Will the Real Tax Rate Please Stand Up

Warren Buffett and Mitt Romney have something in common beyond wealth. Both pay federal income taxes at a 45 percent rate. That’s three times the 15 percent rate mentioned by Mr. Buffett and reported in the press. That rate is also higher than the 30 percent “Buffett Rule” that President Obama is touting in the name of fairness.

How can this be? How can Buffett and Romney pay so much more in taxes than we see discussed in the press? Doesn’t everyone know that the very rich have the advantage of being able to rent representatives and senators to write the best tax code money can buy?

The answer lies in understanding what economists call “tax incidence”— knowing who really pays a tax. We’re going to get to that understanding by starting with a rapidly growing lemonade stand.

If you have a lemonade stand, it is considered a “proprietorship.” You’re the owner, operator and the person who earns income selling the lemonade. You subtract the costs of doing business from the sales of lemonade and that becomes your earned income. Since it is labor income, it is subject to employment taxes. It is also subject to the broader federal income tax.

But you have a vision. You want to become the Starbucks of lemonade. You open multiple stands. The net income of the business soars. Your new CPA says you need to turn your proprietorship into a corporation. Since you enjoy having a big income, you make it an “S” corporation, a form that allows you to pass all net income through to yourself for tax purposes and, perhaps, a few other shareholders.

That income, like the proprietorship income, will be subject to both the employment tax and the federal income tax. You’ll pay at a 12.4 percent rate on the first $110,100 you earn for the employment tax. (The Medicare tax is an additional 2.9 percent.) As a practical matter, you’re earning so much that you leave the employment tax far behind. The only tax that matters is the federal income tax. On that, you pay at a rate as high as 35 percent.

Now suppose Ubiquitous Lemonade grows even larger.

What do you do?

You become a “C” corporation, one that is a taxable entity unto itself. As a consequence, you now have to pay the corporate income tax. Whatever your corporation earns, it may be taxed at a rate up to 35 percent. For each $1 of earnings, the corporation can retain 65 cents after taxes. The corporation can then pay you a dividend out of those 65 cents.

When you get that dividend, it will be subject to a federal income tax rate of 15 percent. Since you are paying a 15 percent tax on 65 cents, $1 of what used to be your earnings is now down to 55 cents after taxes.

One of the reasons the tax rate on dividends is so low is that economists see this as double taxation. However you look at it, your effective tax rate is 45 percent because that’s how much of each earned dollar goes to the government. If President Obama gets his “Buffett Rule,” with a minimum tax rate of 30 percent for millionaires, the effective tax rate won’t be 30 percent. It will be 55 percent.

Would that kill the economy? Maybe. Maybe not. It certainly wouldn’t be friendly to income from capital, so we can expect to see yet more money being invested in other countries. We can also expect more wealthy Americans deciding that Australia, New Zealand or Brazil are better places to live, work and collect dividends.

The reality here is that the United States is a high-tax land for everybody.

If you are a typical worker, you probably pay a top income tax rate of 15 percent. You also pay the 15.3 percent employment tax. (If you think you only pay half of that tax, you’ve been snookered by a smart politician. Stop working and your employer stops paying “his share” of the employment tax.) So your real but disguised tax burden is about 30 percent.

That’s two-thirds of what Buffett and Romney pay.

What should our tax rate be? I don’t know. But it would help if the politicians started with the right numbers.