Proposed ‘Buffet Rule’ misunderstood

by Mark Davis

Warren Buffet has been making news over the last few years for allegedly paying less income in taxes than his secretary and cleaning lady. This is an injustice that both he and President Obama have decided must be resolved. Obama’s so called “Buffet Rule” is to be created in order to combat this error that has been somehow overlooked by the ever-present taxing authorities. Initially, the claim that a man who is worth more than $44 billion and is the CEO of leading investment firm Berkshire-Hathaway pays less income tax than a simple office worker would seem to be nothing short of a lie. There is, however, some truth to this claim. So how does the second richest man in America pay less of his income in taxes than his secretary?

The answer isn’t a secret seventh tax bracket where you stop paying taxes. The United States has a progressive income tax, so any single person earning more than $110,000 pays a marginal tax rate of 35 percent on his or her income, so the key to figuring out Mr. Buffet’s tax avoidance is in understanding what actually constitutes his income. Buffet, as I mentioned above, is CEO of Berkshire-Hathaway, and he also holds a significant percentage of the company’s stock. As a result, only a small portion of what qualifies as Buffet’s gross income is actually taxed at the standard income tax rate. To be sure, an amount several times that of his secretary’s salary is in fact taxed at 35 percent, but Buffet’s salary and even his interest income make up such an insignificant fraction of his gross receipts that the tax rate on the rest simply makes it insignificant.

As a professional investor, most of Buffet’s income comes from long-term capital gains. For various reasons, long-term capital gains are taxed at an alternative rate. If an earner’s marginal tax rate is less than 15 percent and the gain occurred after 2008 (and before 2013) the capital gain is not taxed (it was taxed at 5 percent prior to 2008). If, however, the investor’s marginal rate is beyond 15 percent, as in Buffet’s case, then the gains are taxed at 15 percent regardless of his marginal tax rate. For readers who have forgotten how averages work, this means that even if a taxpayer’s salary is $10 million, but his or her long-term capital gains exceed $1 billion, his or her average tax rate will be less than 15.2 percent. In Warren Buffet’s case, his net worth fluctuates by billions of dollars every year simply because of the volatility of his investments.

Now the difficulty with the “Buffet Rule” is that it makes two assumptions that should not be made. First of all, it assumes that the rich routinely pay less of their income in taxes than their secretaries. Secondly, and more importantly, it assumes that our country and tax structure would be better off if long-term capital gains were not subject to an alternative tax rate. The first assumption is pretty obviously false, because it requires a rather unique portfolio of investments to occur. In order for the alternative tax rate to significantly affect a taxpayer’s average rate, he or she must be making several times their annual salary in long-term capital gains every year, which means they must have invested their money over a year ago and be realizing gains in excess of their annual salary while still maintaining a portfolio that can achieve the same feat again the next year.

The second assumption is a little more significant to consider. First of all, one should consider why capital gains are taxed at a different rate than regular taxable income in the first place. The reason is no different than that of the rest of the tax code. Taxation has always been a problem of deciding how to effectively harness the productivity of a country without significantly affecting the incentive to work. In the case of the standard income tax, the rate tends to be low. This is because people should generally be able to keep what they earn and most people aren’t going to want to work for half pay. It is progressive in order to put the tax burden on those who can most afford it (it would be pretty silly if we had the unemployed funding their own benefits).

So why are capital gains taxed at a different rate, even though it most frequently benefits the rich? The answer is twofold. For starters, the capital gains tax rate has been adjusted a number of times, starting from the marginal rate eventually down to its current rate, and each time the rate has dropped, revenues from the tax have actually increased. Skeptics would, of course, contend that this does not prove a higher rate will always decrease revenues since each cut of the rate was also followed by a boom in our economy, but it seems more likely if we look at how capital gains are earned. In order for an individual to receive capital gains, he or she must risk his or her already taxed income by investing it in something other than interest (like a bank account). Typically these are the potentially riskier investments. Furthermore, the recipients of these investments are also entities who will use the capital to expand our economy and employ more workers. Even if Buffet disagrees, ease of capital flow is more important than his tax rate.

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