Regarding the “Private Tax System” of the Wealthy
December 30, 2015
Yesterday, The New York Times published an interesting piece by Patricia Cohen and Noam Scheiber about trends in wealth management and tax planning among the richest Americans. The article posits that several thousand extremely wealthy Americans now operate under a “private tax system” that applies only to them. While the authors make somewhat misleading use of tax statistics and ignore a few key issues, they offer useful insights into the current state of the U.S. tax code.
Cohen and Scheiber relay a clear narrative: over the last two decades, high-income Americans have used aggressive tax planning and political influence to substantially lower their tax burdens. They write:
Operating largely out of public view – in tax court, through arcane legislative provisions, and in private negotiations with the Internal Revenue Service – the wealthy have used their influence to steadily whittle away at the government’s ability to tax them… The impact on their own fortunes has been stark. Two decades ago, when Bill Clinton was elected president, the 400 highest-earning taxpayers in America paid nearly 27 percent of their income in federal taxes, according to I.R.S. data. By 2012, when President Obama was re-elected, that figure had fallen to less than 17 percent.
Here, Cohen and Scheiber cite a statistic that looks pretty dramatic: between 1992 and 2012, the income tax rate of the 400 highest-income taxpayers fell from 27 percent to 17 percent. However, this statistic is missing important context: over the same time period, the sources of income for the wealthiest Americans shifted. In 1992, the 400 highest-income taxpayers earned only 32.97 percent of their income from long-term capital gains. By 2012, this figure had risen to 68.45 percent. Because long-term capital gains are taxed at lower rates than ordinary income, this means that the 400 highest-income taxpayers were bound to pay lower taxes in 2012 – simply because their sources of income changed.
This discussion of capital gains raises a larger issue with The New York Times article. Cohen and Scheiber detail several strategies that high-income Americans use to lower their taxes, yet many of these “loopholes” are basically insignificant. The most important reason why the 400 highest-income taxpayers pay an income tax rate of 17 percent is not a loophole; it is the lower rate on long-term capital gains and qualified dividends (20 percent in 2012, 23.8 percent since 2013).
There is a principled reason for taxing capital gains income at lower rates than ordinary income. When an individual is taxed on her salary, she also implicitly pays taxes at the same time on her future capital gains. After all, the more an individual’s salary is taxed today, the less she will be able to invest tomorrow, and the less of a capital gain she will be able to realize in the future. Therefore, income taxes that apply to capital gains are imposing a second layer of taxation on earnings that have already been taxed. To mitigate the distortion of this double tax, most countries tax capital gains at a lower rate than ordinary income.
In other words, the main reason why high-income taxpayers pay less of their income in taxes – the lower rate on capital gains and dividends – is a legitimate and essential part of the U.S. tax system. The New York Times article neglects to mention this important point.
In addition, because capital gains are income that has already been taxed once, the statistics that Cohen and Scheiber present do not tell the full story. While the top 400 taxpayers paid only 17 percent of their adjusted gross income in taxes in 2012, the portion of their income that came from capital gains had already been taxed previously, when it was earned as a salary in a former year. Therefore, the effective tax rate faced by high-income individuals in 2012 does not fully capture the burden faced by these taxpayers.
Despite these issues, The New York Times piece contains several interesting insights about the U.S. tax system. Perhaps the most important takeaway is that the more complex the U.S. tax code becomes, the more it will advantage those who can afford tax lawyers. Cohen and Scheiber describe how high-income taxpayers systemically make use of the most complicated parts of the tax code – partnership law, income sourcing rules, etc. – to lower their tax burdens. Again and again, the authors emphasize that these strategies are unavailable to taxpayers with lower incomes.
It might seem obvious that tax complexity benefits the wealthiest taxpayers. Yet, most of the tax provisions aimed at making the rich pay their “fair share” are among the most complex in the tax code: the estate tax, the alternative minimum tax, and FATCA. In practice, these provisions are probably the most severe for Americans with enough money to be subject to them but without enough money to hire sophisticated tax planners.
Another important takeaway from The New York Times article is that the question “Are rich Americans paying enough in taxes?” is meaningless until you specify which Americans you’re talking about. It’s well-documented that the top 1% and even the top 0.1% highest-income Americans really do pay very high tax rates – well over 30 percent. But the households that Cohen and Scheiber discuss in their article are the top 0.00001% of taxpayers; these families are in an entirely different category, and should be the subject of a completely separate debate.
Update: the I.R.S. has now released data for the 400 highest-income taxpayers in 2013. This new data presents a serious challenge to The New York Times's narrative, that taxes on the super-rich have gone down systemically over time. As the graph below shows, tax rates on the rich spiked in 2013, erasing most of the decline since the early 1990s. This is not surprising; we reported back in August that taxes on the rich had gone up significantly in 2013, due to provisions in the Affordable Care Act and the fiscal cliff deal.