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Investment income fuels tax rate debate

ALBUQUERQUE, N.M. — Debbie Bosanek had one of the best seats in the House at President Barack Obama’s State of the Union address in January, just behind the first lady in the gallery overlooking the assembled members of Congress, the president’s Cabinet, the Joint Chiefs and other of our fellow Americans.

She was there, as such guests always are, to make a political point. Obama, calling for an end to Bush-era tax cuts for the wealthy, said, “Right now, we’re poised to spend nearly $1 trillion more on what was supposed to be a temporary tax break for the wealthiest 2 percent of Americans. Right now, because of loopholes and shelters in the tax code, a quarter of all millionaires pay lower tax rates than millions of middle-class households. Right now, Warren Buffett pays a lower tax rate than his secretary.”

Debbie Bosanek is Warren Buffett’s secretary.

To my knowledge, no one has actually seen Bosanek’s tax returns. Buffett, chairman of Berkshire Hathaway and the third-richest individual in the world, has said his effective tax rate is about 14 percent and Bosanek’s is about 33 percent. Some tax-savvy bloggers on financial web sites that I frequent have pointed out that for Bosanek to pay a tax rate that high she must be making more than $350,000 a year and have very few deductions.

Republican presidential candidate Mitt Romney, who released his tax returns in January, pays an effective tax rate similar to Buffett’s: 13.9 percent.

What is intriguing is that the average tax rate paid by that much-reviled top 1 percent of the nation’s earners, a club to which Buffett and Romney most certainly belong, is about 21 percent. The average middle-income taxpayer faces an effective rate of about 9 percent.

The difference is in the way the nation taxes investment income, specifically long-term capital gains and qualifying dividends. A capital gain occurs for most taxpayers when they sell an asset like common stock or a mutual fund for more than they paid for it. Companies pay dividends to shareholders, which are usually distributions of after-tax profits. Mutual fund investors also have to pay taxes on capital gains the funds realize when they sell shares of stock that they hold and on dividends paid by the companies in which the funds are invested.

Ordinary income, which for most of us is the paycheck we take home, is taxed at a marginal rate of between 10 percent and 35 percent. Long-term capital gains and qualifying dividends are taxed at 15 percent.

Buffett was paid $524,000 in salary and other cash compensation during the 2010 tax year. He made more than $60 million on investment income. Most of Romney’s income is from carried interest, which is a share of profit from his holdings in Bain Capital, his old private equity firm. Carried interest is taxed like long-term capital gains.

Both men donate a boatload of money, resulting in deductions that also reduce their effective tax rates.

It is tempting to lump all investment income taxpayers in the Buffett and Romney category, but the reality is that even taxpayers with the lowest incomes report some capital-gain and dividend income. The Urban-Brookings Tax Policy Center said that 3.3 percent of taxpayers reporting cash income levels of less than $10,000 in 2011 also reported receiving capital gains or dividends. About 12 percent of taxpayers with cash income of between $50,000 and $75,000 a year received capital gains or dividends, as did 41 percent of those reporting between $100,000 and $200,000 in cash income and 90.1 percent of those reporting more than $1 million.

The federal government has been all over the map when it comes to taxing investment income. The maximum rate on capital gains income was almost 40 percent when Jimmy Carter became president, declined to 28 percent during his last two years in office, went down to 20 percent in 1982, then back up to 28 percent in 1987. Capital gains were taxed at 21 percent before the Bush tax cuts took effect in 2004. Most dividend income was taxed at the same rate as ordinary income between 1954 and 2003.

The economic case for preferential capital gains and dividends tax treatment is that it stimulates investment. A 1997 report of the bipartisan congressional Joint Economic Committee projected that reducing capital gains taxes from 29 percent to 20 percent would lower businesses’ cost of capital because potential investors would be more willing to purchase equities if their taxes on sale of their shares were lower. Businesses were expected to increase investment by $18 billion annually, resulting in a $51 billion annual increase in gross domestic product and 500,000 new jobs by 2000.

Today’s debate over tax fairness turns on how much the wealthy should be required to pay relative to middle-income taxpayers. The committee argued in 1997 that capital gains taxes were themselves unfair because of the effects of inflation and double taxation.

Ideally, a stock increases in price because the company that issued it is more valuable. Sometimes, though, equities prices increase as a result of inflation. When inflated securities are sold, the gain can be illusory, but the dollars used to pay the tax on the gain are real.

Writing in The Wall Street Journal in 1994, Harvard University economist Martin Feldstein said that a $10,000 investment in the Standard & Poors 500 Index of common stock could have been sold in 1993 for $42,019, but that $22,545 of that gain was entirely due to inflation.

A major reason stocks increase in value is because companies invest their earnings in their own operations, after they have paid their business taxes. All other things being equal, a dollar of earnings per share invested in the company should increase the share price by a dollar. Since earnings have already been subject to business taxes, chiefly corporate income taxes, when the investor sells the shares at a profit, that reinvested earning is taxed a second time.

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