A Simple Reality In The U.S. Tax Code That Affects Us All

How the U.S. tax code rewards the super wealthy and punishes the working classes.

 
“It was the best of times, it was the worst of times…” -Charles Dickens, A Tale of Two Cities

e’ve come a long way since Dickens’s day, covered enough ground that Chuck himself might actually be impressed.

“Progress,” he’d note, eyeing our glassy skyscrapers and curvy sports cars, our gleaming Lear jets and shiny, solar yachts.

Dickens would be right, too. We have accomplished quite a bit in the last two centuries. Where 19th Century England relied on a mélange of monarchy, aristocracy, workhouses, debtors’ prisons, public squalor, child labor, and union suppression to rob its people of any chance of economic betterment, post-modern America goes for one-stop shopping. We settle for the IRS.

Tax time again, and you’ve probably put the wraps on your annual orgy of screaming, crying, document accumulation, and malfunctioning tax software. (Fortunately, for extreme masochists, there’s still paper and pencil.) You’re tired, maybe even exhausted, but you’re feeling good. You’re off the hook for another year.

But it’s not really over. The IRS is screwing you every day of the year, and they’re doing it with your consent. The worst of times, even if you don’t realize it. But you want to know about it, don’t you? Because if it’s the worst of times for you, it’s likely the best of times for someone else.

Sitting down to write this article, I had certain notions about wealth in America—some of them, no doubt, born of mass advertising and stereotyping. Other assumptions were based on lived experience. I’ve paid attention to financial and economic issues my whole life, followed markets, dealt with realities. I’ve worked in tax and finance, accounting and corporate strategy. I believe in Capitalism and its ability to provide incentive, the fact that free-flowing wealth is probably the most egalitarian means we’ve come up with to stimulate production and, in many ways, progress.

I also believe in Social Democracy. I believe that one goal of an advanced society should be to benefit all its members, that while we cannot guarantee absolute equality we should do everything we can to ameliorate misery and, if possible, create happiness. That happiness bit is in the Declaration of Independence, after all.

I have to say, though, I wasn’t expecting the stark scenario I’m going to lay out for you. Our federal tax code is so blatantly rigged against working people, it’s unconscionable. Even with my experience I didn’t realize the extent of that until I looked at a few very basic examples. Once you see these numbers, you’ll realize it’s time for a big change in America, that the only way we’re going to move forward as a society is to worry about the working class again, to make sure everyone has at least some chance to succeed.

Dickens was onto something with his social criticism, which is why we still read him 150 years after his death. In A Tale of Two Cities he described the two superpowers of his day, England and France (his two cities, London and Paris). He showed us how England (the “nation of shopkeepers,” Napoleon derided) was able to survive in spite of its many flaws, while France was convulsed by revolution, consumed by Madame Guillotine and her Reign of Terror. It was all about economics and social justice then. And it is today. Let things get too far out of balance and you court disaster.

As an illustration of how our tax code works at an individual, granular level, let’s look at the cases of two men, Working Joe and Lucky Heir. Working Joe makes $100,000 a year. That’s a decent salary, right? Really good in some parts of the country, not so much in others. Working Joe could be a professional or a tradesman. He could be a salesman or a librarian. It really doesn’t matter what he does to earn his wages. The key, as far as the government is concerned, is that Joe earns wages, also known in the tax code as “earned income.” So Joe makes his dough and pays his bills (food, rent, healthcare, etc.). One of Joe’s biggest bills, one you’re no doubt quite familiar with right now, is what he pays Uncle Sam. In addition to federal income tax of $18,500, Joe pays $6,200 in Social Security, and $1,450 in Medicare. The grand total of Joe’s federal tax payments is $26,150.

Let’s look at a second case, that of Lucky Heir, the fifth-generation descendant of some formerly alive formerly rich guy. Let’s say Lucky inherited $2 million at some point. This may seem like a lot of money to the average person, and it is. But as professional inheritors go it’s really not much. For example, Fidelity Investments heiress Abigail Johnson is, by some reports, worth a cool $17 billion.

If Lucky Heir invests his $2 million and earns 5% he should be able to generate $100,000 a year in income just like Working Joe. Now, let’s further assume that Lucky derives $45,000 of that income from capital gains like sales of stock, $45,000 from stock dividends (cash payments companies make to their shareholders), and $10,000 from interest (total income of $100,000 just like Joe). Under this scenario, Lucky’s federal tax bill will be a little over $8,000. You’ll recall that Joe paid more than twice that, with his federal tax bill coming in at $18,500. But wait, this excludes one thing: Lucky doesn’t have to pay Social Security or Medicare taxes because he doesn’t have “earned income.” Tack that on (or off, actually) and Lucky pays less than a third what Joe pays.

