Sacrifice Without Balance

In today's post, I'd like to highlight an excerpt from Joseph Thorndike's article, "What the Civil War Can Teach Us About Tax Reform." See Tax Notes, Nov. 21, 2011, p. 944. Thorndike hits a couple points that are consistent themes on this blog. The emphasis is mine.

What can the Civil War tell us about today's debate over deficit and debt reduction? It's the notion of sacrifice that links the two eras. Then, as now, the nation faced a serious fiscal crisis. And then, as now, lawmakers struggled over how to allocate the pain incurred while solving it.

Differences abound, of course. An entitlement-driven fiscal crunch is not the same thing as a war, no matter how severe it might become. Mortal sacrifice on the battlefield is not the same as economic sacrifice from a paycheck.

Still, the notion of shared sacrifice unites those episodes. Clearly, solving today's fiscal problems will be painful, requiring higher taxes and lower spending. The necessary changes won't be pleasant for anyone -- and they will be deeply painful for some, especially those who depend on key social programs.

But today's lawmakers have failed to acknowledge that broad-based sacrifice will be necessary to solve the nation's fiscal problems. No one in either party is willing to talk about meaningful entitlement reform.

Lawmakers are also not being honest about taxes. If higher revenues are going to be part of the solution, then the extra burden will almost certainly fall on everyone. But so far, the champions of higher revenues have been unwilling to acknowledge that everyone will end up paying more. Instead, they have focused narrowly on raising taxes on those with high incomes.

I've said it before and I'll say it again. Democrats and Republicans have been complicit in deficit-spending for decades. They created entitlement programs that are structurally imbalanced and unsustainable. They designed tax expenditures that distort markets, stoking health care inflation and contributing to the real estate bubble. They manufacture drama to score points with political supporters who cannot or choose not to keep track of the bigger picture.

We cannot address these structural and tax policy challenges by increasing taxes on "millionaires and billionaires." There is no "class war" between the 1% and the 99%. If we want a bigger government and if we want to maintain federal spending on entitlements, we'll need to raise taxes on the top, middle, and bottom of the income spectrum. We may need to eliminate "sacred" tax expenditures. We may need a VAT or carbon tax. The status quo is a path towards extreme hardship for millions of Americans when the bottom falls out from under the political class.

All Sizzle, No Steak

Ask a Wall Street financial expert to name the most high-profile resident of Nebraska. They'll probably answer Warren Buffett, the legendary investor and "Oracle of Omaha." Now ask a Nebraska farmer. They'll probably answer Tom Osborne, the legendary football coach of the Nebraska Cornhuskers.

In Nebraska, Cornhusker football is a quasi-religious experience. When the 'Huskers play at home, their stadium becomes the third-largest city in the state (behind Lincoln and Omaha, Buffett's home city). While the 'Husker fans take their teams seriously, they don't converge on Lincoln solely for the football. With college football, comes serious tailgating. And with serious tailgating, comes grilled meat for the inner caveman.

During a 'Husker tailgating party, when the charcoal starts glowing, fans break out the brats and burgers and steaks. Nebraskans want their steaks fresh, juicy and big, with an anonymous American beer on the side. They're looking for the steak in steak, not the sizzle.

On Monday, September 19, President Obama announced five principles of tax reform (part of his plan for economic growth and deficit reduction). As I discussed in my last post, the fifth principle is "observe the Buffett rule." The Buffett Rule says that people making more than $1 million a year should not pay a smaller share of their income in taxes than middle-class families pay.

The rule is all sizzle, no steak. That's ironic, given its namesake. Then again, mega-billionaire Buffett would probably be more comfortable at an Obama fundraising event than a 'Husker tailgating party.

Sizzle, Drizzle, Fizzle

The Buffett Rule attracted immediate criticism. For tax professionals and economists familiar with tax data, the premise of the Buffett Rule didn't pass a "smell test." It just didn't seem like a widespread problem that should become a central plank of tax reform. Gene Sperling conceded as much this week on a White House blog post "clarifying" the Buffett Rule.

The $100 Million Man

For several years, Buffett has claimed that he pays a lower effective (or average) tax rate than his secretary, who earned $60,000 in 2007. Buffett claimed that he paid tax at a 17.7% average rate (for example, $1.77 million in tax on $10 million in income). He claimed that his secretary paid tax at a 30% average rate ($18,000 of tax on $60,000 in income).

