During his State of the Union address, President Barack Obama stated that "Warren Buffett pays a lower tax rate than his secretary." This statement echoed an op-ed that Buffett wrote in The New York Times last August. In this op-ed, Buffett claimed that he only paid 17.4 percent of his income in federal taxes and, using data from the Internal Revenue Service, that the 400 richest Americans only paid an average of 21.5 percent of their incomes in federal taxes. These claims are often used to support the contention that the federal tax code has been rigged in favor of the rich.
However, all of these claims are highly misleading, as they ignore corporate taxes. Consider the 2007 data from the Congressional Budget Office, which, unlike the IRS' data, includes indirect taxes in its calculations of the distribution of federal taxes. If you ignore corporate taxes, the top 1 percent of income earners pay 20.7 percent of their incomes in federal taxes; once you include corporate taxes, that number rises to 29.5 percent.
But why does the corporate tax make such a big difference? The answer is that, when a corporation earns a profit, the federal government taxes this money twice: First, the corporation pays up to 35 percent of the profits in corporate taxes. Second, when the corporation pays a dividend or a shareholder sells stock for a capital gain, the shareholder pays up to a 15 percent tax rate.
As an example, assume that you own a company that earns a $1 million profit. The company pays $350,000 in corporate taxes. You then pay $97,500 in capital gains and dividend taxes. Of the original $1 million, the federal government receives $447,500, and you are left with $552,500.
This is particularly relevant to Warren Buffett, much of whose income is from dividends and capital gains. By ignoring the corporate tax, Buffett can claim that he only pays a 15 percent tax rate on his dividend and capital gains income. But, once you include the corporate tax, the true tax rate could be anywhere up to 44.8 percent.
Now, there are two important caveats. First, the United States' corporate tax system is so riddled with loopholes and deductions that few companies actually pay an average tax rate of 35 percent. Both Congressional Republicans and President Obama claim to support a revenue-neutral reform of the corporate tax code that would eliminate these loopholes and lower the corporate tax rate to a level more in line with other developed countries. This reform should be a no-brainer.
Second, many hedge fund and private equity managers manage to pay only the capital gains rate on what is really non-investment income due to the "carried-interest" loophole. Given that a large majority of the "one percent" CEOs, sports stars, doctors, lawyers, investment bankers and so on pay up to a 35 percent federal tax rate on their labor income, it is pretty indefensible that a small minority pay only a 15 percent tax rate on what is also really labor income. Both President Obama and Mitt Romney have indicated that they would be willing to close the carried-interest loophole.
So how much does Warren Buffett really pay in federal taxes? While it is impossible to know without analyzing both his tax returns and the tax returns of the companies in which he has invested, it is almost certain that Buffett's true tax rate is significantly higher than 17.4 percent. If Buffett truly does pay a lower tax rate than his secretary, that would make him a highly anomalous high-income individual.
According to the CBO, the top 1 percent of income earners paid an average of 25.6 percent of their incomes in federal taxes in 1986, the lowest rate over the last three-and-a-half decades. By 2007, this number had increased to 29.5 percent. In comparison, the middle 20 percent of the population (which includes Buffett's secretary) saw their average federal tax rate fall from 18 percent to 14.3 percent over the same period. Furthermore, the bottom 20 percent of the population saw its average federal tax rate decline from 9.6 percent to 4.0 percent.
In short, with the exception of the carried-interest loophole, it is hard to argue that the federal tax system is rigged in favor of the rich. Maybe you want to argue that its unfair that the typical highest income-earners pay "only" about a third of their incomes in federal taxes while middle-income families pay under a sixth of their incomes in federal taxes. But let's stop pretending that the tax code is somehow "rigged" in favor of the rich.
