Unjust Tax Code

Posted on June 24, 2011

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Republican or Democrat, the U.S. tax code is unjust and favors the wealthy!  I remember a few years ago Warren Buffett offered $1 million to anyone who could find a secretary who pays lower tax rate than he does.  That’s right, Warren Buffett, who’s estimated worth is around $50 billion, and a secretary, a position that pays probably an average of $40,000/year.  Why would Warren Buffett offer such a challenge?  Because he too believes the U.S. tax code unjustly favors the wealthy, like himself!   

To remove any misunderstanding from the beginning, consistent with fiscal conservatives, I believe government should be much, much smaller and taxes in general should be lower across the board.  Additionally, I believe the tax code should be significantly simplified to enhance tax compliance and reduce tax regulation costs. That being said, despite America having arguably the most progressive tax code among other nations, the wealthy in America pay a disproportionate share of their income in annual income taxes relative to those less fortunate.

Progressive Taxes is a Good, Just Method

Viewpoints ranging from Adam Smith to Karl Marx agree that a progressive tax code is a good, just method.  Additionally, 81% of U.S. economists support progressive taxation.  The overall basis for a progressive tax code is the idea that wealthy individuals have a disproportionate ability to become wealthier than the average taxpayer.  Although there are arguments why a progressive tax system is not appropriate, below are a few reasons supporting a progressive tax system:

1)      The wealthy have economies of scale on their side.  The more money invested, the higher its rate of return.

2)      The average living expenses (e.g., food, housing, transportation, etc.) of the not-so-wealthy is a greater percentage of their annual income than it is for the wealthy.  In other words, the wealthy have a much higher percentage of disposable income than the not-so-wealthy.

3)      The rights and freedoms that the government is supposed to protect disproportionately benefit the wealthy as they have more assets or income to protect.

Overall, I strongly believe that a progressive tax system is effective and just.  I have no problem paying a higher percentage of my income in income taxes than some friends and family who do not make as much money.  However, although we claim to have a progressive tax code in the United States, it is not progressive for the majority of the wealthy. 

Why is this you may ask?  Don’t we have tax brackets in which the marginal tax rate gets larger as income rises?  The problem is that the progressive tax rates that we see in the IRS tax tables only apply to ordinary income as opposed to investment income.  This means the progressive tax rates are applicable to income we make as employees, not to income from investment activities.

How the Wealthy Pay Lower Tax Rates

Think of the wealthiest person you know.  What is the source of their annual income?  It shouldn’t be a surprise to you, but most wealthy people do not earn their annual income through employment.  Most wealthy people earn their annual living from their significant investments and other assets.

Those of us who earn substantially all of our annual income from employment, we pay our taxes based on the following tax table (assuming married filing jointly):

Marginal Tax Rate

Married Filing Jointly

10%

$0 – $16,750

15%

$16,751 – $68,000

25%

$68,001 – $137,300

28%

$137,301 – $209,250

33%

$209,251 – $373,650

35%

$373,651+

 

The wealthy who earn substantially all of their income from investment income (also known as long-term capital income when investments held > 1 year) pay only 15% in income taxes and only when they sell their investments.  Below are a few examples to illustrate this point a little better.

Example 1: A secretary who has employment income of $40,000 pays $5,162 in annual federal income taxes (assuming no deductions or credits for simplicity), or approximately 13%.

Example 2: An attorney who has employment income of $500,000 pays $145,308 in annual federal income taxes (assuming no deductions or credits for simplicity), or approximately 29%.

Example 3: A billionaire whose net worth increased by $500 million on unrealized gains on investments and whose realized gains were $100 million pays $15 million in federal income taxes, or 15% of total realized gains. 
If we truly believe that a pure progressive tax code is appropriate and fair, as I believe it is, the way it is currently being implemented in the United States promotes fiscal injustice!  How can anyone argue that it is fair for a highly paid employee, such as the attorney in Example 2 above, to pay 29% in federal income taxes and for a billionaire who earns $100 million in realized gains to pay only 15%?  This is precisely the point Warren Buffet was making when he issued his tax rate challenge.

What is the problem?

Look, if we are going to implement a progressive tax system, it must be truly progressive to be fair.  The problem is that our ordinary tax rates are progressive but capital gains rates on investment income are proportionately progressive.  As a result, relative to the average taxpayer, the wealthy are paying significantly less taxes as a percentage of taxable income.  Effectively, there is a glass ceiling for the average American to achieve the “American Dream” due to an unjust tax code.

How to Fix the Problem

I believe mainstream Democratic and Republican tax platforms are wrong!  

Democrats want to increase both the ordinary income tax rates (those rates in the above table) and the capital gains rate to support their big government.  The problem with this is that those who earn their income through employment, regardless of how much they make, end up paying even higher tax rates than the already high rates they are paying.  Further, simply by increasing the capital gains rate from say 15% to 25% does not fix the fiscal injustice gap (compare 25% paid by the billionaire to the marginal 40% rate (under a possible ordinary tax rate increase) of the attorney. 

Republicans, on the other hand, typically argue for lower ordinary income tax rates and maintaining the capital gains rate at 15%.  Once again, the problem with this scenario is that the fiscal injustice gap remains: compare the 15% paid by the billionaire to the27% marginal tax rate of the attorney.

I don’t pretend to have the perfect answer, but the capital gains tax rate needs to be somewhat proportionately progressive as well in order to fix the fiscal injustice gap between ordinary income and investment income.  An off-the-top-of-my-head example would be to effectively lower ordinary income tax rates and progressively expand the long-term capital gains rate (see the below two tables).

Ordinary Income

Marginal Tax Rate

Married Filing Jointly

10%

$0 – $16,750

12%

$16,751 – $68,000

15%

$68,001 – $137,300

18%

$137,301 – $209,250

22%

$209,251 – $373,650

27%

$373,651+

 

Long-term Capital Gains

Marginal Tax Rate

Realized Gains

10%

$0 – $250,000

15%

$250,001 – $500,000

25%

$500,001 – $1,000,000

30%

$1,000,001 +

 

If a scenario like this were implemented, the fiscal injustice gap would effectively be closed and the three examples I presented above would result in the following:

Example 1: A secretary who has employment income of $40,000 pays $4,465 in annual federal income taxes (assuming no deductions or credits for simplicity), or approximately 11%.

Example 2: An attorney who has employment income of $500,000 pays $101,454 in annual federal income taxes (assuming no deductions or credits for simplicity), or approximately 20%.

Example 3: A billionaire whose net worth increased by $500 million on unrealized gains on investments and whose realized gains were $100 million pays $29.8 million in federal income taxes, or approximately 30% of total realized gains. 

Why the Problem Has Not Been Fixed

My proposed solution is not rocket science.  So why hasn’t a similar plan been implemented?  In short, it’s politics.  Republicans and Democrats are similar in this one fact – it takes significant sums of money to get elected, unless of course you have a grass-roots movement like the Tea Party backing you.  Who do these significant sums of money come from?  The wealthy of course!  It’s not guys like Joe the Plumber who are donating $10,000 to a particular candidate; it’s the billionaire or millionaire who makes millions each year on investment income.

To effectively implement a just tax system, we’re going to need a strong Tea Party-like movement to force our representatives, both Democrats and Republicans  alike, to get out of the deep pockets of wealthy donors and realize that the wealthy voter’s vote does not count any more than the vote of any other American.

 

 

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Posted in: republican