By now, I'm sure you've read this NYT Op-ed called 'Stop Coddling the Super-Rich'. The short summary is that Warren Buffet shockingly reveals his tax rate of 17.4%, much lower than many less wealthy folks. Thus, he proposes to increase the marginal tax rates on personal income, earnings from dividends and capital gains for people making more than one million dollars. To be clear, these are distinct taxes. Personal income tax is levied on your salary while dividends and capital gains taxes are on investment income, such as from the sale of stock.
I admire Buffet's willingness to write such a piece, revealing some of his personal tax details and fueling a much needed and overdue national debate. I firmly agree with the desire to reform our tax code. I'm also intrigued by his suggestion to increase the rate at which capital gains are taxed but I willingly admit ignorance of the consequences of such an approach. As an example of this ignorance, one important point made by Benie Kent's article in Forbes is that increasing the tax on capital gains may have the opposite of the desired effect. Specifically, making it more expensive to invest may result in less investing and therefore less tax revenue despite the higher rates. Yet I digress. Ultimately while I support the spirit of the Op-ed there were a few ways in which it is perhaps a bit misleading, although certainly not in intent, and I want to humbly point them out knowing that I may be mistaken.
Most important is the observation that the marginal rates of the federal personal income tax is not the problem here. For a single tax payer, the marginal tax rate for income is at least 25% for every dollar earned over $35,000 and 35% for every dollar earned over $380,000. So either Buffett is making under 35k or his reported rate of 17.4% is not heavily influenced by the marginal tax rates.
Deductive Reasoning
One obvious question is why isn't his tax more strongly influenced by the marginal rates. It's impossible to know without more disclosure of his tax forms but there are likely two main causes. The first is that most of his income is in the form of capital gains and dividends, which is taxed at a much lower rate, and the second is that he may benefit from income tax deductions. I was surprised that he didn't mention deductions, which I believe have several undesirable properties. They complicate the tax code, allow some extremely rich people to legally dodge tax, and often have unintentional consequences. According to a study by the Tax Foundation (http://www.taxfoundation.org/), the cost of tax compliance in US is estimated to be $265 billion or 2.1% of the GDP. Eliminating deductions would make calculating and complying with tax much simpler and easier. Many deductions have contributed to serious economic problems such as the home mortgage deduction to the recent housing price crisis and the employer-paid health insurance deduction to increased healthcare costs.
Corporate (tax) Ignorance
A potential problem with the 17.4% number is that it ignores corporate tax. Corporate tax is levied on the profits made by a company. Since Buffet is a person and not a company he doesn't discuss corporate tax, so why do I? Well, mainly because I don't necessarily distinguish between a company and its owners. If you or I own stock in a company, then we are by definition owners of that company and profits from the investment come from the company's current and future income. Therefore a tax on corporate profits is also a tax on investment. A comprehensive discussion of tax reform must at least address the corporate tax, which is about 35% in the US.
To Increase or not to Increase
Finally, I want to address the proposal to increase tax rates on personal income. In light of the observation that Buffet's tax is barely influenced by marginal rates one must question his argument to raise them (not to say there aren't other better arguments for raising the income tax). While increasing these rates will have a negligible effect on the tax he pays, and even less on his wealth as aptly pointed out at the end of Kent's article, it would severely affect many other, much poorer, laborers. He proposes to raise the tax only for those who make more than one million dollars. I have two issues with this facet of the proposal. The first is that picking such a threshold on incomes to heavily tax is error prone. If you set it too low you will negatively impact middle class. I emphasize that even if it's initially set to a very high number, the combination of time and inflation may bring it down, a message more humorously depicted by Mike Myers in this video (If you haven't seen Austin Powers the premise is that Dr. Evil is a terrorist who had recently been awakened after 30 years). And, setting and keeping it high will be very difficult due to the huge incentive of revenue gain to the government for lowering it. Furthermore, this type of taxation on only extreme yearly incomes has a bigger and likely problematic consequence.
The problem is that it directly punishes a specific type of risk-seeking behavior I believe to be beneficial. Let me provide a semi-concrete example. Suppose that a young engineer arrives at a metaphorical fork in the road: either take a job with moderate pay at an established and respectable engineering firm or pursue his or her dream by working independently at an internet startup that just might revolutionize an industry. The first choice will provide a steady stream of income with very little risk. The second choice is extremely risky. With some high probability, this engineer will spend a lot of time and effort on a venture that makes no money at all, due simply to the inherent difficulty in starting a business with a radical new idea. On the other hand, there is some small chance it will be successful, bring in millions of dollars of profit, and provide value to many people. I view Buffet's proposal to increase the personal income only at high rates akin to discouraging the second choice. In the extreme case where the government takes all money made over a million dollars, the second choice becomes financially irresponsible. Furthermore, this discouragement would contribute to the fact that the second choice is already the much harder one, requiring more work under stressful and less comfortable conditions. Yet, I find this type of risk-seeking behavior to be fundamental to many of our society's great achievements.
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