The Buffett Rule: A Basic Principle of Tax Fairness

by InvestorPlace Staff | April 10, 2012 6:01 am

[1]The following is the full transcript of “The Buffett Rule: A Basic Principle of Tax Fairness,” a report by The National Economic Council presented April 9.

The Buffett Rule is the basic principle that no household making over $1 million annually should pay a smaller share of their income in taxes than middle?class families pay. Warren Buffett has famously stated that he pays a lower tax rate than his secretary, but as this report documents this situation is not uncommon. This situation is the result of decades of the tax system being tilted in favor of high?income households at the expense of the middle class. Not only is this unfair, it can also be economically inefficient by providing opportunities for tax planning and distorting decisions. The President has proposed the Buffett Rule as a basic rule of tax fairness that should be met in tax reform. To achieve this principle, the President has proposed that no millionaire pay less than 30 percent of their income in taxes.

Why the Buffett Rule Is Needed

  1. Of millionaires in 2009, a full 22,000 households making more than $1 million annually paid less than 15 percent of their income in income taxes — and 1,470 managed to paid no federal income taxes on their million?plus?dollar incomes, according to IRS data.
  2. Of the 400 highest income Americans, one out of every three in this group of the most financially fortunate Americans paid less than 15 percent of their income in income taxes in 2008.

In his State of the Union address, President Obama called for comprehensive tax reform that cuts rates, cuts inefficient tax loopholes, cuts the deficit, increases job creation and growth, and sets out a very simple principle of fairness: No household making over $1 million annually should pay a smaller share of income in taxes than middle?class families pay. To achieve this, the President has proposed that no millionaire pay less than 30 percent of their income in taxes.

This is the “Buffett Rule.” As Warren Buffett has pointed out, his effective tax rate is lower than his secretary’s — and that is wrong. To be clear, there is tremendous variation in tax rates for high?income households, with many, like small business owners who receive primarily labor income and take advantage of few special tax benefits, paying taxes at an effective rate not dramatically lower than their statutory rate. But as a recent analysis by the Congressional Research Service concluded, “the current U.S. tax system violates the Buffett rule in that a large proportion of millionaires pay a smaller percentage of their income in taxes than a significant proportion of moderate?income taxpayers.”

This basic source of unfairness is what this principle would address, by limiting the degree to which the most well?off can take advantage of tax expenditures and preferential rates on certain income. In a time when all Americans are being asked to come together to make the sort of shared sacrifices that will allow our country to continue making the crucial investments that are necessary to grow our economy, continuing to allow some of the wealthiest Americans to use special tax breaks to avoid paying their fair share simply cannot be justified. Moreover, addressing these inequities through tax reform that includes a Buffett Rule can also improve the efficiency of the tax system by discouraging tax planning and reducing distortions to behavior.

I. The Average Tax Rate Paid by the Very Wealthiest Americans Has Fallen to Nearly Its Lowest level in Over 50 Years

For the very wealthiest Americans, the amount of taxes they have paid on average has fallen sharply over recent decades.

Figure 1 shows the trend in average tax rates since 1960 for top? and middle?income earners. Importantly, these estimates calculate effective tax rates in each of these years based on the actual income distribution in 2005, with their incomes adjusted for the national average wage growth each year before and after. This effectively controls for changes in the distribution of income so as to give a clear reading of what happened purely as a result of changes in tax policy. In contrast, other estimates also show that the tax system has become substantially less progressive but understate the magnitude of this change because they cover the same period that the highest income Americans were earning more relative to others.

II. Average Tax Rates for the Highest Income Americans Have Plummeted Even As Their Incomes Have Skyrocketed

Over the past four decades, income inequality has risen dramatically, severing the link that previously existed between economic growth and middle class standards of living. By the time the financial crisis struck, these trends had resulted in the wealthiest Americans receiving a greater share of the country’s total pre?tax income than at any time since the Roaring Twenties.

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III. Some of the Richest Americans Pay Extraordinarily Low Tax Rates

The average tax rate masks the fact that some high?income Americans pay near their statutory tax rate, while others take advantage of tax expenditures and loopholes to pay almost nothing. For example, a hedge?fund manager might characterize his or her compensation as capital gains, thereby paying a fraction of the taxes they would pay if their income was classified as wages, the same as other working Americans. It is these high?income taxpayers that the Buffett rule targets. The Buffett Rule is not an across?the?board tax increase on high?income households; it is a way to ensure that no millionaire is paying less than the middle class.

Percent of the 400 Highest Income Americans Paying Less Than a Given Effective Federal Income Tax Rate in 2008 
Under 10% Under 15% Under 20% Under 25% Under 30% Under 35%
% of Top 400 8% 33% 61% 74% 85% 100%

IV. Many High?Income Americans Are Paying Less As a Share of Their Income Than Middle Class Americans

Because some of the richest Americans pay taxes at such extraordinarily low rates, they end up paying less in taxes as a share of their income in taxes than middle?class Americans. To be clear — on average, high income Americans do pay more. That is because the United States has a progressive tax system in which tax rates generally rise with income, albeit not as much as they have in the past.

However, these average trends mask the substantial variation in tax rates, which is even greater for very high?income households. Some of the wealthiest Americans can hire lawyers and accountants to take advantage of tax expenditures and loopholes that enable them to pay a lower share of their income in taxes than average Americans. In particular:

  1. Twenty?four percent of all millionaires (about 55,000 taxpayers) face a tax rate that is lower than the tax rate faced by nearly 1.5 million taxpayers making between $100,000 and $250,000 (the 90th percentile for this group).
  2. Twenty?one percent of millionaires (about 50,000 taxpayers) face a tax rate that is lower than the tax rate faced by 3 million taxpayers making between $50,000 and $100,000 (the 90th percentile for this group).
Click to Enlarge

V. The Economic Argument for the Buffett Rule

Economic research has shown that taxes are more efficient (or less distortionary) when taxpayers have fewer opportunities to avoid them. The Buffett Rule would reduce these opportunities for the highest income Americans, limiting the extent to which they can take advantage of inefficient tax shelters or accounting mechanisms to avoid paying taxes.

The opinions contained in this column are solely those of the writer.

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