Why Warren Buffet is right, the rich are undertaxed.

If anything, Warren Buffet understates in his recent op-ed the extent to which the American middle class is paying more in federal income tax than the top investment and hedge fund managers like him.

A married couple with combined taxable income of $150,000 would be in the 28% marginal tax bracket and will pay an effective federal income tax rate of about 21%, and will pay payroll taxes on top of that. But an investment or hedge fund manager with taxable income in the hundreds of millions, or even more, will likely pay federal income tax at an effective rate of about 15%, with most or all income exempt from payroll taxes.

This is because income earned from labor is taxed at graduated rates, currently up to 35%. But income from capital, dividends and capital gains from assets held more than a year, is taxed at a flat rate of 15%, thanks to the so-called Bush tax cuts. Investment and hedge fund managers compensate themselves primarily with a share of the gains earned by the investments they manage, and they treat that compensation as income from capital taxed at the 15% rate. And payroll taxes apply only to earned income, not investment income.

By what logic is income from capital taxed at a significantly lower rate than income earned from labor? Here’s the best explanation I can find. See if you are convinced.

First, proponents of a lower capital gains tax argue, some of that capital gain may be due to inflation. You bought a stock at $70 and sold it at $80 for a gain of $10. But some of that $10 may be attributable to inflation, and it would thus be unfair to tax the entire capital gain as ordinary income. Agree?

Second, that stock may have accrued the gain over several years. If recognized over several years, the annual gain would not be large enough to push the taxpayer into a higher bracket. But by recognizing the gain all at once, by bunching it in a single year, the taxpayer may be unfairly pushed into a higher tax bracket without a lower rate for capital gains. Does that make sense?

Finally, if capital gains were taxed as ordinary income, taxpayers sitting on accrued gains could choose simply not to sell, depriving the economy of the benefit of having capital deployed in the most efficient and profitable way. We would all suffer!

I’m not convinced by those arguments, but even if you are, none of them justify treating dividend income from stocks as capital gains.

Warren Buffet can’t quite bring himself to actually advocate taxing income from investments and labor the same way, at the same rates. He simply argues that the rich can afford to, and should, pay more in federal income tax. And he’s certainly right about that.

It is interesting that every industrialized nation I know of also provides a reduced tax rate for income from capital. Even formerly communist societies like China and Russia allow their highest-income taxpayers a lower tax rate for income from capital as opposed to labor. So it’s no surprise that the income gap between rich and poor is growing in those countries just as it is in the United States.

Actually, it’s not entirely clear that the investment and hedge fund managers are correct in their treatment of their share of investment profits as capital gains, even under current law. I think a sound argument could be made by the Internal Revenue Service that such profit shares are actually compensation for services, which should be taxed as any other earned income according to the graduated tax rates.

But it would take an aggressive administration in Washington, D.C., to withdraw the administrative precedents and take on all the powerful interests who would be adversely affected by such a ruling. In our current divided and partisan political environment, we are unlikely to see such a ruling, especially from an administration desperately seeking compromise rather than confrontation.

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