During his State of the Union address last month, President Barack Obama proposed a "Buffett Rule," which would impose a minimum average tax rate of 30 percent on all income above $1 million per year. However, this rule was conspicuously absent from the president's budget proposal last week. This was for a good reason: Regardless of the ethical theories to which you personally subscribe, the Buffett Rule is a terrible idea.
Before proceeding any further, keep in mind two points. First, as I have previously argued, the claim that a significant proportion of high-income individuals pay a lower average federal tax rate than typical middle-income individuals is largely a statistical illusion created by data that ignore corporate taxes ("Buffett's Taxes", Feb. 1). Second, the Buffett Rule would raise very little revenue: The non-partisan Tax Foundation estimates that it would raise $40 billion per year. For comparison, total federal tax revenues during the 2011 fiscal year were $2.3 trillion, and the budget deficit was $1.3 trillion, according to the Congressional Budget Office.
While the top federal marginal tax rates on labor and interest income are currently higher than 30 percent, the top federal statutory income tax rate on capital gains and dividends is only 15 percent. As a result, the Buffet Rule would cause a significant increase in the marginal tax rate on investment income from equities but not on labor income or investment income from debt. Thus, the Buffett Rule would only worsen the preference given to debt over equity by the federal tax system. Many people have complained about highly leveraged financial institutions and about private equity firms that load up other firms with debt; the Buffett Rule would only exacerbate these two problems.
Now, the economy is a complex, interwoven system. As a result, a tax change will have many indirect effects other than simply raising revenue. One branch of normative economics that studies these issues is known as "welfare economics." Welfare economics essentially combines our economic knowledge with utilitarian or Rawlsian ethical assumptions in order to produce policy recommendations.
Let's be clear about what these ethical assumptions actually mean. A utilitarian or a Rawlsian does not believe that a high-income individual has any inherent right to keep any portion of their income; if it were not for the incentive effects of taxation, the top marginal income tax rate for all income should be 100 percent. Obviously, given these ethical assumptions, typical left-of-center economic policy prescriptions the government should redistribute income to poorer individuals, for instance arise naturally from the field of welfare economics.
Now, believe it or not, the baseline result from standard welfare economics is that the marginal tax rate on investment income should be asymptotically zero. Over the last two decades, further research has added many "ifs" and "buts" to that specific conclusion. But the more general conclusion that investment income should be taxed at a lower rate than labor income has held up quite well.
Most other developed countries have heeded this conclusion. As a result, the United States currently has the fourth highest marginal tax rate on dividend income among all countries in the Organization for Economic Cooperation and Development. According to the Tax Foundation, if the Buffet Rule were implemented in the United States, that would raise the real marginal tax rate on dividends (i.e., inclusive of corporate taxes and adjusted for inflation) from 52 percent to 61.2 percent. This would be the highest marginal tax rate on dividends among all countries in the OECD.
Now, if you agree with the Democrats' plans to increase federal government spending over the coming years, then we obviously need to raise federal tax revenues. But the right way to do so would involve eliminating deductions from the income tax code and implementing a national sales tax. For comparison, these changes would move the U.S. tax system in the direction of the Nordic countries' tax systems.
In short, the Buffett Rule is simply not in keeping with standard welfare economics. Put differently, even if you believe that high-income individuals have no inherent right to keep any portion of their incomes, and even if you believe that federal spending and thus taxes need to increase significantly, the Buffett Rule is a terrible idea that deserves a place in the dustbin of history.
