LESSONS LEARNED #85: “The rich pay more than their fair share of income taxes to provide tax relief for the poor and middle class.” –Old Pithy

Posted by PITHOCRATES - September 29th, 2011

Investors Pay a Lower Tax Rate on Investment Income because Investing is Riskier than Earning Income

There’s a lot of class warfare going on right now.  It’s open season on anyone deemed to be rich.  You have President Obama saying the rich don’t pay their fair share of taxes.  That it isn’t right for Warren Buffett’s secretary to pay her taxes at a lower tax rate than her boss.  Statements like this can be very misleading.  Because Warren Buffett’s secretary pays nothing in tax dollars compared to what Warren Buffett pays.  But it sure fans the flames of class warfare.  Which helps when you want to raise taxes on someone.  (Or get reelected).  Because no one wants their own tax rates to go up.  Just those on others who make more than they do.

Except, of course, Warren Buffett.  And some other millionaire investors.  Who are asking President Obama to raise their taxes.  And he has obliged.  At least, he’s trying.  He wants to implement a millionaire’s income tax.  A little extra from those who can most afford it.  Of course, Warren Buffett won’t pay this millionaire’s income tax.  Because he doesn’t pay income taxes.  He’s an investor.  He pays capital gains taxes.

Investors pay a lower tax rate on capital gains than on income.  Because investing has risk.  Working doesn’t.  You never risk losing your income by working.  But you risk your capital by investing.  Hence the lower rate to encourage this risky behavior.  Investing in others.  Like entrepreneurs.  Some of who strike it rich.  Many more, sad to say, fail.  And investors lose everything they invested.  It’s a risky business for investors.  That’s why when their investments pay off they pay off big.  To cover all of those investments where they lost everything.  Raising tax rates on investors, then, would dissuade investment.  Stop the job and wealth creation these successful  entrepreneurs provide.  And deprive the treasury of all the tax revenue they would have created.

The Rich are Paying a Premium in Taxes for being Successful

Let’s look at some data.  Let’s mine some IRS tax returns.  See who is paying income taxes.  And who isn’t paying their fair share.  Let’s break the numbers down into 4 groups.

The poor and middle class (those earning up to $50,000 per year).  The middle class/upper middle class (those earning from $50,000 to $100,000).  The elite white collar and small business owners (from $100,000 to $500,000).  And the rich (over $500,000).  These breakdowns and labeling is not an exact science.  But it’s close enough for analysis.  Below we’ve graphed both percent of total income.  And percent of total taxes paid.  For each of these groups.  All data is mined from SOI Tax Stats – Individual Income Tax Rates and Tax Shares.  And crunched in an Excel spreadsheet.

These are the rich people.  Note that they pay a larger percentage of total taxes than their percentage of total income.  The red line is always well above the blue line.  On average their share of taxes is 8.54% greater than their share of income for the years graphed.  So the rich are paying a premium in taxes for being successful.

Of particular interest is what happens to the rich during a recession.  At both the early and late 2000s recessions their share of income tanked.  As did their share of taxes.  Their share of total taxes fell some 5% in the early 2000 recession.  With a third or so of all taxes coming from these rich, when they lose money so does the U.S. treasury.  This quickly revised those Clinton projected surpluses into deficits.  And it wasn’t anything George W. Bush did.  This was the fallout from the bursting of the dot-com bubble (it was the irrational exuberance that made all of this wealth and tax revenue in the first place.  That and the Lost Decade in Japan.  Not the Clinton tax rate hikes).  Rich people lost money; rich people paid less taxes.

And speaking of Democrat Bill Clinton, note how the rich got richer when he was president.  Not what you would expect from a Democrat.  The champions of class warfare.  But it is true.  While Bill Clinton was president the rich’s slice of the income pie grew approximately 10.51%.  Gee, I wonder what happened to the poor and middle class during this same time.

White Collar Workers and Small Business Owners have a Tax Share Greater than their Income Share

Now let’s take a look at the elite white collar workers and small business owners.  Management, professionals, doctors, lawyers, entrepreneurs, etc.  Here we see that they, too, pay a larger percentage of total taxes than their percentage of total income.  But not as much.  Their tax premium for success is not as great as it is for the rich.  It averaged approximately 3.42% for the years graphed.

Note that the recession didn’t have as great as an effect on them as it did for the rich.  They don’t have as much to gamble with.  The less risk the less reward.  And the fewer losses.  Besides, with small business owners slow and steady wins the race.  They pour all of their investment capital (i.e., their earnings) into their businesses.  And then work 80+ hours a week to wring out every last dime from that investment.

Some industries weather recessions better than others.  Some just get by.  Conservative by nature, they expand during good times.  But not too much that they can’t sustain the larger size during bad times.  For they aren’t rich enough to absorb large losses during really bad times.  Unlike rich investors.  So their income growth is flatter.  But more steady.

The Middle Class/Upper Middle Class have a Tax Share Less than their Income Share

Now the middle class/upper middle class.  Those earning from $50,000 to $100,000.  Typically those living well while still working for someone else.  Note that their share of the tax burden has been in a decline.  Much like their income.  However bad that is, they do pay a smaller percentage of the total tax than their percentage of total income.  The blue line is above the red line.  In other words, they have a tax discount.  A discount that has averaged 5.33% over the years graphed.

Interestingly, these graphs are almost the mirror image of those earning $500,000 or more.  Particularly strange is that their share of the income increases during times of recession.  Which probably reflects their incomes being a larger percentage of the remaining pie after the rich lose so much during bad economic times.

Did the Poor and Middle Class get Poorer under Bill Clinton?

And now the poor and middle class.  Whose share of the tax burden has also been in decline.  As has been their income.  But they, too, pay a smaller percentage of the total tax than their percentage of total income.  Their tax discount has averaged 6.62% for the years graphed.  Which is even more generous than that given to those earning $50,000 to $100,000.

Remember how the rich got richer under Democrat Bill Clinton?  Well as they got richer the poor and middle class got poorer.  Again, not what you would expect from a Democrat in office.  While Bill Clinton was president the poor and middle class’ slice of the income pie decreased approximately 11.85%.  Can this be true?

When the Rich get Richer the Poor get Fewer in Numbers

Well, yes and no.  If you look at the number of returns filed you find out something interesting.  Not only did income decrease for those earning $50,000 or less, their numbers shrank, too.  To illustrate this we’ve compared the number of income tax returns for our income group breakdowns for the years 1996 and 2000 (the beginning and end of the Clinton years for the data graphed).

There was a net decline of 8.85% of people earning $50,000 or less.  Where did they go?  To a higher income group.  The poorest earners in our breakout decreased in numbers.  While the higher income groups all increased in numbers.  Meaning when the rich get richer the poor get fewer in numbers.  In other words, a rising tide raises all boats.

The Best Way to Raise Tax Revenue is to let Rich People get Rich

So what have we learned?  First of all, the rich pay more than their fair share in taxes.  In fact, they pay a portion of the taxes of those earning less than them.  That is, the rich provide tax relief for the poor and middle class.

So the rich getting richer is good.  The richer they get the larger percentage of the total tax burden they pay.  And the more people they move from lower income groups to higher income groups.  By providing investment capital to entrepreneurs.  Who create jobs.  That give the poor and middle class better opportunity.

And the more jobs the more taxpayers there are.  So you have the rich getting richer and paying more taxes.  And these new employees in higher paying jobs paying more in taxes.

Now that’s good tax policy.  If your goal of tax policy is to raise tax revenue.  And if it is then the best way to do that is to let people get rich.

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