Adult Conversation About Income Tax Policy

By The Banker | Blog Posts
14 Nov 2012
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With the Fiscal Cliff[1] looming, kids, it’s time for “The Talk.”

By ‘The Talk,’ I mean yank our minds into the grown-up world.  We have been innocent about how money really gets made, and kept, and taxed.  The ‘adults’ know, but they haven’t felt comfortable sharing the real truth.  We didn’t know, and we didn’t think we could talk about it.  It seems embarrassing for some reason.  Almost dirty.  Maybe it’s the way we were brought up.  Nevertheless, now’s the time for ‘The Talk.’

Here it is in a nutshell: The way the ‘grown-ups’ – our elected officials – set tax policy tells us how they value different ways of making money.  They see three different ways to make money, and they clearly favor the first two.

Inherited Money

According to our tax code it turns out the very best way to make money is the old-fashioned way:  Inherit it.

As of this writing, the first $5 million from a deceased individual can pass to you tax free.  Our elected leaders want you to know that the best way to get rich is to be born into a rich family and have the right people die at the right time.[2]

Stated that way, it seems a bit un-American, no?  A bit, well, aristocratic.  Nevertheless, that’s far and away the best way to earn your first $5 million.  Our leaders want you, Richie Rich, to have your first $5 million tax free.[3]  Mwah!

Make money with your money

The second best way to get wealthy, according to the tax code, is to already have a lot of money, and then earn money on your money.

If you already have a lot of money, then a significant proportion, probably a majority of your income, will come from three sources: Tax Free Bonds, long-term capital gains on your investments, or corporate stock dividends.[4]

The best of these investments, tax wise, is Triple Tax Free municipal bonds, which are exempt from local, state and federal income taxes.  You earn just about 0.5% interest[5] these days, but if you’ve got $100 million in triple tax free muni bonds then you’ve got yourself $500,000 a year, tax free!  That pays for quite a few golf outings a year, with money left over for the lobster roll at the club and a tip for the valet.

The next best way to make a living from your investments, according to the tax code, is to buy and hold stocks for at least 18 months before selling at a profit, so that your earnings will be taxed at a rate of only 15%, the long-term capital gains rate.

Should you be so fortunate as to start out in life with a massive stock portfolio, your elected officials say to you: “Good Job!  That’s an excellent way to make a living!  Let us incentivize you to earn the majority of your living by having your pile of money do all the work, while you join that swell municipal bond fellow at the club.”

The third best way to earn money from your money is to hold stocks for at least 60 days, thereby earning qualified dividends, likewise taxed at a comfortable 15% rate.[6]

I interpret all of these three tax policies combined as our elected officials’ way of saying that the next best way of making a living – after being born into a rich family – is to sit around like Scrooge McDuck investing money, and only paying 0% and 15% on one’s income.[7]

Mitt Romney’s 14% effective tax rate in 2011 derives from this tax advantaged way to ‘earn’ a living, just as your elected officials would like you to.

Working for a living

The ‘grown-ups’ who make tax policy tell us this is the worst way to make money.  You see, if you work for a salary, that income is liable to be taxed at the maximum income tax rate.

If you can make less than $35,350 a year, fine, they’ll tax you at a 15% rate.

But over that, you’re looking at 25%, 28%, 33%, or up to 35% for those making over $388,351.  The lesson of the tax code is that people who actually work for a living, rather than inherit from Daddy or live like Scrooge McDuck, should be taxed the most.  “Working for a living?” they taunt us, “that’s for chumps!  Tax that man at the maximum possible rate!”

That’s “The Talk” about our tax policy which creates better and worse ways to make money in this country.  No, Virginia, there is no Santa Claus, but there is a Richie Rich and a Scrooge McDuck.  And our elected officials just love them!

 



[1] Is it weird that I love the sound that the phrase ‘Fiscal Cliff’ makes in the mouth?  Its poetry, really.  To mangle a bit of Nabokov:  “Fis.Cal.Cliff.  Taking a trip of three steps through the split fricative to tap front teeth, at three, on the lower lip.”

