Tonight, President Obama is going to talk about income inequality and how unfair the tax code is as it stands right now because the wealthy pay less on income that comes from investments. I'm going to spend a few minutes showing why this is fundamentally untrue and a dangerous stance for our businesses if this fallacy is accepted.
Let's first talk about the differences in how our tax code treats income. The income that most of us get in our paycheck is what I will refer to as regular income. The percentage of taxes you pay on this depends on how much money you earn in regular income and can vary from 10% for the lowest earners to 35% for the highest earners.
The income that comes from investments (capital gains and dividends) is treated separately by our system. If you have held a stock for over 60 days and that stock pays a dividend, it is considered a "qualified" dividend and you pay a lower rate on this income. This rate is 0% for the lowest two income brackets and 15% for everyone else currently. Capital gains are similar. If you held a stock for over a year and then sell it, the profits are considered long term capital gains and are taxed at the same rate as qualified dividends. It should be noted that any ordinary dividends (stock being held under 60 days) and short term capital gains (stocks bought ad sold within one year) are taxed at the same rate as regular income.
Now at first glance it may seem unfair that someone who held a stock for a few years and made a million dollars on it pays a lower tax rate than someone who earns $35,000 from their job, but let's explore that a little more thoroughly. First, we should note that any money used to buy stock has already been taxed once. Therefore, if someone earned $35,000 they would pay 25% on their ordinary income. If they then invested some portion of that money and sold it two years later for a one million dollar profit, they would then pay 15% on that one million dollars. It's plain to see that this is not unfair, because they already paid their fair share on their ordinary income and shouldn't be punished for investing in a successful business.
If we go even further into this we can explore what this money was used for during the time it was invested. The main purpose of stock markets is for public companies to raise money needed to start or build businesses, and in turn, create jobs. People who buy stock hope that the company will generate profits which will be passed on to them via higher stock prices or dividend payouts. It is the business profits that are passed on to the stock holder that are taxed at this "lower" rate than regular income. However, businesses in the United States currently pay 35% in corporate income taxes before any of the profits are paid to shareholders. So in reality, the effective tax rate on any profits from business that are passed on to individuals is 44.75% (35% plus 15% of the remainder). Hopefully, it is clear now that the individuals who already paid their fair share on ordinary income, took some of what was remaining to promote a successful business that created jobs for more people, and then paid taxes on profits that had already been taxed once have paid their fair share.
Now let's talk about the ramifications of having higher taxes on investment income. Since this is pretty elementary, this part will be rather short. If you increase the taxes on interest income, you lower the incentive for individuals to invest. If you lower the incentive for individuals to invest, you decrease the ability for businesses to raise money to start and expand businesses that create jobs. If you have less businesses creating profits and jobs, not only does your economy lag, but your tax revenue falls as well.
I understand our country is searching for alot of answers on how to balance the public welfare with individual liberty, but I can guarantee the answer is not to tax investment income higher.
Let's first talk about the differences in how our tax code treats income. The income that most of us get in our paycheck is what I will refer to as regular income. The percentage of taxes you pay on this depends on how much money you earn in regular income and can vary from 10% for the lowest earners to 35% for the highest earners.
The income that comes from investments (capital gains and dividends) is treated separately by our system. If you have held a stock for over 60 days and that stock pays a dividend, it is considered a "qualified" dividend and you pay a lower rate on this income. This rate is 0% for the lowest two income brackets and 15% for everyone else currently. Capital gains are similar. If you held a stock for over a year and then sell it, the profits are considered long term capital gains and are taxed at the same rate as qualified dividends. It should be noted that any ordinary dividends (stock being held under 60 days) and short term capital gains (stocks bought ad sold within one year) are taxed at the same rate as regular income.
Now at first glance it may seem unfair that someone who held a stock for a few years and made a million dollars on it pays a lower tax rate than someone who earns $35,000 from their job, but let's explore that a little more thoroughly. First, we should note that any money used to buy stock has already been taxed once. Therefore, if someone earned $35,000 they would pay 25% on their ordinary income. If they then invested some portion of that money and sold it two years later for a one million dollar profit, they would then pay 15% on that one million dollars. It's plain to see that this is not unfair, because they already paid their fair share on their ordinary income and shouldn't be punished for investing in a successful business.
If we go even further into this we can explore what this money was used for during the time it was invested. The main purpose of stock markets is for public companies to raise money needed to start or build businesses, and in turn, create jobs. People who buy stock hope that the company will generate profits which will be passed on to them via higher stock prices or dividend payouts. It is the business profits that are passed on to the stock holder that are taxed at this "lower" rate than regular income. However, businesses in the United States currently pay 35% in corporate income taxes before any of the profits are paid to shareholders. So in reality, the effective tax rate on any profits from business that are passed on to individuals is 44.75% (35% plus 15% of the remainder). Hopefully, it is clear now that the individuals who already paid their fair share on ordinary income, took some of what was remaining to promote a successful business that created jobs for more people, and then paid taxes on profits that had already been taxed once have paid their fair share.
Now let's talk about the ramifications of having higher taxes on investment income. Since this is pretty elementary, this part will be rather short. If you increase the taxes on interest income, you lower the incentive for individuals to invest. If you lower the incentive for individuals to invest, you decrease the ability for businesses to raise money to start and expand businesses that create jobs. If you have less businesses creating profits and jobs, not only does your economy lag, but your tax revenue falls as well.
I understand our country is searching for alot of answers on how to balance the public welfare with individual liberty, but I can guarantee the answer is not to tax investment income higher.
update: “Roughly half of households pay no federal income tax. The average income-tax rate for the middle slice of households—those making between $34,300 and $50,000—was 3.3% for 2007. The average income-tax rate was 14.4% for the top fifth, and 19% for the top 1%, before dropping slightly for the very highest earners who typically receive a large percentage of income from investments”
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