The Effective Rate Debate 1

I’ve been meaning to write an actual tax blog post for some time, just to try it out. I picked something fun and controversial. Hope you enjoy it.

The debt ceiling debate has been about as ubiquitous as car insurance commercials over the past few weeks. Like all good political debates, we’ve had no shortage of name calling and mud throwing, and even some real information distributed every now and then. One particularly titillating revelation was that the super wealthy only pay an effective tax rate of 17%! That’s 9.9 points down since 1992!

GASP! I thought the highest marginal rate was supposed to be 35%! If the super wealthy don’t pay it, who does?

While these numbers have been touted around as if the facts should be some surprise, I didn’t even bat an eye. “Of course that’s what they pay,” I said to myself (though not out loud. I’m boring, not crazy), “they don’t have any ordinary income.”

Brief history. Americans don’t like inequality [yes, I know, citation needed]. Legislation trying to equal things out comes about every now and then, trying to make things “fair.” Usually the bill sounds nice, it passes, Congress cheers for helping out the little man, then nobody ever actually checks if it did what they wanted it to do. Maybe it worked, maybe it didn’t, but measuring something as nebulous as “fair” is  even more difficult than deciphering the plot to Donny Darko (I still think it was just a bunch of Jake Gyllenhall scenes spliced together from his other movies, but I digress).

In one of my college tax classes, we talked about a particular “fairness” law—an early one to pass regarding pay. Everyone knew CEOs got paid way too much. They thought if we made executive pay public, people would get so mad that companies would be shamed into lowering CEO salaries. Guess how well that worked? Keep in mind that CEOs aren’t exactly the most humble people around.

Just think if all of your co-workers’ salaries were released. If someone was making way more than the rest, would you demand that his or her salary be lowered, or would you want yours raised up to that level? Yeah . . . same kind of thing happened here. CEO X finds out that CEO Y of comparable big company is making twice as much, so CEO X demands the same salary as CEO Y. Of course company X could fire their CEO, but now nobody else is willing to take the job unless they get paid what CEO Y does.

After many years of this, people finally realized what happened and got upset. We probably could have made the CEO salaries private again and things might have gone back to normal, but everyone (i.e. politicians) knows that repealing laws doesn’t get your name on a bill . . . I mean doesn’t fix the problem, so it’s always better to try to fix the broken law with another one.

Along comes Code Section 162(m). Congress decided that a salary over $1 million was unreasonable in these publicly traded companies. Their thought process: If we made anything over $1 M non-deductible, companies would have to pay taxes on any salary over that mark (where before companies could deduct any amount of CEO salary), plus the CEO would have to pay taxes on it too. “Yippee!” politicians cried, “More tax revenue!” Plus the company would really have to justify paying over $1 million since it’d cost them.

Overnight, salaries for all CEOs dropped to $1 million or less.

But wait! Didn’t that one CEO just make $500 trillion dollars?

Yep, he sure did (and, unfortunately, it is mostly ‘he’s, but that’s definitely a different topic).

See, there’s this little thing companies discovered called “linking pay to performance.” Suddenly, instead of paying salaries, companies were paying CEOs in stock options, which is often cheaper for the company since they don’t have to pay out real cash. They just throw these options at the CEO, the CEO figures out a way to make the stock prices goes up, then he cashes out. That’s a capital gain, and those have a maximum 15% tax rate. CEOs suddenly get even more money and pay even less taxes on it. And Congress, in that Code Section 162(m), didn’t include this type of money in the $1 million dollar cap. Whoops.

So far, CEOs: 2, Congress: 0.

As noted above, tax rates of the super wealthy has decreased 9.9 points since 1992. Guess when this law passed?

Whoever guessed 1993 wins the prize. I give you permission to buy yourself a cookie (unless you’re not allowed to buy and/or eat cookies).

It’s that pesky capital gains rate that keeps the effective tax rate on the very rich so low. None of those fat cats are out flipping burgers for wages. They have investments. They have stocks and bonds. They have property. They get dividends. It’s not like they’re sitting on a horde of cash like Scrooge McDuck that we can just raid and hand out, despite what Michael Moore wants us to believe. Whenever they make money on these investments, it’s taxed at 15% (there are exceptions, but I’d rather not talk about them right now).

Of course, it’s not all because of Code Section 162(m). We can also thank George W. Bush and his colleagues, and Barack Obama (despite his best efforts otherwise) for the 15% capital gains rate. If we raised that, the wealthiest would pay a higher tax rate and we could put our pitchforks away for the time being. Whether it would actually increase tax revenue is up for debate, but at least we’d feel better, since, you know, we made things  fair.

That’s how it works, right?



DISCLAIMER: Yes, I am an accountant, and even a licensed CPA, which obviously means I’m dull and a drag to talk to. And while I can legally give tax advice, this article is NOT tax advice, nor accounting advice, nor anything but my own personal opinion, so don’t take it as something other than that. If you want tax advice, I’m sure there are plenty of accountants out there who are more than willing to help you out for a fee. My firm may even be one of them.