- A recent poll found that 60 percent of Americans favor the Buffett Rule and only 37 percent oppose it
- The Alternative Minimum Tax strips away many popular deductions, trying to catch taxpayers who are loading up on loopholes
- Capital gains taxes apply to income earned from selling investments like stocks and real estate
Raise my taxes, please!
That was the request of Warren Buffett, the 81-year-old CEO of Berkshire Hathaway and the third-richest man in the world. In August 2011 he penned a New York Times op-ed calling for higher taxes on millionaires like himself.
Buffett’s central claim was that for the most recent tax year, he paid lower rates than his employees, even though he earned millions more. “What I paid was only 17.4 percent of my taxable income,” he wrote. “That’s actually a lower percentage than was paid by any of the other 20 people in our office. Their tax burdens ranged from 33 percent to 41 percent and averaged 36 percent.”
The idea of a tax code so riddled with loopholes that a billionaire could pay lower rates than his secretary quickly became a potent political symbol. President Barack Obama proposed the Buffett Rule: “No household making more than $1 million each year should pay a smaller share of their income in taxes than a middle class family pays.”
An April bill by Sen. Sheldon Whitehouse (D-R.I.) would have levied a minimum tax of 30 percent on incomes over $2 million. Though the bill died in the Senate, an Associated Press/GfK Group poll found 60 percent of Americans favoring the rule and only 37 percent opposed. Even among Republicans, 43 percent backed the concept.
The Buffett Rule appears to make for good politics, but how does it rate in terms of economics?
Not so well, say tax and finance faculty at the University of Texas at Austin. “It’s a political gimmick,” says Robert Peroni, professor at the School of Law. “I definitely think we need to reform our tax system, and that one aspect of that will be that many high-income people will be paying more in taxes than they are now.” But the Buffett Rule, he argues, is a bad way to pursue a good goal.
He agrees that Buffett has shed light on a genuine problem. Although most millionaires pay higher tax rates than most middle-class earners, there are a significant number who don’t. A March analysis of IRS data by the Congressional Research Service, found that 94,500 taxpayers with incomes over $1 million paid effective federal tax rates under 26.5 percent. Meanwhile, 10.4 million earners under $100,000 were paying rates over that figure.
Alternative Minimum Tax
So, why not sock a minimum tax on millionaires? The central problem, says Lillian Mills, accounting professor at the McCombs School of Business, is that one already exists. And both Democrats and Republicans agree it works poorly.
The Alternative Minimum Tax was first enacted in 1982, with a similar goal to the Buffett Rule: to root out rich tax dodgers. It requires them to calculate their incomes in two different ways — first for the standard income tax and again for the AMT — and pay the higher of the two taxes. The AMT strips away many popular deductions, trying to catch taxpayers who are loading up on loopholes.
“It adds a lot of complexity, when you have to figure your taxes in two different ways,” says Mills. “This is a complexity that arose out of a lack of courage. Congress wanted to make sure that people who were claiming tax subsidies still paid a minimum amount of tax. But they didn’t have the courage to just eliminate the subsidies.”
Besides being complicated, the AMT has been catching many earners who aren’t millionaires. That’s because its income threshold was never indexed to rise with inflation. As Americans’ incomes have risen, more and more middle-class families have crossed that threshold and become subject to the tax.
In recent years, Congress has repeatedly patched the AMT by temporarily raising its income thresholds. But the current patch expires at the end of this year. Without a new one, according to the Tax Policy Center, the AMT will strike 63 percent of married households with incomes between $75,000 and $100,000.
Add in the Buffett Rule on top of the AMT, and Americans would face three tax systems. “We already have one system that’s a mess,” says Peroni. “Let’s not enact another one.”
Besides, the extra tax revenue would barely make a dent in federal deficits. The congressional Joint Committee on Taxation estimated the Whitehouse bill would raise an extra $4.7 billion a year, while Whitehouse himself pegged it at $16 billion.
“If you cut federal spending 1 percent across the board, you would balance the budget a lot more than the Buffett Rule ever thought of doing,” says Jim Nolen, a distinguished senior lecturer in finance who recently retired from McCombs.
Instead of the Buffett Rule, there are more effective ways to prevent wealthy taxpayers from slipping through the cracks, say some professors. One is to raise tax rates on investment income.
Capital gains, which come from selling investments like stocks and real estate, are currently taxed at a top rate of 15 percent, compared to 35 percent for ordinary wages. The Congressional Budget Office reports that the top 0.01 percent of taxpayers get 44 percent of their income from capital gains and only 12 percent from wages. That’s why investors like Buffett and Mitt Romney pay effective tax rates close to 15 percent.
Most economists say it’s appropriate to tax capital gains more lightly, says Mills. “We tax them some, but not equal to earnings, driven by the economic theory that we don’t want to discourage the investment that is the engine of our economy.”
But the gap between wages and investments could be much narrower, without discouraging investment, says Peroni. He would raise the top capital gains rate to at least 20 percent.
But the most effective way to achieve Buffett’s goals, he says, would be to repeal most of the deductions that have crept into the tax code since its last major overhaul, in 1986. Congress could then lower tax rates on everyone. Middle-class taxpayers would benefit the most, since they tend to take fewer and smaller deductions than wealthy ones.
“Let’s get the basic income tax system correct,” says Peroni. “We should be reforming income taxes across the board, not just focusing on the upper income levels. Let’s see what people’s taxable incomes are after these breaks are eliminated.”