Pants On Fire

President Obama made the following statement the other day.

“It is wrong that in the United States of America, a teacher or a nurse or a construction worker who earns $50,000 should pay higher tax rates than somebody pulling in $50 million.” 

I practiced tax law for 25 years.  I know something about tax rates, capital gains rates, marginal tax rates, effective tax rates and a lot of other tax trivia.  I don't want to call the President of the United States what Rep. Joe Wilson called him but his pants are pretty close to being on fire with that statement.

Let's assume that there is a nurse, teacher or construction worker who earns $50,000, is single and claims the standard deduction.  They have no other income.  This would result in the highest income tax cost you could have.  $50,000 of adjusted gross income less a $3,700 personal exemption and $5,800 for the standard deduction would leave $40,500 of taxable income.  This would amount to a $6,250 federal income tax bill=an effective tax rate of 13.5%.  The effective tax rate is your income divided by the total tax.  The marginal tax rate is the tax rate on each additional dollar you earn.  For the worker here, the marginal rate is 25%.

Contrast that with someone earning $50 million per year, even if it is assumed that they took $5 million in itemized deductions for mortgage interest, state taxes and charitable contributions, and $49.5 million in qualified dividends and capital gains and just $500,000 in ordinary income (salary and interest income for example).  This would potentially mean that about $44 million could be taxed as low as 15% assuming no adverse minimum tax consequences.  I will make that BIG assumption.

The remaining $500,000 would be taxed at ordinary rates of $110,017 on the first $379,150 according to the 2011 tax tables with a 35% marginal rate on the balance.  This would be an additional $42,298 in additional income taxes.  Thus, the total income tax bill would be $6,752,315-also an effective tax rate of 13.5%.  The marginal rate is 35% for ordinary income like salaries and interest income but 15% for capital gains and dividends.  This is what keeps the effective rate low in this example.  Almost all of the income is from investment income.  Of course, that investment income comes by way of this individual risking their investment capital.

I talked about this previously in my post "The Person Behind The Tree".

The biggest difference between the wealthy and the middle class is the investment income they are deriving from risking their capital.  This is really driven by capital gains income.  It is the big differentiator between the rich and the middle class. As my father used to tell me, "You don't get rich working.  You get rich when your money works for you."

Of course, to get your money working for you, you need to put it at risk.   Money is much like seed. Seeds don't do anything if they sit in a drawer, cabinet or bag in the barn.  However, if they are properly planted, nurtured and cared for, one seed can grow into an enormous tree which can bear a lot of fruit. That tree can begat an entire forest. 

Right now we don't have enough people willing to plant seeds.  Is this the time to tax the person behind the tree that has the seeds for the next tree?

The President is clearly playing games here as a lot of stories have pointed out including this one from the Peter Ferrara in The American Spectator and this op-ed from the Wall Street Journal. The WSJ  shows the average effective federal income tax rate on various income levels in the chart below. The reality is that the average tax rate on millionaires is 3 times the rate on workers making $50,000 when you look at actual tax return data.  As the Journal points out, there are very few Buffetts in the country.

As Ferrara points out in his article, the top 1% already pay more than the entire bottom 95% combined.  How much more should we expect them to pay?  What is a fair share?  Who determines it?

Another problem with the President's assault on millionaires concerns the dynamics of income in the United States.  The fact is that the income of many of these people flucuate considerably from year to year.  A lot of people who have $1 million in income in one year have it because they sold a business or a farm that they might have worked their whole life for.  They have that income in one year but not in the next.

The Tax Foundation studied the issue of Income Mobility and the Persistence of Millionaires in a detailed study last year that looked at IRS data for the tax years 1999-2007.  These were the key findings.

• Concerns over increased income inequality should be tempered by the fact that a substantial number of households move up or down through the income distribution over time.
• Nearly 60 percent of households in the bottom income quintile in 1999 were in a higher quintile in 2007, and roughly 40 percent of tax returns in the top quintile in 1999 were in a lower quintile in 2007.
•  Roughly half of millionaires during the 1999 through 2007 period attained this status just once during those nine years. Only 6 percent of this group were millionaires in all nine years.
• The volatile nature of capital gains realizations appears to be a major explanation for the transiency of millionaires.

In reality, only 9% of the "millionaires" had that level of income in each of the nine years of tax data.  50% of the "millionaires" only achieved that level once duing the nine years.  Just as interesting is how much mobility was found in all income levels.  Nearly 60% of the taxpayers in the bottom quintile of earnings in 1999 had moved higher by 2007.  Proving this is a land of opportunity.  However, 40% in the highest were in a lower quinitle 9 years later.  Proving it is hard to stay on top in a country that encourages innovation, ingenuity and ideas.

There is always someone who should want to replace you on top of the hill.  When we lose that we have really lost everything in this country.

President Obama has apparently decided that it is easier to engage in class warfare than to encourage people to scale the hill.  Ronald Reagan always worked to foster an aspirational society.  Our current President is focused on a distributional one. He seems to have no interest in encouraging people to scale the hill.  He is only focused on forcing the people on the hill to throw money down the hill.