Jim DeBree | Beware of the Democrats’ Big Tax Plans

Jim de Bree
Jim de Bree
Share on facebook
Share
Share on twitter
Tweet
Share on email
Email

The Democrats are promoting new taxes. Rep. Alexandria Ocasio-Cortez has suggested that individual income exceeding $10 million annually should be taxed at a 70 percent rate. Sen. Elizabeth Warren suggested an annual wealth tax that would be impractical to administer.

If you are an upper middle class household, defined as a household earning between $125,000 and $1 million, you should be concerned because history shows that tax increases on the so-called rich end up being paid by these households. A large number of SCV households will be affected. 

There has been a considerable amount of hyperbole by both those on the left and right that requires some tax expertise to properly evaluate. 

In order to understand the situation, one must differentiate between marginal tax rates and effective tax rates.

Marginal tax rates are the percentage of an additional dollar of income that will be paid in taxes. Generally, the marginal tax rate is supposed to increase as income grows.

Effective rates, on the other hand, represent the percentage of total income that is paid in taxes. It is difficult to appropriately analyze effective rates because of limitations in the information available and the inability of the IRS to accurately determine a mega-wealthy taxpayer’s true economic income. Generally, effective rates increase until taxpayers reach income levels of about $1 million. It is hard to measure income above that level because wealthy people invest heavily in tax exempt investments and in real estate, which allows a significant portion of their cash flow to be sheltered by depreciation deductions. Furthermore, taxpayers who earn over $1 million tend to have more income that is taxable at favorable capital gains rates, which generally do not exceed 20 percent.

According to IRS data released for 2015, households earning between $100,000 and $1 million paid taxes ranging from 16 percent to 29 percent of their adjusted gross income (“AGI”). For these people, AGI is a relatively good estimate of their economic income. The rates fell for households reporting an adjusted gross income of $2 million or more. Based on my experience with high net worth clients having economic income of seven or eight figures, their reported AGI is usually considerably lower than their true economic income because a significant component of their economic income is excluded from AGI. The actual effective rate paid by these households is typically substantially lower than that of upper middle class households and lower than what is reported by the IRS. 

When Mitt Romney released his 2012 return, I recall that his effective rate was only about 14 percent. (Capital gains rates have increased since then, so based on current law, he would probably pay about 19 percent of his AGI in taxes.) 

This is consistent with IRS data published for 2016 disclosing the effective tax rates of the 500 individuals reporting the highest AGI. These households generally paid an effective tax rate (i.e., taxes as a percentage of AGI) of about 19 percent. There is no available data demonstrating whether AGI is an accurate measure of economic income for those households.

Raising the top marginal rate is not likely to have a big impact on the taxes paid by the wealthy unless capital gains rates for the mega rich are increased, tax exempt income becomes taxable at ultra-high income levels and the entire tax system is revamped in a manner adding additional complexity to existing tax rules.

If you are in the upper middle class demographic, you should be apprehensive. Based on historical precedent, tax increases aimed at the mega wealthy are eventually borne by the upper middle class. The wealthy have the resources to plan around those increases. Consequently, Congress ultimately lowers the income threshold of affected taxpayers because the tax increases on the mega-wealthy fail to generate the expected tax revenue.

For example, in 1913 the income tax was legalized upon ratification of the 16th Amendment. In the first year, few households paid tax and the top rate was 7 percent. Five years later, the tax was significantly expanded to capture a substantial number of additional households and the top rate was increased to 77 percent.

The 1969 Tax Reform Act imposed what was then called the “Minimum Tax.” According to the Act’s legislative history, it was targeted at 155 ultra-wealthy households who paid no tax. In 1978 the tax became the “Alternative Minimum Tax” (AMT) that was refocused to apply to homeowners in high-tax states. In recent years, many middle class households were subject to the AMT. 

In 2017, the Tax Cuts and Jobs Act repealed many itemized deductions, effectively replacing the regular tax with a tax similar to the AMT for middle class households. 

Given historical precedent, Ms. Ocasio-Cortez’s proposal, if enacted, eventually would exacerbate the tax burden for upper middle class households.

Jim de Bree is a semi-retired CPA who resides in Valencia.

Related To This Story

Latest NEWS