NEW YORK - Warren Buffett proposed a new tax rule to the U.S. Government for people who make over $1 million in a year which includes 450,000 Americans. This proposal has become known as the Buffett Rule. The legendary investor knows he is manipulating the argument when he says he pays lower taxes than his secretary. For one, he is actually saying he has a lower tax rate and dropped the word rate to make a better argument and he isn't actually paying a lower rate when you look at the aggregate numbers. The rich pay low tax rates because capital gains taxes are taxed at a maximum of 15%. This rate is for rich and poor alike but the difference is some of the rich primarily derive their incomes from investments. However before they made investments they likely were paying a high tax rate. Many Americans see this number and wonder why they are in a higher tax bracket. It is fairly simple though and Buffett perhaps is erring in his opinion and he is most likely erring intentionally. Buffett knows the U.S. deficit is a huge problem and perhaps an irrational argument that to him does not hurt the ordinary American or business would be a good way to raise revenues. The rule would perhaps add $50 billion to U.S. Revenue but this is not exactly the point. Taxing rich people at 100% would add trillions in revenue it does not mean it is necessarily fair. Tax rules should be fair and make sense. The Buffett Rule is draconian to the rich.
Here is why the Buffett rule is wrong. Currently the tax rate in the United States for corporations is 35%. If the tax rate on corporations were 100% then shares would never appreciate. Not every company is at 35%, companies like Exxon are at 45% while Apple is at 25%. Most U.S. Companies though hover around 35% tax rate.
In our example lets assume a corporation is 100% owned by one person and the corporation pays no dividend and the stock has a discount rate of 7%. This example lets everyone see that a corporation is like an individual paying taxes. The only difference in the real world is one individual usually holds a small piece of the bigger pie. The discount rate means the stock appreciates by that amount a year assuming there is no divided. Lets assume a 1 Price to Earnings Multiple *(PE), 5, PE and 10 PE and the corporation makes $100,000 in net income. At a 1 PE the corporation will be worth $100,000 (100,000 in earnings * a 1 PE) by market value and at the end of the year it will grow to $107,000 assuming the shareholder sells it at the end of the year he will pay taxes on this $7000 at 15% and he will already have paid $53,846 in taxes on corporate earnings for a total taxes payable at $1050+53846 or $54846 divided by the corporate earnings is a 35.6% tax rate which is much higher than the ordinary individual. At a 5 PE the taxes payable will be $5250 + 53846 or 38.4% and at a 10 PE it would be a 42% tax rate. All of these rates are much higher than that of the ordinary individual.
Obviously capital gains are a deferred tax payable and you don't have to pay until you sell. However raising the capital gain tax rate to 35% would make the taxable income payable by the rich far more than the poor.
Everyone is looking at the problem one dimensionally and not considering the fact that the corporations are already paying tax at a higher rate than these individuals. The idea of a capital gain tax only makes sense if the corporate tax rate is far below that of the individual as the tax on the gains should equalize what the corporation and the person would pay in the aggregate. For instance if the corporation paid a 0% tax rate then the individual should pay higher capital gains to compensate for this disparity between the personal and corporate tax rate.
The Buffett rule is wrong and hopefully it is never implemented. It is not unfair that people who make investments are taxed at a low rate because their corporations they invest in pay high tax rates. There needs to be more equitable ways going forward for the U.S. to increase revenues. Not this draconian rule.
*Note PE are an incredibly simplistic way to value companies and is used simply for illustrative purposes.
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