If I were an econ or math professor I might be inclined to assign an extra credit for a short explanation of Buffett’s tax rate comparison to his secretary’s.
Nobody seems to be able to get this much ballyhooed comparison — and inspiration for Obama’s “Buffett Rule” — correct.
Here’s what my answer to the assignment would look like:
The above table shows a comparison between the taxes and tax rates paid by Buffett and his secretary, Debbie.
The first comparison (1) is made by Buffett in the media and is composed of three parts:
- Payroll taxes (Social Security and Medicare) paid by each individual.
- Payroll taxes paid on behalf of each individual by their employer.
- Individual Federal income taxes paid.
Buffett includes the portion of payroll taxes paid by their employer on their behalves, but ignores the corporate income taxes paid on his behalf by the companies that paid him dividends, which make up nearly all of Warren Buffett’s taxable income.
Dividends are taxed twice, once when earned as income by the company and again when the company pays the dividend to its owners.
Buffett and other commentators treat the low dividend tax rate as if it were a random and unfair artifact of the tax code.
Rarely is it acknowledged that there is a rationale for a lower dividend tax rate and it’s not just to make the rich richer.
Part of the rationale is that the combined corporate and individual tax rates on dividends is high at around 45% -50%. As Congress evolved the tax code — with the input from economists — one of reason they set the dividend tax rate low was to help offset the effects of the double taxation.
When the total dividend tax rate was higher, companies avoided paying dividends because of the high tax rate. Some managers used double dividend taxation as an excuse to hold on to shareholder money and blow it in bad investments.
Others used a more tax efficient method of distributing money to owners — share repurchases. Since there is no good reasons for the tax code to favor one form of cash distribution (repurchases) over another (dividends), dividend taxes were lowered to make both methods more equal.
But, therein lies the danger of such clever and complex systems: The next set of folks forget or don’t understand the rationale. Or, perhaps they understand it, but choose to exploit (and feed) the misperception of low tax rates for their own political purposes.
To get a more apples-to-apples comparison between the real tax rates Buffett and Debbie pay (comparison 2), I estimated that the companies that paid dividends to Buffett had already paid $14 million in taxes on his behalf. Now, this isn’t wholly accurate. They really paid more (the real number is probably closer to $20 million), but I’m simplifying for the sake of understanding.
When I add the corporate taxes paid in, I find that Buffett pays a substantially higher tax rate (50%) than Debbie (37%) and the “Buffett rule” has not been violated. Not even close.
One final note: In addition to underestimating the amount of corporate taxes paid, some could quibble that my analysis ignores taxes Buffett paid when we earned the dividend-paying holdings to begin with. That’s true and that means his dividends are actually taxed three times. But, I thought just adding in what the company pays on his behalf in the current period should make a strong enough case for casual observers that Buffett and Obama are deceiving the public for political purposes.