Many people complain that taxes are unfair. There’s a good reason for this. Taxes really are unfair! There are many specific provisions benefiting specific groups of people, but there is also a gross unfairness among the major forms of income:
- income earned from work, what the tax code refers to as earned income,
- investment income, and
- gratuitous income or gratuitous transfers, the type of income beneficiaries receive from an individual, trust, or estate.
In the United States, as in most parts of the world, work is the most heavily taxed form of income. Poor people earn most of their money from work. Thus, taxes on work are a much greater burden to the poor than to the wealthy. Though tax rates are usually higher on the wealthy than on the poor, the poor need all of their money just to live. But, because much of it is taxed, many poor people need government handouts just to survive.
By contrast, taxes on investments and gratuitous transfers, income that accrues mostly to the wealthy, are much lower. In the United States, not only is work subject to the highest marginal rates, but it is also subject to a hefty proportional tax that applies to virtually all income earned from work, as can be gleaned by its common names, employment taxes or payroll taxes. While there are many deductions against taxes on income and gratuitous transfers, and on the marginal taxes on work, there are a few deductions against employment taxes. For instance, contributions to tax-deferred retirement accounts can be deducted against income subject to marginal taxes, but not to employment taxes. Likewise, the standard deduction and several tax credits lowers earned income subject to marginal taxes, but not employment taxes.
But even without employment taxes, taxes are still unfair. Specific provisions favor several groups of people, most of them well-off, some, even rich. This unfairness can be best illustrated by different taxpayers who receive different types of income. Note that the time and effort required is inversely proportional to the tax burden. For instance, beneficiaries who inherit money do not have to pay any tax on their income, while people who work to earn the money must pay a hefty marginal tax rate plus employment taxes. To illustrate the unfairness of taxes, we will assume 2018 tax rates and tax laws, and that incomes remain the same throughout the lives of the taxpayers, and that there is no inflation.
Comparing Taxes between Someone Who Earns Money from Work and Someone Who Receives Money as a Beneficiary
A self-employed working stiff who works for 40 years earning $50,000 per year, earns a lifetime income of $2 million. On the other hand, Richie Rich inherits $2 million. He never has to do anything to receive it, because he picked the right parents, and guess what? He doesn't have to pay any federal taxes on it, either. That's because, in the United States, estates are taxed but not the beneficiaries, but even with the estate tax, the tax code provides a unified tax credit that allows each taxpayer to pass more than $11 million of their wealth completely tax-free, and in the case of parents, that means that they can pass $22 million of wealth tax-free to their children. Moreover, Richie Rich received his money in the state of Nevada, which, like many states, assesses neither an estate nor an inheritance tax.
Now, Richie Rich could invest that $2 million, and even without being an investment guru, he can simply invest that money in stocks that pay qualified dividends that earn at least 3%. At a 3% rate of dividend income, he will earn $60,000 a year, but, because it is investment income — not income earned from work — he doesn't have to pay employment taxes on it. Moreover, because the dividends are qualified, there is a 0% tax rate on $38,700 of that income, and only a 15% rate on the remaining amount, yielding a current total tax of $3195 on $60,000 of income, an effective tax rate of only 5.3%. On the other hand, just paying the 14.13% self-employment tax on $60,000 worth of working income equals $7,065 in taxes! Add the marginal taxes, and the working stiff is easily paying more than 3 times the amount of tax than Richie Rich, while earning $10,000 less annually. Moreover, the working stiff must spend all his disposable income for life's necessities, thus leaving little to save or to invest.
And of course, states and municipalities also realize that people have no choice but to work, so they pile their taxes also on working income. In addition to the burdensome income taxes on work, municipalities and states also enact flat or regressive taxes that hurt poor people more than rich people. States and municipalities tax workers, because most are too poor to move away and because they have no choice but to work for a living.
While the working stiff works year after year working at a job that he despises, Richie Rich goes to exotic locations, has fun, and gets all the girls. Richie Rich also has a lot of family connections, so when he goes on vacation, instead of a hotel, he stays at a nice residence of 1 of his parents' friends, thus avoiding paying local taxes that he would otherwise be paying if he stayed in a hotel. He also gets to borrow his parents' friend's car instead of renting a car and paying local taxes.
