There has been tremendous hoopla regarding Mitt Romney’s income tax rate. His tax returns show that he paid something just less than 15 percent -- the capital gains tax rate. That makes sense. Most of his income was derived from dividends and capital gains. Further, Mitt gave a lot of money to charity, so he had deductions. Still, this seems a small percentage compared to the income taxes paid by many working-class Americans. Warren Buffett has famously proclaimed that he paid a lower tax rate than his secretary. Something must be wrong!
Both of these examples are used to support higher taxes favored by the political left. They are also oversimplifications that obscure the truth. The reason is that while ordinary income is taxed only once, at the personal level; capital gains are taxed twice, both at the personal level and at the corporate level.
Consider an individual, who owns a share of stock of a particular company. We’ll call this person Mitt. This means that Mitt owns a part of that company. In effect, he owns a share of the profit of the company. Let’s also say that this company has an employee. We’ll call him Barack. He represents the working class.
After all expenses but tax, the company has earned some amount of money. Let’s say that Mitt’s share of the pretax earnings is $1 (based on the fact that he owns one share of stock). There are two scenarios. First, the company could use the dollar to pay Barack additional compensation, the way that most working-class Americans derive their income. Alternatively, Mitt could receive the money as a dividend distribution. Let’s look at how taxes play out under each scenario.
If Barack receives the $1 as compensation, the company won’t have to pay taxes on the dollar. Paying employees is a pre-tax expense for businesses. However, Barack will have to pay ordinary income taxes on this money. Let’s say that his marginal tax rate is 35 percent (that’s probably a high estimate, but we’ll err on the side of conservatism). That means that Barack will pay $0.35 in income tax and he will get to keep $0.65.
Now, let’s consider the scenario where the company decided to pay a dividend with this pre-tax dollar. In this case, the company would have to pay taxes on the dollar. Let’s say that the company’s marginal tax rate is 35 percent. The company will pay $0.35 in corporate taxes and Mitt will receive $0.65 in dividends. However, Mitt will still have to pay a 15 percent tax on the dividend. Therefore, he will have to pay almost $0.10 of additional tax and will be left with only about $0.55.
In summary, if the company paid Barack $1 of compensation, he would get to keep $0.65 after tax. If the company used the same pre-tax dollar to pay Mitt a dividend, he gets only $0.55 after tax, because the money is taxed both at the corporate level and at the individual level.
Although Mitt’s tax rate looks to be 15 percent, the government actually nets almost 30 percent more money ($0.45 instead of $0.35)! So, if the taxes that the company paid on Mitt’s share of the earnings are added to the 15 percent that Mitt paid personally, the effective tax rate was actually 45 percent compared to Barack’s effective tax rate of 35 percent!
When people, including President Obama, say that those paying capital gains tax are paying less than those paying ordinary income tax, they are ignoring the fact that the capital gains have already been taxed at the corporate level. They are not mentioning that the 15 percent tax at the personal level is a second bite at the apple. They are telling a half-truth that supports their call for higher taxes, but distorts reality. Yes, those paying capital gains taxes should pay their fair share, and they already are.
These are the facts. We realize that this will upset some people because the facts don’t support their economic or political agenda. We fully expect to get angry responses. Still, that doesn’t change reality.
Doug and Polly White are Principals at Whitestone Partners; a management-consulting firm that helps small businesses to grow profitably.