Thursday, August 25, 2011

Was Buffett Right? Do Workers Pay More Tax than Their Bosses?

By Roberton Williams

When Warren Buffett called for higher taxes on the wealthy in a New York Times op-ed last week, the billionaire investor argued that he and wealthy people like him face lower federal rates than the rest of us. Low rates on long-term capital gains and qualified dividends and limited exposure to payroll taxes mean low taxes for the rich, he asserted, while more typical workers don’t get those breaks. He’s right on many of his points but not about the rich paying less tax (relative to income) than average—or even well off—taxpayers.

First, what did Buffett get right? Taxpayers who get lots of income from capital gains and dividends pay less tax than those who earn most of their income from wages. People who get all of their income from long-term capital gains and qualified dividends will never pay a combined federal individual income and payroll tax rate of even 15 percent, no matter how much they make. That’s because the maximum tax on their investment income is 15 percent and they don’t face payroll taxes. (See graph. Note that the graph shows the highest possible tax rate by assuming the taxpayer 1) claims only the standard deduction and personal exemptions; 2) gets no benefit from other deductions, exemptions, exclusions, or tax credits; and 3) bears the cost of both the employer and employee shares of payroll taxes.)

In contrast, single people who get all their income from wages always pay more than 15 percent once their income hits about $12,500. When their income reaches about $500,000, their combined tax approaches 38 percent. The same story applies to married couples, although their effective tax rate is always less than that for singles if only one spouse works. At any total income level, you will always pay a higher tax rate if your income comes in the form of wages than if it is from investments only.

The tax differential between earnings and investment income may be tempered somewhat, if corporate taxes reduce investment returns. Economists disagree about who actually bears the burden of the corporate income tax but some of it likely falls on investors and thus boosts their effective tax rate. Of course, if some falls on workers, it also raises the effective tax rate on their earnings.

Overall, Buffett’s story is correct, but he did get a couple of things wrong.

First, the 41 percent top tax rate he ascribed to his fellow workers appears to be a marginal rather than an average rate. That is, it’s the tax on an additional dollar of income rather than total tax measured as a percentage of total income. A single worker’s earnings must approach $500,000 before his combined income and payroll tax hits even 35 percent and the effective tax rate never tops 38 percent. For a married couple, total earnings have to near $1 million to hit those levels. Those are still very high rates, well above Buffett’s 17.4 percent, but they’re not as high as he asserted.

More importantly, because of progressive tax brackets and the many exclusions, exemptions, deductions, and tax credits, typical taxpayers actually pay effective tax rates well below the levels Buffett cites. And high-income taxpayers usually pay a higher effective rate than he does. The average household in the middle 20 percent of the income distribution (income between about $34,000 and $65,000) will pay combined income and payroll taxes equal to 12.0 percent of total income this year, compared with 19.6 percent for those in the top 20 percent (income over about $104,000) and 20.2 percent for those in the top 1 percent (income over roughly $533,000).

Warren Buffett may be right when he says that high-income taxpayers could pay more, especially given the extremely rapid rate of income growth at the top of the distribution. And he’s certainly correct when he says that the low tax rate on investment income cuts his tax bill well below that of many Americans. But he’s off base when he suggests that all high-income taxpayers pay a smaller share of their income in taxes than their middle-income coworkers.

No comments: