Tuesday, November 22, 2011

You Pay Hidden Entitlements for the Rich

When the rich rob from the poor, it's called "business". When they fight back, it's called "class war". When the rich dodge taxes, it's called a "loophole". When the poor dodge taxes it's called "tax evasion."

Taxes. It's a boring subject, unless you're a tax attorney, economist, mathematician, or a member of the top 1%.

Tax rates, deductions, exemptions, deferments, allowances, depreciations, and all those numbers and percentages can be mind-numbing.

But because we have such a complicated tax code that's written in legalese, most of us can't understand it, even though there's one thing we all know for certain...and that's that we all want to pay less in taxes.

Most people don't feel they earn enough as it is. We know we need to pay taxes, but we also want to pay as little as we can, and yet still get the biggest bang for our buck. We realize, when we're rational, that we need taxes to run government. We need highways, a power grid, a standing army, clean water, and all those other things that we want to make us feel comfortable and safe.

And we certainly don't want to pay any more than we have to, and only want to pay our fair share. But the average taxpayer, who only earns between $25,000 to $35,000 a year, needs to at least have some basic understanding of how the tax code works - - so they'll know if they're being fleeced by their elected officials - - those who write and pass the tax laws.

The research and time I put into writing this post wasn't fun, but it was a challenge, and I enjoy challenges. But the most difficult part wasn't researching the tax code so that I  might better understand it...but to write a post so that average people like myself could understand. I know, a near impossible task.

But look at the bright side is, this post is not 50 volumes thick and over 200,000 pages long., as is our current tax code. So I'll begin here...

Capital Gains Taxes: Hidden Entitlements

Unlike regular working people, the very affluent (the ultra-wealthy) aren't paid a wage or salary, who is then obligated to pay 35% of their earnings in federal income taxes (the highest marginal rate). The ultra-wealthy primarily earn their most of their money with stocks and bonds, and then they pay a capital gains tax of only 15% - - the same exact tax rate as someone who only earns $8,500 a year (which equates to $4.09 an hour if they work 40 hours a week).

If a hedge-fund manger or a CEO of a large bank or corporation were compensated with $8.5 million in stock options one year, they would pay the same exact percentage of their total personal earnings in taxes as would a 16-year-old teenager working 20 hours a week for a whole year at Wal-Mart...15%.

If you earned $34,500 in profits from selling stocks in a railroad company that you had held for one year, you'd pay just as much in taxes to the IRS as someone else who earned $34,500 a year in wages ($16.58 a hour) who had actually been going to work every day and building that railroad - - 15% in federal income taxes, as opposed to 15% in capital gains taxes

One man had to get up and put on his shoes every morning for a whole year and swing a pick-axe or shovel, the other man just had to call his stock broker and say, "Sell."

Here's why the ultra-wealthy need tax attorneys and we don't. If everybody paid the same "effective" tax rate on ALL the personal income they earned every year (enter your ___% here), the U.S. tax code could be very simple. You'd earn so much in wages (or profits), then you'd pay so much in taxes. Simple.

But the tax rates are not simple at all (and are constantly changing) because the ultra-wealthy have always felt entitled to pay LESS in taxes than ordinary working Americans; so all throughout the history of the IRS they have petitioned (lobbied) Congress for special provisions in the tax code (deductions, exemptions, deferments, allowances, depreciations, etc.) to have themselves pay less (as a percentage of their personal income) in taxes than we do.

That's why this post deals primarily with just "capital gains", because this is how, for the past 90 years, the rich (the top 1%) have kept getting exponentially richer - - - while the rest of us (the 99%) have kept getting poorer.

Our very complicated tax laws are written by lawyers (and so probably, deliberately obtuse). But generally speaking, most common folks don't understand the U.S. tax code. It contains over 50 volumes and is over 200,000 pages long. Attempting to read just one page can give someone such as myself a massive headache. Besides, most of us just use the 1040-EZ form or we'll go to H&R Block.

How Capital Gains Taxes are Entitlements for the Ultra-Wealthy

Capital gains taxes should really be called "loopholes for the rich and famous".

Capital gains (excluding a one-time exclusion of your principal home) are profits reflecting increased values of stocks, bonds, investment real estate, and other "capital assets." Capital gains are treated much more favorably than other types of income, especially for the very high income people.

Capital gains are not taxed at all unless and until they are "realized"--generally upon sale of an appreciated asset. And when gains are realized, top-bracket individuals pay lower tax rates on capital gains than on so-called "ordinary" income.

