The Very Rich Really Are Different

By :: May 12th, 2011

"Let me tell you about the very rich. They are different from you and me,” wrote F. Scott Fitzgerald. He wasn’t talking about taxes (the laws were very different back in 1926) but his assertion certainly applies to the way the wealthy fare under today’s tax law.

For proof, take a look at the annual IRS accounting of the income and taxes of the 400 taxpayers with the highest adjusted gross income (AGI). The latest report added 2008 to data for the previous 16 years.

One way the super-rich are different: Their effective income tax rates have plummeted since they peaked in 1995. In contrast, effective rates for the rest of us have barely changed. Here’s the story.

To make the Fortunate 400 list in 2008, your AGI had to approach $110 million. Average income for the group topped $270 million. That’s more than 4,700 times the $58,000 average for all tax filers. And the rich paid a lot of income tax—just shy of $49 million on average, more than 6,750 times the $7,200 average for the rest of us.

The very rich not only made lots more money, they made it in a very different way. Nearly 60 percent of their 2008 AGI came in the form of capital gains, almost all of it taxed at 15 percent. These über-rich earned just 8 percent of their AGI in salary and wages. The rest of us? We got just 5 percent of our income from gains but 72 percent in salaries and wages.

But the Great Recession hit the rich—hard. Their AGI plunged by nearly a quarter between 2007 and 2008, compared to a 5 percent fall for everyone else (see first graph). And the drop was almost all in those tax-preferred capital gains: their gains fell nearly a third—$29.2 billion—almost exactly matching their drop in AGI. The rest of us also saw our investment income fall between the two years, but since gains are such a small share of our income, the drop didn’t affect our AGI as much.

Their income collapse could not have made these folks very happy but their tax situation was worse. Not only did their AGI go into free fall, but their effective federal income tax rate actually rose from 16.6 percent in 2007 to 18.1 percent in 2008 (see second graph). That’s not what you’d expect when your income falls, but that’s what happens when most of the drop came from tax-preferred gains. For the rest of us, the average effective tax rate fell from 12.8 percent to 12.4 percent.

Before you start feeling too sorry for the fortunate few, however, check out the sharp drop in their effective tax rate over the past 15 years—down from 30 percent in 1995 to the 18 percent rate in 2008. Compare that with the 24 percent rate paid in 2008 by people with income between $500,000 and $1 million. The rest of us also saw our tax rate drop from a peak of 15.4 percent to 12.4 percent in 2008. But that doesn’t take into account that AGI of the top 400 jumped 277 percent in real terms between 1992 and 2008, compared to a 77 percent increase for everyone else. Adding insult to injury, with so little earnings and so much investment income, the very rich pay a relative pittance in payroll taxes compared to the rest of us.

Now for the caveats. First, AGI doesn’t include all income. Exclusion of income from specific sources like municipal bond interest means that the IRS statistics don’t necessarily include the richest 400. And the income included in AGI has changed as well, so comparisons across years may be a bit misleading. What’s more, the Top 400 continually changes. Only four taxpayers appeared in every one of the 17 years the IRS examined. Nearly three-fourths of those who ever made the list showed up just once. That suggests that rare events—selling a business or closing a one-off killer deal—is enough to get you on the list. Once. On average, the very rich were rich enough not quite twice.

Still even a one-time appearance puts you in pretty good shape. The average taxpayer would have to work well into the 68th century to earn as much as the average “400” member made in 2008 alone. With some careful financial planning and conservative investments, even the one-timers will probably outlive their nest eggs.