain" in that it is worth considerably more in 2010 - still less than the original $100 was in 1960, but 50% more than the $100 bill in the drawer. However, your point is well-taken that in real dollar terms, the person still has a loss in both situations.

    In a larger sense, though, it seems like you are just proposing that it would be more fair if the tax system taxed your long term capital gain on the increase relative to inflation vs. the increase relative to your initial investment. An alternate way of thinking of this would be that your basis in the stock (typically purchase price) would be adjusted upward based on inflation. That's a novel proposition that would require further thought. It would seem like it would decrease tax revenues in the short term. However, in the long term it might lead to greater desire to invest.

    One thing to consider is whether the current tax system already takes this into account. For example, why have both a short-term and a long-term capital gains rate (especially a long-term rate that is lower). Once reason for the lower long-term rate may already be to induce people to invest in the US for the longer term.