Tax Follies

The Wall Street Journal recently reported, based on 2006 data, that the top 400 taxpayers in the nation paid the lowest tax rate since the recession year of 1991. The article does mention that the driver of the low tax rate is that most of the income for taxpayers is in the form of capital gains, which are taxed at a maximum rate of 15% versus 35% for ordinary income.

The implication of the article is that there is something wrong or inappropriate with such low tax rates for people with such high income.

There is one critical fact that the article doesn't discuss, which is overlooked by critics when discussing the capital gains and dividend tax rates. Shareholders of companies face double-taxation on the same underlying earnings. First, companies pay taxes of up to about 39% on their U.S. income. Then individuals pay taxes on either dividends or capital gains, which when including state taxes can add another 24%.

As example, imagine a company earns $100 in the U.S. before taxes and pays all of its net income to shareholders as a dividend. The company will typically pay $39 in corporate taxes, leaving it with net income of $61. Shareholders will then pay about $15 in taxes on the receipt of dividends, leaving them with a net of about $46 - resulting in an all-in tax burden of 54%.

So the low tax rates on individual tax returns only captures one layer of the tax burden such income effectively pays. That is the underlying economic reality.

It gets complicated by the fact that some corporate income is earned overseas at lower tax rates (meaning U.S. tax rates are higher than overseas), some shareholders aren't taxpayers (such as pension funds) or pay taxes at lower rates, and capital gains and their realization occur over time.

The U.S. is unusual in that it engages in this double taxation; many European countries don't. That's a comparison to Europe the left doesn't make, and for good reason. We tax capital at very high rates, notwithstanding the claims of the left.