As a result, investment markets that primarily service the very well off are often designed to maximize the share of profits that are in the form of capital gains--both realized and unrealized. Indeed, on individual tax returns, total realized capital gains (such as the buying, holding, and selling of stocks) far exceeds dividends earned on stocks (dividends, being the quarterly income paid by a company who issues the stock) by 73%.

For the highest income people-- making more than $200,000 a year--realized capital gains exceed the total amount of dividends and interest combined. Almost two-thirds of total capital gains reported on individual tax returns go to people whose incomes exceed $200,000.

Only 8% of the total capital gains are reported by the three-quarters of tax filers with incomes of $50,000 or less (such as those who live in, then sell their homes for a higher price). Thus, more than any other type of income, capital gains are concentrated at the very top of the income scale.

Because the taxation of capital gains is more important to the rich and politically powerful than the treatment of any other type of income, capital gains taxation has been extremely controversial over the years. At the onset of the income tax, "realized gains" were taxed at the same rates as other income--up to 77% during the World War I period.

That's how hedge-fund managers, bankers, and CEOs keep getting exponentially richer than the rest of us...they're paying less taxes! Read: Tax breaks for billionaires: Loophole for hedge fund managers by the Economic Policy Institute (a non-profit and non-partisan think tank).

Capital Gains Taxes are Historically Low in 2011

The top marginal tax rate in 1945 was 94% (on all income over $200,000). Top marginal tax rates stayed near or above 90% until 1964 when the top marginal tax rate was lowered to 70%. The top marginal tax rate was again lowered to 50% in 1982 -- and eventually to 28% in 1988.

However, in the intervening years Congress had subsequently increased the top marginal tax rate to 35% (the rate it is today in 2011). But with the bulk of earnings being made by hedge-fund mangers, bankers, and CEOs coming from stock trades (capital gains that are taxed at 15%), the wealthiest individuals in the U.S. are now paying historically low income taxes.

PolitFact: The top income tax rates on ordinary income (e.g. hourly wages, salaries, commissions) were lower between 1988 and 1992 than they are today, but otherwise, they have been higher for the every other year since the 1950s. And the "effective tax rates" for high-income earners were either at their lowest since 1960 or very close to their lowest ever. Meanwhile, the capital gains tax rates that are used to tax hedge-fund managers, bankers, and CEOs have been at historical lows since 2003 with the Bush tax cuts. They also pay much less as a percentage of their total personal earnings in Medicare and Social Security taxes because of a "cap".

Now the question becomes, "how do we get our leaders in Congress (especially the Republicans) to change the tax code so that capital gains are taxed as ordinary income?" (Especially since half the members in Congress are millionaires themselves AND they use insider trading to earn money with stocks.)

Income tax and capital gains tax rates from 1916 to 1993 - Chart below prepared by Citizens for Tax Justice (click to enlarge).

How the rich robbed the poor for the past century

A Short History of Capital Gains Taxes

From 1913 to 1921 capital gains were taxed as ordinary income until 8 years before the stock market crash of 1929 when the Revenue Act of 1921 was introduced during the Roaring Twenties. The new Secretary of the Treasury Andrew Mellon (a Republican and also owner of Mellon Bank) argued that significant tax reduction was necessary in order to spur economic expansion and restore prosperity. It was the first Republican tax reduction in history, and was enacted on November 23, 1921 under the Republican President Warren G. Harding.

Mellon also obtained a repeal of the wartime excess profits tax. The top marginal rate on individuals with ordinary income fell from 73% to 58% by 1922, and preferential treatment for capital gains was introduced at a rate of 12.5%. Secretary of the Treasury Andrew Mellon had hoped for more significant tax reduction. Read my post: Mellon: The Banker Who Rigged the U.S. Tax Code

Between 1921 and 1932 the maximum capital gains tax rate was 12.5% (half the tax rate of 25% for ordinary income) from 1925 to 1931. The top tax rate for ordinary income rose to 63% in 1932, but the 12.5% top capital gains rate was retained. Example: If you earned $1 on a railroad stock, you'd pay half as much in taxes to the IRS as someone else who earned $1 in wages who was actually building the railroad.

The vast majority of a wealthy person's earnings is almost always accrued through capital holdings - held and accumulated as "investments" (stocks, bonds, real estate, etc). They are not paid a regular hourly or salaried wage, so they pay the lower tax rate (capital gains taxes) and not the higher tax rate in regular federal income taxes. (You've heard the saying, "It takes money to make money.")

