October 2016

Our Un-American Tax System: The High Tax Penalty for Making Money the Old-Fashioned Way

Author: Lew Wessell

Despite all the political rantings about the “horrors” of our tax system, I’ve heard and read almost nothing about what I consider to be the system’s most unfair, un-American aspect of all: the high penalty it places on nearly every form of earned income and, conversely, the privileged rates it bestows upon unearned, investment income.

Facts: The highest marginal federal tax rate for earned income is 40.5 percent, consisting of the regular federal income tax top bracket of 39.6 percent plus the Obamacare .9 percent surcharge on incomes over $200,000. In addition, earned income is subject to Social Security and Medicare taxes which are 7.65 percent for individuals on salary and an effective 13.2 percent for self-employed individuals.

Compare these tax rates to those levied upon unearned income from qualified dividends and long-term capital gains. These earnings are taxed at various rates ranging from 0 percent for taxable incomes up to $75,000 (on joint returns), to 15 percent for those making up to $465,000 per year, to a max of 20 percent for those making over $465,000 per year. There is also an Obamacare 3.8 percent surcharge on investment income for higher earning individuals and couples. Thus, the maximum federal tax rate for long-term capital gains and qualified dividends is 23.8 percent vs. a max of 40.5 percent for ordinary income.

Here are two real life examples from 2015 federal 1040s that show the stark difference in tax treatment for these two types of incomes.

Earned Income: Married couple, early 30s with combined income of $165,000 consisting of $141,000 of salary and $24,000 of Schedule C income. No “unearned” income. Standard deduction. Federal tax bill of $30,774.

Unearned income: Married couple, early 60s, combined income of $165,000 consisting of $23,000 in dividends ($12,000 qualified), $132,000 of capital gains ($120,000 long-term and $12,000 short-term), and $10,000 of other income consisting of an annuity and other “ordinary income” items. No earned income. Standard deduction. Federal tax bill of $10,322.

Same amount of income, but triple the tax for the young couple—a $20,000 penalty courtesy of the American government, simply because the younger couple made their money by working, not investing!

The American work ethic and productivity is the envy of the world’s economy, yet we tax the direct fruits of our labor force at a significantly higher rate than any other type of income. The entrepreneur who starts a business and hires workers—the American economic hero—is taxed the hardest, while the trust fund baby or retired executive who lives off dividends and long-term capital gains is often barely taxed at all.

It wasn’t always so. Since 1913, long-term capital gains have, at various times, been taxed at ordinary income rates, been given exclusion amounts of varying percentages, and have required holding rates of from six months to five years. With the passage of Ronald Reagan’s landmark Tax Reform Act of 1986, preferences on dividends and long-term capital gains were eliminated completely and all income—earned and unearned—was taxed at the same rates, with a maximum marginal rate of 28 percent.

Since the 1986 act, there have been at least 15 major tax bills and two major economic downturns that slowly but surely have gotten us to where we are today. President George H.W. Bush reinstated a maximum rate on long-term capital gains (28 percent), and President George W. Bush did the rest, installing brand new 0 percent and 15 percent rates for both qualified dividends and long-term capital gains.

So, how is the preferential treatment of long-term capital gains and qualified dividends justified? A commonly heard argument is that the preference is justified because these are earnings that have already been taxed. This is simply wrong as far as the long-term capital gains tax is concerned, as only the gain from investments is taxed, not the investment itself. On the other hand, this is a valid point with regard to qualified dividends; corporations are taxed on their profits but not allowed a deduction when those same profits are distributed out to shareholders as dividends; i.e., dividends are taxed at the corporate level and then again at the individual taxpayer level. Having granted that point, a special 0 percent or 15 percent tax rate on qualified dividends is a crude solution at best. My personal preference would be to allow corporations to deduct their dividend distributions just as they do their interest payments. Why not? Dividend income, like all other income, would get taxed once either at the corporate or individual level.

Another common argument used to justify the highly preferential treatment of earnings on investments is that low tax rates are necessary to incentivizing investors. Really? As if investors would stop investing if we went back to the way things were under Reagan? More to the point, what about incentivizing the entrepreneur who’s actually starting and running the business. If “small business” is truly the engine that drives the American economy and is the primary creator of jobs, why do we so severely tax that small business and its owner from the outset?

A troubling but not unexpected aspect of this issue is that there doesn’t seem to be much awareness of the problem at all. Successful young working people—and make no mistake, this is a problem affecting primarily young Americans who haven’t yet had a chance to accumulate any investable capital—are generally aware of the fact that they pay a lot of taxes, and they want to see rates lowered.

But, due to, I believe, a general ignorance of finances and a particular ignorance of the tax code, they do not understand that they are suffering disproportionately. Wealthy Americans, living primarily off the fruits of their capital, not their labor, are actually taxed quite gently. The merely affluent of this generally older, wealthy class are typically paying tax at a privileged lower rate, while the truly wealthy are often paying even less by investing in such highly tax-favored financial instruments as municipal bonds. When Warren Buffett states that he is taxed at a lower rate than his secretary, it’s not just a vapid sound bite; it’s absolutely true!

The solution? A good first step would be to simply tax all income equally: salaries, interest, dividends, capital gains, Social Security, etc. The result would be to lower the tax burden on the young and all workers and increase it on investors and older Americans. To protect the less affluent among us and to further encourage young workers starting out, perhaps a widening of the lower tax brackets, coupled with an additional bracket or two for the super wealthy, would be helpful. All could be tweaked to be revenue neutral.

The aim of these changes to the tax rules would be to once again have a tax system that truly reflects our common American values and encourages and rewards the most important drivers of the American economy: the entrepreneurs who create our small, dynamic businesses and the workers who make them a success.

To share your comments, email Lew at lewwessel@hargray.com

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