The numbers recited by Buffett never made sense to me. I understand why an uber-wealthy individual taxpayer might pay a low effective tax rate. More on that below. I don't understand how a secretary earning $60,000 could get stuck with tax at a 30% rate. As discussed in the next section, it seems unlikely (impossible?) that Buffett's secretary pays tax at a 30% average tax rate.

Why can an uber-wealthy individual taxpayer pay a low effective tax rate? Seems kind of unfair, right? Under current law, qualified dividends and long-term capital gains are subject to tax at a 15% rate. The 15% tax rate is intended to reduce the double-taxation dilemma that occurs when a corporation distributes its previously-taxed earnings to its shareholders. If a high proportion of an individual's taxable income is derived from dividends or capital gains, that individual's effective tax rate gets "averaged" down towards 15%.

In fact, under current tax rules, a mega-millionaire could earn millions from tax-exempt bond investments, and pay an effective tax rate of zero! Imagine a successful Internet entrepreneur cashed out at the top of the bubble in 1999, paid taxes on his fabulous gains, and rolled $100 million of cash into tax-exempt bonds yielding 5%. His tax-exempt bonds would generate annual cash income of $5 million. However, the income from the bonds is exempt from federal income tax. Zero tax on $5 million in income results in a 0% effective federal income tax rate. That's a lower rate than Buffett, his secretary, and the other 99.99% of us endure.

Of course, Congress didn't exempt state and municipal bond income from taxation as a favor to our $100 Million Man. The exemption for interest paid on tax-exempt bonds represents a subsidy to state and local governments. The federal tax subsidy reduces the cost of financing by permitting state and local governments to issue debt at lower yields. The subsidy reflects a policy choice, and arguably a "bad" policy choice that encourages undisciplined spending by state and local governments.

Note that Congress could increase the 0% effective tax rate applicable to our $100 Million Man by eliminating the tax subsidy for states and municipalities. Eliminating the tax subsidy would increase borrowing costs and decrease the funds available for other state and local objectives. Maybe that's better policy in the long run. But the political left assaults common sense when it demagogues "millionaires and billionaires" who benefit from structural policy decisions (like the tax subsidy for state and municipal bonds). Our $100 Million Man isn't "gaming" the system to achieve a 0% effective tax rate. He's simply playing by the rules of the game that Congress put on the table.

Numbers Don't Lie

Let's get back to Buffett and his secretary. Buffett has complained that he pays a higher effective tax rate (at 17.7%) than his secretary (at 30%). President Obama has seized Buffett's complaint and incorporated it into his "principles" that should guide "fundamental tax reform."

Because the President has made Buffett's complaint a prime-time issue, it raises three questions. Is the complaint accurate, i.e., does Buffett really pay a lower effective tax rate than his secretary? Is the problem widespread based on existing tax data? And is Buffett's concern fundamental to our long-term fiscal solvency and economic competitiveness?

No, no, and no.

[1] Buffett's claim does not seem accurate, much less possible, based on prevailing tax rates. Of course, we don't have complete facts on Buffett's secretary. Is he or she married? Does he or she have children? If married, what kind of earnings does his or her spouse bring to the table? The list could go on for 10 paragraphs.

Having been deprived of the actual facts by Buffett and Obama, I plugged some assumptions into a tax calculator. I assume that Secretary reports $60,000 in taxable income, claims the standard deduction ($5,700), a single exemption ($3,700), and takes advantage of the reduced Social Security tax rate in 2011 (4.2%). On my assumptions, Secretary is in the 25% tax bracket, but pays income tax at a 17.3% average rate. (For another cut at the exercise, see this hypothetical from Peter Pappas.)

We'll never know if Buffett was exaggerating the numbers, confused about the fact that marginal tax rates exceed average tax rates, or had special knowledge about his secretary's tax position (e.g., secretary is married to a spouse with a $200,000 income). However, it seems highly unlikely that Buffett's claim was accurate. So the fifth "principle" guiding Obama's tax reform platform is based on exaggeration, confusion, or some combination of the two.

[2] The "problem" identified by Buffett (based on exaggeration or confusion) is inconsistent with the existing tax data, as discussed here and here.

The nearby table is copied and pasted from the Wall Street Journal article. Although the mega-billionaire Buffett (at 17.7%) may pay a lower effective tax rate than an average working professional married couple with taxable income of $250,000 (at 19.6%), that is not the case for the average "millionaire or billionaire." Both the average millionaire (at 23.3%) and the average working professional married couple (at 19.6%) pay significantly higher effective tax rates than the average middle-class secretary (at 8.9%, assuming taxable income in the $50,000 to $100,000 range).

