Millionaires should not pay a lower effective tax rate than middle-income people. And yet two features of our code allow a millionaire like Warren Buffett to pay a lower effective federal tax rate than his secretary, who earns $60,000. First, payroll taxes apply to the secretary’s wages but not to investment income, which largely goes to the rich. Second, the personal income tax has special low rates that apply to certain investment income (capital gains and stock dividends) but not to the secretary’s wages.
Of course, many millionaires also earn wages and therefore pay more than investors like Mr. Buffett. But Citizens for Tax Justice recently estimated that about a third (32%) of taxpayers with income exceeding $10 million are like Mr. Buffett in that they get the majority of their income from investments. We also looked at taxpayers like Mr. Buffett’s secretary (taxpayers making between $60,000 and $65,000) and found that only 2 percent receive most of their income from investments. Over 90 percent of the taxpayers in the $60,000 to $65,000 income range receive less than a tenth of their income from investments.
We estimate that in 2011, the third of taxpayers making over $10 million who get most of their income from investments will pay just 15.3 percent of their income in federal income and payroll taxes on average. The 90 percent of taxpayers in the $60,000-$65,000 range who get less than a tenth of their income from investments will pay 21.3 percent of their income in federal income and payroll taxes on average. This is undeniably unfair.
Congress could reduce this unfairness by eliminating the breaks for capital gains and stock dividends in the personal income tax. Far from being a radical proposal, this was part of the tax reform signed into law by President Ronald Reagan.
If lawmakers are unable to restore Reagan’s reform, then they should enact Senate Democrats’ proposed surcharge on the portion of taxpayers’ adjusted gross income (AGI) exceeding $1 million. This would leave in place the breaks for investment income in the personal income tax, but at least the surcharge would apply to investment income just as it applies to wages. It would therefore reduce the ability of wealthy investors like Mr. Buffett to pay lower effective federal tax rates than working class people. We estimate that only one-fifth of one percent of U.S. taxpayers would pay the proposed surcharge.
Taxing millionaires may sound attractive and easy, but it’s really just bad policy.
Think about it. If the goal is to reduce the federal deficit, there are only two main ways to increase tax revenue for the federal government. Politicians can either seize the money through higher tax rates (assuming they can collect it since tax avoidance will naturally go up), or they can pass pro-growth policies that will grow the economy, and thus grow the tax base from which to receive the revenue.
To liberals and conservatives alike, the latter should be far more preferable. Supporters of the surcharge may want to make a “fairness” argument, and that’s their prerogative, but they shouldn’t claim that raising taxes on anybody is a good idea when the unemployment rate is 9.1%. Like it or not, the “millionaires” who are being targeted are also likely to be among those who are most capable of creating jobs.
Also, there is broad, bipartisan support for lowering the corporate tax rate while getting rid of senseless loopholes that favor various special interests. If a surcharge becomes law, it becomes incongruent with that effort. Why? Because gamesmanship will occur where individuals will purposely file their tax returns as corporations in order to avoid the higher rate. That will only push much-needed tax reform further into the future. And that’s something we can’t afford in this day and age where capital can go anywhere on the planet in a moment’s notice at practically no cost. We need a lower corporate tax rate now – we have the second highest in the developed world – or foreign countries are going to eat our lunch.
If tax reform is simply not doable in an election year (after all, politicians’ goals aren’t always aligned with those in the private sector), and we quickly dispense with the idea of a surtax on millionaires, the next best thing Congress can do is allow American corporations to repatriate their overseas income at a lower tax rate. This will increase tax revenue to the government and it will give corporations the capital they need to reinvest in jobs and innovation. It would also give the economy a nice pro-growth boost. Congress could also index capital gains to inflation. Talk about a fairness argument – nobody should pay taxes on “phantom” gains that were caused by a weak dollar. If gains were indexed, the stock market would immediately jump. That would push up everyone’s 401k and IRA plan.
But putting these smaller ideas aside, I urge Congress to ignore the political risk and summon the courage to take on the big task of tax reform. Whether it’s in the Super Committee or tasked by leadership through the committees that have jurisdiction, it doesn’t matter. Our fragile economy needs it. Now.