Federal Income Tax Preferences Favor the Very Wealthy

August 28, 2012

I really appreciate the service provided by NPR and WNYC in terms of trying to present a variety of positions and opinions on our economy, our country and a broad array of other subjects.

Tonight, I listened to an interview of former Gov. John H. Sununu by Brian Lehrer.

Gov. Sununu has some interesting perspectives based on years of academic and political leadership, as well as a sound educational foundation – including a PhD from MIT.

Gov. Sununu has some strong opinions, some of which he shared with listeners in the interview.

One opinion I heard revolved around federal income taxes on dividends and capital gains.  As I understood Gov. Sununu, his posture is that we need to protect the favored tax status on dividends and capital gains because this rewards and encourages entrepreneurs to take risks, to create new enterprise, and to create and sustain new jobs.

I like this strategy for active equity investors who devote a substantial amount of their own personal time and energy, in addition to their capital investment, in the business.

Where I believe we ought to consider drawing the line is with passive equity investors.

Under the leadership of President Ronald Reagan, Congress enacted the Tax Reform Act of 1986, which essentially eliminated many of the tax preferences formerly available through real estate investment transactions.  In the Revenue Reconciliation Act of 1993, Congress “relaxed” the rules somewhat for active real estate investors, allowing those who meet defined requirements necessary to be considered a real estate professional to bypass the passive activity rules for real estate investments in which they materially participated.

Today, we allow those who are essentially passive equity investors to treat significant amounts of passive income from equity investments in the form of dividends and capital gains as preference items for federal tax purposes.  Meanwhile, hard working Americans – including most small business owners – are taxed at standard income tax rates, compounded by the mysterious “Alternative Minimum Tax”.

Our standard income tax system is indexed so that as taxable income increases, the effective tax rate increases.

As an example, an American family with 2 adults which had a taxable income of $100k from employment in 2011 were in the 25% tax bracket, but they didn’t have to pay 25% in federal income taxes on the full amount. Rather, they paid 10% on the first $16,050, 15% on the next $49,050, and 25% on the last $34,900. This works out to a federal income tax obligation of $17,687.50, or an effective rate of just under 18%.

Now, contrast this against a passive investor who receives most of his income from passive activities, and where there is no indexing in place.  How is this rational, appropriate or equitable?

I would have hoped to hear a well-educated and knowledgeable individual like John H. Sununu give us a more informed and critical analysis of the overall situation here, versus trying to create what sounded on the radio to be a biased, inflammatory and very narrow interpretation of the facts.

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