The Weekly Sift

The screwiest thing about the American tax system is its work penalty: If you earn your money by working, you may well be paying higher taxes than somebody who makes the same amount of money without working, via dividends or capital gains. You’re certainly not paying less.

A simple example shows what I’m talking about: Suppose a single person has $40,000 of taxable income. (That’s the amount on  line 43 of the 1040 or line 6 of 1040EZ; in other words, you’ve already subtracted all your exemptions and deductions and you’re down to the amount you take to the tax table to figure out what you owe.) If s/he got that income without lifting a finger, say by letting dividends and capital gains distributions accumulate in a brokerage account, then the federal income tax bill is $6,000. (15%, in other words.)

But if that money came from working for wages, then the bill is $36 higher: $6036. So our hypothetical worker pays a $36 penalty for working rather than living idly off investment income.

The simple work penalty. That may not sound like much — unless any work penalty riles you as much as it riles me — but so far we’re just talking about the simple work penalty; as you’ll see, it gets worse the more things we take into account.

Here’s how you figure your simple work penalty: Multiply your taxable income by 15% to see what you’d pay if you made that money without working, then check your tax return to see how much you paid. (Or look up your income on the tax tables that start on page 79 of the 1040 instructions.) We’ve already seen that a simple work penalty starts at $40,000 for single people. It starts at $53,500 for a head of household or $80,000 for a joint-filing married couple.

No matter how little you make, you will never pay less than the idle guy who made the same amount from investments. When he figures his tax (on, say, the worksheet in the Schedule D instructions), one of the last lines has him figure how much he’d pay if he just used the regular tax tables like you do. If that amount is less, that’s what he owes.

Even the simple work penalty turns into real money if your wages are high. Say you’re a salesman working on commission and you had a really good year: Your taxable income is $100,000. If you’re single, you owe Uncle Sam $21,460. But the idle guy with $100,000 of taxable income from dividends and capital gains is still just paying 15%, or $15,000*. You’re penalized $6,460 because you made your money by working.

It gets worse. Anybody who has money to invest knows that the game is rigged even worse than that, because investors don’t owe any capital gains tax until they sell the thing that increased in value. So if an investor doesn’t want to pay tax, he just doesn’t sell.

Again, an example makes it real: Suppose a guy bought $10,000 of stock in Walgreens back in 1990 when it was selling at (a split-adjusted price of) $2.75. Ignore the dividends he’s been making all those years; the value of the shares themselves has gone up more than 17 times, so his 10K is now worth $177,300, making a gain of $167,300. How much tax has he paid on that gain over the last 23 years? Zero, because he hasn’t sold. If he never sells, and his heirs sell when they inherit, the tax is never paid. Even if he does sell and pay his 15% eventually, it doesn’t even out, because his money has been compounding tax-free all those years.

And what about payroll taxes? Payroll taxes apply to wages, but not to investment income. In general, wage-earners pay 1.45% of their wages in Medicare taxes and 4.2% in Social Security taxes**, for a total of 5.67%.

If you think of all that as just “taxes”, as money hoovered up by the government never to be seen again, then the work penalty is much higher. Let’s go back to our single guy with $40,000 of taxable income. Say he took the standard deduction of  $5950 and had no dependents other than himself, so he had $3800 of exemptions. So his gross wages were somewhere around $49,750 and he paid $2821 in payroll taxes. The investor paid zero, so that would make the gross work penalty $2857 — a much bigger chunk of change than the $36 simple work penalty. (Under the same assumptions, the $100K worker makes $109,750 gross and pays $6223 in payroll taxes, raising his gross work penalty to $12683.)

But that’s not really the right way to think about it, because some payroll taxes are social insurance payments that you will see direct benefit from. Unless you’re planning to have a fatal accident before you get old, paying money into Social Security now increases the benefits you will receive later, because (in spite of what conservatives tell you) Social Security is not going away. So the investor pays less Social Security tax than you, but he’ll also see less benefit down the road.

The same may not be true of Medicare, though, because it has all-or-nothing eligibility. In order to get coverage after 65, either you or your spouse has to pay into the program for ten years. After that, you get no additional coverage for paying in more.

So that 1.45% in Medicare taxes you paid in 2012 may well be garnering you no additional benefits over the non-paying investor (if, say, either or both of you already have your ten years in). So I think it’s entirely legitimate to include that in what we might call an adjusted work penalty. If we do, then the $40K worker pays a $757 work penalty and the $100K worker’s penalty is $8051.

By that definition, all workers, no matter how little they make, pay an adjusted work penalty. The investor with the same income will never pay a higher amount of income tax, and the worker pays an additional 1.45% in Medicare tax that may provide him/her no additional benefits down the road.

So suppose you work 30 hours a week, 52 weeks a year, at the $7.25 minimum wage, and you’ve been working for ten years or more. You have gross wages of $11,310. An investor whose only income is $11,310 of dividends and capital gains pays the same income tax you do, and in addition you pay $164 of Medicare taxes that provide you no additional benefit.

End the work penalty. Is that crazy or what? Why does our tax system penalize people for working rather than idly collecting dividends or sitting around owning things that go up in value?

Conservatives are always talking about ways to make the tax system “fairer”, by which they usually mean “flatter” —  they want to lower the tax rates paid by people who make the highest wages. (Why that is “fairer” is a mystery to me. I think a progressive tax system is fair.)

But eliminating the simple work penalty absolutely would make the system fairer: Stop treating different kinds of income differently. Wages, dividends, capital gains — they’re all income. Tax them the same. And beyond that, why not tax investment income for Social Security and Medicare?

* I know what you’re thinking: Wouldn’t the alternate minimum tax kick the investor’s taxes up? No, it wouldn’t. The AMT counter-acts excessive deductions and tax-free income, but doesn’t affect the advantages of dividends and capital gains.

** Until their wage income hits $110,100. In 2012, earnings higher than that paid no additional Social Security tax. The 4.2% was a special rate for 2012, temporarily reduced from the ordinary 6.2% (matched by another 6.2% from the employer).