The onset of the Great Depression and public disillusionment with stock speculation of the Roaring Twenties led to increased capital gains tax rates in the 1930s. For a short period, realized gains were taxed under a complicated schedule. This system was widely criticized as unwieldy and complex, and in the early 1940s it was scrapped.

For the next 25 years taxpayers had the option of excluding half of their capital gains or paying a maximum rate of 25% (useful to those whose regular tax brackets exceeded 50%).

In the late 1960s, the special 25% maximum rate was repealed. In conjunction with other tax changes, the top capital gains rate rose to about 39% by the mid-1970s.

Tax Codes as they Pertain to Capital Gains Taxes (1969 to the Present)

The Tax Reform Act of 1969 lowered the maximum tax rate on ordinary income from 70% to 50%. The explanation of the tax act prepared by Congress's Staff of the Joint Committee on Internal Revenue Taxation explains the Alternative capital gains tax rate and the Alternative Minimum Tax.

From 1969 capital gains taxes went from 27% to 32% in 1970, to 39% in 1971, to 45% in 1972, to 49% in 1976, then back down a notch to 48% in 1978.

Then in 1978, congressional Republicans joined by a substantial minority of Democrats pushed through a major capital gains tax cut. Reluctantly signed by President Carter, it lowered the top rate from 48% to 28%, by excluding 60% of realized capital gains from tax.

President Ronald Reagan's 1981 cut in the top regular tax rate on unearned income reduced the maximum capital gains rate even further, this time to only 24%, then 20% in 1982- - its lowest level since President Hoover's administration.

Reagan’s signature policy was a cut of the top tax rate for ordinary income from 50% to 28%.

In conjunction with sharply increased depreciation write-offs in 1981, Carter's 1978 and Reagan's 1981 capital gains tax cuts caused a proliferation of tax shelters (helping set the stage for the savings and loan crisis later in the decade). The goal of most of the tax shelters was not only to defer taxes, but to convert ordinary income into lower-taxed capital gains.

The Deficit Reduction Act of 1984 reduced long-term capital gains holding period from one year to six months.

In 1988 and 1989 the capital gains tax rate was 33%.

One of the greatest achievements of the 1986 Tax Reform Act (the second of Reagan's two tax cuts) was to tax " realized capital gains" at the same tax rate as regular wages, dividends or other income... as ordinary income. Previously, realized capital gains had been preferentially treated as 60% tax-exempt.

But in 1990, Congress reinstated the capital gains preference, by capping the capital gains rate at 28% while setting the top regular income tax rate at 31%.

In the 1993 budget bill, the capital gains preference was greatly expanded to provide what amounts to a 30% capital gains exclusion for top-bracket taxpayers (the difference between the new 39.6% top regular tax rate and the continuing 28% maximum capital gains rate). The 1993 act provided an additional 50% capital gains exclusion for profits from certain "risky" investments that are considered likely to fail - - - 97% of the tax savings from the current special maximum capital gains tax rate for individuals goes to the top 1%.

The Taxpayer Relief Act of 1997 signed by Bill Clinton reduced the capital gains tax rate from 28% to 20%.

In 1999 Bill Clinton signed the Republican-sponsored Gramm-Leach-Bliley Act which de-regulated the banks. Then four years later in 2003 we had the infamous Bush tax cuts that lowered capital gains tax rate to the near historically low* tax rate of 15% while the top marginal federal income rate for people earning over $311,950 a year in wages was 35%.

* The historically low capital gains tax was 14.5% in 1921 when it was first initiated - - and top marginal federal income tax rate at that time was 73% on the most wealthy before it was lowered to 58%.

Capital Gains Taxes AND Loopholes

Here's where most of us might need a tax attorney.

NOTE: Capital gains are not taxed until assets are actually sold. As a result, investors can put off tax on their gains indefinitely. They can also avoid paying taxes on "realized gains" by selective "realized losses" on other investments in the same year. This deferral is unavailable to other kinds of income such as savings account interest, or even if the money is left in the bank.

EXAMPLE: Multi-billionaire Warren Buffett has structured his investment company so that it hasn't paid a dividend since 1966. Instead, as the 2nd richest man in the world, Warren Buffett's $39 billion+ in accrued capital gains remains "unrealized" and thus not taxed.

