By Edward Zelinsky
Although he had said it before, Warren Buffett struck a nerve with his most recent observation that his effective federal tax rate is lower than or equal to the effective federal tax rates of the other employees who work at Berkshire Hathaway’s Omaha office. Mr. Buffett’s observations have provoked extensive comments both from those supporting his position (e.g., President Obama) and those critical (e.g., the editorial writers of the Wall Street Journal).
In response to Mr. Buffett’s remarks, President Obama has promulgated what he calls “the Buffett Rule,” namely, that those making $1,000,000 or more per year should pay an effective federal tax rate higher than the effective rate paid by moderate income taxpayers. To implement this rule, Senate Majority Leader Harry Reid has proposed a 5.6% federal surtax on annual incomes over $1,000,000. The Congressional Research Service (CRS) has issued a report on the Buffett Rule. Deviating from Mr. Obama’s formulation of the Buffett rule, Mr. Buffett himself has indicated that he only favors higher income taxation for “the ultra rich,” a group which apparently consists of individuals earning substantially more than $1,000,000 annually.
The debate following Mr. Buffett’s comments has been spirited, but, for many, confusing. Here is my effort to clarify the facts and arguments.
1) FICA taxes are the predominant tax burden on most working Americans. As I discussed in last month’s blog, many working Americans pay little or no federal income taxes, but do pay significant FICA taxes to finance Social Security and Medicare. Democrats and Republicans alike have ignored this reality. Democrats prefer to ignore the heavy FICA tax burden on lower income Americans to preclude an honest discussion about the fairness of those taxes to younger Americans, even after considering the Social Security and Medicare benefits younger Americans may receive in the future. Republicans avoid the reality of FICA taxation because it undermines the mantra that half of all Americans pay no federal income tax. That statement is true but incomplete. Working Americans who don’t pay income taxes do pay significant FICA taxes. When Mr. Buffett compares his federal taxes to those paid by his secretary, it is the secretary’s FICA taxation which constitute much of the secretary’s obligation to the federal Treasury.
2) As to the taxation of the affluent, the real issue is the lower rates applicable to capital gains. The CRS estimates that approximately 1/4 of those with annual incomes over $1,000,000 violate the Buffett rule by paying federal taxes at effective rates equal to or lower than the effective tax rates of Americans of modest incomes. Besides the FICA taxes borne by working Americans, this phenomenon is caused by lower federal taxes on capital gains. Today, capital gains (including dividends) are generally taxed at a maximum federal tax rate of 15%. This is essentially the same as the combined employer-employee tax rate which applies under FICA to the first dollar of a working American’s wage income.
3) Millionaires pay higher taxes on their ordinary incomes. Mr. Buffett is evidently one of the millionaires whose income largely consists of lightly-taxed capital gains (including dividends). However, the bulk of those making more than $1,000,000 pay taxes at much higher rates than does Mr. Buffett because they earn ordinary incomes such as salaries and other business profits. These millionaires generally do not violate the Buffett rule since the federal income taxes assessed on their ordinary incomes put most of these millionaires into effective tax brackets higher than those applying to Americans with more moderate incomes. According to the CRS, millionaires who principally earn ordinary incomes such as salaries (rather than lightly-taxed capital gains) pay effective federal taxes of approximately 30%.
4) An across-the-board surcharge on millionaires’ incomes is overly-broad. Insofar as Mr. Obama touts the proposed 5.6% surcharge as implementing the Buffett rule, this across-the-board surcharge would be overly-broad. It would apply both to those millionaires, like Warren Buffett, who pay federal income taxes at lower capital gain rates of 15%, and to the bulk of millionaires who pay on their ordinary incomes higher federal income taxes in the vicinity of 30%, roughly double the capital gains rate. Thus, the real issue raised by Mr. Buffett’s observations is the proper rate for the taxation of capital gains including dividend income.
5) The (unknown) economic incidence of the corporate tax is critical. Some of Mr. Buffett’s critics suggest that he (and others) have higher effective tax rates than appears to be the case because their incomes are first taxed by the corporate income tax. For these critics, Mr. Buffett’s federal tax burden is actually the sum of his personal tax on his capital gains plus the corporate taxes paid by Berkshire Hathaway and the other corporations Berkshire Hathaway owns. The CRS is unconvinced and concludes that much capital gain income is not first subject to corporate tax. Other commentators suggest that some of the corporate tax burden is shifted onto the consumers of corporate-produced products in the form of higher prices and onto corporate employees in the form of lower wages. The truth is that the economic incidence of the corporate income tax is unknown and unknowable – which is one of the reasons politicians like corporate taxes.
6) The federal government accepts voluntary contributions. In response to Mr. Buffett’s remarks, commentators, including my daughter, Jacoba Urist, have observed that anyone who wants to pay the federal government more can: The federal Treasury accepts voluntary contributions and, indeed, has a specific account to receive such contributions.
7) Higher taxes on the wealthy will eliminate only a small part of the nation’s budget deficit. Mr. Buffett’s critics contend that higher taxes on millionaires cannot solve the nation’s budget problems. This contention is correct. The nation’s budgetary deficit is far too large to be solved merely by taxing more those taxpayers who earn annually in excess of $1,000,000. Mr. Buffett indicates that his version of the Buffett Rule “would probably raise about $20 billion annually from about 50,000 people.” To be sure, $20 billion is a lot of money. However, in the context of the federal government’s gargantuan budget deficits, it is the proverbial drop in the bucket.
8 ) The case for higher tax rates on the affluent is ultimately moral and political. Higher taxes on the affluent are not a panacea for budget deficits nor are such taxes without negative effects. As to the latter, for example, if capital gains rates are increased, at the margin, some taxpayers will elect to defer the sale of their capital assets and thereby delay their higher taxes. The greater the increase in capital gains rates, the greater will be this deferral effect.
Ultimately, the case for higher tax rates on the affluent is moral and political. The nation cannot solve its budget deficits without such unpopular measures as reduced defense spending and higher retirement ages for Social Security and Medicare. Those millionaires who violate the Buffett rule, the argument goes, must step up to the plate with other Americans to put the nation’s fiscal house in order.
Edward A. Zelinsky is the Morris and Annie Trachman Professor of Law at the Benjamin N. Cardozo School of Law of Yeshiva University. He is the author of The Origins of the Ownership Society: How The Defined Contribution Paradigm Changed America. His monthly column appears here.