Should Billionaires Pay Lower Taxes Than You Do?

Warren Buffett complains that he only paid the government 17.4% of his income last year and calls for investors to pay more

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Billionaire investor Warren Buffett wants to pay more money in taxes. He also thinks that other rich investors like him aren't paying their fair share. In order to level the playing field, he wants to see the tax code reformed so that investments don't receive such favorable tax treatment. Let's look at the logic behind taxing investors so little, and whether there are some sensible reforms to make here.

Buffett's Argument

First, what exactly is Warren Buffett complaining about in his New York Times op-ed this morning? He bemoans the fact that he only paid a 17.4% tax rate last year, which would effectively put him in the bracket for making an income of between $8,500 and $34,500. Of course, he didn't. The numbers he provided imply that he made close to $40 million. That's not a bad year. So what's going on here? He explains:

Some of us are investment managers who earn billions from our daily labors but are allowed to classify our income as "carried interest," thereby getting a bargain 15 percent tax rate. Others own stock index futures for 10 minutes and have 60 percent of their gain taxed at 15 percent, as if they'd been long-term investors.

Buffett seems confused about why it is that investors aren't taxed at a higher rate. Why isn't their dividend and capital gains income taxed like the income of any other worker? So let's help him to understand why such income is taxed at a lower rate. There are two main reasons.

Corporate Income Taxes

Buffett fails to mention that the corporations who issued the stock he's talking about face an income tax of their own. Most public companies, if they're making more than $18.3 million per year, pay 35%. This is also the rate for the top individual tax bracket.

So think about a dividend. The income that a corporation makes is first taxed at 35%. Then, a dividend is paid out -- after taxes. If you obtain that dividend, should it be taxed? Well, it already was -- at 35%. For this reason, it makes sense to tax it at 0%. If you tax it more, then you are taxing the income it produced twice.

The retained earnings (after-tax income not paid out to dividends) that a firm makes contribute to its growth, which should cause its stock price to rise. So if you sell the stock, you'll have a gain on sale. Like the dividend income, this gain has already been taxed at 35%. So again, it makes sense to tax the capital gain at 0%.

Taxation of Gains on Payroll Income

But that's not all. Let's think about the mechanics of investing. Let's say you want to invest in the Disney Company, because you like think its stock will perform well in the future. You have some savings, which you accumulated by spending less money than you earned in your job over the past few years.

That money you invest has already been taxed, since it came from your income. So if Disney's stock does well and you sell it for a gain in five years, should you be taxed on that return? Remember, the money you invested already got hit with a tax when you first earned it. Like before, it makes sense for the capital gains tax to be zero here. Why should you be penalized for investing that money instead of spending it?

Where Buffett's Argument Begins to Make Sense

This doesn't mean that there's nothing to Buffett's argument. It could make sense to tax investors at a higher rate in two situations.

Professional Investors

If a professional investor manages to earn money by investing for her clients, then her earnings should be taxed at the regular payroll tax rate. That is to say, if the income that someone collects by investing isn't derived from his capital he directly invests, then he should be taxed like any other worker. To the extent that investors manage to escape regular payroll tax rates by collecting capital gains by investing other people's money, reform should be sought.

But professional investors also often invest some of their own money along with their clients' money. That any income derived from capital that they put in themselves should be taxed just like the capital gains of non-professional investors.

Short-Term Gains

In the examples above, we were imagining that the investor held the stock for several years, as the corporation's income was taxed each year. As a result, the profit on capital gains should not also be taxed. But what if an investor holds the stock for only days, hours, or even minutes? Now it could make sense to tax the gain. In this case, the investment is speculation, which shouldn't receive the same benefit as investing that contributes to a firms' long-term capital position. Indeed, such short-term capital gains aren't really subject to the corporate income in the same way as long-term gains.

It could also make sense to tax short-term gains, because this isn't really the sort of investing the market should want to encourage by providing an ultra-low tax rate. The stock trading game is getting out of hand, so taxing short-term gains -- like those for stocks held less than one year -- at a higher rate could help to discourage excessive trading. Short-term gains are already taxed at a somewhat higher rate than long-term gains, but Buffett is right to imply that they should be taxed like regular income.

By making these two tax reforms, the government would see some additional revenue, but probably not as much as Buffett would like. Though, his op-ed really does raise the question: if he's so angry about how little taxes he paid, what's holding him back from paying more? He could always be the first to set a precedent by paying taxes on his capital gains at the rate his income bracket would imply.

Quick note/update on two points: Some readers have complained that it isn't technically double taxation of payroll income, because you are being taxed on the gain from your investment -- not that original income in particular. This is technically right, so I have changed the sub-heading above. My point still holds, but it's a subtle, philosophical argument, which I'll try to make quick and simple. It boils down to the idea that even taxing the return on capital investment is a form of double taxation -- on human capital.

Let's say you've got an intangible thing called human capital. If you're a shoe salesman, that human capital produces shoe sales. So effectively, it's traded by workers to employers, who compensate them accordingly. That's how you get income. And it's taxed. By investing that income, it will grow -- producing some return. But the amount by which it increases doesn't come by you trading additional human capital for additional income -- those returns are based on the income you've already derived through human capital already used up, which was taxed. For that reason, it isn't immediately clear (to me anyway) that the additional investment income ought to be taxed.

Second, other readers complain that some corporations pay a much lower effective tax rate. First, individuals also often pay a lower effective tax rate than their technical rate might imply. But moreover, an argument that corporate loopholes should be filled and/or the tax code simplified is completely separate. I agree that a simpler tax code would be fantastic, and should definitely be sought. But this point doesn't negate the logic to why capital gains taxes are so low, since corporations are already taxed once.

Finally, just to be clear, policy can always ignore these points and tax investors more anyway -- by all means. What I hope to do here is merely to explain where the logic for low capital gains taxes come from.

Another update/explanation on the human capital taxation argument: I received a few e-mails, and I think others might also misunderstand my point here. I am not saying that money can never be taxed twice as it flows through the economy. For example, if I have some savings that I use to create a company, would my employees be exempt from taxes? Absolutely not -- precisely because they're providing me their human capital for which they're provided that income.

The implication of this philosophical idea -- that only income derived from human capital should be taxed -- is that corporate taxes would disappear, since only payrolls would be taxed. (I've actually always viewed corporate taxes as double taxation for this very reason which would actually make capital gains triple taxation!) If you're already taxing employees at all levels, then why is the corporate entity itself also being taxed? That profit that it will reinvest will ultimately end up a part of someone's income, whether it's through the income of workers at a supplier, builder, etc.

In a sense, both of my points in the post are mutually exclusive, as I provide two different ways to look at the argument against taxing capital gains. I didn't go this deep, because I was trying to keep the post simple, but hopefully this helps to explain my point better for those interested.

If we're aiming for a system where economic growth is maximized, I think this would be best. The government can always obtain more tax revenue by upping its tax rates on payrolls, of course. So it doesn't limit taxation in any way, necessarily. It just simplifies things and allows investment to flourish.

I should add: I support a very, very high estate tax, even 100% wouldn't bother me. So the idea here isn't for tax-free investment income to be passed down, but reinvested.

Tuesday morning follow up: Here.

Image Credit: REUTERS/Jo Yong hak