Our current tax system is slanted in favor of the super-rich.
That’s the basic judgment that Warren Buffett made when he recently pushed to make billionaires pay a tax rate similar to their secretaries. To understand why Warren Buffett is right you need to understand the role of the capital gains tax. It is reason # 2 for repealing the Bush Tax Cuts.
We treat different forms of income differently in our tax code. A basic distinction is that between ‘ordinary income’ and income from ‘capital gains’. Broadly defined, ordinary income is income from work; a capital gain is income that is received from profits on wealth. In other words, you gain from capital when the value of an investment (i.e. mutual funds, bonds, stocks, options, real estate, and collectibles) increases above the price at which you bought it.
One of the major trends in our tax code over the last three decades is the shift from relying on taxing wealth to taxing work. Changes in the capital gains tax has been one of the drivers of that trend. Here are three ways its happened:
1) We have reduced the Capital Gains Tax rate. From rates over 30% in 1970s we, we reduced it to 15% in the Bush Tax Cuts.
2) We began taxing qualified dividends at the capital gains rate. The Bush Tax Cuts dropped from them from a 35% top rate to 15%. (Okay, what the %#!@ does that mean? Dividends are payments made to a corporation’s shareholders, essentially, distributing its earnings to the owners of the stock. Qualified dividends are those that meet criteria related how long you’ve held the stock and how the corporation is related to the U.S.)
3) We redistributed our national income upward. From 1979 to 2007, the annual incomes of the middle 60% of American households increased 38% while the annual income of the top 1% of households increased 277%.
Over the same time, the average tax rates of the top 1% have dropped from 37% to 29.5%. For the top 400 households it dropped from 26.4% to 16.6%.
In other words, more & more of our national income went to those who paid less & less in taxes.
At the heart of these increased incomes and decreased rate are capital gains. Getting capital gains is an elite activity: 80% of capital gains income over the past 30 years has gone the top 5%. About half of all capital gains have gone to the top one-tenth of 1%.
Given the overwhelming consolidation of these gains at the top; the tax pay outs are also consolidated at the top. In 2011, 75.1% of the benefit of the lower capital gains rate went to the richest 1%. In the same year only 3.9% of that benefit went to the middle 60% of households. And it’s real money being debated: the capital gains tax break is projected to cost us $402.9 billion during 2010-2014. It’s worth repeating: $300 billion of $400 billion worth of tax expenditures will go to the top 1%.
In the short-term, fixing this is simple. Congress just needs to let the Bush Tax Cuts expire for those making over $250,000 per year. The expiration would raise the capital gains rate to 20% and would flip the qualified dividends rate up to 39.6%.
Over the long-run, though, this topic deserves a more robust debate. Should our tax code privilege wealth over work? Can we afford a two-tiered tax system where the super-rich pay less and everyone else pays more? Should our government serve those who’ve benefited the most or those who are working their way up?
If you think these choices seems overly stark, stay tuned. In our third post, we’ll discuss the estate tax.