Fair — or Unbalanced? Decoding the Buffett Rule Debate

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Is the tax system in the United States fair?

That’s kind of a trick question, as fairness and unfairness are usually in the eye of the beholder. Often, a case for fairness boils down to nothing more than self interest. And because there is no final word on the subject, the debate can go on forever.

In the current round, Washington is wrangling over President Barack Obama’s call for a “Buffett Rule” to make sure the wealthy pay a “fair share” of taxes — a percentage of income at least as large as that paid by the middle class. Obama says the rule, named for Warren Buffett, the legendary investor who heads Berkshire Hathaway, would raise additional revenue to help reduce the federal budget deficit, expected to be $1.3 trillion this year. “I will veto any bill that changes benefits for those who rely on Medicare but does not raise serious revenues by asking the wealthiest Americans or biggest corporations to pay their fair share,” Obama said.

Opponents, including many Republicans, say raising taxes on the wealthy is unfair because, regardless of the percentage of income paid, the rich already pay far more in actual dollars than other taxpayers. The richest 10% of households pay more than half of all federal taxes collected, according to the Congressional Budget Office.

And opponents say a tax hike on the rich would be self-defeating because it would undermine job creation and discourage people from working harder to make more money. “If you tax job creators more, you get less job creation. If you tax investment more, you get less investment,” Republican Paul Ryan, chairman of the House Budget Committee, said in a television interview.

But, politics and practical issues aside, what is fair?

“Historically, the reason this becomes so contentious, and the reason people shout and fur flies and hair rises on the back of the neck is because, on reflection, there’s more than one lynchpin for fairness,” says Thomas Donaldson, professor of legal studies and business ethics at Wharton. Still, he adds, just-minded people should agree on a basic principle: Any notion of fairness should provide for everyone to benefit somehow, even if the benefits are not spread equally. Therefore, concepts of fairness must always consider other people’s interests, not just one’s own.

Underlying the fairness debate over taxes is a practical issue: Can the federal government get its fiscal house in order without raising taxes on someone? While many Republicans prefer spending cuts and oppose any tax increases, many economists think tax hikes must play some role. “It’s clear to me that both spending and taxes have to be adjusted as part of a grand compromise,” notes Wharton finance professor Richard Marston. “Bush’s tax cuts created too large a hole in revenues,” he adds, referring to the cuts in 2001 and 2003 under President George W. Bush.

As much as three quarters of the deficit problem can be resolved with spending cuts, such as long-term solutions to the Medicare funding problem, according to Mark Zandi, chief economist and co-founder of Moody’s Economy.com. But the rest, he says, will probably have to come from tax increases such as cutting or eliminating deductions, which typically benefit the wealthy the most. “I think there’s general agreement that we need $4 trillion in deficit reduction over the next 10 years.”

While the debate over tax fairness goes on all the time, new discussion was sparked by an August 14 guest column by Buffett in The New York Times, in which he said that he and his rich friends had been spared from the “shared sacrifice” national leaders advocate when they talk about reducing the government’s ballooning deficits.

“While the poor and middle class fight for us in Afghanistan, and while most Americans struggle to make ends meet, we mega-rich continue to get our extraordinary tax breaks,” Buffett wrote, adding: “Last year my federal tax bill — the income tax I paid, as well as payroll taxes paid by me and on my behalf — was $6,938,744. That sounds like a lot of money. But what I paid was only 17.4% of my taxable income — and that’s actually a lower percentage than was paid by any of the other 20 people in our office. Their tax burdens ranged from 33% to 41% and averaged 36%.”

Why the Wealthy Pay Less

This is possible because the country’s “progressive” tax system taxes different levels of income, and different types of income, in different ways. For a married couple filing a joint return, for example, the first $17,000 in taxable income is taxed at 10%. Income from $17,001 through $69,000 is taxed at 15%, from $69,001 to $139,350 at 25%, from $139,351 to $212,300 at 28%, from $212,301 to $379,150 at 33%. Income above $379,151 is taxed at 35%. These “tax brackets” are the same for everyone, regardless of income. Billionaires pay 10% on their first $17,000 in taxable income, just like everyone else.

