econscius

Trust A CPA: Warren Buffett is Wrong About Tax Rates

In Federal Deficit, Income Tax Rates on August 19, 2011 at 1:33 am

Legendary investor Warren Buffett penned a New York Times opinion piece about tax rates.   Surprisingly, he presents some very misleading information.  Fortunately, anyone can easily obtain actual average tax data from the helpful IRS website.  Yes, I said “helpful IRS”. 

Mr. Buffett says he calculated his personal average tax rate, including Social Security and Medicare payroll taxes, and came up with 17.7%.  Other people in his office paid more, anywhere “from 33 percent to 41 percent and averaged 36 percent”. [1]    I assume his co-workers’ calculations are accurate.  But Buffett is an aberration among the rich and his staff is not middle class, as we know from comparing them to the IRS’s own tax tables.

The chart below shows the actual average federal income tax paid by 2008 income cohort.  The top 1% paid an average 21.0% of income, the top 50 percent paid an average 13.2% and the bottom 50% paid a mere 2.6%.

FIG.1 [2] Item, tax year             Total
Average tax rate (percentage):  * Top
1 percent
Top
5 percent
Top
10 percent
Top
25 percent
Top
50 percent
Bottom 50 percent All Taxpayers
               
2008 21 18.84 17.33 14.92 13.23 2.59 11.91
               
* The average tax rate was computed by dividing total income tax (see footnote 3) by (positive) adjusted gross income.
Source: IRS, Statistics of Income Division, July 2010    

Mr. Buffett includes payroll taxes in his numbers.  In fact, he includes the portion of payroll taxes paid by his employer on his behalf.  This is interesting because liberals usually ignore the payroll taxes your employer pays on your behalf, in order to show Americans paying lower-income tax rates.  Still, let’s use his numbers.  Social Security and Medicare taxes were set up to loosely match a person’s contributions with the expected benefits.  As a result, both the benefit and tax are capped.  In 2010, the Social Security (6.2%) tax is accessed on the first $106,800 of income and Medicare (1.45%) taxes have no limit.  Your employer pays a matching tax. [3] 

Consider the income tax tables:

FIG. 2 [4] If your filing status is Married filing jointly:
       
If your taxable income is:  
       
Over- But not over- The tax is: of the amount over-
 $             –  $  16,750 10%  $                        –
     16,750       68,000 $1,675 + 15%                 16,750
     68,000    137,300 $9,362.50 + 25%                 68,000
   137,300    209,250 $26,687.50 + 28%               137,300
   209,250    373,650 $46,833.50 + 33%               209,250
   373,650   $101,085.50 + 35%               373,650

I won’t bore you with technicalities, but the term “income” refers to Adjusted Gross Income (“AGI”), which takes out exemptions for individual and dependents and credits such as student loans, 401(k) deductions and pre-tax expenses for health insurance.  Mr. Buffett is misleading by ignoring these credits (he uses “taxable income” which ignores the non-taxable income received by lower and middle-income taxpayers). [5]

Mr. Buffett’s other 20 people in his office are said to pay an average 36% in income taxes.  His office mates cannot be middle class as he portrays them.  The top marginal income tax rate is 35% and the average rate actually paid is always lower because tax rates work like a step-ladder.  The first $16,750 we earn is at a 10% income tax rate, then we pay 15% up to $68,000 and so on.   Taxpayers also take deductions for mortgage interest, state and property taxes, and charitable contributions, which reduces the average income tax rate paid.  We can say conclusively that none of Mr. Buffett’s office workers earn less than $68,000 AGI and appear to be well into the six-figures. 

Here’s the math.  Let’s assume Mr. Buffett’s co-worker has an AGI of $373,650 (actual income would be more because AGI is lowered by 401(k) and pre-tax deductions).  The income tax is $101,085 (27.1%). 

The maximum Social Security tax, including what your employer pays on your behalf, is $13,243.  The Medicare tax on $373,650 is $10,836.  When we add these three taxes together, the average tax rate is 33.5% of AGI.  Do the math on an earner at $209,250 and obtain an average tax rate of 31.6%.  AGI of $137,243 yields 31.9%.  AGI of $68,000 works to 30.8%.

All taxpayers take deductions which reduce “AGI”.  There are itemized deductions for state income taxes, property taxes, mortgage interest, childcare and charitable deductions.  Or you receive a standard deduction if you do not itemize.  These deductions lower the income tax percentages shown above.

Another way of checking Mr. Buffett’s high numbers for his employee tax rates is to use the IRS data above.  A taxpayer in the middle (50th percentile) is paying 13.2% of income in taxes.  Even adding Social Security and Medicare taxes paid by the employee and employer, the percentage is below 30%.

The figures Buffett provides for his 20 office mates are questionable; they do not mesh well with actual IRS data as I just showed above.  Certainly a Buffett employee who is earning $400,000 AGI and paying about 35% in taxes hardly counts as “middle class”.  The IRS data show the middle class is paying much lower rates.

Mr. Buffett is only tracking taxes, but it is worth noting the poor and middle class receive the greatest government benefits as a percentage of their salary.  School lunches, food stamps, financial aid for college and the like logically go primarily to those at the bottom of the tax scale.  The rich pay for private schools while the poor and middle class generally attend public schools. 

