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Buffett’s Million Dollar Bet

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As we near the end of the year, the big issue of the Bush tax cuts remains unresolved. As we inch into December and still have very little idea as to how the tax brackets will look next year, I thought it would be interesting to take a look back at a popular sound bite from Warren Buffet.

One of Warren Buffet’s most famous quotes is that he pays a lower tax rate than his receptionist. He’s said it numerous times, including at a $4,600 a seat fundraiser for then-Senator Hilary Clinton. His exact quote from that night – ““The 400 of us [here] pay a lower part of our income in taxes than our receptionists do, or our cleaning ladies, for that matter. If you’re in the luckiest 1 per cent of humanity, you owe it to the rest of humanity to think about the other 99 per cent.”

It wasn’t until today, over three years later, that I learned that Warren Buffett called out his fellow Forbes 400 “members” in an interview with Tom Brokaw.

How Is That Possible?

At first glance, it seems preposterous right? How would a billionaire pay a lower tax rate than his receptionist? The answer lies in how our taxes are structured. You have two major types of income – ordinary income and investment income. Ordinary income is the money reported on a W-2, which is what most people get. Investment income refers to capital gains and long term capital gains, on assets owned for over a year, the rate is far lower.

If you earned $1,000,000 in income, you’d be in the highest marginal tax bracket of 35%. Assuming only the $5,700 standard deduction (and no other deductions or credits), you’d pay a composite tax rate of around 32.5% on that $1,000,000 of income. Now imagine if you earned $1,000,000 in long term capital gains – you’d only pay 15% since that’s the long term capital gains rate. You pay twice as much if the earnings comes in the form as ordinary income.

The Forbes 400

The 400th person on the Forbes 400 from 2008 (24 people are tied for 377th) has a net worth of $1.3 billion. Now let’s just take 1% of that, or $13 million, and put it into a basket of dividend stocks that earn around 3%. 3% of $13 million is $390,000 a year in dividend income. Dividend income is taxed at a mere 15%.

Most billionaires probably have more than 1% of their net worth invested in these “safer” types of investments. They also probably don’t draw much of a salary, relative to their investments. So Warren Buffett is not going out on a limb by saying billionaires pay a lower tax rate than their secretaries/administrative assistants.

Arguments as to why this is OK:

  • 47% of households paid nothing in taxes for 2009, according to the Tax Policy Center as reported in this article. After all the deductions and credits, 47% pay zero dollars in taxes. The bottom 40% actually profit off the system of credits!
  • If 47% pay nothing, who pays? According to the CBO, in 2007, the top 25% paid 68.9% of federal taxes but earned 55.9% of pre-tax income. The top 1% earned 19.4% of income and paid 28.1% of taxes. High earners paid a lot in taxes but shoulder more of the tax burden.
  • This gives an incentive to invest because long term capital gains are taxed at a lower rate. This puts more money into traditional investments like the stock market and real estate, which benefits more than high net worth individuals. As appealing as it may seem to increase the tax rates on the wealthy, the key question becomes whether you think the government can spend it better than they do.

Everytime we do a post on taxes I’m eager to hear you’re opinion on it, so let me know what you think!

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60 Responses to “Buffett’s Million Dollar Bet”

  1. Shirley says:

    This is a new concept to me.
    So, if I am retired and have an IRA that I receive monthly disbursements from, I am paying the ‘income tax’ rate on those disbursements. Say that my IRA is making great long term capital gains (which should be taxed at a much lower rate) but that money is being reinvested into the total portfolio of my IRA.

    I only pay taxes on disbursements as I receive them from the IRA, so I am paying ‘income tax rate’ even on the long term capital gains because they end up in disbursements.
    Do I have this correct? …sorta, kinda?

    • NateUVM says:

      Well, an IRA kinda changes things around…

      In exchange for 1) not paying any income tax on what you put into the account (via the deduction on your tax return) and 2) not paying any capital gains or income tax on the gains or dividends and letting all of it grow, tax-deferred until you start to make withdrawals (disbursements), your withdrawals are taxed at the higher tax rate associated with ordinary income.

      It’s a trade-off, to be sure. But also why you can’t really compare IRAs to the investments being discussed in this post.