[3] Finally, the "problem" identified by Buffett (based on exaggeration or confusion) is not fundamental to our long-term fiscal solvency or economic competitiveness, as I discussed in my last blog post.

White House Spin Fizzles

In light of the numbers, the Obama administration went into spin mode. Gene Sperling posted this defense of the "Buffett Rule" on the White House blog last week. Sperling clarified several of the questions that jumped to my mind when I heard about the proposal. Ironically, however, Sperling's attempt to rebut criticism of the proposal confirmed that the "principle" is a class-warfare tactic that will distract from actual tax reform.

So what did Sperling say?

[1] The Buffett Rule will only potentially apply to those with taxable income over $1 million -- approximately 0.3% of American taxpayers. We're off to a shaky start. I thought this was supposed to be a "fundamental" principle of tax reform. And it only potentially applies to 0.3% of taxpayers?

[2] Even among that 0.3% of American taxpayers, it affects only those within that group that pay low tax rates:

In fact, many — if not most — of the few true small business owners making over $1 million already pay ordinary income tax rates (and not the preferential rates) and thus would not be impacted at all by the Buffett Rule.

Okay, so the Administration believes that "many" but not "most" taxpayers reporting more than $1 million in taxable income pay tax at ordinary income rates (35% in 2011). That seems consistent with the data (see table above; the average tax rate paid by taxpayers in this group was 23.3%). However, now we're talking perhaps 0.1% or 0.2% of American taxpayers under the microscope.

[3] The Buffett Rule is not about "all taxpayers." It is about those taxpayers who are able to pay at lower tax rates than middle-class families:

Take IRS data on the taxes paid by the 400 highest-income households in 2008, all making over $110 million per year and making an average of $271 million per year. Some of those 400 taxpayers do pay their fair share, but according to that data, one-third of this group pays less than 15 percent of their income in taxes and 85 percent pays less than 30 percent.

Now, we're getting somewhere. It appears that the Administration is obsessed with roughly 133 taxpayers (one-third of 400). Because 133 taxpayers recognize a disproportionate amount of income from qualified dividends and capital gains (see above), the Buffett Rule has become a central plank of tax reform? Excuse me while I read the White House blog again, because I must be missing the joke.

[4] Sperling then launches into a series of hypotheticals where he, perhaps channeling Buffett, confuses marginal tax rates for average tax rates.

Conclusion

I'm pretty much sick of Warren Buffett and his bumbling foray into tax policy. Team Obama has taken an alleged "problem" involving 100-200 uber-wealthy taxpayers, and begun marketing the "solution" as fundamental tax reform. The emphasis on average tax rates might be a good class warfare tactic, but it misses the critical question. The critical question is: how much of the total income tax burden should we impose on the top 0.1% of taxpayers (or top 0.3%, or 1%, and so on). Perhaps we'll look at the numbers and conclude that they're paying their "fair share." Perhaps we'll conclude that they're not. A focus on "average tax rates" simply distracts from the question.

Meanwhile, the Nebraska Cornhuskers are 3-0 going into a game against Wyoming. Break out the steak, and leave the sizzle to Team Obama.

White House Clarifies "Buffett Rule"

Late on Wednesday afternoon, Gene Sperling posted on the White House blog (see Buffett Rule Fact and Fictions).

Sperling commences the blog as follows:

On Monday, the President proposed the Buffett Rule as one of five principles for comprehensive tax reform. This is a rule of simple fairness—no household making over $1 million annually should pay less in federal taxes* than middle-class families pay. Contrary to some misconceptions, the Buffett Rule is not designed as the sole or main source of raising new revenues, but one of five principles that should be achieved by tax reform:

1. Cut rates
2. Cut inefficient and unfair tax breaks
3. Cut the deficit by $1.5 trillion over 10 years
4. Increase investment and growth in the United States
5. Observe the “Buffett rule.”

Of these principles — all of which we believe are key to reform — the Buffett rule has received the most attention. It has been attacked with claims of “class warfare” that are completely without merit. How can it be class warfare to ensure that there is greater parity between the taxes paid by the most well-off and those paid by tens of millions of hardworking families? Still, since not all of the reports about the Buffett Rule have been accurate, I want to clarify what we mean – and why the President believes this is an important principle.

[*Note: Sperling probably meant to say that "no household making over $1 million annually should pay federal taxes at lower effective rates than the rates that middle-class families pay." The remainder of Sperling's post focuses on average tax rates paid by individuals with varying degrees of income. Alternatively, perhaps Sperling was referring to millionaire/billionaire investors who derive 100% of their disposable income from tax-exempt bond investments, and thus literally pay zero income tax to any jurisdiction.]