Although the top rate of 35% kicks in at $379,151, a couple with $400,000 in taxable income would pay less than 35% overall because most of the income would be subject to rates from 10% to 33%. The 35% rate would apply only to the $20,840 above the $379,151 threshold. This system would still leave the wealthy paying a larger overall percentage, or “effective rate,” than people with less income, were it not for other features.

All taxpayers, for example, are entitled to a “standard deduction,” or income that is not subject to any income tax. For 2011, that is $5,800 for individuals and $11,600 for couples filing joint returns. For those who itemize their tax returns instead of taking the standard deduction, there are deductions for children, mortgage interest, local taxes paid and charitable contributions, to name just a few. As a result, more than 40% of households pay no income tax at all.

However, everyone who earns income, even those with no income tax, is subject to the separate 6.2% payroll tax for Social Security and Medicare. (This was reduced to 4.2% this year to stimulate the economy.) But the payroll tax applies only to the first $106,800 in income. Buffett’s examples include the payroll tax, adding 6.2% to the income tax for his office workers who earn less than $106,800. Because wealthy taxpayers do not face payroll tax for income above that limit, their payroll tax is less than 6.2% of their total income, helping to explain how a lower income worker can pay a higher overall percentage than a rich person.

But the chief reason Buffett and people like him can pay a lower effective rate is that much of their income is from stock dividends and capital gains, or the profit on investments. Those sources are taxed at only 15%. Whether Buffett’s case is really typical of most wealthy taxpayers has been the subject of much debate, as many well-to-do people who live on big salaries, rather than investments, do pay at high income-tax rates.

Buffett’s specifics aside, Obama and many Democrats argue that the wealthy should pay more, period. They say the wealthy were the chief beneficiaries of the Bush cuts which helped shift the federal budget from surplus to deficit. Now that times are tough, the thinking goes, the wealthy should pay more to help fix the problem. Under Bush, the top tax bracket fell to 35% from 39.6%, and the capital gains rate was cut to 15% from 20%. Obama and most Democrats in Congress think the cuts should be allowed to expire as scheduled at the end of 2012. (The original 2010 expiration was extended.)

Obama has proposed the Buffett Rule as a guiding principle, leaving the details to a Congressional commission composed of six Democrats and six Republicans that, by late November, is to come up with $1.2 trillion in deficit reductions over the next decade. Obama wants the deficit cut by a total of $3.6 trillion over 10 years, with 60% coming from spending cuts and 40% from additional tax revenues.

Among the tax-revenue options are restoring the pre-Bush income tax rates, raising rates on dividends and capital gains and eliminating certain credits and deductions, possibly including the popular deduction on interest paid on mortgages. Obama has said he does not want to raise taxes on couples making less than $250,000 a year, or individuals below $200,000.

While Democrats and Republicans agree that the commission must come up with very large spending cuts, they are wrangling over how much should come from defense, Medicare, Medicaid and Social Security, the four giants of federal spending. The two sides have not been able to agree on what would be “fair.”

That is not surprising, as parties with opposing interests can easily come up with reasonable definitions of fairness that are very different, says Donaldson. A classic illustration of the dilemma, he notes, concerns a band of isolated soldiers dying of thirst. A small group crosses enemy lines at great risk and returns with a limited amount of water. An argument over fairness ensues. The weakest soldiers say they should get the water because their need is greatest. Others say everyone is part of the group and should get an equal share. The water party says it should get more because it took the risk. And the officers say they should get more because they are officers.

The tax debate involves similar choices. To one person, it would be fair for everyone to pay the same lump sum in annual taxes. To another, paying the same percentage of income would be fair. To a third, a fair system would blend the first two, while exempting certain types of income and perhaps charging a surtax on others.

According to Donaldson, Buffett has attracted attention, in part, because he advocates a system that would benefit others at his own expense. “You can have great inequalities in wealth, but those inequalities should [in some way] benefit those at the bottom” as well as those at the top, Donaldson notes. It can be fair, he adds, for a doctor to earn more than a laborer, so long as the laborer benefits from medical care.