      • Shirley says:

        Thanks Nate. I am getting things better sorted out in my mind lately… but still have a long way to go. ;-)

      • sophomore says:

        NateUVM is correct on the traditional IRA but note that the Roth IRA is computed differently. In a Roth IRA, you pay income taxes up front and no taxes on withdrawal. If you are currently in a low tax bracket or expect income rates to increase, the Roth IRA is probably the better choice. Uncle Sam is like the old auto mechanic commercial – you can pay me now or pay me later.

  2. “the key question becomes whether you think the government can spend it better than they do.”

    That is NOT the key question. That is the party line of those who don’t want to pay taxes. In fact. it’s a stupid question.

    It is not a question of whether the gov’t can spend it ‘better’ or ‘more efficiently.’ It
    is a question of what is necessary to operate a government, what it does for the population, and how to pay for those services.

    We all agree that we don’t like everything about how government spends – but we don’t get to pick and choose. In theory our elected officials make that choice, but now, all decisions are based on politics. The current compromise is better than nothing, but it is not good. No one loves it. The deficit will grow.

    Those who hate taxes voted for two concurrent wars, with not one penny to pay for them. That is financial suicide. These costs cannot be shoved down the throats of future generations. That is one major culprit for today’s situation.

    Both parties contributed to bailing out the banks instead of bailing out Main Street. That’s why we are in such trouble today. The bankers hoard, Main St would be spending.

    I wish I earned enough to pay $10 million in taxes every year. It’s a privilege to live in the US and those who bitch about high taxes have no idea of just how high they are around the planet.

    Income taxes in the US are too low. Sure waste can be cut from the budget, but that’s not good enough.

    • Bey says:

      “Income taxes in the US are too low”. Great, another idealistic citizen who wants me to be a better citizen. Listen, if you and all the others beating this drum feel so strongly about it, whip out your checkbook and give the government some more of your dough. I have the strange feeling you never have. You’ve probably taken every last deduction and credit coming to you, just like the rest of us. If all of you who want to take my money would give up your own instead, we’d all be happy!

    • Maddhatter says:

      I think you missed a big component. Should that be a government concern? I think what Jim’s question gets to is whether society would be best served with that money in the government’s hands or the hands of the people who earned it. Maybe it is just me, but I don’t think that is stupid. Of course, I think the key with any tax increase is the justification behind it. Why not cut spending instead? Are all of the government programs really something that is a government’s concern? Roads and defense – okay, sounds good. Steroid panels and bailing out poorly managed companies – I’m not so sure.

      The big problem I have with your post is that you lack aspiration (we are better off than most people in the world, so just don’t bitch and deal with it). Why not ask whether the government is going to spend it better than the people who have earned the money?

    • TomM says:

      Wow, I don’t even know where to begin. I don’t care if our taxes are the lowest in history. Big deal. Let’s make them event lower, spend less, become more efficient with the spending of the taxes, etc. Hey, how about we make all government agencies pretend like they are real businesses, that have live within their budget, prove their worth and/or turn a profit, or they go out of business (get eliminated). Like that would ever happen….lol.
      As for the war, remember, the war was voted on by both parties. You can’t go to war without both sides agreeing.
      As for the bailout…..I do agree with you there. We bailed them out and they turned around and paid themselves bonuses as if they had done a good job. But who didn’t see that coming?
      Yes, it is a privilege to live in the US. Which makes us free to bitch about whatever we like….unlike the rest of the planet.
      And as others have mentioned….if you feel our taxes are too low, feel free to pay more. The government certainly allows you to pay more if you like.

      • AndrewP says:

        “Hey, how about we make all government agencies pretend like they are real businesses, that have live within their budget, prove their worth and/or turn a profit, or they go out of business (get eliminated). Like that would ever happen….lol” – This has to be one of the most fantastic posts I have seen anywhere (sarcastically). Find the government agencies that are designed to bring in more than they spend and I will agree with the who will spend it better question. By nature, taxes are their revenue. How do you suppose the police should bring in a profit? DCFS? Homeland Security? The Department of Education? Denfense? Should I go on, or do you get how ridiculous your comment is?