The upshot of all this is that Lucky will have another $18K or so rattling around in his jeans at the end of the year ($26K – $8K = $18K). Lucky’s beginning $2 million aside, he is actually becoming wealthier at a faster rate than Joe, the wealth gap between the two men increasing constantly based on the simple fact that the IRS treats income from investments more favorably than earned income. Nor is one year the end of it. This goes on and on. Without any changes, this will continue until the end of time or America, whichever comes first.

So let’s play it out. Based on one year’s income of $100K Lucky has an additional $18K to invest. Imagine this continues for an entire adult lifetime, say 60 years. In that time, Lucky will pay nearly $1.1 million less in taxes than Joe. Even without the compounding power of investment returns, Lucky’s wealth will be $1.1 million higher than Joe’s for no reason other than that the U.S. tax code favors him. That’s not the end of it, though. The truth is that investments do make returns. That’s how Lucky generates his income after all. And the truth in this case is that the $1.1 million Lucky saved in taxes will, if invested at 5%, actually be worth $6.3 million after 60 years.

The unfairness of our tax code is more pronounced at lower income levels. At a $25K annual income, the total federal income tax bill including Social Security and Medicare is a little less than $4K for a one-person household. On the other hand, for an investor who generates $25K in income, the federal tax bill will be $0. That’s right, $0. Over his lifetime, the investor will pay about $220K less in taxes than the worker, an amount that will at 5% interest grow to more than $1.3 million in 60 years.

I hear you out there, Ms. Doctor. You think you’re one of the rich and the system benefits you, too. As a result, you may be willing to turn a blind eye to how unfair the system is to the rest of us. After all, you’re a job creator yourself. It takes money to make money, nothing comes free, and all that. So here’s another example just for you.

If you make $1 million in wages, your yearly federal tax burden is about $380K. If a peer of yours, let’s call him Very Lucky Heir, generated that same $1 million income through investments in the mix (45-45-10) that we looked at above, Very Lucky Heir’s taxes would only be about $221K. Over 60 years the millionaire wage earner (Ms. Doctor) will pay nearly $9.5 million more in taxes than Very Lucky Heir, an amount that would grow at 5% interest to more than $56 million.

Now imagine this happening on a massive, societal basis—which it is. The reality of the U.S. tax code is that a whole lot of Working Joes (most Americans, in fact) pay higher taxes so that comparatively few Lucky Heirs can accumulate more and more wealth. In 2011, according to the IRS, the total of interest income ($193.1 billion), capital gains ($375.3 billion), and dividends ($194.6 billion) for individual tax returns was $763 billion. That’s over three-quarters of a trillion dollars receiving preferential tax treatment.

Based on the examples above, the amount of lost revenue might be anywhere from $100 to $150 billion, which would represent around 20% of our 2014 federal budget deficit of $744 billion. If we reformed our federal income tax system to tax wage income and investment income equally, we might see out budget deficit shrink to $594 billion. There are other changes we could make to the tax code, of course, such as raising marginal tax rates for the super rich, considering a net worth/wealth tax, higher corporate tax rates, taking off the Social Security earnings cap ($117K for 2014), and going to graduated rate systems for Social Security and Medicare. These changes would each generate additional revenue, further closing our deficit. However, each is deserving of a fuller discussion than this piece can offer.

Our current tax code is unfair, regressive in the opportunities it provides working people to gain financial stability. No one is begrudging Lucky Heir his inheritance, but is it fair for him and all his descendants to be subsidized indefinitely, paid by the rest of us to be full time investors? And not just paid, but paid better than we pay ourselves? What would seem more fair, more in line with Social Democracy and enlightened Capitalism, would be for all types of income to be taxed under the same progressive rate structure.

My friends on the right may suggest that we need to make investment attractive, that there has to be an advantage to risk-taking. They might propose that Lucky Heir won’t invest unless he receives a favorable tax treatment. This is foolish. The idea that Lucky will forego investment, deciding instead to subsist on whatever he can make by actually working, is ludicrous, perhaps even ridiculous enough to pull Charles Dickens back into our game.

“He says what?”

“What can I say, Chuck, Lucky’s not thinking clearly.”

“Is he familiar with the guillotine?”

“Umm…Yeah, I think he must be. He’s no dummy.”

“He must think himself immune then. He must…” here Dickens gets an evil glint in his eye and trails off.

“What?”

“There was a queen once. When she was told that her subjects had no bread, she suggested they eat cake.”

“I’m not sure I…”

“Her subjects collected her head.”

 
Editor’s Note: A line regarding $25,000 falling below the poverty line for a family of five has been removed as it did not reflect the author’s original intention to focus on individual taxpayers.