Or Richie Rich goes to the shore, where he stays at a nice residence that his grandparents own, which is also free of charge.
If the working stiff got those services, he must claim the value of the services as income, which, of course, would be taxed, because income is taxable whether it's received as money, services, or benefits. Richie Rich doesn't have to worry about that, because gifts are tax-free to the donee. Services received in exchange for work are taxable. When it's received as a gift, it's not taxable.
Meanwhile, the working stiff goes to a local shore, pays for a hotel, and rents a car, where a large portion of the daily rates is taxes. Hotels and car rentals are taxed heavily, because it is a way to tax people who don't have representation in the municipality or the state. This is why Florida and Nevada have high sales taxes, but no income taxes, since they can get tourists to pay most of their tax revenue requirements.
Not only that, Richie Rich gets to go to Harvard, not because he had stellar grades, but because his parents donated $2.5 million to Harvard right before he applied, so he gets into an elite school, can get better jobs, and develops new connections with rich friends that will only help him even more later in life.
Now, Richie Rich is receiving valuable services that he would otherwise have to pay a lot of money for, but because he's getting it free because of his connections, he avoids all the taxes, receiving an equivalent income untaxed by any government.
Not only that, but Richie’s friends come from many different places, so he can travel to those places and stay with his friends at very little cost to himself. The working stiff, on the other hand, must pay large sums of money to do such extensive traveling, if he even had the time to do it.
If the object of the tax code is to promote work, then taxing work more than gratuitous transfers or investment income undermines that goal. The worker contributes not only by paying taxes but also through the work that he provides to society. On the other hand, what is Richie Rich contributing to society? Unfortunately, in the vast majority of economies on this planet, it's the freeloader that gets to pay less taxes, because, in every society, work is the most heavily taxed form of income. And it is the heavy taxation of work that helps to pay for the very lucrative government handouts of lower taxes on investments and gratuitous transfers! (And yes, these are government handouts, as I will explain later.)
A Married Couple Receiving Qualified Dividend Income
Investments are taxed much less than work. To illustrate this inequity, consider a married couple earning $101,200 from qualified stock dividends, but with no other income. And even though they don’t have any other income, they are still receiving almost twice as much as a typical household in the United States.
Qualified dividends are dividends from a US corporation or a qualified foreign corporation, where the underlying stock was held for a minimum of 121 days. For a dividend to be qualified, the stockholder must hold the stock at least 60 days before the ex-dividend date and 60 days afterwards. For long-term holders, these conditions are easily satisfied.
The 0% capital gains rate applies to the 10% and 12% tax brackets. But these brackets apply only after the standard deduction or itemized deductions, whichever is greater, are deducted. Because the standard deduction for a married couple in 2018 was $24,000, and the upper limit of the 12% bracket for married filing jointly is $77,200, a married couple will qualify for the 0% rate for up to $101,200 of income, because they can subtract $24,000 standard deduction from their income to determine their tax bracket. This income could be higher if they have significant itemized deductions. The net effect is that a married couple can earn $101,200 in qualified dividends and not have to pay a penny of federal tax. Considering that the average dividend of the S&P 500 is about 2.1%, that couple would need to have almost $5 million in assets to earn that much income. Moreover, even dividend paying stocks increase in value over time, so their assets will continue to increase, and they will not have to pay income tax on the capital gain until they sell their stock. When they do that, then the long-term capital gains rate will apply, so the tax bite will be significantly less than it would be if they had earned that income by working for it. Moreover, if they lived in a state like Florida, Texas, or Nevada that has no income tax, then they would not even have to pay state income tax on their earnings. Their earnings would be truly tax-free!
Moreover, qualified dividends, unlike ordinary dividends, do not contribute to adjusted gross income (AGI), so tax deductions and credits and other limitations based on income will not be affected by the receipt of qualified dividends, no matter how much that is.
