The Buffett Rule Is an Imperfect Form of Tax Justice, but an Important Step in the Right Direction

Presumptive Republican Presidential nominee Mitt Romney finally released some of his tax returns last week, in a move that was both inevitable and politically damaging.  Not only did Romney make himself look weak and indecisive in forcing a confrontation that he could not possibly win, but in doing so, he all but invited people to talk about the subject of rich people’s taxes, more generally.  President Obama should hope that his opponent in this Fall’s election continues to be this inept.

Beyond the direct political fallout that Romney’s tax situation created for the Presidential campaign, it also reinvigorated the national conversation that the Occupy Wall Street protests initiated last year.  If the Republicans did not want the policy debate to return to questions of inequality, then the last week has surely been a disappointment for them.  We are—quite appropriately—once again focusing on the extreme inequities in American life, in terms of both how much the rich receive in income, and the surprisingly small amount that they pay in taxes.

The Special Tax Treatment that Is Given to Wealthy Americans’ Income

President Obama’s recent State of the Union Address called upon Congress to make sure that Americans with incomes in excess of one million dollars pay no less than 30% of their incomes in taxes each year.  This target was based on Warren Buffett’s famous observation that he pays less in taxes, as a percentage of his income, than his secretary does—or, for that matter, than any of his employees do.  (There is, of course, nothing magical about the 30% cutoff, but it is a useful benchmark.)

Anyone who looks at the federal income-tax brackets would find it impossible to imagine that this version of the Buffett Rule is even necessary.  The top tax bracket rate is 35%, and it began when a taxpayer’s 2011 income reached $379,150.  It thus seems impossible that a millionaire could pay a smaller proportion of his or her income in taxes than someone with a more modest income.  (There are some technical matters that need not divert us here, but the larger idea is that the tax system is currently designed to be progressive, with rates topping out at 35%.)

Mitt Romney’s situation, however, has shone a light on what had been a very well-kept (but open) secret: We impose a mere 15% tax rate on income that is in the form of capital gains—that is, income that a person receives from investments in property, stocks, bonds, and so on—even when the taxpayer’s income would otherwise put him or her firmly in the 35% bracket.  We thus treat unearned income—money that people receive not for working, but simply for lending people their money—much more favorably than we treat income earned from working.

As a result of this inconsistent treatment of income under the tax code, we learned last week, Mr. Romney’s income in 2010 exceeded $21 million, and yet he paid less than 14% of that in taxes.  Because Romney’s income comes from his investments (mostly in the company he founded, Bain Capital), he pays taxes at the lower 15% capital gains tax rate.  (There is also an aspect of the story of how Romney paid so little in taxes that is based on the “carried interest” loophole, which has garnered some press coverage.  As egregious as that loophole is, in this context it is only a sideshow, distracting from the bigger picture.)

Are Low Tax Rates Necessary to Induce People Like Mitt Romney to “Sacrifice” Consumption Today in Favor of Investment for the Future?

The emerging story, therefore, is that people who work for a living are expected to pay more in taxes than those who have enough money that they do not have to live from paycheck to paycheck.  That raises a key question: Why would our tax system countenance such an apparent attack on the value of work?

The theory is that it is necessary to induce people to save their money—putting it into the financial markets, where entrepreneurs will borrow it and use it to generate jobs for everyone in the future.  This is sometimes referred to as “sacrifice,” because economists describe the decision to save as an alternative to spending one’s money on consumption (that is, buying goods and services, like rent and food).  If a person decides to engage in self-denial in the interest of having money in the bank, then he or she can be said to have sacrificed consumption today in favor of consumption in the future.

Describing what people like Mitt Romney are doing as sacrifice, however, reduces the definition of that word to a cruel joke.  The Romney family wants for nothing, and to say that we are taxing them at reduced rates in thanks for their willingness to engage in self-denial is to drain words of all meaning.

Whatever one thinks about the moral character of saving, however, it requires an additional step to justify special tax rates for capital gains, beyond merely saying that people must be induced to save their money.  This further argument is that because investors are concerned with after-tax returns, they will supposedly reduce their savings (and thus choke off the funds available for economic expansion) in the face of higher tax rates on the interest and dividends that they earn on their savings.  Because Congress has apparently bought into this idea, it has, for the past two decades or so (as well as at other times in our history), given special tax breaks to those who earn income from capital gains, as opposed to working for a living.

There are (at least) two problems with this theory.  First, it actually provides no guidance whatsoever to anyone who wants to know where to set tax rates.  The only thing this theory tells us is that capital gains taxes should be lower, but lower than what?  And, especially now that Newt Gingrich has argued that capital gains should be tax-free, we must ask whether there is anything magical about zero as a tax rate.  If reducing tax rates on capital-gains income will encourage rich people to save more money, then why not take the next logical step and actually subsidize their saving?  Nothing in the “incentive theory” of taxation tells us where to set rates.

The second problem with the theory supporting lower capital-gains taxes is that it is unsupported by evidence.  As I pointed out in a Verdict column last September, “Why Are So Many People Willing to Imagine That Tax Cuts for the Rich Will Help the Economy?“ economists have been trying for decades to determine whether special tax rates to encourage financial investment actually deliver what their advocates promise.

