Much reporting (or more specifically, parrotting of information) has been done recently on the allegation that Warren Buffett pays a lower effective tax rate than his secretary. There are several key components to this statement which make it factual, but very misleading. I don’t want to get too deep into the politics of it, but I thought I would provide a few highlights from my perspective (not that it will change anything).

Warren Buffett is correct that his effective tax rate is much lower than that of his secretary. This is because Warren Buffett makes most of his income from long-term investments while his secretary makes most of her income from compensation from working.

Congress has passed the Internal Revenue Code so that the income from investments is taxed at a favorable rate (long-term capital gains are now taxed at a maximum rate of 15%), while other “ordinary income” (e.g., wages, earnings, interest, rents) are taxed at the marginal rate, which is now capped at 35%.

Now, we will assume that Warren and his secretary both take the same salary from his company ($200,000). Since both are married, they will both owe taxes at the about the same rate (one might have deductions the other doesn’t, so it won’t be exact). But, in addition to the salary that Warren takes, he gets $1,000,000 in long-term capital gains distributed to him. This is only taxed at 15%. When you factor in this lower rate on significantly higher income, the effective rate is reduced significantly.

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1. Although Warren is paying a lower effective rate, he is still paying more in taxes. In the simple scenario above, the taxes were $150,000 more than what his secretary paid. In real life, this is probably far greater.

2. The reason there are favorable rates on long-term assets is because those assets are taken out of the individual’s own use and invested where other individuals get use of them and pay their share of taxes on the use. ($1 Million invested with a company will likely result in 10 more employees, who then have to pay their own share of taxes on the wages paid them.) In addition, Congress considers the time value of money, which says that $1 today will not be worth $1 in the future due to inflation, so the lower rate encourages investing that dollar today.

3. Warren could rearrange his portfolio so that he doesn’t get the long-term rates. He could sell every asset he owns one day shy of one year, then reinvest in the same company. By Warren taking this step, he will recognize income on his investments every year and won’t have to be burdened by the lower rate.