Personal Finance: Capital taxed at lower rate than labor for reason

Personal Finance: Capital taxed at lower rate than labor for reason

February 1st, 2012 by By Chris Hopkins in Business Diary

It is frequently reported that Warren Buffett pays a lower overall rate of tax than his secretary pays. This is correct, but such distinctions are meaningless without some knowledge of the specific circumstances.

It is necessary to understand the sources of the income in question to fully appreciate why Mr. Buffett's (no doubt well-paid) assistant remits a greater percentage of her paycheck to the IRS than her oracular employer.

The bulk of Buffett's compensation comprises capital gains and dividends. These forms of income generally are taxed at a rate of 15 percent, provided that the investments are held for at least a year. While this rate is certainly lower than the average effective rate on ordinary income, direct comparison is misleading because of the different level of risk.

Capital gains result from appreciation in the value of an investment, be it stocks, real estate, gold coins or Beanie Babies. But a gain is by no means guaranteed, and investments can and do produce losses. Most of us have had the dubi-

ous pleasure of buying high and selling low; risk of loss is inherent in the investment process.

To compensate investors for the possibility of getting wiped out, a lower effective tax rate on the potential gains is necessary and apposite. Obviously, no such risk exists with ordinary income. Warren Buffett's secretary collects her paycheck regardless of whether Berkshire Hathaway stock rises or falls.

Furthermore, each source of income has a substantially different incidence of prior taxation. Wage income has not been previously taxed, but it is an expense and hence a tax deduction to the employer. Capital gains, on the other hand, result from the investment of dollars that have already been taxed once upon receipt by the investor.

For example, suppose you earn a paycheck which was taxed at a combined federal income and Social Security tax rate of 45 percent and that you invest the after-tax proceeds in Coca-Cola stock.

If the stock appreciated, and the gain was treated as ordinary income, you would pay an additional 45 percent tax on the amount of the profit. If the stock price tanks, however, your tax benefit is limited to $3,000 per year unless you have other capital gains to offset.

Dividend income is arguably even worse from a taxation perspective. Dividends are after-tax distributions of profits earned by corporations.

Shareholder capital is clearly at risk through ownership of the stock. However, for most public companies, the dividend payment has already been taxed under federal corporate tax statutes, so any levy on dividend distributions is a double tax.

Capital is the mothers' milk of economic growth. Lacking a supply of investors ready and willing to risk their capital in search of an appropriate after-tax return, commerce would grind to a halt.

Profits and losses from investment activity are entirely different from wage income and should be taxed commensurately with their risk. Promoting capital formation and investment is always the most direct route to growth and jobs.

Get answers to financial questions on Wednesdays from our columnists who work in the financial services industry. Christopher A. Hopkins CFA, is a vice president at Barnett & Co. Submit questions to his attention by writing to Business Editor Dave Flessner, Chattanooga Times Free Press, P.O. Box 1447, Chattanooga, TN 37401-1447, or by emailing him at dflessner@timesfree