So why are qualified dividends given this preferred tax treatment? What problem were the legislators trying to solve by allowing people to collect so much dividend income tax-free? What would be the consequence of taxing qualified dividends the same as earned income? Well, people would not consider whether the dividend was qualified or not. Indeed, the definition would no longer be apt because a qualified dividend has a special tax status. So, if investment income were taxed like earned income, people would still invest, because otherwise they would earn nothing, and remember, they do not have to spend nearly as much time or effort as working would require, especially with long-term investments. If they held the money as cash, then they would lose money through inflation, which is a type of tax.
Real Estate Sales and Depreciation
There are several tax advantages for real estate. Taxpayers who sell their primary residence can exclude up to $250,000, or $500,000 if married filing jointly, from their income, thereby eliminating all federal taxes from such income, and because it is a capital gain, there are no employment taxes either. This is more than 5 to 10 years of disposable income earned by working people, who most certainly are going to pay considerable taxes on their income.
Owners of real estate property rentals have at least 2 very nice tax advantages: depreciation and the Qualified Business Income Deduction (QBID). Residential real estate has a depreciation lifetime of 27.5 years, which allows landlords to deduct 3.64% of the original value of the property annually, not including land, which is not depreciable. For every $100,000 of depreciable real estate, the taxpayer can deduct $3640 annually, until the property is fully depreciated. Moreover, even though rental income is considered to be passive income, up to $25,000 of any losses with rental property can be deducted from other types of income, such as income from work, if certain tax rules are satisfied.
Owners of real estate rentals who actively manage the property can also claim the QBID, which allows them to deduct up to 20% of their profit annually, a savings of $2000 for every $10,000 of qualified business income. Normally, the QBID only applies to businesses where the owners actively conduct a business. Therefore, the QBID only saves these business owners the marginal tax, but not employment taxes. However, if tax rules are satisfied, then landlords can still claim the QBID even though the rental income is considered to be passive income, and not earned income, so it is not subject to employment taxes. Thus, landlords save on employment taxes on their entire rental income plus they still get to claim the QBID, saving them an additional 20% of their income taxes. So, if Donald Trump earns $100 million from his property rentals, then he can deduct $20 million from his taxable income. So he saves 37% of that amount, or $7,400,000, in taxes. He is also potentially saving up to several million dollars through depreciation of the properties. (Most of Donald Trump’s real estate is probably classified as commercial property, which is depreciable over a 39-year period, equivalent to about $2564 for every $100,000 of property value.)
So how does the government offset this shortfall in revenue? Why, it gets it from you! Or the government borrows the money, leaving it to you, your children, and your grandchildren to pay it off sometime in the future. Meanwhile, Donald Trump gets to live in paradise, while you, the scraggly child, continues to toil away at the job that you probably hate so much, slaving away under your Dilbertian boss!
Carried interest is the poster child of tax unfairness. While it does not contribute much to the federal budget, some people estimate it to be as much as $3 billion to $16 billion over a decade, it nonetheless illustrates just 1 method that rich people pay a much lower effective tax rate on their income than would be suggested by the progressive marginal tax rate. This tax loophole is especially egregious, since many of the people who get this tax break are billionaires, and it is billionaires who have fought to keep the benefit. Donald Trump said he was going to end the loophole, but like so many other things that he has said, he has failed to do so.
Some rich people have argued that raising taxes on carried interest would not contribute much to the fiscal budget, and that it would destroy jobs, decrease investment, and discourage entrepreneurship across America. Of course, it is very difficult to imagine how making billionaires pay the same tax rates that much poorer people pay would destroy jobs, decrease investments, or discourage entrepreneurship, but these rich people hope that you accept their specious arguments blindly. And while the taxes would not contribute much to the federal budget, it would certainly make the tax system much fairer, because people really do hate unfairness, regardless of how much it would contribute to tax revenue.
The performance fee of private equity, venture capital, and hedge funds can be quite substantial for partners of these funds, and even though it is earned by working for it, just as a janitor would work for his income, the performance fee is treated as a capital gain, meaning that it is taxed at a top rate of 23.8% instead of 37%, the top tax rate on earned income. Additionally, these partners also avoid the Medicare tax that would ordinarily apply to such income, which, for the amount that these partners earn, would be the regular 2.9% Medicare tax and the additional 0.09% Additional Medicare Tax that applies on earned income above $200,000 ($250,000 for married filing jointly).
