## Tuesday, February 14, 2012

### How Buffett Rule critics try to dodge the 30% tax rate by referencing the marginal rate

One of Obama's proposed tax policies for 2013 is the implementation of the Buffet Rule.  This rule is fairly simple, it sets a minimum tax rate for those who make more than \$1 Million at 30%.  The reason we need this rule is to plug up loopholes in the tax code that tax dividends and capital gains at 15%. These loopholes allow people who have massive amounts of assets to essentially pay a 15% tax rate on all of their income because these people can structure their income as capital gains and dividends rather than ordinary income.

The current tax system vastly favors investors over average workers by taxing pure investors at lower rates.  The Buffett rule tries to plug this loophole for those making more than a \$1 million by requiring them to pay at least 30% of their income in taxes.

The tax foundation has an article in its Tax policy Blog with the inflammatory title: "Buffet Rule would Cause Marginal Tax Rate of 90%."  Before you become mislead by that title remember that the buffet rule actually sets a tax rate of 30%.  The use of the number 90% in the title is totally misleading because the actual tax rate is 30%.  So where do they get this misleading 90% tax rate?  Well for simplicity's sake let me dive in with a simpler example than they use that shows just how absurd their argument is.

Imagine that a person is taxed at 15% on all their income.  If they make \$100,000 then they pay \$15,000 of taxes.  If they make \$500,000 they pay \$75,000 in taxes.  If they make \$999,999.99 they pay nearly \$150,000 in taxes which is 15% of their income.  Now, under the buffet rule the second they jump up to \$1 Million they suddenly pay 30% in taxes which results in \$300,000.  You would be right to say "wow" because earning one extra penny doubles the taxes!

So now that you understand that I'll explain to you what the Tax Foundation does to reach their 90% tax rate.  They start with the assumption that the actual tax rate on every penny up to \$999,999.99 is taxed at 15%. Thus they say that \$150,000 of taxes is attributable to that first \$999,999.99.  We can calculate the tax rate by dividing the amount of taxes paid by the income taxed.  Thus, if we pay \$150,000 in taxes on \$999,999.99 of income we are paying a 15% tax rate.

Ok so what does the tax foundation do next?  They essentially say that since that last penny jumps the rate up to 30% that the second \$150,000 in taxes is completely attributable to that lone penny.  Lets calculate the tax rate on that penny which equals \$150,000 in taxes divided by \$.01 giving us a 1.5 Billion% tax on that lone penny.  Wow, crazy isn't it! The government wants to impose a 1.5 Billion percent tax on a single penny. A tax greater than 100% means you are paying more than you are earning. But, wait, remember the actual tax total tax rate is 30% and thus this use of a 1.5 Billion percent tax rate is really just a way of manipulating the numbers to make it look like the tax rate is absurdly higher than it really is.

So in my example the tax rate on that lone penny is 1.5 Billion percent.  You might wonder how this relates to the tax rate of 90% listed by the tax foundation.  Well, the tax foundation likely knows we would see through their tricky math if they used ridiculous numbers like a 1.5 Billion percent tax rate on a single penny.  So they actually change Obama's proposed tax and make it phase in between incomes of \$1 to \$2 Million.   They then say (Correction: The Tax Foundation was quoting Senator Sheldon Whitehouse's proposed implementation of the buffet rule and not proposing its own implementation. Thus my statement that "they ... change Obama's proposed tax" is misleading.  They have simply chosen to interpret Whitehouse's proposed implementation of the plan. I interpreted the use of the passive voice "proposed solution" as a solution they were proposing to the cliff problem instead of Sheldon Whitehouse's.  I wish to apologize for my unintended confusion and state that I stand corrected on this issue.  Thank you Nick Kasprak for the correction.). The tax foundation used Sheldon Whitehouse's plan for how to implement the buffet rule.  Under this plan you pay 0% of this 30% tax at \$1 Million and 100% of the 30% tax at \$2 Million.  A bit confusing, I know, but the end result is to make it so that the tax gradually increases up to 30% rather than instantly rising from 15% to 30%.  The result of using a gradual increase in tax rate rather than a sudden change is to reduce the tax rate on that final penny by spreading out the increase over your income.  Thus instead of having a 1.5 billion percent tax on a penny, they find there is a 90% tax on an income increase from \$1.80 to \$1.81 million dollars. But don't forget the actual amount of tax being paid is still 30%.  It appears that a primary purpose for showing this manipulated 90% number is to inflame you into thinking the government is charging a 90% tax rate, which they are not, they are charging a 30% tax rate.

Now lets take a step back and remember what the initial problem was: that people making millions of dollars were paying only a 15% tax rate when people making less than \$100,000 pay up to 28%.  This is hardly a fair scenario where the extremely wealthy are paying less tax than many people making less.  The tax policy group's technique shifts the issue away from this disparity and will lead people to see only the 90% tax rate that would seem high and unfair.

I want to change gears now and go to the actual problem.  The tax policy group correctly points out that there is going to be a "cliff" in taxes at \$1 million where your taxes due suddenly jump from \$150,000 to \$300,000. This means that a person who makes more than \$1 million will take home less in some cases than a person who makes under \$1 million.  The difference is greatest right at that one penny before \$1 million where on the low side you take home \$850,000 and at the million mark you take home \$700,000.  Making \$150,000 less because you earned one penny more hardly seems fair and looks like it would cause many people to arbitrarily limit their income until they get high enough above \$1 million so that they actually make more than they lose. If we do the math a person taxed at 15% making just below \$1 million will take home more after tax income than anyone making \$1.21 Million or less.  Thus, the incentive is to never make between \$1 and 1.21 million.

This is an actual problem with a policy like this. It unfairly imposes a giant tax jump at an arbitrarily determined number.  So how do we solve this?  Well the most fair way would be to simply to tax all income under the same rate structure regardless of how it was earned.  Thus we would do away with the low 15% tax on capital gains and dividends and tax these gains at ordinary income tax rates.  Remember we have decided to give investors a beneficial low tax bracket of 15%.  Thus, they should hardly complain when they are made to pay at the same rate as others who have the same income.

However, simply removing the preferential capital gains and dividends rates is problematic too.    The reason we have these low rates is to encourage people to invest in property and businesses thus we do not want to simply do away with these encouraging rates.  Thus we have two competing policies: 1) that people who make more should pay more in taxes versus 2) our desire to encourage investment with low tax rates.

The Buffett rule is one solution to these competing policies and it does have a large cliff (tax rate jump) problem.  The tax foundation states that there is no way the Buffett Rule can get around this tax cliff problem absent using long range phase ins.  Well, they might be correct that the Buffett rule can't avoid the cliff problem but the real issue is: do we care?  The tax rates for those making over a million in dividends is absurdly low compared to general income tax rates.  The real way to look at this is not that people making more than \$1 million are being punished, they aren't, they are still paying less than they would if they had earned income instead of dividends.  Instead we should remember that we are giving a benefit to lower income investors and thus encouraging their investment.