Recent discussion of the "Buffett Rule" proposal, which would increase taxes on the wealthy, has focused attention on U. S. tax rates. It gives Americans a chance to better understand our tax policies. The plain truth: The more money you make, the more tax you pay.
My intention in this column is not to make a political point. My intention is to dispel a myth that the tax code favors the rich; hence, why try to better yourself? One destructive conclusion stemming from such a belief is to equate the tax code with capitalism, which is comparing apples to lemons.
Mitt Romney, the probable Republican Presidential candidate, came under attack from both Democrats and other Republican primary candidates for his high income and net worth and his low overall tax rate. The arguments are that Romney made his money by the wrong type of capitalism and that he pays too little in federal taxes.
The tax returns Romney has made public show most of his money comes from investment returns on his holdings rather than from wages or a salary. His overall tax rate in 2010 was 13.9% and his estimated rate for 2011 is 15.4%. This caused a predictable outcry that his tax rate is lower than the income tax bracket of many middle class Americans.
President Barack Obama's 2011 tax return shows a tax rate of just over 20%. Former Republican candidate Newt Gingrich paid 31% of his 2010 income in federal taxes.
To the uninformed, these varying tax rates initially look unfair. What many people don't understand is the big difference between "ordinary income" (from wages, a salary, short-term capital gains, and interest) and "passive income" (from stock dividends and long-term capital gains). The federal government taxes ordinary income at up to 35% and passive income at 15%.
Why the different rates?
First, let’s look at dividend income and long-term capital gains taxes. Dividends come from corporations that must first pay income taxes on any profits. Long-term capital gains come from shares of a company purchased and held for more than 12 months.
Since the effective corporate rate is 39.2% (the top federal rate and the average state tax rate), the corporation has already paid taxes on all income, including what is paid out to investors as dividends. Prior to the Bush tax cuts in 2001, dividends were taxed at almost 40%. This meant every dollar of dividend income was taxed twice, once at the corporate level and again at the individual level. The result was that 60 cents out of every dollar of profit made by a company was paid to the federal government. The Bush tax cuts continued the practice of double taxation, but lowered the amount paid at the individual level to 15%.
The same double taxation applied to long-term capital gains, except that the tax rate was a flat 28% before the Bush tax cuts reduced it to 15%.
This double tax makes it seem that the wealthy pay less tax than they really do. An individual may pay 15% on passive income of, say, $5 million. Yet corporations have already paid taxes of around 39.2% on that same income, for a total tax rate of 54.2%. Of the $5 million in profit, over $2.5 million goes to Uncle Sam. That would seem to be more than a "fair share."
According to Congressional Budget Office figures from 2011, the top 1% of taxpayers pay an average of 29.5%, those in the income percentiles from 81% to 99% pay 22.8%, those from 21% through 80% pay 15.1%, and the bottom 20% pay 4.7%. Those numbers, of course, don't include the 49.5% of Americans who pay no federal income tax at all.
Even factoring in the different tax rates on ordinary and passive income, it's clear that the more money Americans earn, the more taxes they pay. What could be more fair than that?
Rick Kahler, CFP, is president of Kahler Financial Group in Rapid City, S.D.
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