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Buffett Rule Opens Much-Needed Dialogue

10/11/2011 --

Professor Joel Slemrod says President Obama's proposal to ensure high-income tax rates equal middle class rates is unlikely to pass, but at least it provokes conversation.

ANN ARBOR, Mich. — If the Obama administration has its way, billionaire investor Warren Buffett's revelation that he pays a lower tax rate than his secretary could lead to new tax policy for the entire nation. The president has proposed that people who earn more than $1 million a year should pay at least the same percentage of their income in taxes as the middle class.

The administration has yet to provide details on how to implement the proposed income tax reform, dubbed the "Buffett Rule." Instead, they've asked the Congressional Supercommittee — currently tackling the spending and deficit agenda — to take it up. (Senate Democrats also recently proposed a 5.6 percent tax on people making more than $1 million to pay for the president's jobs plan.)

Professor Joel Slemrod says that though the proposal sounds deceptively simple, it actually is quite complicated to implement. For example, investment income, which generates much of the wealth earned by those in the high-income bracket, is taxed differently than a salary. In this Q&A, Slemrod, the Paul W. McCracken Collegiate Professor of Business Economics and Public Policy, says he doubts the "Buffett Rule" itself will become law. But it does open a dialogue the country sorely needs to have on what Americans want the government to do, and how we should pay for it.

When the president proposed this idea, do you think he was trying to make a larger point about reforming the tax code, or is this a tactic to fire up his political base?

Slemrod: I think it's both. I think he believes that Democrats care a lot about the justice of the assignment of the tax burden. I think also this is a legitimate tax policy question: whether the current tax progressivity is where we want it to be. The proposal was short on detail and more of a general call that those in the upper tax brackets pay at least as high a percentage of their income as those in the middle class. But it's complicated due to the special rate on capital gains. There's where much of the high-income people earn their money, as opposed to a salary.

When you peel it back, is this really a call to raise the tax on capital gains?

Slemrod: Good question. A major reason the average personal rate looks lower for high-income people is the composition of their income. In good years they earn a big portion of income from capital gains. To address this, one would inevitably have to address the preferential tax rates on capital gains. I think the disparity in the source of income between high income people and average earners is most stark with capital gains. That's because if you hit it big, let's say you get a $5 million capital gain, it automatically puts you in the high-income group. The capital gains come sporadically, but when you hit it big and get them, you're in the top bracket. Itemized deductions also reduce the average tax rate for high-income households, but the capital gains tax is a bigger issue.

What's the historical context of the capital gains tax? It's a maximum 15 percent now. How recent is that and what has it been historically?

Slemrod: For most years, at least in the last half century, capital gains have received preferential tax treatment. The only years that wasn't true were 1987 and 1988 when the top tax rate fell to 28 percent, the lowest it's been in recent history. When it did, there was no capital gains preference. But as soon as the top rates went back up, a capital gains tax preference was reinstated. The 15 percent cap now is lower than it has been for a long time. But there is a reason why the rate on capital gains and dividends is lower than other forms of income. It's because all dividends and most capital gains come from corporate shares, which have already been taxed by the corporate income tax. Not all corporate income is subject to corporate income tax and some companies are very good at avoiding it. But the corporate income that is subject to the tax has been taxed once, and so the capital gains tax is a second layer of tax. From a tax-policy-geek perspective, that's the tricky thing — there's actually a reason why the tax rates on dividends and capital gains are lower.

U.S. Treasury Secretary Tim Geithner said there are a number of ways to achieve the Buffett Rule, so apparently the administration is open to ideas. What are some of the ways this can be done?

Slemrod: Well, one could reduce the preferential rate on capital gains and or dividends. One also could cut back on the tax saving from itemized deductions that high-income people can get. The Obama administration has proposed to cap the tax benefit for itemized deductions, say at around 28 percent. For example, if you gave a dollar to charity it would reduce your tax liability by 28 cents at most, even if your tax bracket were higher than that. Just raising the income tax rates on high-income people would get part of the way there, although it would only affect the income not subject to the special capital gains rate. Another proposal would tax "carried interest" — the share of profits received by general partners in private equity and hedge funds — as ordinary income instead of as capital gains.

Would the amount raised by any of those actions be significant?

Slemrod: That depends on what you're comparing it to. Compared to the long-term fiscal imbalance the federal government faces, it would be a small fraction. That alone is not going to solve this problem. In general, tax increases on high- income people probably won't be enough, even though it's not chump change. While millionaires, or those who earn over $250,000 per year, comprise a small percentage of the population, the increase in income inequality that began 30 years ago has accelerated. The richest 1 percent now receives about one-quarter of national income, nearly three times as much of a share of the national income as they received three decades ago. It's not a lot of people, but a big share of the national income goes to these people.

What are some of the unintended consequences for people outside the targeted bracket?

Slemrod: Well, if you put a higher tax on income it reduces the incentive for people to do all the things they might do to earn income, things like getting an MBA or starting a business. To the extent these decisions affect others, say those who the business might have employed, that would be an unintended consequence. If somebody decides not to spend time in their garage thinking of the next big invention, that would be a negative spillover. The problem is that if we have to raise a certain amount of taxes, and we want to do it through income taxes, any plan you come up with will reduce the incentive for somebody to earn more income. You just can't escape it.

From a policy standpoint, how likely is it that this rule will be implemented?

Slemrod: In the short run, I think it's very unlikely. There's no way a Republican-controlled House is going to vote for something like this. Whether this changes the likelihood that higher taxes on high-income people would be part of some grand compromise that will address our long-term fiscal imbalance and our short-term economic problems is hard to say. I do think the idea has some traction. In some European countries, tax rates on high-income people have gone up. One reason it stays in the news is that every so often some prominent high-income American — and not only Warren Buffett — says he or she would be willing to support high taxes on people like themselves. One Republican political tactic, which is to label suggesting such a policy as class warfare, isn't helpful. It's a legitimate issue to discuss how the cost of government should be shared among us. That is something every society has to decide. We should talk about it.

Terry Kosdrosky



For more information, contact:
Terry Kosdrosky, (734) 936-2502, terrykos@umich.edu