** Mon 07 January 2019
The tax situation in the United States is pretty messed up.
Much ado has been made over the last week about AOC suggesting bringing back the pre-Reagan era 70% marginal tax rate on regular income over $10,000,000. This means that if you made $12 million in normal income in a single year, you would pay 70% of the last $2 million to the federal government.
At the same time, the American taxpayer still hasn’t seen Donald J. Trump’s tax returns. There has been speculation about why they have not been made public. I am pretty sure I know the reason: people would be disturbed not only how little taxes he is paying, but also how low his adjusted gross income (AGI) is. In other words, I would guess that Trump is holding a lot of his wealth in offshore accounts, outside of the grasp of the IRS.
Since I graduated from college in 2007, I have had a small window into the financial lives of very wealthy people, from hedge fund managers to Silicon Valley millionaires and billionaires. At the same time, many people I know (myself included, depending on the year) have joined the ranks of the High Earning, Not Rich Yet (HENRY) class of working Americans. This has given me some perspective on our current tax policy, which to me seems in many ways to be grossly unfair to people who depend on a regular job for their livelihood.
While I am no economist, just a lowly computer programmer, I will dig into these topics to offer my perspective and experience.
Capital gains rate: does it still make sense?
Generally speaking, people in the United States make two different kinds of income: normal income and capital gains. “Normal income” is the kind that you make as a full time employee (reported on a W-2 form) or an independent contractor (reported on a 1099 form). “Capital gains” is profit from investments or proceeds from assets bought and sold, like stocks or real estate.
Personally, most of the income I make is from normal employment, followed by book royalties from “Python for Data Analysis” which are recognized as 1099 independent contractor income. Depending on the year, I may make some investment income, but as a non-millionaire, it is a relatively small amount of money.
The thing about capital gains versus normal income is that the marginal tax rate on capital gains is much lower. Short term capital gains (e.g. money that you made from day trading stocks or options) is treated like normal income, so let’s consider Long Term Capital Gains (LTCG): profit made on assets held for one year or more. The LTCG tax rate for 2018 is either 15% or 20% depending on whether your total income (adjusted gross income, or AGI) is more or less than about $400,000, i.e. whether or not you are a member of the “1%” of earners in the US.
By contrast, normal income tax rates top out at 37% on income made over $500,000. Income between $38,701 and $82,500 is taxed at 22%, which is already higher than the LTCG rate. Additionally, depending on where you live, such income may be subjected to additional state and local taxes. If you live in New York City, these state and local taxes can add up to about an additional 10%. This can mean paying nearly 50% of income marginally in various forms of taxes.
In many cases, the wealthier someone is, the higher the fraction of their income is capital gains. They may not make any normal income at all, simply “living off their wealth”. Many people consider this “not having to work to live” to be the definition of being rich or wealthy. I’ve heard friends talk about what their “number” is (how much money they need to have in the bank) where they feel like they don’t have to work anymore.
What is disturbing to me about the capital gains tax rate is that if you compare two people who respectively make $250,000 per year and $5 million per year, the person making $5 million per year may well be paying a lot lower net tax rate on their earnings. Why, as you become increasingly wealthy, should your tax rate go down?
The reason for the low LTCG tax rate, of course, is to “incentivize investment”. I can understand the original rationale for this, but the way that the tax code has evolved has subverted much of the original intent. The wide disparity in tax rate between normal income and LTCG has created an enormous incentive for the uberwealthy to structure their income to pass through various “loop holes” in the tax code to be recognized as capital gains. As one famous example, hedge fund managers for years have been passing their performance and management fees through the “carried interest” loop hole, so that even if a fund manager makes $100 million in fees in a single year, they will only pay 20% in taxes.
Personally, I think super rich people paying only 20% tax rate, regardless of how they made the money, is ridiculously unfair to all of the Americans who work full-time to make ends meet, many of whom are paying a higher tax rate. If I were in charge of the tax code, I would tax capital gains for high income individuals at normal income tax rates or close to it.
The problems don’t stop at the capital gains tax rate, so let’s move on to the next important topic.
Next level rich: paying no taxes
As far as I can tell, many people with extremely high net worth (over $100 million) are concerned with two things:
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Not paying taxes
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Passing on their wealth to their children tax-free when they die
This last topic has been a frequently bone of contention in American politics: on death, estates are generally subjected to taxation (known as the “estate tax” or also the “death tax” by some opponents). One argument frequently cited by opponents is that this money has “already been taxed”, so taxation on transfer to children is effectively “double taxation”. Whatever.
The desire of the ultrawealthy to avoid taxes has spawned an industry of “estate planners” and attorneys who assist in various tax avoidance schemes. Without getting too much into the details, let’s look at some principle use cases to understand how this works.
If you are extremely wealthy, the biggest expenses in your life may be the following:
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Real estate
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Cars
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Private aviation (including private jet ownership)
The big question is: why would you “patriate” income in the United States to pay for these things if you don’t have to? For a lot of super rich people, significant capital gains are generated from international business activity and held in offshore bank accounts, typically in “tax havens” like the Cayman Islands. Why transfer money to your US accounts and pay taxes if you can have a shell company in the Cayman Islands pay for your private jet expenses and buy and hold your real estate?
Outside of providing a tax-free way to pay for one’s lifestyle, tax havens serve an additional purpose: avoiding the inheritance tax on death. The children of the super rich are likely to continue living a similar kind of lifestyle, and they will keep working with the same tax attorneys and estate planners who helped their parents avoid taxes in the first place.
This brings us back to Donald Trump. A recent New York Times investigation alleged that Trump’s father, Fred Trump, engaged in various schemes to transfer hundreds of millions of dollars in wealth to his children without paying taxes. Why would the son (Donald) be any less of a tax cheat? What difference does it make to his children if their wealth is held in the Cayman Islands or in the United States? This, I think, is the real reason why we’ll never see Trump’s tax returns. It would raise too many questions about where income is generated and where it is held.
Summary
The unfortunate part of all of this is that there is little that the United States government can do to address the problems with tax havens and the ultrarich.
Outside of this though, very rich people really ought to be paying a lot more taxes income earned in the United States. To me, the most fair thing seems to be:
- A much higher marginal tax rate on income in excess of $1 million
A much higher long term capital gains rate for high earners, if not equal to the normal income tax rate
I recognize that neither of these things is likely to happen in the current political climate, but it is important for more people to believe that these ideas are neither radical nor unreasonable. Even if the above proposals are implemented, rich people are still going to “cheat the system” in some ways, paying far less than their share of taxes.
As a working professional, I am happy to do my part to fund the government, and I am okay with my tax rate staying the same or increasing. I think everyone else, including very rich people, should do the same.