On that basis, it might have been fair for the wealthy to have received the lion’s share of the Bush tax cuts if the non-wealthy benefited in some way. Conservatives argue that tax cuts for the wealthy help everyone by stimulating the economy and creating jobs. Republican presidential candidate Mitt Romney, for example, takes a traditionally conservative line in proposing to cut corporate taxes to 25% from 35%, making the Bush tax cuts permanent and eliminating taxes on dividends, interest and capital gains for people making less than $200,000 a year.

“The right course for America is to believe in growth,” Romney said in announcing his tax plan in early September.

Do Taxes Make Us Lazy?

While there are lots of ways to look at the numbers, it is difficult to draw a definitive conclusion about the relationship between tax rates, economic growth and job creation. The Bush cuts, centered on the wealthy, did not spur growth and job creation. In fact, the economy and financial markets did better in the 1990s, when tax rates were higher. On the other hand, the 1990s did not include a financial crisis like the one that struck in 2008.

Zandi notes that at high levels, taxes can undercut job creation, but “not at the rates that are being discussed here.” Allowing the Bush cuts to expire, for instance, would raise the top income tax rate by only 4.6 percentage points, to 39.6%, compared to more than 90% in the 1950s and 50% as recently as 1986.

Conservatives also argue that higher tax rates discourage people from working harder to earn more income and produce more tax revenue. Critics of this view say that if financial incentives were that critical, there would not be so many examples of extremely wealthy people continuing to work after money was no longer an issue. Many people choose careers that do not offer high pay. And even if some highly compensated people declined some work because of higher tax rates, other people might step in to do the work that was left undone.

Buffett argued that higher taxes would not undercut investment that is key to economic growth. “I have worked with investors for 60 years, and I have yet to see anyone — not even when capital gains rates were 39.9% in 1976-1977 — shy away from a sensible investment because of the tax rate on the potential gain,” he wrote in the Times. “People invest to make money, and potential taxes have never scared them off. And to those who argue that higher rates hurt job creation, I would note that a net of nearly 40 million jobs were added between 1980 and 2000. You know what’s happened since then: lower tax rates and far lower job creation.”

While low taxes can leave employers with more money to hire workers, the current lack of hiring does not appear to be caused by a shortage of money. Large American corporations are sitting on record cash reserves that could fuel a hiring binge but has not. Many economists point out that employers do not hire simply because they have the money to do so, but because they need more workers to meet growing demand. Ultimately, the new workers are paid from the revenues generated from additional sales.

Much of the recent debate has centered on taxes paid by the wealthy, but a solution to the deficit problem will have to address tax rates for the non-wealthy as well, says Marston. “The deficit is higher for two reasons…. Taxes fell under Bush for everyone [and] expenditures have soared under Obama — and under Bush, with his unfunded wars and prescription [drug] benefits.”

As a percentage of gross domestic product, spending by the government has soared. At around 35%, it is above its long-term average, though just shy of levels reached in the early 1980s and early 1990s, and well below the levels above 50% during World War II. At the same time, tax revenues are relatively low relative to GDP. Receipts from individual income taxes equaled about 6.2% of GDP in 2010, for example, the lowest level since 1950, and well below the 10.2% in 2000, just before the Bush cuts in 2000. The current low rate is due to the cuts, lackluster income growth and high unemployment

“I don’t see a way to solve the deficit problem without either a large increase in income taxes on everyone or a consumption tax,” Marston notes. “But frankly I don’t see the Republicans accepting either anytime soon.”

Wharton finance professor Franklin Allen also thinks the U.S. may eventually need to introduce a national sales tax, or value-added tax, though this has not been much discussed. “They need to raise revenues [and] they need to get rid of this deficit,” he says, warning that growing debt forces ever-greater portions of federal revenues to go to debt service, bleeding money needed for ordinary government functions. “Somebody’s got to pay [to reduce the deficits], and it probably makes sense for the rich to pay for some of it,” Allen notes.

Although the wealthy have benefited from lower tax rates over the past decade, they are currently suffering as concern over government debt in the U.S. and Europe roils the financial markets, Allen notes. Attacking the debt problems effectively could help right the markets, leaving wealthy investors richer even if they have to pay higher taxes, he adds. “They are going to lose a lot more if the country collapses.”

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