Capital gains tax breaks for gifts and inheritances: Currently, heirs can sell inherited property and pay no tax on capital gains that accrued prior to the time they inherit. In other words, capital gains taxes on inherited property are completely forgiven.

In the case of gifts, the recipient takes over the giver's "basis" in the donated property--generally the cost when the property was first acquired. That carryover of basis--instead of taxing the gain--allows a continued deferral of unrealized capital gains.

Special additional industry-specific capital gains tax breaks: Historically, favorable capital gains treatment has normally been limited to profits from the sale of investments (stocks, bonds, etc.). But several industries have succeeded in getting part of their normal business profits treated as capital gains. Special capital gains treatment is currently available for sales of timber, coal, and iron ore and for certain agricultural income.

Other special capital gains loopholes include:

  • Indefinite tax deferral for so-called "like-kind exchanges" of real estate. Normally, when someone sells appreciated property he or she must pay tax on the capital gain. But someone who sells rental real estate and purchases other rental property can put off paying capital gains taxes on the sale indefinitely by pretending to have "exchanged" the properties with another investor.
  • The refinancing loophole. Owners of investment assets that have gone up in value can cash in their capital gains without tax by borrowing against the appreciation. This is an enormous tax shelter for, among others, wealthy real estate speculators (although it doesn't make the official tax expenditure lists).
  • An exception from the normal $3,000 annual limit on capital loss deductions, for losses on the sale of certain "small business corporate stock." Except for a $3,000 a year de minimis rule, realized capital losses can only be used to offset realized capital gains. Otherwise, investors with a portfolio of winners and losers could realize losses to wipe out taxes on their wages and other income, even though their total capital gains position (realized and unrealized) was positive. But for certain "small business corporate stock" investments, up to $100,000 in losses can be deducted. This subsidy is presumably designed to ease the pain of backing money-losing operations, and thereby encourage wealthy investors to invest in businesses that are unlikely to succeed.

Low Corporate Taxes = Excessive CEO Salaries

It doesn't matter what a corporation pays in taxes as compared to GDP, or how it's compared to any other index of measure (to skew the numbers), it's what they actually pay to the U.S. Treasury after loopholes (aka "deductions") that matters most. And for the last 25 years corporations have actually paid historically low taxes.

While today some corporations may have paid the maximum rate of 35% (when it was over 50% in the 1950s), many others paid ZERO, with the average being only 18%.

The same can be said for their CEOs and other high-income earners. While although the top bracket is also almost historically low (at 35%, when it was once over 90%), what they actually pay is nearer to 15% because the majority of their income is earned through capital gains.

And because corporations have been paying a low effective corporate tax rate for decades, that didn't keep them from outsourcing jobs overseas for cheap labor, but rather, it did enable them to pay very excessive CEO salaries...who only mostly pay 15% in federal income taxes on their capital gains.

Addition sources other than the hyperlinks within this post:

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  1. And with Herman Cain's 9-9-9 Plan, it will lower the capital gains tax rate again (which is already historically low at 15% since the Bush tax cuts in 2003). The capital gains tax rate under Cain's plan would be an astounding low of only 9%.

    And Newt Gingrich (and others) are pushing for this tax rate to be ZERO!!!!

  2. Short list of Republican and Tea Party millionaires who are pushing for lower capital gains taxes:

    Bill O'Reilly, Paul Ryan, Sean Hannity, Eric Cantor, Glenn Beck, Rick Santorum, Rupert Murdoch, the Koch bothers, Michele Bachmann, Paul Rand, Nikki Haley, Sarah Palin, Karl Rove, Grover Norquist, Rush Limbaugh, Newt Gingrich, Herman Cain & Mitt Romney.

  3. The tax brackets and income tax rates could remain the same, just tax all capital gains and dividends as regular income.

    For corporations, the tax bracket could be lower but only if ALL loopholes were eliminated, so they pay the ACTUAL tax rate, and not an "EFFECTIVE RATE".

  4. CEOs only “earn” bonuses when their company “performs.” One measure of that performance: “earnings per share,” or company income divided by outstanding shares of stock. Execs have figured out they don't have to boost earnings to hit their per-share targets. They simply reduce the number of company shares — by having their companies “buy back” shares of their own stock off the open market. U.S. corporations overall have so far this year authorized $445 billion worth of buybacks.

  5. Almost 70% of all capital gains taxes are paid by the top 1%

    A week after hinting he may raise the capital gains tax, Jon Huntsman proposed eliminating it altogether.