How Taxes Work for the Wealthy

Now that the Republicans have gained control of the house again, we are hearing many of the same tax arguments they have spouted in the past.  Lower the top tax brackets and eliminate capital gains and that money will trickle down to the rest of the people.  As someone who has experience managing a large amount of money, I thought I would lay out a demonstration of what rich people pay in taxes.  The numbers I am going to use are generic numbers, but I believe they are representative of a typical portfolio.  I also know this is kind of dry reading, but I hope you get my point by the end.

Let us use a typical CEO.  According to salary.com, the median CEO compensation plan of salary, bonuses and benefits is over 1.3 million dollars a year.  To make the math easier, I am going to use 1.2 million.  Let us assume that this typical CEO has accumulated 20 million dollars in personal wealth as well, which given that salary does not seem unreasonable.  We'll use a fairly conservative allocation of their investment for that wealth and allocate 60% to stocks, 20% to government bonds, 10% to personal real estate and the last 10% to liquidity.

Let's see how this person is taxed.  First the 12 million dollars in stocks.  As long as you hang onto a stock for more than a year, the income from the sale of that stock is considered a capital gain and not personal income.  Right now capital gains are taxed at 15%, and it is a long held Republican goal to eliminate capital gains taxes altogether.  Of course, there is little reason for this person to sell any stocks other than to occasionally rebalance his portfolio, so he is likely to pay little or no tax on this over the course of a year.  I realize stocks can go down in value as well, but held long enough they historically gain value averaging around 10% a year.  Let's use only 5% to be real conservative.  His stock value still gains $600,000 in value tax free over that year.  In addition to the value inflation, a well balanced stock portfolio will typically pay at least 3% a year in dividends (again this number is very conservative).  Dividends are also capital gains, and currently get taxed at 15%.  3% of 12 million is $360,000.  15% of that is $54,000, leaving a nice $306,000 in cash after taxes.

The other 8 million dollars of this CEO's portfolio is actually completely tax free.  That is because 4 million is in government bonds and 2 million is in a liquid treasuries fund and the last 2 million that CEO's main line mansion.  How much does this make?  Typically, government bonds pay around 5% income per year, which means he will make $200,000 tax free from that investment.  Treasuries pay very little now, but not too long ago they too were paying 5%, and we can assume that they will be back there soon.  This is another $100,000 in tax free income.  As for the house, as long as you purchase a new home, you can sell your old house tax free, no matter how much it increased in value.  Despite the recent recession, housing historically goes up 5% in value over time, but given the current housing crisis I am just going to ignore this particular income.  Imagine that homeowners.  His house value is so little compared to the rest of his portfolio that we can just ignore it.

So let's break down this person's income versus taxes.  First his income.  His 1.2 million salary is taxed as normal income, which currently is at about 1/3 after all his deductions.  That makes for $800,000 take home pay and $400,000 in taxes.  His income is increased by the $306,000 he gets from the dividends after paying the capital gains tax and the $300,000 he gets from his tax free investments.  Rounded off, that's 1.4 million in after tax cash income.  Add in the $600,000 increase in his stock portfolio value (remember we are using only 5% for this number rather than a more likely 10%), and he has gained a nice 2 million dollars for this year from a gross income of about $2,450,000 (I am trying to round off to make things easier).

(Update, I had to recalculate since I used his net pay instead of his gross pay to calculate his tax rate.  His tax rate is actually lower than my initial estimate).  What did he pay in taxes?  His salary was taxed for $400,000.  His capital gains were taxed for $54,000.  That is around $450,000 in taxes on $2,450,000 in gross income, which is a rate of 18%.  That is less than the 25% income tax rate paid by someone -  say a restaurant dish washer - making $35,000 a year.  That is almost as low as the 15% someone making a mere $10,000 per year would pay.  Of course a person making $35,0000 a year would end up with around $2,000 a month to pay things like housing, health care, transportation, food and everything else we need to pay for.  The person making 10 grand better hope he has a spouse making more or he is probably living in the streets.  Our hypothetical CEO, on the other hand has to make due with $115,000 a month to pay for his living expenses (the 1.4 million in cash divided by 12).  Moreover, the CEO would have long ago paid off all his debt, while the dish washer likely has at the very least a mortgage or rent payment, a car payment and credit card debts. Ask yourself whether you truly think that these two people should be paying similar tax rates, much less that the CEO actually pays a lower rate than the dish washer.

Now just to be clear, I have nothing against people making lots and lots of money.  I've done pretty well myself.  But in an atmosphere where our national debt is soaring out of control, where 10% of Americans can't even find a job, where our infrastructure is 40 years old and crumbling and where our country is slipping competitively against the rest of the world, it makes no sense to me to give that CEO even more money to spend than he already has.  Let's say we raised his tax rate to 40% and the capital gains tax to 20%.  What would happen?  His take home pay from his salary would drop from $800,000 to $600,000 and his take from his capital gains would drop from $306,000 to 288,000.  He would still get his $300,000 tax free income.  That means he would go from a little over 1.4 million in take home pay down to a little less than 1.2 million. 

While that sounds like a pretty big drop, it still gives him $100,000 a month to play with.  I defy you to think of how you could reasonably spend $100,000 every month, especially if you didn't even need to pay off any loans.  Realistically, while $220,000 a year in additional taxes sounds like a lot, it will have absolutely no impact at all upon his life style.  Also, this whole calculation only looks at a single year.  Wealth compounds.  Let's say he somehow manages to spend the ridiculous sum of $1,000,000 over that year (he buys a fleet of fancy Italian sports cars).  The $400,000 left over added to the $600,000 gain in his stock portfolio means that he will actually be worth 21 million next year and all of these calculations go up an additional 5%.

This is not meant to demean the worth of this hypothetical CEO.  I have run my own business and know that it is a lot of hard work.  I've also washed dishes at a restaurant, and given the choice I would rather run a business for a living.  Still, both the person making $1.3 million a year and the person making $35,000 a year work hard for their money.  However, the simple reality is that the CEO won't really miss the extra tax money while the dish washer needs every cent he can get.  And that 1.3 million number is simply the median.  Half of America's CEO's make more than that.  Not to mention the money made by all the other high paying professions out there.  The U.S. has just come off a reckless 10 year spending spree and we need to pay for it some way.

Taxes are obviously not the only answer.  Something needs to be done about social security, medicare and our military spending.  Still, when the new Republican majority in the house starts to demand lower taxes for the rich and the elimination of the capital gains tax, we just need to sit back and do some simple math and ask ourselves whether we really want to jeopardize our childrens' futures so that a handful of Americans can buy a new fleet of Ferraris every year.  I personally think asking some people to drop from $115,000 a month in spending money down to $100,000 a month is a perfectly reasonable request.  What do you think?