Should The U.S. Follow Britain’s Lead And Raise Taxes On The Rich?

Obama’s proposal to raise taxes on those making over $1 million unleashed heated discussion over what the effect of such an increase might be. Will it reduce wealth inequality and close our deficit, or will it hurt the economy by stifling entrepreneurship and job creation? A similar debate took place earlier this year in Britain and resulted in a temporary increase in the tax rate for the top 1% of earners, from 40% to 50%. While it’s too soon for any definitive research on the impact of the change, twenty prominent British economists recently sent a letter to the Financial Times arguing that for its repeal. Does this mean Obama’s approach is misguided as well?

Why Do We Need A Millionaires’ Tax When We Have The AMT?

“I reject the idea that asking a hedge fund manager to pay the same as a plumber or a teacher is class warfare. It’s just the right thing to do… This is not class warfare. It’s math. The money’s gonna have to come from someplace.” – President Obama speaking in the Rose Garden today

Today, President Obama unveiled a plan to reduce the deficit by $4 trillion and pay for the new round of economic stimulus, the American Jobs Act, he sent to Congress last week. In a Rose Garden speech about the plan, the President repeatedly emphasized the idea that spending cuts need to be balanced with tax increases. What will likely be one of the most controversial  elements of the plan is Obama’s proposal that individuals making over $1 million pay a certain minimum tax rate. Nicknamed the “Buffett Rule” after Warren Buffett’s advocacy of higher taxes for the super-rich, the proposal aims to rectify the fact that, due to the quirks of our tax system, some ultra-wealthy individuals pay lower effective tax rates than upper-middle income households.

Some of you may be scratching your heads, wondering, don’t we already have a tax that’s designed to ensure the wealthiest households pay a certain minimum tax rate? Why, yes we do: the Alternate Minimum Tax or AMT. Individuals with income above a certain threshold have to calculate what they owe under the AMT, which has a different set of rules than the regular income tax system, and then pay whichever is greater, their regular income tax or the AMT.  Why do we need a millionaires’ tax if we have the AMT? Simply put, the AMT is not achieving its intended goals.

Infographics Follow-up: Tax Rates Of The Super-Rich

On Tuesday I wrote about Warren Buffett’s recent op-ed in the NY Times arguing that the super-rich aren’t paying their fair share of taxes. Yesterday Roberton Williams at the Urban-Brookings Tax Policy Center posted an interesting graph that shows how preferential rates for dividends and capital gains income affect the overall tax rates households pay.

Source: Urban-Brookings Tax Policy Center, 2011

The graph is a bit complicated at first glance, so here’s a breakdown:

• It shows effective tax rates (ETR), which sum individual income taxes and payroll taxes (I explained why payroll taxes matter in my previous post).
• The blue bars show the average ETR a household pays if they earn less than 10% of their income from dividends and gains on investments.
• The red, green, and purple bars show the average ETRs paid by households that earn more of their income from investments. The purple bars, for example, represent households that earn at least 2/3 of their income from these sources.

As I explained the other day and as the graph shows, the more of your income you earn from investments rather than wages, the lower your overall tax rate. And it’s almost exclusively the top earners who are making large shares of their money from investments and getting those lower tax rates shown by the red, green, and purple bars.

If this is still a little confusing, let’s consider two hypothetical families:

Family #1: An upper-middle class family earning $90,000 a year, which puts them in the fourth income quintile. 97% of families in this group make less than 10% of their income from capital gains and dividends. So this family is almost certainly going to be in the blue bar group and will likely pay an average effective tax rate of 16.1%.

Family #2: A super-rich family earning $5 million a year, which places them in the top 0.1% of earners. Almost half of families in this category make more than 10% of their income from capital gains and dividends. If our hypothetical family earns half of their income from these sources, they will be part of the green bar group and will be paying an effective tax rate of around 15%, lower than Family #1.

