I enjoy the fact that the people who read articles on this site are of many ages, races, income levels, and political persuasions. As such, this post will not be an endorsement of President Obama nor Mr. Romney, but rather a quick explanation of why some rich people pay such a low percentage of their income in taxes, compared to working and middle class folks like teachers, secretaries, engineers, and pilots. I’ll take a look at how it happens, why it happens, and provide my two cents on whether current tax practices are helpful.
Regular 9-to-5 Workers Who Do a Job and Come Home
If you get up in the morning, go to work, and get paid every 2 weeks by a company or a small business, then you most likely fall into the category of a wage earner. Wages are taxed as ordinary income. This means you do a job, somebody pays you for it, and the government takes a chunk so our country can buy cruise missiles, roads and bridges (here and abroad), and all of the wonderful things that keep the USA running. Depending on how much you make in a year, the government taxes you at a different percentage.
The table below shows the 2012 Federal Income Tax Brackets. Remember the first column is for married people, the second is for those filing as single.
Note: Most states also have their own taxes (not Texas thank goodness!) and some cities do as well.
Now Here’s the Deal with People Who Manage Money For a Living, Like Mr. Romney
People who invest and manage money for a living earn cash differently. These money managers get paid mainly in two ways:
(1) They charge major investors a fee based on the total value of the assets being managed (usually 2%).
(2) They keep a percentage of the profits that they make on investments for clients (usually 20%)
Now here’s the interesting part. Income that money managers receive on fees is taxed like wage income (which is basically under the same set of rates that we pay). BUT (and it’s a big one), income received on investment profits is taxed as a capital gain. Capital gains are taxed at the low rate of 15%.
I’m still a little confused, can you give me an example or two?
Let’s say I decided to give up my day job as an oil and gas analyst and try my luck at managing money.
I create a firm called JG Capital. I have some clients that give me money to invest in publicly traded companies for the long term and other clients that give me chunks of money to invest in private businesses to flip for a profit relatively quickly (3-5 years).
Example 1 – Fee Income
JG Capital is given $100 million by a rich guy who thinks that I have a knack for picking stocks. Due to fluctuations in the market and a few bad choices, the $100 million doesn’t go up in value, nor does it go down in value in a given year. Therefore no profit for my investor.
Don’t worry though, I still get paid.
Given the “2 and 20” numbers from the previous section, I will pay myself $2 million per year (2%), just because that’s my fee for making decisions with other people’s money.
$100 million x 2% = $2 million fee for investing this guy’s money. This $2 million will be taxed at 35% which equals to a $700,000 tax bill. Fair enough.
Note: Had I delivered a profit during the year, I would also take 20% of that profit.
Example 2- Capital Gains
An even richer guy gives me $1 billion (with a B) to invest. He’s not interested in having me manage his money for the long term (therefore I’m not going to charge him a 2% annual fee), but rather to quickly identify a private company than can be bought and sold for a profit very quickly. I decide to use all of the money to buy a new tech company with a lot of potential, but not-so-good management. I hire a few people, fire a few people and sell the company 3 years later for $1.1 billion. My investor is beyond happy. I’ve made a $100 million profit. Again using the “2 and 20” numbers, I will pay myself 20% of the total profit. In this case, it’s $20 million.
$1 billion turned into $1.1 billion. $100 million profit x 20% = $20 million for my pocket.
This $20 million profit is taxed at the capital gains rate of 15%, a $3 million tax bill.
I gave the initial investment plus $80 million back to my investor of course.
In short, assuming each of these examples were different clients investing with my firm, I earned $22 million ($2M + $20M), but paid $3,700,000 in taxes. Also assume that both examples occurred during the same tax year.
My total federal tax bill was 18.5%. Lower than a FedEx delivery man making $36,000 per year. People like Mitt Romney pay even less than 18.5%, because they have teams of tax professionals helping them to take advantage of several different types of tax deductions.
Why is this allowed?
Whether you agree with it or not, our tax code looks favorably upon investment income. Governments typically believe that low tax rates on capital gains will encourage people to make investments in businesses, which hopefully will have a positive overall impact on the economy. These investments (in theory) will ultimately lead to hiring people, buying equipment, and making products that people want to buy.
While school teachers and engineers are important parts of society, these wage earners do not make the bulk of their income from investments and are therefore taxed under a different set of rules.
JG’s 2 Cents
In my short career, I’ve had a handful of conversations with a few mega money guys. The classic argument for taxing capital gains at low rates is that it incentivizes people to make investments.
I’m going to call BS on that one.
If I can sell a company for $100 million more than I paid for it, I’m going to do it…whether or not the government takes 15% or 35% of it! Of course I’ll want to take home more, but I’ll still be a rich guy doing rich guy things; driving rich guy cars, living in rich guy neighborhoods.
I would argue that there would be no slowdown in investment. None. Lots of complaining, but I don’t see a flight of capital leaving the USA. For all of our faults, our capital markets are considerably more transparent than elsewhere in the world.
I’m not going to lie. I hope to someday join the upper echelons of society with respect to income. I also find something not quite right with Bill Gates, Warren Buffett, and Carlos Slim paying less in taxes (percentage-wise) than the people who mop their floors.
Call me crazy!
What do you all think?
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