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Taxing Rich People: Who Are They?

The debate in Washington rages over whether or not to extend the Bush tax cuts.  Essentially, the debate has come down to whether or not to extend lower tax rates to those individuals in the highest marginal tax bracket. 

President Obama wants the tax rates to increase for individuals making more than $200,000 and couples making over $250,000.  It’s an interesting choice of words.  Presently, tax brackets are determined by taxable income, which is your adjusted gross income less deductions (e.g., mortgage interest and charitable deductions).  By referring to income, is he referring to taxable income or adjusted gross income?

Aside from that question, the debate is centered around taxing the “rich” people.  Some opponents have argued that targeting the wealthy is a form of class warfare.  However, it’s widely understood that we have a progressive tax system, and the more you make, the more you pay.

If you’re going to tax the rich, it’s good to understand who they are.  Being rich is a relative term.  One person’s idea of being rich is quite different than another.  For my grandparents, $100,000 was a fortune, but some people will spend more on a car.  Being rich can also vary dramatically depending upon where you reside.  Making $200,000 a year in west Texas is vastly different than making $200,000 living in Manhattan.

If you consider that one-third of the world lives on less than $2 per day, every American is rich.  In short, most people don’t feel rich. Thus, when we advocate taxing the rich, we’re typically thinking of someone else.

In the debate about extending the Bush tax cuts, a viewpoint of who is rich is an important consideration. President Obama argues that those affected can afford to pay more, and the increased taxes won’t affect their spending.  The proponents of extending the lower rates believe that the government will be taking money away from business owners and entrepreneurs who may invest those dollars into business ventures that will help stimulate the economy.

When thinking of rich people, A-list celebrities and names like Gates, Buffet and Rockefeller often come to mind. You imagine people who live in mansions, travel, shop and generally life a life of leisure. In the world of the rich and famous, paying extra taxes has little impact on their lifestyle.  While these people exist, they are by far the minority of the “rich” people who will be affected by the pending tax increase.

A large majority of the people who are in the highest tax brackets are people who own businesses.  If you look at the IRS statistics, S Corporations and partnerships comprise the majority of all business tax returns filed.  S Corporations and partnerships do not pay taxes at the entity level.  The taxes are paid by their owners.  Thus, the income of the business is included in the owners’ returns, but income doesn’t necessarily equate to cash in the owners’ pocket.  It’s common for the business to retain money for working capital and expansion.

This is the crux of the issue.  The more money the business pays in taxes, the less that is available for economic growth.  An increased tax burden probably won’t put the company out of business, but it might keep the business from hiring additional employees or purchasing new equipment.  Since the government is attempting to spur economic growth and reduce unemployment, whatever hinders business growth is counterproductive to this goal.

Assume a person makes $1 million a year and pays an additional 5% of taxes, which is $50,000.  If the person has the $1 million in cash for their lifestyle, the extra $50,000 of taxes paid probably won’t make a huge difference in their spending.  However, if the $1 million of income is the profit from a business, the extra $50,000 of taxes could be the equivalent of another full-time employee. 

In the debate over extending the Bush tax cuts, I think it’s important to know who is going to be affected by the tax changes.  I believe Congress has a bias in their understanding.  If you look at the background of the members of Congress, very few are business owners or entrepreneurs.  Therefore, I think they have a distorted view of the impact that increased tax rates have on behavior.  Based upon their characterization of wealthy people, it seems most of them think wealthy people have trust funds and large investment portfolios, rather than entrepreneurs running a business.

If it’s all about lifestyle, then the additional taxes probably won’t have much of an effect, but if it’s money associated with operating a business, extra taxes may mean slower expansion and few employees hired.

Who are the rich people?  Hopefully it’s you.

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