A Brief Review of the "Buffett Rule"

Billionaire investor Warren Buffett's secretary Debbie Bosanek sat in in First Lady Michelle Obama's box for the State of the Union addresss. (Credit: CBS)

How must it feel to be diminished from secretary for one of the richest men in the world to a political prop for a politician’s reelection stump speech?

I wonder. At least it was on national television. Yet, perhaps, that’s what Warren Buffet’s secretary is looking for. Since at sometime late last summer, or perhaps in the early fall, President Obama has referred to what he calls “the Buffett Rule.” Last week, during a State of the Union speech that drew heavily from Republican talking points, took jabs at US Senators alarmed by an unconstitutional appointment while the Senate was still in session, and promised, well, almost the same things that the State of the Union promised last year, President Obama gestured to Debra Bosanek, Buffett’s secretary, as an example of the inequality of our tax code. He said that

Right now, because of loopholes and shelters in the tax code, a quarter of all millionaires pay lower tax rates than millions of middle-class households. Right now, Warren Buffett pays a lower tax rate than his secretary.

To clarify, this is not due to any loopholes or shelters–rather, this is because the tax rate on wages is far higher than the tax on investment. You pay more when you draw a salary or wages than when you earn your income from investments. Because Warren Buffet–like Mitt Romney, by the way–does not draw any salary, but lives off of the return on his investments, he pays a lower percentage of that return in taxes. As Robert Green explains in Forbes,

Many wealthy Americans have significant investment portfolios, which sometimes generate a large amount of capital gains income taxed at the lower 15% tax rates. Many of these taxpayers have an effective tax rate close to 15% because they offset ordinary income with charitable tax deductions, avoiding the alternative minimum tax and its rate of 28%, too.

Clarifications aside, now, it’s clear that there are several problems with President Obama’s statement in the State of the Union, problems with the “Buffet Rule” in general, and problems in trying to capitalize on the envy of those with less of those with more. As a preliminary matter, let me just say that I find it dishonest for the President to write off a relatively straightforward piece of the tax code–a tax on wages versus a tax on investment–as “loopholes and shelters.” They are negatively loaded terms that not only misinform the listener, but hurt the real public policy discussion about the merits of different tax rates for different income rates, as well as different types of income.

Minus ten points for Barack Obama.

With the misleading rhetoric out of the way, let’s get back to the Buffet Rule itself. Is it good policy? Would it accomplish what President Obama asserts it will do? What might be the real purpose of the proposal?

First, what is the Buffet Rule?

According to a White House document dated January 24, 2012, the Buffett Rule will

[…] ensure everyone making over a million dollars a year pays a minimum effective tax rate of at least 30%. The Administration will work to ensure that this rule is implemented in a way that is equitable, including not disadvantaging individuals who make large charitable contributions.

In other words, the intent is a tax rate of 30% for millionaires with carve outs or tax deductions for “large” charitable contributions.

The Buffett Rule does not appear to examine how that money is earned. Rather, the criteria for the tax is A) that you earned a million dollars in a given year, and B) what size of charitable contributions did you make?

What would be the effect?

To me, this is the interesting question. When the President spoke about the rule in his speech, he couched it in the language of inequality, decrying the unfairness that the rich pay less of their income in taxes than those who are not rich. (I’ll avoid using phrases like “the poor,” “the middle-class” or the like because I find it difficult for anyone to agree upon what is “enough” income). For example, he said that

Do we want to keep these tax cuts for the wealthiest Americans? Or do we want to keep our investments in everything else – like education and medical research; a strong military and care for our veterans? Because if we’re serious about paying down our debt, we can’t do both.

Beside the fact that there are substantial and serious arguments being made that the tax cuts to which he is referring have benefited the non-rich as much if not more than the millionaires of America, President Obama has set up a false choice. The programs that he says are threatened by failure to tax millionaires at 30% include our investments in the following:

Education
Medical research
A strong military
Care for veterans
Paying down the national debt

To understand whether these programs are really at risk, we need to understand how much the Buffett Rule would raise in tax revenues (assuming that there are no other effects to doubling the tax rate on investment). When I checked, I found a variety of numbers. The think-tank “Citizens for Tax Justice” estimated that the Buffett Rule would raise $50 billion in tax revenues in a single year and affect .08% of taxpayers. Evidently in favor of the Buffett Rule, Citizens for Tax Justice explains what inequities would be solved by the policy.

For the first group [non-millionaires], about 90 percent have very little investment income (less than a tenth of their income is from investments) and consequently have an average effective tax rate of 21.3 percent. For the second group (the Buffett and Romney group) about a third get the majority of their income from investments and consequently have an average effective tax rate of 15.2 percent. This is the problem that the Buffett Rule would solve.

A comparison of tax rates by the Citizens for Tax Justice think-tank. Learn more here.

Others are not so sanguine about the amount of tax revenues. The Tax Foundation, another D.C. think-tank, suspects that the revenues the tax would raise are actually closer to $36.7 billion, or about $13 billion less than the Citizens for Tax Justice estimate. The difference between the two think-tanks–one liberal and one more conservative–is immaterial, though. The amount is, in the words of the Tax Foundation’s Scott Hodge, “a drop in the bucket.”

