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A Tax Floor, with No Ceiling

by James Pethokoukis

The “Buffet rule” is the wrong model

It’s one of the great mysteries of Barack Obama’s presidency: Why did he stiff-arm the recommendations of the Bowles-Simpson commission — the bipartisan debt-reduction panel that the president himself created in 2010? On the surface, it’s quite a puzzler. The Bowles-Simpson proposal would have put federal debt on a path to 40 percent of GDP by 2035, versus 84 percent under the Congressional Budget Office’s current-baseline scenario and 187 percent under the CBO’s more realistic “alternative” fiscal projection. And Bowles-Simpson would have achieved that goal by enshrining Obamacare — even accelerating its implementation, in some instances — while permanently raising taxes to their highest share of GDP in the nation’s history. Had Obama embraced the commission’s recommendations, he might have been able to ram sweeping fiscal reform through Congress, guaranteeing his policy legacy and creating a powerful argument for his reelection.

But Bowles-Simpson never became Obama-Bowles-Simpson. And Obama’s State of the Union address provides the key to understanding why. In the speech, the president proposed what he called the “Buffett rule”: “Right now, because of loopholes and shelters in the tax code, a quarter of all millionaires pay lower tax rates than millions of middle-class households. Right now, Warren Buffett pays a lower tax rate than his secretary. . . . If you make more than $1 million a year, you should not pay less than 30 percent in taxes.”

Obama’s specific terms and conditions are crucial. He could have said merely that millionaires should not pay a lower tax rate than middle-income Americans and left it at that. Instead, he specified a particular tax rate and made it a minimum requirement. As it happens, that floor of 30 percent about matches the average effective tax rate of the top 1 percent of American households. (Buffett pays around a 17 percent rate because most of his income is from investments and is taxed at a preferential 15 percent rate. Same goes for Republican presidential contender Mitt Romney.) The Bowles-Simpson proposal went in completely the other direction. It recommended cutting top marginal rates across the board, specifically stating that “the top rate must not exceed 29 percent.” Indeed, one Bowles-Simpson scenario would have slashed the top marginal rate to 23 percent — the lowest since 1916. Those cuts in marginal rates would have been combined with the elimination of most tax breaks, making Bowles-Simpson a large net tax increase. But whereas Obama would create a floor for tax rates with the Buffett rule, Bowles-Simpson would have created a ceiling.

Obama’s political motivation for cooking up the Buffett rule is obvious: creating a populist wedge issue for the election. But it’s more than that. The Buffett rule is a direct outgrowth of the Democrats’ rejection of the Bowles-Simpson premise that federal spending as a share of GDP should be limited to 21 percent of the nation’s economic output, which is about its historical average. Liberals argue that the aging of the population and the need for new government “investments” will require federal spending to be much higher in the future than it has been since World War II. Indeed, three liberal think tanks recently constructed long-term budget plans, and their average projection for federal spending by 2035 was 25 percent of GDP — with a bullet. Generating federal revenues anywhere close to that level would require sharply higher taxes on the wealthy and, most likely, a value-added tax on everyone else. (This explains why we’ve never seen a long-term budget plan from the White House. The jig would be up.)

Liberal economic thinking now has gone far beyond the belief that the top tax rate should return to where it was during the Clinton administration, when it was about 40 percent. Many left-of-center policymakers have embraced research by economist Peter Diamond (whom Obama was unable to get confirmed as a Federal Reserve governor) suggesting that top rates should revert to at least 70 percent, where they were when Ronald Reagan took office in 1981, and maybe as high as 80 or 90 percent.

So Obama has no interest in any plan that boxes him in on taxes. The Buffett rule was Obama’s de facto response to Bowles-Simpson, one that revealed his long-term vision for a high-tax, high-spending America. As a purely economic matter, the Buffett rule would make for terrible tax policy. The current tax code is already dangerously top-heavy after a series of tweaks over the past two decades that created a system in which wealthier Americans pay a huge share of taxes. According to the Tax Policy Center, in 2010 the top 0.1 percent paid an average tax rate — including income and payroll taxes — of 30.7 percent, right at the Buffett-rule level. By contrast, middle-income Americans — defined as those in the middle fifth of the income distribution — paid just 12.8 percent. The bottom 40 percent of taxpayers had an average total tax rate of even less, just about 3 percent when you take into account various tax credits.

Even considering how much money the wealthy earn, their taxes are disproportionate to their income. In 2009, the top 1 percent paid a whopping 36.7 percent of federal income taxes but earned only 16.9 percent of adjusted gross income. And the richest of the rich, the top 0.1 percent, paid 17.1 percent of income taxes while earning 7.8 percent of adjusted gross income, according to the Tax Foundation. The bottom 50 percent paid just 2.3 percent of income taxes. You could argue that Obama’s “fair share” mantra should really mean a big tax hike on middle-income Americans, not the rich.

On paper, the Buffett rule would raise about $40 billion a year, which assumes a) no new crafty tax-avoidance strategies from the attorneys serving the rich and famous and b) no economic impact from the tax hike. But raising taxes on investment — that is, savings put to work creating wealth in the real economy — is hardly the best thing for  a stagnant economy. The theme of Obama’s State of the Union speech, recall, was the need to create an economy that is “built to last,” not one temporarily and dangerously inflated through debt-fueled consumption. Yet the Buffett rule would worsen the tax code’s preference for spending and debt over investing and equity by raising the tax on capital to 30 percent from 15 percent. Profits are taxed once at the corporate level and then again when distributed as dividends or as capital gains when a stock rises in price and is sold. So the effective tax on capital is closer to 50 percent. The current preferential tax rate for investment income is meant to at least partially reduce this double-taxation burden, as well as to reflect the fact that much of the nominal gain on many long-term investments is simply inflation, not a real return. Obama’s Buffett rule would worsen such distortions and create more incentive for corporations to take on debt, since companies can deduct interest payments when they calculate their taxable income.

Here’s a handy economic heuristic: Tax what you don’t want, not what you do. Studies from economists left and right have shown that eliminating the tax bias against capital in favor of one that discourages debt would boost long-term economic growth. One tax-reform plan is the Bradford X tax, a progressive consumption tax. Households would not pay tax on interest, dividends, capital gains, or other income from saving. Firms could immediately deduct business investments rather than depreciate them over time. Capital would be cherished, not punished. One widely cited study estimates a 6.4 percent gain in long-run output from the adoption of such a tax, which could result in a full percentage-point gain in government revenue as a share of economic output. A new study from Colgate University finds that lower investment taxes “stimulate innovation and enhance labor productivity in the long run.”

Encouraging investment is how you create an environment in which private capital can be efficiently allocated and generously rewarded. Instead, Obama is proposing a system in which government would extract potential investment capital from the private economy and redistribute it to favored constituencies through welfare programs and economic policies. Investing will create an economy “built to last.” The Buffett rule will create an economy built to fail.

– Mr. Pethokoukis, a columnist, blogs for the American Enterprise Institute.

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