The Capital Gains Mass Tax Fraud

As I've written repeatedly, two kinds of people have been getting richer for the past 30 years: the executives who sit on each other's boards and vote each other higher and higher pay, and today's senior citizens, the richest in history, particularly retired public employees, whose unions control state and local governments while cheating their younger members and the public. As I have demonstrated each year, most recently in my previous post, the retired, especially retired public employees, pay vastly lower taxes on the very same income — or even a lower income — than moderate and middle income young families. Presumably as part of the same self-dealing and institutional mass rape that provides them with higher incomes.  One should not be surprised, therefore, that the rich pay lower taxes too. And since in this era of Generation Greed ideologies are frauds, one should not be surprised that policies that provide massive public advantages for the privately better off have bi-partisan support.

Warren Buffet has had a public dare for years — for any CEO to prove that he had a higher marginal tax rate (the rate paid on the last dollar of income) than his secretary. No one has taken him up on the offer. The reason is that wage and self employment income, from the first dollar, is subject to a 15 percent payroll tax (15.3% in downstate New York going up to 15.5% in New York City, as a result of the MTA bailout). Investment and retirement income is exempt. While some of this is in theory paid by employers, in practice the burden is shifted to employees in the form of lower wages. As proof, wages for those earning up the level on which the payroll tax is levied — only on the first $100,000 or so of income — have been slipping relative to inflation for 30 years, while wages for those over the limit — where the employer can pay more wages without paying more tax — have been soaring.

For wage earners, federal, state and local income taxes are on top of that 15 percent. For the worst off, no income tax is charged and the Earned Income Tax Credit offsets part of the burden of the payroll tax. But for moderate, middle and upper-middle income workers, the federal rate starts at 10 percent and soars as high as 39.6 percent. Meaning the combined marginal tax rate on work income rises from 25 percent to 54.6 percent. State and (in New York City) local income taxes, which retired public employees don't have to pay, are currently around 10 percent but will probably rise to 15 percent for the middle class in the next few years, even as the public services the middle class relies on — such as schools and mass transit — collapse to as money is diverted to pensions and debts. As Reagan and Weingarten taught us, deficits and enriched unfunded pensions don’t matter to the rich and powerful who matter, because they take theirs off the top.

At the federal level, however, the wealthy don’t even pay the regular federal income tax rates on their work income. Because they vote as corporate board members to give each other the majority of their compensation in the form of capital gains instead, which is subject to a lower 15 percent federal income tax rate. So moderate to upper-middle income households have a marginal tax rate of 25 to 55 percent, while billionaire’s pay just 15 percent. Can there be a rational explanation as to why having a lower tax rate on capital gains is fair?

Well, actually there is, and (courtesy of an article by John Steele Gordon I read in American Heritage magazine some years back, it goes something like this. Capital gains are not like other income. Take a capital gain I might receive, for example. First I work, and pay significant taxes on my work earnings. I can selfishly and shortsightedly spend all that money on myself, and owe no further taxes. Or I can invest the money in some socially useful investment such as a stock or a bond, providing capital so that business and infrastructure can expand. If I’m lucky, I might get a capital gain, but would be a gain on capital upon which I had already paid taxes, meaning I would be taxed a second time. If I’m not lucky, I might have a capital loss, which plenty of people have had in the past decade. In that case, I would have deferred my gratification and been punished for it. Wage earnings cannot be negative, and are only taxed once. Therefore, capital gains should be taxed less or not at all, to encourage “savings and investment.”

I also heard Larry Ellison, founder and CEO of Oracle, make this argument in response to a question as to what the federal government could do to encourage high tech job growth. Well, he said, his employees already pay lots of taxes, so the government should cut his capital gains taxes to encourage him to keep getting richer instead of spending the money.

Yes, there are people who agree with this point of view. But then, what would you call it when people pay income taxes at the lower capital gains rate on income that hasn’t already been taxed as work earnings, and cannot also take a loss? I’d call it tax fraud, and if it is legal under a tax regime – which it is in the United States – then the government imposing that regime is illegitimate. Basically, a high and rising share of income earned by the wealthy has been subject to tax fraud.

Let’s take the example of a CEO, and his cronies on the board. If they pay him $10 million in wages to work for a year, that $10 million would be taxed at the regular rate. If they pay $100,000 in wages and grant $9.9 million in stock options, on the other hand, only the $100,000 would be taxed at the regular rate. The rest would be subject to the lower capital gains tax. Note that the CEO doesn’t have to come up with money he has already earned to buy stock – the options are part of his pay, but not for tax purposes. So much for having already paid taxes on the earnings.

Generally, stock options pay off big time even if the value of a company’s stock just rises at the average rate for stocks over the long term, or even less. But if it doesn’t, the CEO merely declines to exercise the option, and loses nothing. So much for the possibility of taking a loss. In fact, the cronies on the board often change the terms of the options after the fact to turn a loss into a gain so the CEO gets their money anyway. And there is little to prevent the CEO from using questionable accounting and dangerous debt to temporarily inflate earnings, to push up the stock price and cash out at the right time, before the consequences arrive and the company goes down the tubes. As has happened over and over for more than a decade.

In a stock option, in theory, the CEO has to have money to exercise the option and buy the stock at less than its current price, right? Well the boards of cronies often loan the CEO company money to exercise the options. Well, what if the CEO doesn’t sell before the stock goes down and still owes all that money? Well, corporate boards have repeatedly forgiven loans in just those circumstances, so the other shareholders take the loss.

Yes, not every stock option has been pre-priced, and not every stock option has involved a forgiven loan. But that is only because the stock options usually pay off. The CEOs know they won’t take losses. It’s heads I win, tails I either win or break even, and no money invested. And somehow they still call it a capital gain, which is a return on invested capital. Without an investment.

One should not be surprised that the Republicans propose to eliminate capital gains taxes. The proposal is part of a plan that would eliminate Social Security and Medicare for those under 55, replacing them with vouchers payable only to extent that federal spending is less than 19 percent of GDP, including interest on the exploding national debt. There would be no limit on Medicare spending for those now 55 and over (no death panels), so that debt would soar in the years before those now under 55 would theoretically become eligible for the vouchers. And federal investment in infrastructure and education, which those 55 and over don’t need, would be slashed.

One may be surprised, however, to find that it was Democratic President Clinton who first made the tax rate on capital gains lower than it had been on ordinary income. Clinton re-politicized the tax code, adding all kinds of breaks and deals, undoing the tax reform of 1986, the most just thing that has happened in public policy since 1980, which cut rates and got rid of breaks and deals. And it is Democratic Senator Schumer who has defended the “heads I win and call it a capital gain, tails I don’t lose” compensation of hedge fund managers. All the income of hedge fund managers, it seems, is somehow classified as “capital gains.”

To understand why this is, just remember that the Democrats and Republicans are not two parties with two different ideologies, they are two mafias, each controlled by Generation Greed, each seeking favors for its own set of special interests. And the entertainment, financial and high tech industries are as much as part of the Democratic mafia as the oil, defense and pharmaceutical industries are part of the Republican mafia. Both have their own set of rich people to cater to at the expense of the taxpaying serfs. Both end up selling out the future so the serfs won’t realize what has happened to them until later (it’s getting close to later).

Is new legislation required to correct this injustice? I don’t think so. I think the IRS should go back over every stock option and grant, and examine every instance of “carried interest” over the past 15 years and ask two questions – did he person receiving the capital gain buy the asset with money on which he already paid taxes on ordinary income? And was there a risk of loss? If not, make them pay back taxes on their ordinary income with interest. Let’s call this mass tax fraud what it is.