The head of the world’s largest hedge fund agrees with Democratic-Socialist Congresswoman Alexandria Ocasio-Cortez on the need to address yawning income equality in the U.S., but he warned that her strategy of taxing the super-wealthy could have unintended consequences on the economy.
‘We’re in agreement on the problem that’s behind that suggestion,” Ray Dalio, founder of Bridgewater Associates, said in an interview with CNBC at the World Economic Forum in Davos, Switzerland. “We have to make capitalism work for the majority of Americans. I don’t know that we’re in agreement on the mechanics.”
Dalio added, “How tax rates are changed will have a huge effect on incentives and could have a huge effect on capital flows, and that will have big effects on markets and economies. It’s going to be a bigger market-influencing issue than people now realize.”
Ocasio-Cortez’s mention in early January of a 70% tax on the wealthy provoked heated reaction from both supporters and detractors, with House Republican whip Steve Scalise deriding the idea as a “leftist fantasy program.”
But the debate sparked by the Democrat from New York also revealed some misunderstandings about how America’s tax system works.
Marginal vs. average tax rates
On CBS’ “60 Minutes” Ocasio-Cortez mentioned that historically America has had higher tax rates, and that in the 1960s, “once you get to the tippy tops, on your 10 millionth dollar, sometimes you see tax rates as high as 60% or 70%.”
Though Ocasio-Cortez added that the 70% rate wouldn’t apply to all of that income, that detail seemed to get lost in the contentious aftermath. Her comments were widely interpreted as meaning that she wanted the federal government to take 70% of Americans’ income in taxes, a view Scalise broadcast on Twitter TWTR, -3.47%
But as Ocasio-Cortez clarified in subsequent tweets, her “60 Minutes” comments referred to the “marginal” tax rate.
What does that mean? Here’s the key distinction: Marginal tax rates are only applied to part of someone’s income, not to all of their earnings. In other words, someone making $10 million would not lose 70% of that money to taxes under Ocasio-Cortez’s proposal. A 70% marginal tax rate on earnings above $10 million would only apply to the portion of income above $10 million.
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For example, if you were getting paid $11 million at your current job, only the last $1 million would be taxed at 70%, said Mark Mazur, director of the Tax Policy Center at the Urban Institute and Brookings Institution. The remainder would be taxed at lower tax rates used for lower incomes.
“It’s important to distinguish between the marginal tax rate and the average rate,” Mazur told MarketWatch.
A household’s average tax rate — also called their “effective” tax rate — is the total share of their income that they pay in taxes. It’s usually much lower than their top marginal rate, as this chart from the Center on Budget and Policy Priorities shows.
Tax brackets vs. tax rates
This is where tax brackets come in. A tax bracket refers to the range of income that gets taxed at a particular rate.
But here’s another critical point that gets lost in the social-media scrum: Just because you’re “in a 24% tax bracket” doesn’t mean your entire income is taxed at 24%. Under current tax law, if you were a single person, you would only pay that 24% rate in 2019 on income between $84,201 and $168,400.
Marginal tax rates have fluctuated since income tax was established. The top marginal tax rate peaked at 92% in the early 1950s, according to the Tax Policy Center. In 2019, under the new tax law, the top marginal rate of 37% will apply to income above $510,300 for unmarried individuals, according to the Tax Foundation.
There is more than one way to tax the rich
Ocasio-Cortez’s tax proposal is aimed at the super-rich, but when it comes to taxes, the super-rich are different from you and me, as F. Scott Fitzgerald may or may not have said. (And as MarketWatch reporter Brett Arends pointed out this week, they may also share many of the same qualities.)
Increasing taxes on earned income wouldn’t necessarily hit the rich where it hurts the most.
As Mazur noted, when Americans envision a rich person they may think of an NFL player with a $22 million yearly salary. But in reality many of America’s wealthy don’t accrue their wealth from paychecks, also known as earned income.
“If you’re Scrooge McDuck, hedge fund manager, much of your income comes from investments,” Mazur said. “It’s coming from long-term capital gains or dividends, which are preferentially taxed.” (Long-term capital gains tax rates, for example, range from 0% to 20% this year.)
“If this 70% tax bracket only applies to earned income, then it’s only going to hit a very small slice of people who earn income above that level,” said Daniel Bunn, director of global projects at the Tax Foundation.
“One thing that’s generally true is that folks that have income of $10 million or more, a lot of their income is what you would call unearned income: capital gains, or benefits from a business that you own or operate, and that may put you in a position where you’re not necessarily taxed at what you might otherwise think based on the top marginal rate,” he added.
Those earning income above $10 million is a much narrower group than the top 1% — it probably amounts to fewer than 0.05% of households, Bunn said.
Dalio touched on that point in his comments at Davos. “If we’re to have a 70% marginal tax rate, most individuals affected by it will calculate whether they should instead operate as a corporation in order to convert ordinary income to capital gains, so I wonder how that will be handled,” he said, according to CNBC. “And I wonder what will be done to influence whether capital will leave the country.”
Who pays the most taxes?
“While there are examples of rich people in the United States paying very low average tax rates, our system is — on the whole — average rate progressive,” said Daniel Hemel, an assistant law professor specializing in taxation at the University of Chicago law school. “Average rate progressive” means that average tax rates rise with income.
For 2019, the overall average tax rate (accounting for all types of federal taxes) is 31.1% for families in the top 0.1%, 25.2% for families in the top 10th of income earners, and 18.4% overall, Hemel said, citing Treasury Department data.
The top 1% of income earners paid an average tax rate of 26.9% in 2016, while the bottom 50% of income earners paid an average tax rate of 3.7%, according to IRS data, Bunn said.
This story was updated on Jan. 23, 2019.