Sunday, January 22, 2012

Low tax rate for Investments

It has become common knowledge that Warren Buffet and similar wealthy people pay a lower tax rate than poor people.   This happens for several reasons:

  • Tax rate on capital gains is 15%, much lower than the tax on ordinary income.   This is done to encourage investments.
  • Up until the end of this year, the "Qualified Dividend Tax Rate" is either 0% or 15% (really 15$, to get the '0%' rate you basically have to be so poor you won't have significant dividend income.)  Again, this was done to encourage investments.
  • They can choose to give money to a charity instead, reducing the taxes they owe.   Usually they have to give more money to the charity then they save in taxes - but they have more control over what the money does.   This is done to encourage charitable donations - which often do things the government would have to spend money on themselves if the charity didn't do it.
  • They can pay for extreme accounting.  Often this involves accounting tricks done solely to lower your taxes,  For example, they can move money to another country and pay that countries taxes instead of American taxes.  Or they can declare their car/vacation home/plane to be owned by their corporation, and have the corporation write it off as a business expense that LOWERS the total taxes paid.  There is some danger to this - if the corporation goes bankrupt they lose the car/home/plane.

This post is about the first two.

First, do we need to encourage investments?  In general there are just three things we can do with money - A) spend it.  B) bury it or C) invest it.   If you give it to a bank, that is an investment - the bank invests it and takes most of the profit.  Oh, sometimes for short periods of time, banks hold extra cash (= bury it) but they HATE doing that.   It cuts down on their profit.   Usually banks bury only as much cash as the law requires them to have on hand.  So they only do it for extra money for short times, when they are scared.  More importantly, tax rates do not affect that decision.   Honestly, like banks, not many people bury the money.   That's pretty rare.  We don't dig holes and bury the money, nor do we put it in a mattress.  So we don't need to worry about that.  We either spend it or save it.

The question is, is investing cash or spending it better?  Well, when the economy is doing poorly we generally want people to SPEND the cash, rather than invest in it.  If you invest it, it helps the future, while spending helps the present.   The economic theory is a bit complicated, but that's what it comes down to.   Businesses need money from purchases more than they need cheap loans, at least when the economy is doing poorly.   If you have high profitability, you can always get loans.  When the economy is doing better, we prefer investments, as investments keep progress coming.

So we don't always want investments - we often want people to spend the money.    But honestly, that isn't very important.  For the sake of argument, let's assume that we really do want to encourage investments.

Does a lower tax rate significantly increase investments?   Well, not everyone has money that they don't need to spend.   For our purposes, there are only 3 types of people.  The middle class (99 per-centers), the "Virgin" wealthy and the "Experienced" wealthy.

The 99% of us that are not wealthy have about 50% of the investments (Source).  The wealthy 1% have the other 50% of investments.

Those 99%?  They need and like that lower tax rate.  Otherwise they might not invest at all.  It makes sense to give them a lower tax rate for capital gains and dividends.   But they don't invest huge amounts because they don't have it.  About the only time they have more than $10,000 of investment income is when they sell a home - and homes are already treated differently for capital gains purposes.  Let's keep that rule about home sales.

But lets talk about the other 1%.  They are split between the Virgins and the Experienced.  The Virgins are lottery winners, Athletes, Musicians etc.  These are people that, while they may be phenomenally competent (or just lucky) in a particular field, did not have to develop business expertise.   Honestly, they don't know how to handle money.  They may have earned it with lots of hard work, but that is not what we are talking about.  The point is that while they don't know about money - or tax rates.  If they get good advice, or simply are intelligent, they will invest a lot of their money - regardless of tax rates.   Because a good adviser knows that the virgins tend to lose money.  We see it all the time.   If on the other hand they get bad advice and are stupid, they won't invest.   It won't matter what the tax rates are because these people (or their advisers) won't know that it is important.  

Next are the "Experienced".  These people may be stupid and may be incompetent - but they either know how to handle money or trust someone that knows how to handle money.   Otherwise they would have lost their money (just like about 50% of the Virgins do after a couple of years).  They (or their adviser) knows that investments are more important regardless of tax rates.  They will invest even if tax rates match normal income rates because that is the smart thing to do.  You want your money to do the work, not you.

So the solution is simple.   Each year, have the first $10,000 (adjusted for inflation) of capital gains/qualified dividends be TAX FREE.   Keep the current exceptions for the primary house you live in (and/or a secondary home).  But all other capital gains/qualified dividends after the first $10,000 are taxed at your NORMAL tax rate.  Same as anything else - your salary, the gambling winnings, the alimony you receive, everything.

This still encourages the 99% to invest.  In fact, it is even BETTER than the current system of a set 15%, as they pay no tax.  It even encourages the 1% to invest a little bit.    Those of them (virgin or experienced) that are smart enough to keep their money, at least.

Most importantly, it is pretty much identical to the system we use for regular money.  If you just make $10 grand a year, we don't really tax you on it.  It's called a standard deduction.  So in effect, if all you do is investment income, then you get two standard deductions - the regular one plus the 'investment income deduction'.

(Note, this analysis assumes that the housing exclusions for capital gains is kept.  Real estate sales are an exception to the rule about people making investment decisions based on taxes.)

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