[2] Yankees owner and billionaire George Steinbrenner famously died in 2010, the one year in recent memory during which the Estate Tax was wholly repealed.  George was worth an estimate $1.1 Billion, so the fact of the Estate Tax repeal in 2010 made the Steinbrenner heirs $500 million richer than they would have been had he died in 2009, as the estate tax rate was 45% of inherited wealth that year.  As a Red Sox fan, I’m just so happy for those boys, Hal and Hank.  It couldn’t have happened to a nicer family.

[3] We will hear, or we should hear, quite a bit about the estate tax in the coming weeks, as the limit exemption on tax-free inheritance reverts back to $1 million and a 55% rate in 2013, if Congress does not take action. “Death Taxes on Small Businesses” is how one political side always describes the Estate Tax, but that’s mostly a load of bull.  The real implication of the estate tax is to what extent our leaders signal that the best way to get $5 million is to be born into the right family.

[4] If you’re not making any money through tax free munis, long term stock holdings and dividends, well then you can just skip to the third section, you working stiff.  Our elected officials can’t be bothered with you, if you can’t take a hint about how to make money.  Jeez.

[5] On 5 year municipal bonds, for example.

[6] The low 15% ‘qualified dividends’ tax incentive ends in 2012, unless Congress acts to extend or modify it, as Congress did, with Obama’s approval, in 2010.

[7] The other great advantage to being Scrooge McDuck from a tax perspective, is that – unlike a working-stiff salaryman – you can choose what year to harvest stock market gains.  Scrooge McDuck can end up with virtually no taxable income in any given year should he choose to sell no appreciated stock.  Or Mr. Duck can match up investment losses with investment gains to have no net taxable income, or even to trigger a tax refund.  In a related story, did you know Mitt Romney got a $1.6 million tax refund last year?

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8 Comments

  1. ilyanna says:

    So what is your response to those Scrooge McDucks and Richie Riches who argue that while their rate is low, their aggregated payment is significantly higher than all us working-class chumps put together, and therefore it’s “only fair”?

    • The Banker says:

      “I pay more in aggregate” is a non-compelling argument to me, since the 1% also benefits more in aggregate from a system of protection for private property entirely built to help them keep their property. People without wealth to protect receive far less in ‘value’ from the entire justice system built to protect private property. They don’t have any significant property to protect!
      The other common argument, which the 1% may or may not literally believe, is that their capital is somehow so incredibly essential to the functioning of the investment and innovation parts of the economic system that to decrease it through taxation is always and in every case a negative for total productivity in the system. [That's Ed Conard's argument in his book I reviewed] While capital is necessary, there’s plenty of capital sloshing around right now for investment and innovation. There’s undoubtedly some point at which extra taxation does hurt the overall productivity engines of the economy, to make higher taxes a negative for the productive economy, but I think we’re far from that place right now.
      Also, estate taxes are, in my humble opinion, the least damaging taxes when it comes to affecting the productivity of the economy. But they’re the least understood since the smallest % of people pay them, so its the easiest place for legislators to curry favor with their most important constituents – generous campaign donors – without the population noticing. In that sense, Bush/Cheney were brilliant at getting done what they wanted to get done.

  2. Alonissos says:

    Very clear and important yet rarely written about

    • Chris Whyte says:

      “‘I pay more in aggregate’ is a non-compelling argument to me, since the 1% also benefits more in aggregate from a system of protection for private property entirely built to help them keep their property.”

      I couldn’t agree with you more. I’ve never understood how the rich don’t recognize the fact that they have a system entirely designed to protect their wealth. This system also provides them with additional access to easy money, even in highly-leveraged situations, beyond what’s available to even the upper-middle class in non-leveraged situations.

      Even our military isn’t intended to protect our freedom anymore, it exists to protect our wealth.

  3. ilyanna says:

    Thanks — I needed a riposte for the thoughtlessly wealthy in my life. Not that there are many. maybe, 1% of my friends . . .