The very best that can be said—and even this is a stretch—is that the evidence is mixed.  To continue to set our tax policy on the basis of a theory that is based on weak-to-nonexistent empirical evidence is to engage in little more than wishful thinking—thinking that benefits the rich at the expense of everyone else.

Indeed, Mr. Romney is a veritable poster child for what is wrong with the capital-gains tax break.  If our concern is that higher tax rates on investment income will cause a “capital strike”—with rich Americans refusing to continue to sacrifice on behalf of the rest of us—then we should reasonably be able to imagine that Mr. Romney would have refused to save his money if he had had to pay a higher tax rate on his capital gains.

But in that situation, what would Romney’s alternatives be?  He could spend all of his money, in the belief that it is no longer worth the self-denial that would be necessary to prevent himself and his family from immediately spending the twenty million or so dollars of annual income they receive from investments—as well as the $200 million (give or take a few tens of millions of dollars) in personal wealth that generates those gains.

Or, if Romney cannot find one-quarter-billion dollars worth of movie tickets and ski vacations to buy, then the alternative is to invest his money abroad, or to otherwise move his money beyond the reach of the tax authorities.  Although there is surely some danger that this will happen in the case of any increase in tax rates, the evidence shows that the amount of such evasion is quite modest, and surely not enough to offset the benefits of collecting more tax revenue.

In addition, as the economist Robert Frank pointed out in a column in last Sunday’s New York Times, charging relatively high tax rates on wealthy people’s income—regardless of its source—will not discourage them from trying to earn more money, so long as the tax rates apply uniformly to all rich people.  Because wealthy people measure themselves against other wealthy people, a uniformly-applied tax system will leave all relevant incentives in place, while providing no special incentives to engage in wasteful behavior to avoid taxes.

Indeed, eliminating the special tax rate for capital gains would eliminate one of the most important perverse incentives that currently exists in the tax code.  In search of lower tax liabilities, high-income people currently hire high-priced tax lawyers and accountants, who devise strategies to magically turn regular income into capital-gains income (by, for example, having a business owner pay himself in stock dividends, rather than in salary).  This is purely wasteful behavior, and it would cease immediately if there were no tax advantage from changing the form of one’s compensation.

If our goal in designing a tax system is to reduce the incentives to game the system, therefore, we should tax capital gains the same as regular income.  And we should make sure that all wealthy people face the same higher rates of taxation.

The Buffett Rule as a Step Toward Reaching Our Ultimate Goals

Even after considering all of these factors, we still have very little guidance as to exactly how high tax rates on the wealthy—or anyone else, for that matter—should be.  The call for a 30% tax rate, therefore, is necessarily a call for “rough justice.”  We do not know that a thirty- percent tax rate is ideal (in fact, there is every reason to believe that we could never find an ideal tax rate), but for America today, it is surely a move in the right direction.

One version of the Buffett Rule would simply alter the Alternative Minimum Tax, which was originally designed to prevent the wealthiest Americans from combining clever tax strategies in order to eliminate their tax liabilities entirely.  Earlier this week, Senator Sheldon Whitehouse of Rhode Island introduced a bill that would impose a 30% minimum rate for all taxpayers with incomes above two million dollars per year (phasing in that rate, starting at an income of one million dollars).

This would be unnecessary, of course, if it were not possible for wealthy taxpayers to use special provisions to reduce their tax payments.  The larger point, therefore, is not what particular form the tax increase should take, but that the most fortunate Americans should pay more in taxes than they currently do.

One might still ask, however, how much would be enough.  Is there a rate of taxation that is sufficient, beyond which even the wealthiest person should not be required to pay?  The answer is no, for somewhat counter-intuitive reasons.

In the current political environment, it is not surprising or inappropriate for President Obama and his allies to focus on the tax rates that the wealthy pay, relative to everyone else.  Relative tax rates offer a window into how the burdens of paying for the government are being shared.  Thinking about it in this way, however, leads to the unfortunate idea that people with zero tax liabilities are “getting a free ride.”

As I discussed in a Verdict column last November, the very idea that tax payments reflect one’s contribution to society is mistaken.  Everyone benefits economically from the existence of a government, and everyone—including those with the highest apparent tax rates—is better off, even after paying taxes, because they live under a government that enables and regulates economic activity.

This insight suggests that “making every rich person pay at least 30% of their income in taxes” is simply a crude (but necessary) method of recognizing that having a government is an essential condition for anyone to become rich.  If we, as a nation, are committed to having a real safety net– as even Mitt Romney has said that we should be—and to providing for our shared futures through public investment, health insurance, and dignified retirements, then we must also commit to paying for all of those things that could enhance our greatness as a nation.

In the broadest sense, therefore, we cannot define the fairness of the tax system by comparing tax rates.  In an extreme case, it could even make sense for one wealthy person to pay for the entire government’s budget—because that person’s wealth would not be possible without the government, and because that person could still be quite comfortable, even after paying his or her taxes.

Although we cannot define the fairness of the overall tax system by comparing tax rates, we can certainly see unfairness where it exists.  Our government is currently having trouble funding even the most basic human services, while the millionaires and billionaires are left with after-tax incomes that make a mockery of any notion of just deserts.  The Buffett Rule is not the whole solution, but it is an important first step.