  3. Shirley,

    You deposited taxable income into the IRA, and you never paid taxes on that cash. That’s why you cannot get capital gains rates on the profits. It’s all gains from untaxed income, and now the taxes must be paid

  4. Kevin M says:

    Here, let me fix that for you:

    “47% of households paid nothing in income taxes for 2009.”

    If they worked, they still paid FICA taxes and sales taxes.

    • Evan says:

      Wouldn’t most get FICA back? and there is no federal sales tax (yet)

      • Chuck says:

        No, nobody gets a refund of FICA.

        • Kevin M says:

          The point Evan was making is that people who pay FICA taxes but no income tax will receive some of that money back in the form of benefits such as disability payments, social security retirement benefits, etc.

          Regardless of whether they receive more (or less) in benefits than they pay in taxes, to focus solely on income taxes, as the Tax Policy Center quoted by Jim did, is to present a skewed picture.

        • Sun says:

          You pay someone as an independent and put the payroll tax burden on the contractor.

  5. RT says:

    While those bottom people may pay no “federal income tax” they do pay taxes. Payroll taxes, SS, Medicare, Property, Auto, Sales etc.

  6. tom says:

    I love Warren Buffett, but I HATE that quote.

    As you mentioned, a lower capital gains tax is the reason for it, and the more money you make in capital gains, the less your actual salary income tax matters. They still pay an absurd tax on their salaries (those who still get a salary).

    Excluding capital gains, they are taxed at 35%.

    That the richest men/women are making bank off of investments, I say so what? They’ve earned that right. If they are savvy enough to make more money off of the money they’ve already earned, more power to them.

    • Kevin M says:

      I’m in a fixing mood today:

      They are not taxed at 35%. 35% is the marginal rate, it is the tax paid on income over 373,650.

      For examplke, take Warren Buffet’s reported income for 2010 of 519,490 (http://www.reuters.com/article/idUSTRE62A5SH20100311) and the 2010 tax rates, he would have paid 29% in taxes (assuming no deductions or adjustments). But his adjusted gross income would be less than 519,490, so Buffett paid less than 29% of his income in taxes. Buffett is quoted as saying he paid only 19% of his income in taxes for 2006.

      So, if they’re savvy enough, no rich person is taxed at anything near 35%.

      • freeby50 says:

        All the very rich people limit their salary income to avoid paying the marginal tax rates. Its a simple tax dodge and obvious one to do.

        Would you rather pay yourself a $5M salary and get taxed up to 35% on it or would you just sell $5M of stock and pay 15% tax?

  7. Tim says:

    You make some good points, but I think it’s important to consider other taxes as well: it’s not really meaningful to consider the income tax in isolation from all other tax sources. That analysis also neglects other taxes, which generally take up a larger portion of the income of people on low to middle/high incomes: payroll tax, sales tax, property tax, etc.

    Payroll taxes, especially, once you combine social security, medicare and unemployment insurance, add about 15% to the effective tax rate on people’s income from work below $100,000 or so.

    So the vast majority of people in the US are already the same tax rate on their income as the capital gains tax rates even before you take income taxes into account.

    While in theory the social security taxes at least end up paying directly for benefits received by those people, the reality is a bit more complicated. In the 80s the Social security tax rate was increased so as to build up the social security trust fund in anticipation of boomers retiring. This has more or less worked: the trust fund is huge right now and will cover benefits for quite a way into the future with minor adjustments (despite the rhetoric about social security, the program is currently in good shape so long as minor adjustments continue to be made).

    In the meantime the extra revenue from payroll taxes allowed the government to lower income taxes and capital gains taxes: I guess the bargain was that more of government would be funded through payroll taxes in the meantime, until later on when baby boomers started retiring and the people who had been enjoying lower income tax rates would have to start shouldering more of the burden again. We’ll see now whether that deal is kept to: it seems now that somehow the consensus has changed to lowering income tax rates further at the expense of social security beneficiaries.