Why Investors Pay Less Tax than the Rest of Us
Urban-Brookings Tax Policy Center // Roberton Williams // August 31, 2011

FYI, these are the income groups shown in the graph:
Lowest quintile: < $17,000                                Top quintile: > $103,500
Second quintile: $17,000 – $33,500                Top 1%: > $532,500
Middle quintile: $33,500 – $60,000                 Top 0.1%: > $2,179,000
Fourth quintile: $60,000 – $103,500

Wealth, Taxes, and Warren Buffett

Guess what share of his income the third richest person in America paid in federal taxes last year? 45%? Maybe 38%? It has to be at least 25%, right? Actually, Warren Buffett paid 17.4%, a lower tax rate than any of the twenty other people working in his office, who paid an average of 36%. Interestingly, Buffett isn’t happy about his low tax bill. Two weeks ago he wrote an attention-grabbing op-ed in the New York Times asking Congress to please tax him and other super-rich folks more.

So, just how does it happen that Warren Buffett pays a lower tax rate than his coworkers? It has a lot to do with how different types of taxes are structured.

1. The super-rich make most of their income from earnings on investments, rather than wages paid for work (which is where the average, non-retired person makes most of her money). People who “make money with money,” as Buffett puts it, see much of their income taxed at the capital gains rate of 15%, rather than the highest personal income tax rate of 35%.
2. People who earn more pay a smaller portion of their income in payroll taxes (the taxes designated for Social Security, Medicare, and unemployment), since Social Security taxes are only paid on income up to $107,000.

According to the Urban-Brookings Tax Policy Center, Buffett’s point about the discrepancy between the tax rates on investment income and wage income is a valid and important one. However, most high-earners pay a higher tax rate than Buffett’s 17% and most low- and middle-earners pay a lower rate than the 36% Buffett’s colleagues pay. For Buffett to imply that all, or even most, wealthy people pay a lower tax rate than low- and middle-income people is inaccurate.

The thing is, Buffett’s argument doesn’t really apply to your run-of-the-mill millionaires making $1 or $2 million a year. A lot of those people still earn most of their income from wages so they end up paying higher tax rates than someone making, say, $50,000. It’s the super-rich investors like Buffett who get the low tax rates. The average federal tax rate for the top 400 taxpayers is around 18%, which is significantly lower than the rate for someone making, for example, $180,000 or $1 million. The graph at left, from the excellent blog Visualizing Economics, shows just how far the average tax rate for the top 400 taxpayers has dropped  in the past two decades.

Another thing Buffett has been criticized for is not mentioning the corporate income tax in his article. Corporations pay taxes too, at a rate of about 35%, but since corporations aren’t people the burden of these taxes gets passed on to actual humans – to investors in the form of lower returns on their investments or to workers in the form of lower wages. Buffett’s true net tax rate, some argue, is 17.4% plus whatever share of corporate taxes fall on investors. The problem is, economists can’t agree on who, investors or workers, bears what share of the corporate tax burden. Given this disagreement, perhaps Buffett was right to leave it out of his argument.

Beneath all this is the question of fairness and how much every group should ideally contribute. For more on this, see one of my older posts here.

Stop Coddling The Super-Rich
Warren E. Buffett // NY Times // August 14, 2011

Was Buffett Right? Do Workers Pay More Tax than Their Bosses?
Tax Policy Center // Roberton Williams // August 23, 2011

Taxes – What’s A Fair Share?

If you were to redesign our tax system from scratch, what would it look like? What would each person’s fair share of the burden be?

Our federal system primarily taxes individuals’ incomes, not their overall wealth. You pay taxes on your money when you earn it and you don’t have to keep paying every year on the things you buy with that income, like real estate and financial investments (though you do have to pay taxes on the capital gains you make when you sell these assets). Local tax systems, which are based mainly on taxing property, work differently – you pay taxes on assets you own, every year, as long as you own them.

What’s interesting is that when you look at how the tax burden is spread across different groups, it reflects the distribution of wealth more closely than it does the distribution of income. The top 5% earn 35% of all income but pay a whopping 59% of all taxes. Sounds unfair, right? Until you consider that this group owns 64% of all the wealth in the country.

