Warren Buffet is making headlines, complaining that he does not pay enough in federal income taxes.  His overall tax rate is around 17 percent, less than the marginal rate paid by his much-lower-income assistants. On the basis of this comparison, he concludes that the “mega-rich” can and should pay more.

Personally, I have no problem with Buffett and his super high-income buddies paying higher rates. But Buffett’s effort to claim the spotlight in the soak-the-rich debate really isn’t about Buffett or his mega-income colleagues.  His proclamations are intended to serve as Exhibit A for all those, including Obama, who so badly want to drive up rates on a much broader group who fit within their definition of  “rich.”

Buffett’s words have impact for a number of reasons.  He is doing something unique and contrary to his own self-interest – complaining that his tax hit is too low.  He has massive wealth and a proven capacity to play in the big leagues of the investment world.  And he’s a personality who likes to draw attention.  So all high-tax advocates and the Obama-friendly media will instantly jump on any of his words that appear to bolster their position in the juiciest class warfare issue on the table.  Buffett has made it easy for others to leverage his personality and his oversimplified comparison to advocate positions that go far beyond his relatively simple message.

So why is Buffett’s marginal rate only 17 percent?  It’s because he makes his money by investing in stocks.  He is paid dividends on his stocks that are taxed at a maximum rate of 15 percent.  And when he sells a stock that he has owned for more than one year, any capital gain recognized on the sale is taxed at a maximum rate of 15 percent.  Those who make the lion’s share of their income by collecting dividends and generating capital gains are going to pay a lower overall marginal rate than those who earn wages or invest for interest income. It’s a given.  It’s by design.  Buffett’s comparison does nothing more than illustrate this basic reality.

The real question raised by Buffett’s comparison (and the homerun question for all investors) is whether there should be a rate break for dividends and capital gains.  As for the dividend rate, it’s important to remember that it’s the smaller part of a two-part story.  Income generated by a profitable corporation is first taxed to the corporation at 35 percent (34 percent for corporations with taxable incomes of less than $10 million).   The balance left for the shareholders of the corporation (65 percent) is subject to a second tax of 15 percent when it is distributed as dividends to the shareholders.

So although Buffett and all other shareholders show a tax of only 15 percent on their returns, the overall double tax burden on each dollar earned and distributed by a corporation is 44.75 percent.  It’s why we have the highest corporate tax rate burden in the world that puts us at a competitive disadvantage with other countries.  Indeed, many argue that there should be no tax at the shareholder level on corporate dividends in view of the huge bite taken at the entity level. The 15 percent rate that shows up on Buffett’s return doesn’t begin to tell the whole tax story on corporate earnings.

How about the 15 percent long-term capital gains rate?   Various arguments have always been advanced to support this break.  A lower rate compensates for the inflationary impacts of holding as asset, incents investors to buy and sell more often, and encourages risk taking and more aggressive investing.  Studies exist that suggest that government tax revenues are actually increased with a lower capital gains rate; the escalating revenues generated by a higher volume of transactions more than offset the impact of the lower rates.

The capital gains tax has always been a political football, and we have no reason to believe that this reality will ever change.  Many powerful forces view it as nothing more than a sop to big business and the rich, while others passionately label it an essential element of a strong and vibrant economy.  Just over the past few decades, we have seen the gap between ordinary and capital gains rates completely eliminated, narrowed to levels that were not compelling for planning purposes, and, as now, widened to levels that get everyone excited.

The preferential dividend and capital gains rates were originally scheduled to expire at the end of 2008.  They were extended through 2010 and then kicked over again to end of 2012.  If Congress does nothing by the end of 2012, starting in 2013 dividends will be taxed the same as all other ordinary income (subject to a maximum rate of 39.6 percent) and the capital gains rate will jump to 20 percent. So the fate of these two huge tax breaks (incentives?) is up for grabs – again.  They promise to be hot issues as we march towards the 2012 elections.

I have my own take on how I would like these core investment tax breaks to play out going forward.  If I had it my way, the dividend rate and the long-term capital gains rate would remain the same, but both of these rates would jump to 20 percent for any taxpayer with an  adjusted gross income in excess of $500,000.  So I agree with Buffett’s core message that the serious rich, including the Wall Street crowd, who make their money playing with public company stocks can pay more.

But (and this is the real key), I would have a zero capital gains rate for any gain recognized on an investment in a non-public corporation that has assets of less than $50 million (a “Small Corporation”) if the shareholder holds the stock for at least five years.  And I would reduce the corporate tax rate to 25 percent for all corporations and to 20 percent for the first $10 million earned by a Small Corporation and eliminate all double taxes on money earned and distributed as dividends by a Small Corporation.  So, for smaller businesses, I swing completely to the other end of the spectrum. Under such a scheme, all investors, even those in Buffett’s class, would have much stronger dividend and capital gains tax  incentives to aggressively grow small businesses, the engines that drive job creation.

There is no question that Buffett and his mega-rich colleagues can afford to pay more taxes.  They can afford just about anything. But Buffett and his counterparts do not fairly represent those who fit within the new definition of rich (taxpayers with incomes in excess of $250,000).   Any proposal to clip the Buffetts of this world for a few extra bucks should not spill over to those who are trying to finance and build private businesses that will put people to work.  We must be careful with Buffett’s words.

May 12, 2012