Taxes: Don’t Raise the Bridge, Lower the Water

Here’s a modest proposal. Let’s not raise taxes on the wealthy.  Let’s lower them for everyone else.

The idea is to lower taxes on the non-wealthy in a way that will help them become wealthy.

Let’s not raise the tax bridge.  Let’s lower the tax water.

I came to this notion while writing a recent column, “Taxes and the Long Road to Richistan.” In it, I showed that people who worked for a living (that’s most of us) suffer under tax rates that are a much greater burden than the tax rates the wealthy carry.

Effective Tax Rate for the Wealthy

Here’s an example. Most wealthy people – who get most of their income from dividends, capital gains and rents – pay taxes at a rate of 15 percent on an income up to $434,550. The tax take goes up to 20 percent over that. Meanwhile, a middle-income worker earning $40,000 pays taxes at an effective rate of 15.51 percent, if you only include half of the employment tax. Include the full employment tax and the tax rate is 22.80 percent.

While wage earners may delude themselves that their employer pays half of the employment tax, they need only become self-employed to discover who really pays the tax. If you are self-employed, you pay the entire tax. So you already know.

The result of having a preferential tax rate for income from capital is that a wealthy person can have at least 10 times the income of a median worker and pay at the same, or lower effective tax rate.

Would you call that kind of stinky? I would.

The obvious solution from those leaning left would be to increase the taxes on capital. The left loves righteous punishment.

More taxes isn’t a good idea. Lower taxes is.

But paying more taxes on wealth isn’t a good idea. When you tax something, you get less of it. As a nation, we don’t want less wealth. That’s cutting off our nose to spite our face. We want more wealth, with its income distributed more broadly.

What we need is a wider gate to wealth for everyone.

So let’s go back to the origins of preferential tax rates. Capital gains taxes get 15 or 20 percent rates. This is a kind of shorthand solution for not taxing illusory gains from inflation. Equally important, the lower rate is a reward for long-term investment.  That’s investments of at least one year.

Qualified dividends get a preferential tax rate on the argument that corporate income is already taxed, so dividends should be taxed lightly.

The origins of mysterious potions

Common explanations notwithstanding, taxes of all kinds are mysterious potions prepared by accountants from recipes developed by lobbyists in dark places. Skeptics should consider the taxes on rental income.  Taxable income from real estate may not exist for tax purposes. Yet somehow the owners keep getting richer without visible income.

Query: What can be done to level the playing field for people who work for a living?

Answer: Reduce or eliminate the taxes that involve truly long-term commitments.  Here’s my list:

            Social Security.  As I’ve written many times, Social Security benefits were never supposed to be taxed. One reason is that we’ve already paid income taxes on this money, so it’s a form of double taxation.

A more powerful reason is that the tax on Social Security benefits was put in place around the same time that 401(k) plans were. The plans were promoted with the notion that we could defer current income taxed at a high rate and withdraw it in retirement at a lower rate.

Well, when you tax Social Security benefits it doesn’t work out that way.

The taxation of Social Security benefits works in practice to put a high effective tax rate on retirement plan withdrawals. It’s a punishment for saving, not an incentive.

This wasn’t loudly discussed at the time. Members of both parties want to be re-elected. That’s why the tax started at a relatively high level of income— few would pay it at the start.

But it wasn’t indexed. While the tax applied to no more than 10 percent of retirees when it was passed, it now applies to more than 50 percent of retirees.

Still worse, the tax can have a devastating effect on retiree income – like income tax bills that double – while providing little revenue for the program. In 2018 the taxation of benefits provided only 4.2 percent of program revenue.

So let’s make Social Security and its benefits tax-free again.

Retirement Plans. We put some of our wages into IRA, 401(k) and 403(b) plans because it allows us to defer taxes on current income until we retire. When we take the money out, we pay at ordinary earned income rates that can be as high as 37 percent.

In fact, the money we put aside is a very long-term investment. We may save for 40 years and live in retirement for another 30, or more, years. However you slice it, we’re making investments that are vastly longer than the one year required to qualify for long-term capital gains preferential rates.

Finally, most of the money accumulated in retirement plans comes from investment returns, not the income we deferred. If you deferred $100 a month of income for 40 years while earning 6 percent annually, you’d accumulate $262,481. Of that amount, only $48,000 would be deferred income. The rest, 82 percent, would be long-term accumulated income. And that income would continue earning investment returns during your retirement.

So why not tax it at capital income rates?

Pension Plans.  Both private and public pensions have similar circumstances. Either you put aside a portion of your earnings or your employer puts aside money for you that is deferred compensation. Either way, it is deferred income going in. It goes in for decades. It comes out for decades. It’s more of a long-term investment, the kind that should be taxed at a preferential rate. Just like other long-term investments.

And, yes, the same proportions apply to pension plans as to retirement plans. Most of the money taken out is from investment income, not original savings.

Related columns:

Scott Burns, “Taxes and the Long Road to Wealth,” 2/02/2020  https://scottburns.com/taxes-and-the-long-road-to-richistan/

Scott Burns, “The Wrongheadedness of Wealth Taxation,” 12/21/2019 https://scottburns.com/the-wrong-headedness-of-wealth-taxation/

Scott Burns, “The Tax Torpedo and the Middle Class,” 7/10/2016   https://scottburns.com/the-tax-torpedo-and-the-middle-class/

Scott Burns, “How the Tax Torpedo Hits,” 2/11/2003  https://scottburns.com/how-the-tax-torpedo-hits/

Scott Burns, “When the rich have it all,” 8/4/2019  https://scottburns.com/when-the-rich-have-it-all/

Scott Burns, “The other road to serfdom,” 10/12/2019  https://scottburns.com/the-other-road-to-serfdom/

Scott Burns, “Eat the rich and take their money (continued),” 9/1/2019  https://scottburns.com/eat-the-rich-and-take-their-money-continued/

Scott Burns, “Is it time to eat the rich?,” 8/17/2019  https://scottburns.com/is-it-time-to-eat-the-rich/

Scott Burns, “Is it time to eat the rich?,” 11/14/2010  https://scottburns.com/is-it-time-to-eat-the-rich/

Sources and References:

Patrick J. Purcell, “Income Taxes on Social Security Benefits,” 12/2015   https://www.ssa.gov/policy/docs/issuepapers/ip2015-02.html

Social Security Trustees Report, 2019 https://www.ssa.gov/OACT/TR/2019/II_B_cyoper.html#96807

This information is distributed for education purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, product, or service.

Photo: Scott Burns, 2/12/2020 Yachts in Fort Meyers, FL

(c) Scott Burns, 2020