  4. John M says:

    That all sounds happy and fair until your situation flips. After you’ve worked hard all your life, maybe built a successful business along the way, or just saved and invested wisely along your 40 year career, you might end up with a lot more than you started with. You might actually end up with a large enough amount to help your kids not have to struggle half their life with money like you had to. You just might end up with enough to help a generation or two down the road from you so that in the end, more people (your descendants) benefit. What a legacy to be able to leave. To reach the end of one’s life and be able to contribute to the well being of several generations so maybe life is a little bit better for them than it was for you. But then people like you come along and make it look like that is somehow a great evil. People that inherit money or make a lot of money off investments aren’t all evil people. Some of them just had great parents or grandparents that worked hard to make their lives better, for generations to come. And the government shouldn’t be able to take that away. For the record, I don’t have a lot of money but I work hard and save in hopes that one day I will. And when that day comes, I sure as heck want the money going to my kids instead of the wasteful US government.

    • The Banker says:

      Hi John,
      Thanks for your comment. I suspect we’d agree on a lot. I’m not a huge fan of wasteful governments either. I’m also in favor of hard work, private enterprise, wealth accumulation, and giving one’s kids the best possible start in life. I don’t think wealth accumulation in one’s lifetime is evil, but rather in most cases its admirable. It’s damned difficult, and I applaud it greatly. I’m also not a big fan of taxes. I dislike paying them, and I think they’re often unfairly applied or excessive. I bet 99% of Americans I’ve ever met would agree on all that.

      The parts where we disagree is: How do we pay for the government we have, and how do we pay for the debts we’ve already accumulated?
      In my opinion (as I said in the posting) some parts of the tax code incentivize the wrong things.
      We have to raise government revenue somehow. But the ways we raise revenue reward unadmirable behavior in important ways, and punish other types of admirable behavior.

      My post was meant to be challenging in a way to the conversation about whether the tax code reflects the incentives we want. Or rather, as I suspect, does it reflect the strange incentives of our Congressional leaders, who are unusually susceptible to the wishes of their campaign donor? I don’t think I’m being cheeky or flip or radical when I say that. I’m just trying to be realistic, and reflect the world as I have observed it in my private sector career.

      • Ted says:

        Alternative theory about the government’s revealed preferences for sources of income: the ascending rates you describe (lowest for inherited, highest for earned income) reflect the fairness of various levels of taxation.

        Earned salary income has not yet been taxed–corporations get a tax deduction for it (they are taxed only on profits), so when they pass it to the employee it is taxed.

        Passive income from investments has already been taxed at least once. A worker needs to earn the money once (paying tax on it), before it can be invested somewhere. Once invested, the corporation making use of the capital pays corporate tax on any earnings before the net amount can be distributed to shareholders (note this is where Buffett’s argument that he pays a lower tax rate than his secretary is a pile of BS–he’s ignoring the fact that his share of Berkshire’s earnings are taxed at 35% (statutory) before he collects his dividend checks and pays a further 15% on them. If you argue corporates aren’t paying enough tax then broaden the corporate base, that’s a different issue). In some sense, taxing investment income is double taxation.

        Inheritance taxes up the ante to triple taxation (at least). Now a worker earns money, pays tax; invests money, pays tax on returns; accumulates assets and pays tax on them (third time) for the privilege of handing them to a child (or any recipient in the case of the gift tax).

        In this view, the tax regime currently in place makes sense with regard to fairness and double/triple taxation.

        It can also be viewed from the perspective of incentives created by the tax system. Economists would tell you to subsidize that which you want more of and tax that which you want less of. The current administration wants more “investment” so they decided to tax it. That makes (no) sense.

        In this model taxes on investment returns should be very low, so as to encourage capital holders to put the capital to work. (Again, Buffett is disingenuous when he says taxes don’t affect business decisions. As every MBA or manager knows, any analysis of an investment opportunity is based on consideration of AFTER TAX cash flows. Move the tax rate up and the marginal project does not get funded. Buffett’s argument to the uninformed masses that taxes don’t matter is not helpful.)

        Complete tax overhaul, moving to a consumption regime (think VAT like Europe has) makes the most sense. It aligns incentives and is capable of raising a great deal of revenue (which is why Republicans are afraid of it).

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