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- Do wealthy people pay less tax?
Dear Investors,
Ever heard of anyone who likes paying taxes?
Its quite an emotional subject because taxes come from your hard-earned labour.
This emotion is often used to divide and conquer with misinformation.
Usually, someone says the rich pay less tax than the poor. Next thing you know, you hate the rich… even though you’re still trying to become rich.
So let’s bust some tax myths.
It can be annoying to hear that wealthy business owners pay less tax than their employees.
Let’s look at how the taxes work.
In most countries the tax system is designed to be progressive. This means that the more you earn, the more you pay. The system is designed like this because people who earn less, need a larger part of their income for the basics. They cannot afford to pay as much tax as wealthy people.
This makes sense, so why is it that people think rich people pay less tax? The answer is misinformation.
Usually, when someone wants to get the masses riled up, they say that the rich pay less tax and then use selective examples to justify it. They say something like “you pay 41% income tax while the rich pay dividends tax at 20%”. This would make anyone angry.
The principles of tax are similar in most countries, so we will apply the principles to two examples, the employee and the business owner. The results may vary in your country, but you’ll get the idea.
The employee
Sarah is a senior engineer with two decades of experience and she earns a salary of 1 million per year. Her country has a progressive tax system and her income puts her in the 41% tax bracket.
Sarah’s income tax payable = 179,147 + (1,000,000 – 857,900) x 41%
Sarah’s income tax payable = 179,147 + 58,261
Sarah’s income tax payable = 237,408
Her effective tax rate is 23.7%.
The business owner
Donald owns the engineering company that Sarah works for. He doesn’t earn a salary, instead he takes 1 million of company profit. The dividends tax rate is 20% and the company tax rate is 27%.
Salary payments are an expense, which are tax deductible to a company. That means Sarah’s salary was fully deductible when it was paid to her. So Sarah’s salary had never been taxed prior to her receiving it.
On the other hand, dividends are paid to the owners of a company out of after-tax profits. In other words, dividends are not tax deductible. So we have to do a two part calculation to see how much tax is payable on Donald’s income.
Part 1: Company tax on profit
Company tax on Donald’s million = 1,000,000 x 27% = 270,000
Part 2: Dividends tax on after-tax profit
Dividends tax on the after-tax profit = (1,000,000 – 270,000) x 20%
Dividends tax on the after-tax profit = 146,000
Total tax paid = 270,000 + 146,000 = 416,000.
The effective tax rate on Donald’s income = 41.6%.
Conclusion
Surprise, surprise, the effective tax rates are almost opposite to what we were led to believe. In fact, the business owner pays much more tax. The reason he pays more is because company taxes and dividends taxes are not progressive. They are flat taxes. In this case, it would have been more tax efficient for Donald to take a salary. He would have ended up with an effective tax rate of 23.7% instead of 41.6%.
Now that you know how it works, don’t fall for misleading stories about the rich paying less. The tax system is designed to prevent that. When you want to assess which way is more tax efficient, always look at the flow of income from start to finish and add up all the taxes that have to be paid. Usually, you will find that the tax system is well thought out and tries to take less from the those who earn less.
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