What is the Buffett Rule?
The Buffett Rule is a tax reform championed by President Obama that would equalize the treatment of capital gains and “ordinary” income for Americans earning above a certain threshold. Capital gains are profits received through the sale or transfer of a capital asset, such as stock or real estate. Currently, capital gains income is subject to a lower top marginal tax rate than ordinary income. This tax policy is intended to encourage private investment. The top rate for “ordinary” income is 35 percent, while the top rate for long-term capital gains is 15 percent.
How long has capital gains income received preferential treatment through the tax code?
Since the 1920s, capital gains have been taxed at a substantially lower rate than other forms of income, except for a brief period in the late 1980s. A detailed historical comparison of the top marginal tax rates on capital gains and ordinary income can be found here.
Since the 1920s, capital gains have been taxed at a substantially lower rate than other forms of income, except for a brief period in the late 1980s. A detailed historical comparison of the top marginal tax rates on capital gains and ordinary income can be found here.
What is the purpose of the Buffett Rule?
President Obama has cited two main reasons for instituting the Buffett Rule: to enhance vertical tax equity and to reduce the federal debt.
As the president argued in his State of the Union address:
“If you make more than $1 million a year, you should not pay less than 30 percent in taxes . . . . 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.”
As the president argued in his State of the Union address:
“If you make more than $1 million a year, you should not pay less than 30 percent in taxes . . . . 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.”
How much would the Rule help to reduce the debt?
In a recent column in the Washington Post, Robert Samuelson did the math and found that the Buffett Rule would do very little to help reduce the long-term deficits that are adding to the national debt. Samuelson explains:
“In September, the Congressional Budget Office estimated the 10-year deficit at $8.5 trillion. The nonpartisan Tax Foundation estimates that a Buffett Tax might now raise $40 billion annually. Citizens for Tax Justice, a liberal group, estimated $50 billion. With economic growth, the 10-year total might optimistically be $600 billion to $700 billion. It would be a tiny help; that’s all. ‘The purpose of the Buffett Rule is not to close the deficit gap,’ Buffett has said. Hard choices remain, in part because existing deficit estimates already assume steep defense cuts.”
“In September, the Congressional Budget Office estimated the 10-year deficit at $8.5 trillion. The nonpartisan Tax Foundation estimates that a Buffett Tax might now raise $40 billion annually. Citizens for Tax Justice, a liberal group, estimated $50 billion. With economic growth, the 10-year total might optimistically be $600 billion to $700 billion. It would be a tiny help; that’s all. ‘The purpose of the Buffett Rule is not to close the deficit gap,’ Buffett has said. Hard choices remain, in part because existing deficit estimates already assume steep defense cuts.”
Why do some believe that the Buffett Rule would do little harm to private investment?
A big question on the minds of policy wonks is whether the Buffett Rule would have any serious impact on economic development. The preferential tax treatment of capital gains is believed by many economists to promote private investment and drive long-term growth in the economy.
Proponents of the Buffett Rule argue that it would have little dampening influence on private investment. They believe that the substitution effect—in which people shift away from capital investment as it becomes relatively more expensive—is likely to be offset by an income effect, where people invest more to compensate for the reduction in their after-tax earnings. Whether the Buffett Rule would weaken private investment really depends on the relative magnitudes of the income and substitution effects. And it’s very difficult to know what those would be given the lack of empirical data on this subject. A 2011 report by the Congressional Research Service (CRS) also appears to endorse the view that a Buffett Rule would have little impact on private savings and investment:
“Behavioral theories of saving emphasize the role of inertia, the lack of self-control, and the limit of human intellectual capabilities. To cope with the complexities involved in making saving decisions, individuals often use simple rules of thumb and develop target levels of wealth. Once their target level of wealth is obtained, many individuals suspend active saving. Saving rates have fallen over the past 30 years while the capital gains tax rate has fallen from 28% in 1987 to 15% today (0% for taxpayers in the 10% and 15% tax brackets). This suggests that changing capital gains tax rates have had little effect on private saving.”
Proponents of the Buffett Rule argue that it would have little dampening influence on private investment. They believe that the substitution effect—in which people shift away from capital investment as it becomes relatively more expensive—is likely to be offset by an income effect, where people invest more to compensate for the reduction in their after-tax earnings. Whether the Buffett Rule would weaken private investment really depends on the relative magnitudes of the income and substitution effects. And it’s very difficult to know what those would be given the lack of empirical data on this subject. A 2011 report by the Congressional Research Service (CRS) also appears to endorse the view that a Buffett Rule would have little impact on private savings and investment:
“Behavioral theories of saving emphasize the role of inertia, the lack of self-control, and the limit of human intellectual capabilities. To cope with the complexities involved in making saving decisions, individuals often use simple rules of thumb and develop target levels of wealth. Once their target level of wealth is obtained, many individuals suspend active saving. Saving rates have fallen over the past 30 years while the capital gains tax rate has fallen from 28% in 1987 to 15% today (0% for taxpayers in the 10% and 15% tax brackets). This suggests that changing capital gains tax rates have had little effect on private saving.”
