The wildcard in the Obama deficit reduction mix is the so-called Buffett rule which says that people with incomes over $1 million should pay a higher share of taxes than middle-class families. There are a range of design questions that need to be addressed in taking this rule from principle to policy. Here are some quick/early thoughts…
- How do you define the middle-class? One approach would be to take the middle quintile (20%) and use their tax rate. But there are many people who identify themselves as middle class that fall outside this range, and thus have higher tax rates than the pure middle.
- Marginal or average? The top marginal tax rate (the tax on an additional dollar earned) is already higher for millionaires on their labor income, but the average effective rate (tax/income) can be brought down via deductions, credits, etc. The spirit of the buffet rule seems to imply average rates – but the tax code is designed around marginal rates. Obviously the two are related and a higher marginal rate will increase effective rates; but may not guarantee higher average rates.
- Income or all federal taxes? Not only does a middle class family pays income taxes, but they also pay (and in most cases pay more) payroll taxes. So the marginal income tax rate could be 15%, but their tax rate more accurately could be 30.3 once you include payroll taxes for Social Security and Medicare, including both employee and employer side. It’s important to set the right bar.
- Cap gains. See Gale’s comments below. The lower rate on capital gains (15%) is what drives down the taxes paid by many high-income individuals. Addressing this disparity would seem to be a core part of the policy design.
- AMT? There is a difference between saying that the average taxes in a group should be higher than the middle-class, and saying that everyone in that group should have a higher share than the middle class. The later may necessitate an approach (similar to an alternative minimum tax) that provides a bottom-line computation that ensures that a minimum share (of all income) is paid. There are design issues that need to be addressed in this approach as well in order to avoid unintended incentives.
Bill Gale over at Brookings has several similar (and better articulated) thoughts on the Buffet rule:
8 The Buffett rule
As a guideline for future tax reform but not as a specific proposal now, the President described “the Buffett rule,” named with reference to Warren Buffett, who has commented that he faces a lower average tax rate than many of his employees as implying that no one with income over $1 million should pay a smaller share of his income in taxes than middle class families pay.
–The notion that people with income above $1 million should pay higher average tax rates than those in the middle class should not be a controversial proposition in principle. It is simply an extremely mild form of progressive taxation.
–However, the guidelines say “no household” with income above $1 million, which might create issues.
–The mild form of progressivity may not hold in the current system because different income types have different tax rates. These income types are concentrated in certain income groups more than others. For example, wages and salaries, which are a big share of low- and middle-income households’ income but not of high-income households’ income, are taxed at a flat payroll tax rate up to a maximum and graduated income tax rates. Capital gains and dividends are taxed at very low rates 15 percent maximum under the individual income tax; these constitute less than 1 percent of the income of the bottom 80 percent of the income distribution, but more than 30 percent of the top 1 percent of households in 2007, the figure will vary from year to year. According to Tax Policy Center estimates, the top one-tenth of one percent of households receive almost half of the benefits from preferential rates on capital gains and dividends. Low- and middle-income households cannot benefit from these tax breaks like millionaires, nor can they exploit other tax loopholes and deductions like high-income households.
–The Buffett Rule could be implemented in different ways: via a surtax on those whose income exceeds $1 million; via a reformed Alternative Minimum Tax which would ensure that high-income, not middle-income, households are primarily affected; or via elimination or reduction of preferential rates for dividends and capital gains. The goal of a progressive tax system is laudable and should be pursued, especially as the greatest income gains have benefitted the top while median incomes have stagnated.