The Democrats have tried numerous times to eliminate this loophole, most notably through the following acts:
- Carried Interest Fairness Act of 2012
- Carried Interest Fairness Act of 2015
- Carried Interest Fairness Act of 2017
- Carried Interest Fairness Act of 2019
But the Republicans, befitting a party that favors the wealthy, have prevented closing this loophole. However, the Republicans did, through their Tax Cuts and Jobs Act of 2017, extend the holding period to 3 years rather than just 1 year, which made it much more difficult for fast trading hedge funds to benefit from this loophole. However, venture funds and private equity funds are still benefiting immensely from this loophole, since they do typically hold their investments for extended periods of time.
How to Earn $10,000,000 — or More — and Not Pay a Single Penny in Federal Taxes
Qualified small business stock is a special type of stock, defined by the tax code, as stock where gains can be excluded when it is sold. Qualified small business stock allows people who invested in the company or received stock as part of their compensation to exclude up to the greater of $10 million or 10 times their investment from their income. So, if an investor contributed $5 million to the stock, then up to $45 million of gains can be excluded from income.
This tax provision is especially beneficial to employees at startups who receive stock as part of their compensation. Even if the stock is received as compensation, no employment taxes have to be paid on the gain, which means that such gains will be free of both ordinary federal tax and employment tax.
There are certain requirements to qualify for this income exclusion: the company must have an aggregated adjusted basis of gross assets not exceeding $50 million at the time of the stock issuance, the stock must be held for at least 5 years, and the company must make something, rather than simply providing services, thus excluding law and accounting firms. Specifically, at least 80% of its assets in value must be used in the active conduct of a qualified trade or business.
Although this tax break has been available since 1993, most taxpayers rarely used it because capital gains rates were lower, while corporate taxes were higher, and the percentage excluded was restricted to 50% of the stock. However, the law was changed in 2010, allowing 100% of the gains on such stock to be excluded.
How much does this provision cost the federal government? The top capital gains rate of 20% plus the additional net investment income tax of 3.8% would yield $2,380,000 in taxes on $10 million, but this is only applying the capital gains rate. If employees of the company received the stock as part of their compensation, then the money is earned by working for it, so it should be taxed as earned income, applying the ordinary progressive marginal rate plus employment taxes, which would yield even more revenue. Employment taxes alone would equal $309,645 on $10 million.
Some employees who work at multiple startup companies can receive this benefit continually, since as long as the tax rules are satisfied, there is no limit to how many times this exclusion provision can be used. Some tax advisors are suggesting that by putting the money into separate irrevocable trusts, then even more money can be excluded from income.
The rationale for providing this very generous tax break was to encourage investment, but is not the amount of money that can be earned from such investments enough of a stimulus? As with most big tax breaks, this tax break obviously benefits the wealthy or highly compensated employees.
While politicians often claim to promote work, how do they accomplish their task by taxing work the most? To promote work, should not earned income be taxed the least? Furthermore, there is no deadweight loss from taxing gratuitous income, since people will continue dying at the same rate regardless of the tax rate, and minimal deadweight loss from taxing investment income, since holding cash earns no revenue while losing value from inflation. So, even with higher tax rates on investment and gratuitous income, people will continue to invest and to die.
When one group of people do not pay their fair share of taxes, then other groups must make up for the difference. A government requires sufficient revenue to operate, which comes from taxes or from borrowing, but loans must be paid back eventually. So when the government gives a $4.5 million tax credit to the wealthy so that they can pass their estates onto their beneficiaries tax-free, then that is $4.5 million that the government does not receive from the wealthy estate. Therefore, it must collect that $4.5 million from somewhere else.
By collecting more taxes from the wealthy, the government can lower taxes on the poor, who will use their higher disposable income to spend, which stimulates the economy. And it will reduce the need for government handouts.