Remember all those programs that were at risk? Education, medical research, veterans, national security, and paying down the debt? Our entire budget in the current fiscal year is expected to be $3.693 trillion. Our deficit this year will be in excess of $1.1 trillion dollars (tax revenues will be only $2.964 trillion). So, looking at the package, what is $2.964 trillion dollars plus the revenues brought in by the Buffett Rule (optimistically, $50 billion to use the Citizens for Tax Justice number)?

About $3.01400 trillion, which leaves a $1.05 trillion gap between what we are spending and what we are bringing in.

Veterans benefits? Education? Medical research? National security? Paying down the debt? I don’t think we’re even close to a place where we can assume that passing the Buffett Rule is the difference between cutting those programs and keeping them. To drive the point home, let’s look at how much each costs in the current fiscal year (and avoid for a moment whether the federal government should be even in the business of education or medical research):

Education: $118.1 billion
Medical research: $33.6 billion
A strong military: $868.1 billion
Care for veterans: $135.2 billion
Paying down the national debt: $321 billion (actually, this is just interest on the national debt, not paying down the debt)

Total of those items? $1.476 trillion.

That’s 29 and a half times what even the most optimistic estimate says that the Buffett Rule will make.

That, my friends, is a drop in the bucket.

Other effects?

Besides raising a nearly insignificant amount of tax revenues, what else might be the effect of the Buffett Rule?

One of the problems with the Buffett Rule, says Green in Forbes, is that it’s going to tax the same people three times.

Now compare that double-dip tax break to the double-taxation paid on dividends, and in some cases, capital gains, too. When a taxpayer receives a dividend, taxes are often first paid on the corporate level, perhaps at 35%, and a second time on the individual level at either 15% for qualifying dividends or up to 35% for ordinary dividends.

Do the math and the double tax rate can be as high as 57.75% and that’s just federal. It’s no wonder companies like Apple don’t want to pay dividends and keep profits offshore. We need tax reform, lower corporate rates, and not tax hikes from President Obama.

Are you getting it? The same money is getting taxed, or deducted, twice. Green goes on:

For an investor, interest income and qualifying dividends shouldn’t be taxed as ordinary income tax rates up to 35%. It’s fair for interest income to be taxed up to 35%, since it’s deducted by corporations saving tax at 35% corporate rates, or even other individuals saving taxes at up to 35% individual rates. So, it’s a wash in the case of interest income and expense. By the way, this is another reason to keep corporate and individual tax rates the same. If you lower corporate rates to 25%, lower them for individuals to 25%, too.

Conversely, when corporations pay ordinary and qualifying dividends, they aren’t tax deductible, so the corporation still has to pay the 35% rate. When the investor pays taxes on dividends, it’s double taxation.

Conclusion? The Buffett Rule is Unfair and Ineffective

Note that all of this a tax on financing, the very heart of what allows entrepreneurial growth and risk. Without access to capital, businesses do not grow, new businesses do not start, and our economy slows. Further,

Research shows that 50 percent of “millionaire” taxpayers are only millionaires once. Meaning, they are millionaires in one year because the sold a business, cashed out stock, or won the lottery. A Super AMT would have a chilling effect on people selling their businesses or stock – effectively locking in assets for a long time. That would be bad for the economy by reducing its dynamism.

Is it fair that some of us should pay fewer taxes than others of us? No.

But is that what is happening? Are some of us paying more taxes than others? Not necessarily. Remember that the majority of taxes paid in America are paid by the same people that the Buffett Rule is intended to target. The top 5% of American income earners pay well over half of all taxes. The top 1%–the very same 1% attacked by the Occupy Wall Street 99%ers–paid, as of 2007, up to 19% of all tax revenues.

And 51% of Americans paid no taxes last year.

Why, then, does the President propose and promote a tax change that has little to no support in Congress, is ineffectual at alleviating the deficit, and will only result in a triple tax of the wealthy?

I believe it’s election year rhetoric design to appeal to society’s economic victims. By giving them someone to blame, taking the role as defender of the have-nots, and using the prop of both America’s richest man and his secretary, Barack Obama is deftly avoiding real public policy proposals that might actually help America, not because he doesn’t like America or is a socialist–I don’t believe that he intends that. But, rather, because it would threaten roll back of some of his signatory accomplishments and cede ground to Republican plans that can work. Plans like Congressman Paul Ryan’s Road Map for America’s Future, which would not only save entitlement promises like Medicare but make them fiscally sound. Plans like Congressman Jason Chaffetz’s social security reform which would put social security back in the black.

When your opponents come to the table and your negotiation position begins with “I won,” it’s hard for the President to move middle ground compromises in the interest of America. Barack Obama started his administration with a winner take all attitude and he has long since passed the point where he is willing to compromise on anything but his own terms.

Finally, back to the Buffett Rule. Warren Buffett may mean well, and I urge him and his buddies to put their money where their mouths are and give their “excess” wealth to the federal government. No one is stopping them. In the mean time, it’s use by Barack Obama as a campaign year prop is cynical and superficial, and, worst of all, I think he knows it.