In 2011, Warren Buffett wrote an op-ed in the New York Times noting that he paid a lower effective federal tax rate than anyone else in his office — including his receptionist. The observation became famous because it illustrated, in a single concrete example, a structural feature of the American tax code that had existed for decades: income from capital is taxed at lower rates than income from labor.
That feature is not an accident. It reflects deliberate policy choices made over many decades, justified by a set of economic arguments that remain genuinely contested among economists and tax policy scholars. Understanding why the gap exists is necessary to having an honest conversation about whether it should.
The Two Rate Systems
Ordinary income — wages, salaries, tips, rental income, interest — is taxed at graduated rates that range from 10 percent on the first few thousand dollars to 37 percent on income above approximately $600,000 for a married couple. The system is progressive: higher income is taxed at higher rates at the margin, though effective rates (the percentage of total income paid in taxes) are lower than marginal rates at every income level.
Long-term capital gains — profits from the sale of assets held for more than one year — are taxed at separate, lower rates: 0 percent for lower-income filers, 15 percent for most filers, and 20 percent for those with income above approximately $550,000. High earners also pay a 3.8 percent Net Investment Income Tax on investment income, bringing the top effective capital gains rate to 23.8 percent — still well below the 37 percent top ordinary income rate.
Where the Gap Comes From
The preferential treatment of capital gains has its roots in economic arguments made with varying degrees of rigor since the early twentieth century. The strongest argument is the one about the "lock-in" effect: if capital gains are taxed at the same rate as ordinary income, investors have a stronger incentive to hold appreciated assets rather than sell them, because selling triggers the tax. This can reduce economic efficiency by locking capital into sub-optimal uses.
A second argument concerns inflation. If an asset bought for $100 is sold twenty years later for $200, and inflation over that period was 100 percent, the seller has made no real gain — the $100 in profit has exactly the same purchasing power as the original $100 investment. Taxing the nominal gain as if it were real income overstates the actual return. Lower rates serve as a rough adjustment for this effect.
A third argument, more contested, holds that capital gains represent a return to risk-taking that society benefits from encouraging, and that lower tax rates on investment returns encourage the risk-taking that produces growth and innovation.
"The argument that capital is different from labor because it takes risk ignores the reality that labor also takes risk — people invest years in education and career choices that may not pay off. The tax code doesn't reward that risk with preferential rates."
Who Actually Pays Capital Gains Taxes
The distributional data on capital gains is striking. The top one percent of earners receive more than 70 percent of all capital gains income. This is not surprising — accumulating assets that appreciate requires having assets to begin with, and asset ownership in the United States is highly concentrated. The result is that the preferential treatment of capital gains disproportionately benefits high earners, and the magnitude of that benefit increases at the top of the income distribution.
This is the mechanism behind the Buffett observation. An individual whose income consists almost entirely of capital gains from a large investment portfolio will face an effective federal income tax rate substantially lower than an individual whose income consists almost entirely of wages, even if the capital-gains earner has much higher total income.
The Reform Options
Proposals to reduce the capital gains preference range from modest adjustments to complete elimination. President Biden's 2021 budget proposal would have taxed capital gains as ordinary income for filers with income above $1 million — a change that would have primarily affected the highest earners while leaving the preferential rate in place for most investors. That proposal was not enacted.
A more modest reform would increase the top capital gains rate to 28 percent — where it was before the 1997 Taxpayer Relief Act — without going all the way to ordinary income rates. More fundamental reform would index the cost basis of assets for inflation before calculating gains, addressing the inflation argument while potentially also adjusting the rate. Full equalization — taxing all income at the same rates regardless of source — is the most ambitious option, and the one with the largest revenue implications and the most significant behavioral effects.
The Political Dynamics
Capital gains tax rates have historically been bipartisan in their political sensitivity. Both parties have significant donor constituencies with substantial investment income, and reform proposals that would materially affect those constituencies face internal opposition regardless of which party is nominally in control. The debate is likely to resurface in any comprehensive tax legislation, particularly given the expiration of multiple 2017 provisions in the coming years.
What the Buffett observation captured — and what the data consistently supports — is that the capital gains preference is one of the most significant mechanisms through which the American tax code produces different outcomes for people with similar incomes depending on the source of those incomes. Whether that differential is justified, and what changing it would do, are questions that deserve more sustained public attention than they typically receive.