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Buffett’s Million Dollar Bet

Posted By Jim On 12/08/2010 @ 7:25 am In Taxes | 60 Comments

As we near the end of the year, the big issue of the Bush tax cuts [3] remains unresolved. As we inch into December and still have very little idea as to how the tax brackets [4] 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 [5] – ““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 [6].

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 [7]. 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 [8], 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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[2] Email: mailto:?subject=http://www.bargaineering.com/articles/buffetts-million-dollar-bet.html

[3] Bush tax cuts: http://www.bargaineering.com/articles/expiring-bush-tax-cuts.html

[4] tax brackets: http://www.bargaineering.com/articles/federal-income-irs-tax-brackets.html

[5] that night: http://www.timesonline.co.uk/tol/money/tax/article1996735.ece

[6] interview with Tom Brokaw: http://www.cnbc.com/id/21553857/

[7] article: http://finance.yahoo.com/news/Nearly-half-of-US-households-apf-1105567323.html?x=0&.v=1

[8] CBO: http://www.cbo.gov/publications/collections/tax/2010/AverageFedTaxRates2007.pdf

Thank you for reading!