‘Tax the Rich’ Harder Than it Sounds

10/12/2011 9:15 am EST

Focus: MARKETS

Charles Carlson

Editor, DRIP Investor

Taxing the rich isn’t necessarily the best approach to generating needed revenue, observes Charles Carlson of DRIP Investor.

You may have read that part of President Obama’s deficit-reduction plan is a tax based on what is being called the “Buffett Rule.”

Named after famed investor and ardent Obama backer Warren Buffett, the Buffett Rule would help ensure that individuals with incomes over $1 million would pay federal income taxes at rates at least equal to those earning lesser amounts of money.

The idea for the Buffett tax seems to have evolved from a piece Buffett penned in The New York Times earlier this year. In the piece, Buffett wrote that his effective federal tax rate last year was just over 17%, less than the tax rate of any other person in his office.

“My friends and I have been coddled long enough by a billionaire-friendly Congress,” Buffett writes. “It’s time for our government to get serious about shared sacrifice."

Now, while Buffett’s comments fit nicely with the “class warfare” rhetoric being fomented by the White House, I find his statements a bit misleading. Based on Buffett’s remarks, it would seem that many millionaires and billionaires have lower tax rates than you or me. That is simply not the case.

According to the nonpartisan Tax Policy Center, individuals earning over $1 million this year will pay, on average, 29.1% on federal taxes. Those earning between $50,000 and $75,000 will pay 15%.

But what about Buffett and his 17% tax rate? How does he pay only 17% of his income in federal taxes? Surely it isn’t “fair” that he pays a lower rate than his secretary, is it?

Actually, I would argue that it is not only “fair,” but it is better for you and me and our investments that Buffett’s tax rate is lower than his secretary’s. Here’s why.

The bulk of Buffett’s income—as is the case with many super-rich—is not salary, but investment income. And investment income—capital gains and dividends—is taxed at lower rates for everyone, not just Buffett.

Said differently, any salary that Buffett makes is not taxed at a lower rate than his secretary’s income. In fact, depending on the salary amount, it’s likely it will be taxed at a higher rate. However, while a salary may be most if not all of the annual income for you or me, it represents a very, very, very small portion of Buffett’s annual income.

Capital gains and dividend income represent big components of the annual “income” of the super-rich. And long-term capital gains and dividends are currently taxed at a maximum rate of just 15%.

That’s why Buffett’s effective tax rate is only 17%. His income consists primarily of tax-preferenced investment income.

What concerns me about the “Buffett Rule” is that anything that messes with the preferred tax rates on investment income—even if changes impact only the “super rich”—will likely have a negative impact on the stock market. It’s simple math, really. If you increase taxes on investments, you reduce expected after-tax returns.

And if expected returns are reduced, asset prices will adjust downward accordingly. How much will they adjust downward? I don’t know. But I can tell you that wealthy individuals typically have lots of flexibility to modify their behavior based on changes to the tax code.

If investment taxes are increased on the wealthy because of a “Buffett Rule,” I’d be willing to make you a big wager that the result would not be a positive for stocks. And that’s bad news for all individual investors, rich or not-so rich.

Of course, Buffett is entitled to his opinion. But I do become uncomfortable when someone advocates that the government is entitled to confiscate more of someone else’s money. If Buffett believes he is under-taxed, he has every right to write a big check and send it to Uncle Sam to make up whatever difference he believes represents his “fair share.”

Better still, if he believes the government is entitled to more tax revenue, he should begin paying a dividend on his Berkshire Hathaway shares. Since dividends are taxed twice in our current tax system (once at the corporate level in the form of profits, the second time at the individual shareholder level in the form of dividends), it would seem that paying dividends would be the “patriotic” thing to do.

Quite frankly, I think most investors would just be happy if Buffett spent less time thinking about how the government should be raising taxes, and more time thinking about how to raise the stock price of Berkshire Hathaway.

The last time I checked, Berkshire Hathaway stock hasn’t exactly been Apple-like in its performance. Indeed, the stock has underperformed the S&P 500 by roughly 23 percentage points over the last year.

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