A common misconception is that the United States federal corporate taxes of 21% means business owners get to keep 79 cents to every dollar they earn.
That, however, ignores the layers of taxation they have to pay. In fact, if President Biden’s 5% or as much as 8% “surcharge on high-income people” is passed, after adjusting for inflation, some investors might face over a 100% marginal tax on the profits their investments bring in.
To demonstrate, look at this example involving a high-income person with a normal stream of income of around $25 million every year who is subject to Joe Biden’s top rate 8% surtax.
On top of his passive income, which includes royalties, rents, and certain dividends that do not require active involvement, this person also gets a high salary. On the person’s salary income, he pays federal income tax, and the 8% surtax, then payroll taxes, and local and state income taxes. After all of this, suppose the person takes home a $10 million after-tax salary.
The person might spend the $10 million of his salary or then invest it. Assuming he invests it into corporate stock and that the company takes the $10 million to pay for a 10-year program that brings in a $20 million payout at the close of the decade. The company brings in $10 million of income which is subject to corporate taxes.
First, the company pays the corporate tax at 21%, then the median state takes another 6.5% corporate tax. After allowing for local and state tax deductions, governments get around $2.58 million at the corporate level.
After paying these taxes, suppose the company distributes a pre-tax dividend to the person of $7.42 million, paid out over 10 years after his or her original investment. The person pays a 20% federal capital gains tax, along with Joe Biden’s 8% surtax (notice the second time around the surtax is now a thing), a 3.8% net investment tax, and a 5.2% average local and state capital gains tax.
Among these taxes, governments get around $5.33 million on the $10 million of income on the investment. Only $4.67 million is now left over by the time the person has paid his capital gains and other taxes. The overall value after 10 years is around $14.67 million, compared to the starting $10 million.
However, as 2021 has showed, prices after 10 years will always be higher. Depending on inflation numbers, $14.67 million within 10 years could be worth much less.
Even at the lower 2% inflation of the previous two decades, the investor in this example might only have 20% more buying power after 10 years than if the person had quickly spent this $10 million salary.
At 4% inflation over 10 years, the investor’s buying power would be less than if he had quickly spent the salary.
At current 5.4% inflation numbers, the investor would actually end up with an ROI of negative 13%, due to the combination of inflation and taxes.
Author: Scott Dowdy