    • Grant says:

      Tim, sadly I completely disagree with your assessment of the social security fund. Check out this article about the fund and the delusion the term “fund” really has. I don’t think I’m alone when I say the social security system is in terrible shape. Pay as you go was a terrible system to start off with and now we’re in deep trouble. It reminds me of the housing bubble; as long as housing prices kept going up everyone was great. Just like that the social security system was in good standing as long as the country was growing and had more people to pay for the social security retirees. Sadly that is becoming less of the case. I remember hearing a stat that when SS started there were 12 workers for every retiree, whereas it is expected to be 3 or 4 to 1 in the coming years as the baby boomers retire. Sadly SS is too big for us to let pop but we must make some amends. Here is the article and podcast.
      http://reason.com/blog/2010/11/22/when-npr-recognizes-that-socia

      http://www.npr.org/blogs/money/2010/11/18/131420919/are-the-social-security-trust-funds-a-mirage

  8. mannymacho says:

    The idea that no one has touched on yet is that a company already pays a corporate tax on its profits, which turns into either a dividend or capital gains. When you pay the taxes on dividends, you’re paying taxes on money that has already been taxed. So is it really fair to hit earnings with a 30+ percentage tax twice in a row, effectively giving the government more than half of the earnings? You decide.

    • Kevin M says:

      If I hire a plumber to fix my water heater, the plumber gets taxed on the money I pay him, which was already taxed as my income.

      If I go to Walmart to buy clothes or food or tools or entertainment, Walmart is taxed on that money that becomes its profit, but that money that I paid was already taxed as my income.

      Double taxation is a weak argument.

      • Texas Wahoo says:

        “If I hire a plumber to fix my water heater, the plumber gets taxed on the money I pay him, which was already taxed as my income.”

        But that’s only single taxation. If you consider that double taxation, then corporate capital gains are actually triple taxed.

        But if the plumber is a corporation, the money gets taxed twice. Once when the plumber receives it, and once when the owners of the corporation receives it.

  9. Texas Wahoo says:

    I’m glad that warren buffet wants rich people to pay higher taxes. But wouldn’t raising the highest income tax bracket be the wrong way to do it to get these people. If all of their money is in capital gains, then they should raise the capital gains rate and leave the top tax bracket the same. That way it will eliminate Buffet’s problem of paying less than his secretary without harming people who aren’t as wealthy, but currently have high dual incomes.

    • Jim says:

      The problem with raising the capital gains tax, which will be the subject of a future What If? post, is that it has a lot of far reaching implications. Increasing the top rate just seems “cleaner” without as many dependencies.

      • Texas Wahoo says:

        It may be cleaner, but Buffet will still pay a lower percentage of his income than his secretary. The could literally raise the 35% bracket to 100% and Buffet might still pay a lower percentage because most of his gains are in capital gains.

        It’s easy for someone like Buffet to argue about the top income tax bracket when most of his income will still be taxed at the lower capital gains rate.

      • Sun says:

        Increasing the top rate seems cleaner too since it will also affect tax filers that may not get all their income from capital gains.

      • sophomore says:

        Cleaner … Hmmmm … It is obvious that the posters on this board have never had the joy of another portion of the tax code called the Alternative Minimum Tax (or AMT).

    • govenar says:

      Maybe they could change the capital gains tax to have different brackets, i.e., if your income is more than $1 million, the capital gains tax would be 20% instead of 15%.

      • Texas Wahoo says:

        Shouldn’t it be: “if your capital gains are more than $1 million.” Otherwise truly wealthy people are still getting around it because most of their money does not come from income, it comes from capital gains.

      • daenyll says:

        I like the idea of tiered capital gains, that way your smaller investor just trying to stay ahead of inflation and earn a bit wouldn’t be deterred from investing and it could scale to include the larger investors with most of earnings from gains/dividends rather than income would be contributing to fund government and reduce the deficits/debt

      • freeby50 says:

        We currently have two tiers for long term capital gains. Theres a 0% capital gains rate for people in the 10-15% income tax brackets and everyone above that pays the 15% capital gains rate. Short term capital gains is taxed the same as regular income.

  10. zapeta says:

    My plan is to just keep investing so that I can move more of my my income each year to capital gains and towards lower taxes.

  11. eric says:

    Must add huge net worth in dividend income to list of life’s goals…. :)

  12. freeby50 says:

    Buffets point was about total taxation. That includes the payroll (FICA) tax.

    In the article Buffet compares “my total taxes paid– payroll taxes plus income tax” to his employees.

