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Once Earned, Twice Taxed: Capital Gains are Taxed Twice

Pie chart to demonstrated taxable incomeThe recent discussion of the “Buffett Rule” proposal to increase taxes on the wealthy has focused attention on U. S. tax rates. It’s giving Americans a chance to better understand our tax policy and the economics of the free market system.

Mitt Romney, the probable Republican Presidential candidate, has come under attack from both Democrats and other Republican primary candidates for his high income and net worth and his low overall tax rate. The arguments are that Romney made his money by the wrong type of capitalism and that he pays too little in federal taxes.

The tax returns Romney has made public show most of his money comes from investment returns on his holdings rather than from wages or a salary. His overall tax rate in 2010 was 13.9% and his estimated rate for 2011 is 15.4%. This caused a predictable outcry that his tax rate is lower than the income tax bracket of many middle class Americans.

President Obama’s 2011 tax return shows a tax rate of just over 20%. Former Republican candidate Newt Gingrich paid 31% of his 2010 income in federal taxes.

To the uninformed, these varying tax rates initially look unfair. What many people don’t understand is the big difference between “ordinary income” (from wages, a salary, short-term capital gains, and interest) and “passive income” (from stock dividends and long-term capital gains). The federal government taxes ordinary income at up to 35% and passive income at 15%.

Why the different rates? Capital Gains are Taxed Twice

First, let’s look at dividend income and long-term capital gains taxes on investments held over 12 months. Dividends come from corporations that must first pay income taxes on any profits. Long-term capital gains come from shares of a company purchased and held for more than 12 months.

Since the effective corporate rate is 39.2% (the top federal rate and the average state tax rate), the corporation has already paid taxes on all income, including what is paid out to investors as dividends. Prior to the Bush tax cuts in 2001, dividends were then additionally taxed at almost 40%. This meant every dollar of dividend income was taxed twice, once at the corporate level and again at the individual level. The result was that 60 cents out of every dollar of profit made by a company was paid to the federal government. The Bush tax cuts continued the practice of double taxation, but lowered the amount paid at the individual level to 15%.

The same double taxation applied to long-term capital gains, except that the tax rate was a flat 28% before the Bush tax cuts reduced it to 15%.

This double tax makes it seem that the wealthy pay less tax than they really do. An individual may pay 15% on passive income of, say, five million dollars. Yet corporations have already paid taxes of around 39.2% on that same income, for a total tax rate of 54.2%. Of the five million in profit, over two and a half million goes to Uncle Sam. That would seem to be more than a “fair share.”

According to Congressional Budget Office figures from 2011, the top 1% of taxpayers pay an average of 29.5%, those in the percentiles from 81% to 99% pay 22.8%, those from 21% through 80% pay 15.1%, and the bottom 20% pay 4.7%. Those numbers, of course, don’t include the 49.5% of Americans who pay no federal income tax at all.

Even factoring in the different tax rates on ordinary and passive income, it’s clear that the more money Americans earn, the more tax they pay. What could be more fair than that?

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8 Responses to Once Earned, Twice Taxed: Capital Gains are Taxed Twice

  1. Laura April 23, 2012 at 8:21 am #

    Great article of setting things straight!Always more going on than meets the eye.

  2. Tom Wargin April 23, 2012 at 9:12 am #

    Excellent article to illustrate how “fairness” plays out in the real world. What about AMT and its fairness? Good intentions don’t always equal good results.

  3. Bobbie Munroe April 23, 2012 at 11:55 am #

    I’m not sure if the “double taxed” arguement is as valid with capital gains as it is with dividends. And all of know that the effective top tax rate on corporate income is a lot lower than the nominal rate because of extensive deductions. The bottom line is that we have to get more income from somewhere (surely you don’t disagree with that…expense cuts can not be the only part of any solution). So where do you go? You tell me…..

  4. Rick Kahler April 23, 2012 at 12:36 pm #

    Bobbie,

    You probably won’t like this, but there is no way we finance this on the backs of “the rich.” It’s mathamatically impossible even if we tell them to “send it all in.” Obama’s Buffet Rule would only have raised $5 billion a year. We need $1.6 trillion. if we want to continue the huge entitlement programs we have and maintain a social security blanket that looks like Europe, we are going to need to pay for it like they do. First, in the US 49.5% of us don’t pay any Fed income tax. In the UK almost everyone pays. The tax bracket starts at 10k UK……and the 40% bracket starts at 35k UK. And more importantly, there is a 20% VAT on purchases. Pragmatically, the best we can probably do is to adopt a plan similar to what Obama’s debt commission recommended, $4 in cuts for every $1 in tax increases. I understand that bill was introduced last week into the Congress and went down to a bipartisan defeat with only 40 votes for it! Unbelieveable. Even Obama doesn’t support his debt commissions plan. So, without compromise we continue to head full speed (borrowing $1.6 trillion a year) toward an abyss that promises some type of hyper inflation and plumetting lifestyles.

  5. John April 24, 2012 at 12:46 am #

    The rich paying their “fair share” is nothing more than fomenting class warfare in the hopes that it will garner votes for the democrats. The only tax increases that have any hope of reducing the deficit/debt are on the middle and lower income earners. How about the nearly 50% of Americans who pay no income taxes? What is their “fair share”? Only spending cuts are going to reign in the growing debt that most complain about, but nobody wants their piece of the hand-out pie cut. Sorry, but the goose is laying lemon eggs with a gold filigree. Current spending is unsustainable, as Rick said, and painful cuts are the only solution. Take 100% from the top 1% and the solution remains the same.

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