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Unanswered Issues on the “Buffett Rule”

3 min readBy: Scott Hodge

Last night, President Obama said that American needs a new taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. system, but one that is only for people who make more than $1 million in a year. According to Obama:

“Tax reform should follow the Buffett Rule. If you make more than $1 million a year, you should not pay less than 30 percent in taxes. And my Republican friend Tom Coburn is right: Washington should stop subsidizing millionaires. In fact, if you’re earning a million dollars a year, you shouldn’t get special tax subsidies or deductions.”

Basically, the President is proposing a new “Super Alternative Minimum Tax” of 30 percent for anyone making over $1 million. So if your income is above $1 million, you have to pay 30 percent of your income in taxes, even if that income came from capital gains or dividends, which is normally taxed at 15%. Like the regular Alternative Minimum Tax – which was enacted in 1969 to prevent a handful of millionaires from paying less on their taxes but now impacts over 3 million Americans – this new Super AMT would reduce any deductions that might reduce your effective tax rate below 30 percent.

Tax Foundation economists estimate that the Buffett rule is equivalent of raising the top marginal rate from 35 percent to 44 percent. In other words, the average effective tax rate for millionaires is 25 percent. So, based on the current amount of deductions millionaires take, in order to raise their effective tax rate to 30 percent you would have to raise the top marginal tax rateThe marginal tax rate is the amount of additional tax paid for every additional dollar earned as income. The average tax rate is the total tax paid divided by total income earned. A 10 percent marginal tax rate means that 10 cents of every next dollar earned would be taken as tax. to 44 percent. On a very static basis, we roughly estimate that this policy would raise $40 billion, assuming that taxpayers don’t change their behavior. Compared to a $1.1 trillion deficit next year this is a drop in the bucket.

There are lots of unanswered issues here:

  • Which deductions would be effected? The White House cites only “tax subsidies for housing, health care, retirement, and child care.” But the biggest tax deductions for the wealthiest tax returns (the “Fortunate 400“) are the charitable deduction (comprising 50% of their itemized deductions), taxes paid deduction (30% of their deductions) and the interest paid deduction (17% of deductions). The Buffett tax rule would effectively cap all of these deductions.
  • Most of these high income taxpayers are business owners – LLCs and S corporations. They are already paying the 2nd highest business tax rate in the industrialized world. Locking in this 30 percent rate would immediately make them uncompetitive globally. Also, since top earners have a lot of business income, they can take advantage of various credits such as the Foreign Tax CreditA tax credit is a provision that reduces a taxpayer’s final tax bill, dollar-for-dollar. A tax credit differs from deductions and exemptions, which reduce taxable income, rather than the taxpayer’s tax bill directly. , the R&D tax credit. The Domestic Manufacturing Deduction and the Bonus DepreciationBonus depreciation allows firms to deduct a larger portion of certain “short-lived” investments in new or improved technology, equipment, or buildings in the first year. Allowing businesses to write off more investments partially alleviates a bias in the tax code and incentivizes companies to invest more, which, in the long run, raises worker productivity, boosts wages, and creates more jobs. are also important to many S corporations and LLCs. Will all of these be denied too?
  • 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.
  • The history of the current AMT shows how these class warfare policies eventually trickle down to the middle class.
  • The U.S. already has the fourth-highest overall tax rate on dividend income among the 34 largest economies at more than 52 percent according to the OECD. Only France, Denmark, and the United Kingdom have higher combined rates (corporate level plus individual level). The Buffett rule would likely push this rate up to 61.2 percent for millionaires. What effect would that have on stocks and the cost of capital?

These are only a few of the issues the While House has not addressed – or simply overlooked – in their zeal to tax the rich.