This past year was a very good one for me: a large media company purchased the enterprise in which I had made a relatively small investment. For the sake of discussion, let's say my share of the deal netted me $7 million, more or less. A good day at the office by any standard.
For this happy transaction, my accountant advised me shortly thereafter that I would likely owe Uncle Sam a little more than $1 million in tax. A million dollars seemed like a large check to write to the government, and that started me thinking about America's tax policy. Specifically, I recalled Warren Buffett's observation that his secretary paid a higher tax rate than he did, and that it was hard for him to justify that advantage. I wondered what Warren's secretary would be taxed if she had also earned $7 million—but from her work as a secretary. The answer is that, on $7 million in income, a secretary would have to pay close to $2.5 million in taxes, $1.5 million more than I would.
The difference, of course, is that my good fortune was a long-term capital gain, and a secretary's good fortune counts as "earned income." It's hard to understand the logic of earned income being taxed at about two and a half times the rate of a capital gain.
I tried to think of the possible reasons for the difference—tried to justify why these two tax rates would be so different. I thought first of the advice of certain commentators: If I didn't think I was paying enough tax, I could always voluntarily pay at the same rate as Warren's secretary. Talk about a nonstarter: No way am I going to voluntarily pay more. That noble act would neither correct the unfairness of the system nor make much of an impact on the country's unbalanced budget.
Perhaps I could justify my lower rate on the basis that I had made my investment a few years ago, that some of my return was due to inflation, and that government arguably bore some responsibility for that inflation. But when I dug a little further, I found that over the three years my investment was at risk, inflation averaged about 1 percent annually. Hardly enough to justify the $1.5 million tax advantage. If the goal of a lower rate for capital gains was to compensate for inflation, wouldn't it be easier simply to index the gain for inflation?
How about the argument that my type of income is better for the economy than the secretary's type of income because my investment creates businesses, jobs, and prosperity? Sorry, I can't buy that. Earned income has the potential to create the same sort of economic value as investment income.
As for the argument that my investment was risky and I deserve a little bonus for taking that risk, such reasoning would have more merit if one could claim that earned income bore no risk, such as the risk of layoffs.
By the Numbers: The Myth of the Overtaxed Corporation
For corporations, paying for tax breaks is still the best investment around.
As for the argument that folks like me wouldn't invest our money and stimulate the economy unless we got a preferential tax rate, I don't buy that either. What else would we do with our money except to continue to invest in new and emerging businesses, even if our returns were subject to the same rates as our earned income?
Alas, I can find no real way to justify my good fortune tax rate. I reluctantly conclude that it came about for a specific reason: that the few of us who can afford to make substantial investments (the fortunate one percent) can also afford to invest in the careers of politicians who will vow to keep our unfair tax advantages.
And that's absolutely not justifiable.
This is an edited version of an article that originally appeared in the March 2012 Harvard Business School Alumni Bulletin. Reprinted with permission.
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