Taxing the Wealthy on the Margins and on Average

Warren Buffett, the Oracle of Omaha, reiterated his view on a so-called “millionaires tax” in an op-ed piece in the New York Times on Sunday. If you’d like to read about what a billionaire thinks about what millionaires should do, it’s an interesting read.

Here’s a quick summary of his views:

First, in the not so distant past, marginal tax rates for upper income households and tax rates on capital gains and dividends were quite high and – guess what – the wealthy weren’t throwing their money under a mattress, they were investing. Second, the rich should pay their fair share in taxes.  Buffett suggests that households with incomes above US$500,000 (not the US$250,000 that Obama has proposed) to return to the pre-Bush era tax rates. And he reiterated his “Buffet Rule,” which calls on Congress to develop a minimum tax for millionaires: 30% for income between US$1 million and US$10 million, and 35% for incomes over US$10 million. Finally, he is, of course, pushing for debt sustainability – moving revenues to 18.5% to GDP and spending to 21% of GDP. Buffet cites that the United States currently takes in 15.5% of GDP in revenue and spending is about 22.4% of GDP.

Buffett is close ally to Obama and his thoughts on taxation and public policy are getting a lot of play as Washington debates how to deal with the fiscal cliff.  The big debate of course is on the upper income tax rates and revenue collection.

Here are my feelings on Buffet’s op-ed: Warren Buffett believes that there is a moral obligation to have the rich pay more taxes. I think his facts supporting this view are basically right on regressiveness of tax rates (meaning those with lower incomes pay more as a percentage of their income), when he compares people whose income is derived from investments rather than earned income (analysis of Buffett plan from the Tax Policy center is here).

However, there is truth in the argument that America’s wealthy have increasingly been paying a larger share of taxes. In fact, even as  the tax rates for upper income households went down under Bush (as highlighted using the newly released 2010 IRS data by Bruce Bartlett – also in the Times), the share of taxes paid by the top 1% went from 33.2% in 2001 to 37.4% in 2010.  Bartlett highlights that the rising tax burden of the wealthy is partial due to across-the-board deficit funded tax cuts. Warren Buffett, on the other hand, is arguing that the rich pay a higher tax rate and his focus is on raising the marginal rate to bring up the average tax rate for the wealthy. For example, he cites that the average tax on the wealthy went from 26.4% in 1992 to 19.9% in 2009. If you don’t already know, the marginal tax rate is the tax rate you pay on additional dollar of income. Your average tax rate is just taxes divided by total income.

The marginal tax rate is of course what matters for spending and savings decisions.   People on the right how long thought that raising marginal tax rates will of course deter the wealthy from spending and investing.  However, Congressional Research Service just released a controversial paper showing that…. wait for it…reductions in top tax rates have little relationship to U.S. economic growth.  A relevant quote from the summary is:

There is not conclusive evidence; however, to substantiate a clear relationship between the 65-year steady reduction in the top tax rates and economic growth. Analysis of such data suggests the reduction in the top tax rates have had little association with saving, investment, or productivity growth. However, the top tax rate reductions appear to be associated with the increasing concentration of income at the top of the income distribution.

So, if we as country believe that the rich should pay more than they are right now and we do so by imposing the Buffett rule, would the Buffett Rule make a dent in the deficit?

According the Politifact and Wonk Blog, the Buffet rule as of spring 2012 would bring in an additional US$16 billion in revenue a year and US$160 billion in 10 years assuming the Bush-era tax cuts remain in place and only US$47 billion if the Bush-era tax cuts expire. That’s a big range and the top estimate, i.e. US$160 billion, makes at best a modest dent in the deficit. Keep in mind the increasing the tax rates on the wealthy would add US$800 billion in revenue over the next 10 years. Obama wants US$1.6 trillion in additional revenue over the next 10 years and Boehner wants US$800 billion.

The Buffett Rule does sound like a nice simple, and even more just, replacement of the current AMT.  However, if Congress were to replace the current AMT with the Buffett Rule (which may sound that a logical thing to do), it would, in fact, mean a net loss of between $400 billion and $1.1 trillion in revenue, depending on policy assumption.

The debate over the progressivity of the U.S. tax rates is a key piece of the debate on fiscal policy. If U.S. taxpayers are going to have pay more to fund the government, who is going to pay more – everyone or only some? In an ideal world, a reformed tax code would be simpler and fairer. However, when push comes to shove, a lot of the complexity of the U.S. tax code was put into place incentivize certain behaviors (e.g., buying a house, going to college, saving for retirement). Tax reform is a really hard, painful process. We haven’t done so at the federal level since 1986, but we may necessarily have to so in 2013 to move towards debt sustainability.