This may indeed be the case, but the empirical evidence provided by CRS seems fairly weak for two reasons. First, the important question is not whether the capital gains tax rate has fallen, but whether the rate has fallen relative to the rate on ordinary income. Second, correlation does not imply causation.
Why do some believe that the Buffett Rule would help raise national investment?
Even if the Buffett Rule did weaken private investment, many advocates contend that it would increase public investment by reducing federal deficits. Thus, the Rule’s net impact on national investment could be positive if it strengthens the federal budget without substantially altering the behavior of households and business. This line of reasoning assumes that all revenues derived from the Buffett Rule would be used to address the deficit crisis rather than to pay for cuts in government spending, which is the preference of many conservatives.
As Matt Yglesias explains:
“If you do what the Bush administration did and reduce taxes on investment income purely by borrowing money, it’s extremely difficult to see how that’s supposed to increase overall investment. By contrast, if you finance your capital gains tax cut by reducing [public assistance] benefits, it’s hard to see how that wouldn’t increase overall investment. To be sure, you’d be stealing food out of the mouths of poor children to offer a regressive tax cut, but the net impact will be to increase the national savings rate.”
“If you do what the Bush administration did and reduce taxes on investment income purely by borrowing money, it’s extremely difficult to see how that’s supposed to increase overall investment. By contrast, if you finance your capital gains tax cut by reducing [public assistance] benefits, it’s hard to see how that wouldn’t increase overall investment. To be sure, you’d be stealing food out of the mouths of poor children to offer a regressive tax cut, but the net impact will be to increase the national savings rate.”
Why do conservatives have a problem with the Buffett Rule?
Putting aside facile claims about “class warfare,” there are a lot of reasons why smart conservatives are concerned about the impact of the Buffett Rule.
In his most recent column, David Frum points out that the capital gains tax distorts transfers of ownership that could be extremely beneficial in many cases. He writes:
“If Joe can run the company better than Jane, if Jill can make better use of the corner of Main and Elm than Jack, then we want to see ownership of that company or that corner transferred as expeditiously as possible to the higher and better user. That’s why we encourage transparent and efficient markets for capital assets. A capital gains tax is a tax on the transfer of control of assets. If that tax is set too high, it can discourage even the most glaringly urgent transfers of control. Under Joe’s management, the value of the company may rise 30%. But if the capital gains rate is set at 50%, then the transaction from Jane to Joe will not occur—and everybody will be worse off.”
In addition to this, wealthy folks who earn most of their income as dividends and capital gains—and thus pay a lower top marginal rate—also bear the burden of corporate taxes. The numbers stated on Warren Buffett’s tax returns do not accurately reflect his effective federal tax rate. In fact, an analysis of effective tax rates by the Tax Policy Center suggests that, on average, the U.S. tax code is highly progressive when corporate taxes are taken into account.
Though tax avoidance has become a serious problem with certain corporations, many fair-minded conservatives argue that the correct solution is to fix the corporate tax structure rather than to raise taxes on capital gains. Frum notes:
“A light rate of capital gains is premised upon a well-functioning corporate income-tax system. The US corporate income tax system is anything but. Even very highly profitable companies often pay no tax at all. But it’s the corporate income tax system, not the capital gains rate, that is the problem here.”
“A light rate of capital gains is premised upon a well-functioning corporate income-tax system. The US corporate income tax system is anything but. Even very highly profitable companies often pay no tax at all. But it’s the corporate income tax system, not the capital gains rate, that is the problem here.”
Are there any other reasons to be skeptical of the Buffett Rule?
One final cause for concern among policy-oriented conservatives is that the Buffett Rule will further encourage corporations to use debt financing rather than equity financing. In the wake of a financial crisis exacerbated by debt leveraging, this seems like a dangerous notion. Manhattan Institute economist Josh Barrow writes:
“Because interest is taxed only once and profits are taxed twice, corporations take on more debt than they would in absence of the tax distortion. The distortion is mitigated by the fact that dividends and capital gains are taxed at lower rates than interest income. Because the Buffett Rule would raise capital gains and dividend tax rates and, in many cases, lower the effective tax rate on interest, corporations would face even more incentive to overleverage themselves.”
What are some alternatives to the Buffett Rule?
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