    If you’re a single person making $70,000 with standard deduction you pay 15.7% effective income tax rate and 7.65% to SS/HI. Thats 23.65% right there not even counting state income taxes. Buffet says his effective tax rate was 17.7%.

    THe 47% of people who pay no federal income almost all have very low income. Thats a weak sauce argument unless you think poor people should pay higher taxes.

    • Texas Wahoo says:

      But his income is so low because of the 15% capital gains tax, not the 35% tax rate on income over 250k. Raising the upper limit to 40% would hardly affect his total tax rate at all. His argument is disengenuous.

      He should be lobbying for higher capital gains tax rates.

      • freeby50 says:

        He is lobbying for higher taxes on the wealthy. He says that rich people pay capital gains and dividend and that rich people should pay more taxes. He is not saying that they should keep capital gains low and only raise income taxes. He favors some form of tax reform where wealthy people pay more in taxes. Given everything he said it seems implicit that he would favor raising capital gains rates or otherwise taxing wealthy people for more.

        • Texas Wahoo says:

          You’re right. He probably favors raising both taxes. I just find it silly to use his statement as an argument for raising the 35% income tax backet when he isn’t paying much (if any) in that bracket anyway.

          My favorite part of the Washington Posts synopsys if the Clinton speach:

          “Clinton acted as moderator. Topics included Buffett’s views on the impact of the real estate slump on the economy (he doesn’t see it spilling over to the broader market)…”

          I think he might have missed on that one!

          • freeby50 says:

            Its not clear from the interview exactly how Buffet thinks taxes should be changed. He is clear that he thinks rich people like him should pay more. I think its safe for us to give Warren Buffet the benefit of the doubt and assume his plan would be rational and make sense.

          • Texas Wahoo says:

            I agree. That’s why I tried to clarify that I think the people using his statements (not Buffet himself) to try to raise the income tax brackets are missing the point.

    • uclalien says:

      Are you saying that half of all Americans have a very low income? I don’t buy it. The fact is that this 47% includes everyone with an adjusted gross income of less than about $32k (2008). This may not sound like a lot for those living on the coasts, but other parts of the country have a much lower cost of living. It also includes not only those people with zero income tax liability, but those actually receive a check from the government despite paying nothing.

      Here’s an interesting table I came across a couple weeks back:
      http://www.zerohedge.com/article/entitlement-america-head-household-making-minimum-wage-has-more-disposable-income-family-mak

      We must also keep in mind that Buffet donates a good amount of money each year, which lowers effective tax rate dramatically. Not only that, but as any investor or owner of a corporation should know, he is taxed 2x on that income. He is simply ignoring the 35% corporate income tax that he pays in order to bolster his case that he pays a low income tax.

  13. Sun says:

    Perhaps if there was more accountability of Wall Street and tying incentives to long-term performance, investing would not look as attractive. 15% just makes it a tax shelter. We need investments in other sectors that actually create and sustain employment long-term. The 15% is not allowing this to happen.

  14. Don C says:

    Any discussion on taxes quickly turns into a political argument. Love it!

    Dividend income should actually be tax free. No, I’m not saying this because I think the ‘rich’ should get off easy but most people that don’t get this concept either don’t own a business are are not in tune with taxation concepts.

    Say you sell something on Ebay for a profit of $100. Let’s even say you report it on your return and pay tax at $30. You’re net gain is $70. Would you even think twice about having to pay another 30% (or even 15%) on the remaining $70 just to put that cash in your checking account? Of course not, it’s your money! Now let’s say a corporation shows $100 profit, pays tax of $30, has a net gain of $70. Pays dividends totaling $70, but now you have to pay 15% tax on that too! It’s double taxation.

    For all of those people yelling that the rich should pay more, why not yell at the 47% of the country not paying anything at all! Those damn free loaders, right? It’s very easy to say someone else should pay. Just think of all of the stupid projects and redundant programs that waste our money. We wouldn’t need as much tax revenues.

    • freeby50 says:

      “why not yell at the 47% of the country not paying anything at all! Those damn free loaders, right?”

      Its not like they are evading taxes illegally or anything. Theres only a few legitimate ways to completely avoid all income taxes. The vast majority of those people are low income.