What about Warren Buffett himself?

Because of the wage cap on Social Security, Mr.  Buffett’s payroll tax drops as a proportion of his income grows.  The maximum social security and Medicare tax on $373,650 works out to 6.4% of income.  For Mr. Buffett to pay 17.7%, we may safely assume most of his income is in the form of capital gains and that income is very substantial.

Mr. Buffett’s company, Berkshire Hathaway, must file annual proxy statements with the SEC.  We learn Warren Buffett was awarded total compensation of about $519,490 in 2009 to run Berkshire Hathaway.  His salary was “just” $100,000, he received $75,000 in fees for serving as a director of Berkshire investment Washington Post Co., and he received taxable wages in the form of free personal security provided by the company. [6]  His average tax rate on that income would be about 34.9%.  Mr. Buffett tells us the bulk of his income comes from capital gains, which are taxed at a 15% rate. 

A capital gain is derived from the increase in value in a qualified investment (e.g. a stock or business) over time.  An important fact that Mr. Buffett and many liberals ignore is that capital gains are not indexed for inflation.  If your investment only grows at the rate of inflation, you actually pay income taxes on income that is not “real”.

Capital gains enjoy preferred taxation because you are using your own money to make an investment and the money was already taxed before as income.  Secondly, it serves a societal purpose of encouraging people who can to save and invest rather than spending it on caviar and yachts. 

It would seem reasonable to assume Mr.  Buffett maximizes his eligible charitable contributions since  he is a noted philanthropist.  Charitable tax deductions exist to encourage a societal goal.

It is worth noting a “C” corporation already paid high corporate income tax rates on its income before you, I or Mr. Buffett take any capital gains on that income.  The capital gains rate is lower partly in recognition of this fact.

Mr. Buffett is highly unusual in that his personal investment in Berkshire Hathaway has been stunningly successful; he may be the most successful investor of all time.  Most of us who buy a stock or invest “angel” capital in a friend’s start-up are happy if we might double our money in 5 years (unadjusted for inflation).  Only a precious few are able to parlay a modest investment into massive riches the way Mr. Buffet or Bill Gates have.  They are amongst the world’s richest people and biggest philanthropists.  Personally, I bet their charitable contributions are more cost-effective than funneling the same money through Washington D.C.

According to the IRS, the top 1% of earners accounted for 20% of all income but paid 38% of total income taxes. [7]  Mr. Buffett believes the top earners are not paying enough.  That is a matter of opinion and my purpose here is not to debate the proper tax structure or rate [8].  I have instead shown Mr. Buffett’s statistics for his office staff’s average tax rates are misleading and quite possibly wrong.

###

[1] http://www.nytimes.com/2011/08/15/opinion/stop-coddling-the-super-rich.html?_r=1

[2] Tax Chart by author, source: http://www.irs.gov/taxstats/indtaxstats/article/0,,id=129270,00.html

[3] http://www.ssa.gov/OACT/ProgData/taxRates.html and pg. 19 of http://www.irs.gov/pub/irs-pdf/p15.pdf.   Note the individual rate was lowered by 2.0% to 5.65% for 2011 as a temporary stimulative measure.  

[4] IRS tax table chart by author, source: http://www.irs.gov/pub/irs-pdf/i1040tt.pdf

[5] http://www.irs.gov/pub/irs-pdf/f1040.pdf

[6] http://www.reuters.com/article/2010/03/11/us-berkshire-buffett-compensation-idUSTRE62A5SH20100311  Mr. Buffett runs Berkshire; since he believes his taxes are too low, he could adjust his compensation mix to more salary.  

[7] http://www.irs.gov/pub/irs-soi/08inratesharesnap.pdf

[8] One option that would accomplish what Mr. Buffett wants (and some liberals have advocated) is uncapping Social Security.  Ironically, though, uncapping would crimp people earning $106,800 and above.  While $106,800 is hardly pauper territory, President Obama has exempted people under $250,000  from his proposed income tax hikes as “middle class”.  If liberals were unsuccessful in uncapping Social Security, it will be hitting many people earning $125,000 and $175,000 – people who see themselves as upper “middle class” as does Mr. Obama. 

Social Security payroll taxes were not intended to be used to fund defense, NASA or the TSA, which is what would happen if it were uncapped and the new revenues from the rich were used to fund general government operations.

Pictures from Wikipedia Commons.

Dislosure: the author owns stock in Berkshire Hathaway.

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  1. […] In a typical corporate enviornment, the inner sanctum of a corporate headquarters includes the CEO (Buffett) and the Chief Financial Officer (“CFO”), Corporate Controller, Chief Information Officer, Chief Counsel (top lawyer), a head of Human Resources, a head of Mergers and Acquisition, a few other high ranking executives from sales, marketing, legal and other areas, and perhaps an executive secretary of two.  They are not middle class workers.  Quite possibly all 20 in Mr. Buffett’s office would be six-figure earners, which explains why they would be paying average federal tax rates in the mid 30%’s (see my post https://econscius.wordpress.com/2011/08/19/trust-a-cpa-warren-buffet-is-wrong-about-tax-rates/). […]

  2. Reblogged this on econscius and commented:

    This is six months old but very much back in the news after the Obama State of the Union

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