If you get all your income in a paycheck, your government doesn’t think much of you.
At the state and federal level, money received from other sources — some of which people work hard for and much of it they do not — is valued so highly that it is taxed very lightly. Meanwhile, the poor souls who must eke out their existence for wages have the very first dollar they earn taxed for Social Security and some pay double the tax rate of people earning passive income.
Take, for example, the person with $35,000 to invest who chose 300 shares of Apple at the beginning of 2017. If that investor perfectly timed the market, the stock would have sold on Sept. 5, 2018, when it had nearly doubled in value. The profit, on an initial investment of $34,740, would be $33,957.
Now for the ordinary schlub who works for a paycheck, $33,957 reported as taxable income on the 1040 form would mean wages of $45,957, if he or she is single and claims only the standard deduction. The income tax would be $3,880. Every dollar would also be taxed at 7.65 percent for Social Security and Medicare, adding another $3,515.71 to their federal tax bite. That's an effective tax rate of 16.1 percent.
But instead of paying Uncle Sam $7,396 and keeping the rest, our investor’s federal tax on that portion of their income could be zero.
You see, there’s no income tax on long-term capital gains — the increase in market value of an investment held for a year or more — if the recipient of those gains has what the IRS defines as “ordinary income” of less than $39,350. If ordinary income is more than that, the rate on capital gains is about half the ordinary rate.
For a few years in the 1980s and 1990s, this was not the case. Capital gains were taxed the same as ordinary income, thanks to the 1986 federal tax reform law, a signature achievement of President Ronald Reagan’s second term.
In a June 6, 1985, speech to students at Northside High School in Atlanta, Georgia, Reagan explained his tax plan this way:
“We're going to close the unproductive tax loopholes that have allowed some of the truly wealthy to avoid paying their fair share,” Reagan said. “In theory, some of those loopholes were understandable, but in practice they sometimes made it possible for millionaires to pay nothing, while a bus driver was paying 10 percent of his salary, and that's crazy. It's time we stopped it.”
The equal treatment of ordinary income and capital gains lasted about a decade. A new exemption for non-wage income arrived much more recently.
Tax cuts in Missouri in 2014 and at the federal level in 2017 gave an exclusion for what is called pass-through income, money that is profits of a business enterprise. The exemption applies whether the taxpayer actively works and operates the business or is merely an investor receiving a payout.
The federal exclusion is 20 percent. That means a business that nets an investor $166,500 would result in an exemption of $33,000, about the same untaxed amount as our Apple investor. If the investor is single, uses the standard deduction and the business income is the only income, the tax would be $23,335 on $121,500.
An otherwise identical taxpayer, who receives that $166,500 as a salary, would pay $31,255 in federal income taxes.
To save you from doing the math, that is $7,920 more in taxes than the person with business income.
Who pays more in total to Uncle Sam would be determined by the assessment of Social Security and Medicare taxes. The paycheck employee can't escape it and must pay on every dollar up to $128,400 and for our single person with $166,500 total income, that's another $9,822.
The recipient of pass-through income, if it is reported as self-employment income, must pay 15.3 percent, or $18,589. If they can count it as dividends, that doesn't apply.
In Missouri, the exemption this year is 10 percent of pass-through income, growing to 25 percent as the 2014 tax cut is phased in.
At this point in the column, or even earlier, the reader might be expecting me to blame someone for this patently unfair treatment. It is true that the current policies were enacted by Republicans in Congress and in Jefferson City, but the powerful have never had trouble finding friends in both parties willing to help them make the state and federal treasury pay out like a rigged slot machine. The capital gains tax exemptions were in place in 1986, at a time when Democrats had controlled Congress for three decades, and re-established when President Bill Clinton signed a tax cut in 1997.
In an address to the nation on May 28, 1985, Reagan said this about the tax code:
“They made it more like Washington itself — complicated, unfair, cluttered with gobbledygook and loopholes designed for those with the power and influence to hire high-priced legal and tax advisers.”
And I don’t want you thinking this is a call for a tax increase. Loyal readers know that I hate the federal deficit and think our national legislature is full of cowards unwilling to make us pay for what we want. Like indulgent parents, they won’t say no. Like spoiled brats, the only time we get upset is when they try to impose limits on their largesse.
What it is, instead, is a call for fairness. I’ll just repeat what Reagan said.
When fabulously wealthy people pay a lower tax rate than you or I do, “that's crazy. It's time we stopped it.”
Rudi Keller is news editor for the Tribune. He can be reached at firstname.lastname@example.org.