Where does this pattern come from? The richest Americans’ share of overall wealth is higher than their share of income because they tend to have a greater portion of their wealth in assets (mainly financial investments, real estate, and business ownership), as opposed to middle- and low-income Americans, who have fewer assets and a greater share of their net wealth in the form of cash income. The wealthy’s share of income taxes is greater than their share of income because our tax system is progressive, meaning the affluent pay a bigger chunk of their earnings in taxes than people in the lower income brackets.

There’s been a lot of discussion lately about whether increasing taxes on the wealthy should be part of the solution to our deficit problems. Let’s assume we stick with an income-based tax system; we can still ask ourselves: Should peoples’ taxes correspond to their share of income or their overall wealth? Do the richest Americans pay too much, or not enough?

Sources:

Individual Income Tax Rates and Shares, 2008 // IRS

The State of Working America’s Wealth
Economic Policy Institute // Sylvia A. Allegretto // March 23, 2011

Recent Trends in Household Wealth in the United States: Rising Debt and the Middle-Class Squeeze
Levy Economics Institute at Bard College // Edward N. Wolff // March 2010

No New Taxes: A Pledge That Isn’t As Simple As It Seems

Like a household whose finances are out of whack, our government can deal with its looming budget deficit in two ways: spend less or earn more. Political leaders are currently negotiating to find the right balance of these two strategies, but several Republicans have threatened to block any plan that involves raising taxes. In our current Congress, all but 7 Republican Senators and 6 Republican Representatives have signed Americans for Tax Reform’s well-known pledge to oppose any and all tax increases (only 3 Democratic Congressmen have signed).

But hewing to a mantra of “no new taxes” can be more complicated than it seems, because the division between taxes and spending isn’t always clear-cut. A significant amount of government spending is hidden in the tax code in the form of tax breaks for certain groups: homeowners making mortgage payments, companies conducting scientific R&D, workers receiving employer-sponsored health insurance, and investors earning capital gains. Altogether, the Treasury Department has identified over 170 preferences that cut taxes for specific taxpayers, activities, or types of income. If these “tax expenditures” were structured as spending programs rather than tax breaks, in 2007 they would have accounted for 17% of federal spending.

What makes these tax breaks different from other parts of the tax system, like differential rates based on taxpayers’ incomes? According to a new article by Donald B. Marron, Director of the Urban-Brookings Tax Policy Center, tax expenditures have the same impact on the economy, government budget, and distribution of income as if the government directly handed out checks to the beneficiaries. Elected officials use the tax system because it’s legislatively easier and politically more palatable to insert a benefit into the tax code than to increase discretionary spending by a comparable amount.

“Because tax cuts often sound more appealing to policymakers and voters than spending increases —  especially in today’s political climate — the temptation to spend through the tax code is enormous.” – Donald B. Marron, “Spending in Disguise”

Unfortunately, politicians find it much more difficult to eliminate a tax break than to cut a comparable spending program. We saw this a few weeks ago when anti-tax Republicans struggled with how to vote on a measure to end tax credits for ethanol producers. Some, like Senator Tom Coburn, saw the credit for what it is – a spending program in disguise – while others stayed true to their promise not to vote for tax increases of any kind and rejected the measure.

Marron suggests that by eliminating or simplifying many existing tax expenditures we can streamline the tax code, decrease government involvement in the economy, reduce the deficit, and maintain or perhaps even lower tax rates. But eliminating tax expenditures won’t be painless. Despite our stereotype of massive corporations receiving huge breaks – see Obama’s latest rhetorical target, accelerated depreciation for corporate jets – only 10% of the revenue lost to tax expenditures benefits corporations. The other 90% of breaks are for individuals, though many deductions disproportionately benefit the wealthy.

Sometimes spending through the tax code makes sense: it may be more efficient, accomplish important policy objectives, or benefit a broad spectrum of taxpayers. In other cases, these approaches can be overly complex and used to hide unpopular programs that benefit a select few. But the biggest problem is when politicians and voters don’t see tax breaks, good or bad, for what they are – a form of spending – and treat them accordingly.

Spending in Disguise
National Affairs // Donald B. Marron // Urban-Brookings Tax Policy Center // Summer 2011