      • Don C says:

        You’re right, they are not doing anything illegal. My point is that the country is getting accustomed to expecting somebeody else to pay for everything in life and 47% of the country is not paying any income taxes. It’s not a good financial model for the country. There are too many takers in the system and not enough producers.

        • sophomore says:

          Exactly. I think that one quote attributed to Margaret Thatcher is “The problem with socialism is that you eventually run out of other people’s money to spend.”

  15. wow. this is one of the most fascinating things i’ve ever read on a blog…. anywhere. It explains a lot, and it’s scary – but also, it’s motivation.

  16. jsbrendog says:

    government fail

  17. uclalien says:

    Jim,
    Don’t forget about corporate income taxes. If I invest in a stock, I am an owner of that corporation (no matter how small my ownership stake may be). The corporation pays corporate income taxes of 35%. As an owner, this is my money that would either be put back into the corporation or distributed to me in the form of dividends. On top of corporate income taxes, I am forced to pay capital gains taxes of 15-35% (depending on whether they are long-term or short-term capital gains).

    In other words, owners of corporations (investors) always pay a much higher income tax rate than even 35%. These taxes are simply taken out at two different times during the earning process.

  18. Tim says:

    this whole argument is useless. If they are so concerned about not paying as much tax, then they should just give there money away now rather than later. For those upper income folks who say for the govt to tax them, i say, speak for yourself. If you really feel you make too much, then tell your employer to reduce your income, or write a big fat check to a charity or govt. I have yet to hear any of these crazy people say they are willing to have their employers reduce their paycheck. as far as the whole billionaires giving away their fortunes, it’s silly to say they plan to give it away when they are gone. they should just give it away now if they are serious about it. i find the whole argument nonsense and quite ridiculous.

  19. Tim says:

    oh, raising taxes won’t do a dang thing if the govt doesn’t spend it wisely or better yet, doesn’t spend it. so the whole argument about raising taxes or extending tax break is ridiculous.

    last, i hate the fact the pundits say that extending the tax break would cost $800bn. It costs nothing to give a tax break. It simply means you are not getting as much revenue so you cannot spend as much. It only costs $800bn if you are going to spend $800bn.

    oh, and since when did being successful become a crime in this country? all this talk about going to college and working hard, etc, is useless if it means being unequally punished for your efforts. I don’t make a $1m, but i don’t mind that everyone gets a tax break. what i mind is the notion that the govt and others are whining that they aren’t getting $800bn in revenue. sorry, we all live with limited resources and we all have had to face the harsh realities at borrowing money isn’t a healthy thing. arguing about losing $800bn in revenue (not a cost), is ridiculous if you (govt) are serious about living within your (govt) means.

  20. Grant says:

    Whatever happened to letting individuals choose what is best for society. People have the perception that increased taxes must be accompanied by increased spending, otherwise why are taxes increasing, rigt? WRONG! If taxes are raised fine but I think the government needs to keep budgeting expenditure cuts and put the additional money towards the debt. The problem with government is that they have little accountability for their returns on capital unlike any company or individual. Most intelligent people take their income and put 10 to 20% away in savings and live off the rest. The government decides to use all its income and then borrow even more. We need to recognize that America cannot overextend itself into every war or issue in the country as it is no longer financially feasible. Let individuals donate to charities that they believe to be best for society such as churches or other various organizations. The government doesn’t have to do everything for people in America. Let people help each other out. That is how this country became great and that is how it should remain. With respect to capital gains taxes, I don’t think there is anything we need more in this country than providing incentives for people to plan for their future. Low capital gains taxes is one method to do this. The one fault with this is the treatment for people who don’t make enough to save. I find this hard to believe as I think there are always ways to cut back your cost of living in some way, shape or form but what is reasonable is the question. Regardless, it all comes back to accountability of our taxes and how they are spent. There are fundamental gov’t services needed but we need to trim the gluttonous fat.

  21. Wilma says:

    Um, is everybody forgetting that there is a debt crisis? Its like everyone went out for dinner at an expensive restaurant, and left the teenager working at mcdonalds with the bill. Now if the teenager was dining with us, then would would have at least had a great night. Probleem is they werent even invited.


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