In my last post, I criticized the Buffett Rule (a/k/a Vanderbilt Rule) as motivated by class warfare politics. My critique was partly motivated by the lack of detail underlying the "principle." If the principle were not motivated by class warfare politics, why announce the principle without detail as to its application?

Sperling's post added some meat to Obama's bare-bones "principle." Meanwhile, Sperling tried to rebut the critics who viewed the Vanderbilt Rule as class-warfare politics. I appreciate the effort to clarify some of the obvious question marks. But I'm still convinced that Obama's proposal was motivated by class-warfare politics. I'll touch on that point in this blog post. I'll have some more observations about Sperling's rebuttal argument in my next blog post.

Class-Warfare Politics

Take another look at Obama's five principles for tax reform. The first two principles would require amendments to (or perhaps replacement of) the Income Tax Code, impacting tens of millions of individual taxpayers and many thousands of businesses. The third principle would require a contentious bipartisan effort to begin restoring the nation's long-term fiscal health. The fourth principle acknowledges that our broken tax system and uncompetitive business tax rates increase the cost of doing business in the United States, crippling economic growth and job creation.

We can all agree on those four "principles." We can all agree that they are serious goals, and, in today's political and economic climate, will require heavy lifting by our political leaders. We may disagree on the tax and spending changes necessary to achieve those goals. But the goals are fundamental to our long-term economic competitiveness and prosperity.

How about the fifth principle? As Sperling's post confirms, the fifth principle reflects an unhealthy obsession with the 400 wealthiest American individuals. It is not about fixing the tax system, making life simpler and fairer for tens of millions of individual taxpayers, eliminating "tax expenditures" that distort fundamental economic decisions (contributing to the real estate bubble and the crisis in health care inflation), decreasing the costs of business tax compliance, addressing our long-term fiscal challenges, or improving our global competitiveness.

Compare the fifth principle to the other four principles. If a subset of the 400 wealthiest Americans pay tax at lower effective rates than the middle class, does that impact our long-term economic competitiveness and prosperity? Does that make business tax compliance more costly? Does that distort or complicate economic decisions of tens of millions of taxpayers? Of course not. A few billionaires who benefit from structural tax breaks, fairly or unfairly, are a microscopic tail on an 800-pound dogzilla.

Admittedly, the fact that those lucky billionaires pay lower effective tax rates than some middle-class and upper-middle-class taxpayers rubs me the wrong way. I would personally raise the capital gains tax rate to "pay down" ordinary income tax rates. But those changes are already contemplated by the first and second principles (cut rates; and cut inefficient and unfair tax breaks). We don't need to taint a serious tax reform effort with 2012 campaign slogans ("Hope, Change ... and Observe the Buffett Rule!").

From this independent's view, the Buffett Rule (a/k/a Vanderbilt Rule) does not belong on the list of fundamental tax reform principles. Obama included the "principle" in the list as a class warfare tactic to distract voters from his dismal economic record. I'll discuss the details of Sperling's rebuttal argument in my next blog post.

The Vanderbilt Rule

President Obama has "branded" his proposal to increase taxes on "millionaires and billionaires." The new proposal will now be known as the "Buffett Rule."

The basic principle underlying the Buffett Rule is that uber-wealthy taxpayers should pay higher effective tax rates than middle-class taxpayers.

I'm not sure how the Buffett Rule is supposed to work in practice. Perhaps it is supposed to be a "Super AMT." Perhaps it is supposed to increase tax rates on capital gains for uber-wealthy taxpayers. Or limit the deductibility of charitable donations. Or cap the amount of qualifying tax-exempt income in a given year. Perhaps the President will limit the proposal to taxpayers that report more than $1 million in taxable income during a given year. Or perhaps he will extend it to working professional married couples with $250,000 taxable incomes.

Regardless of the mechanics, the spirit of the President's proposal is simple class warfare. It doesn't take a political messiah to persuade 90% of the voting public to favor increased taxes on the other 10%. You can play with the numbers (95/5, 99/1, etc.)

The irony of the "branding effort" didn't escape financial analyst Jeff Macke at Yahoo Finance Breakout:

Warren Buffett made billions off the financial crisis by getting Goldman Sachs (GS) and General Electric (GE) to pay him usurious rates in exchange for what amounted to endorsement deals. Buffett is giving his entire estate to the Bill and Melinda Gates Foundation because he is of the opinion that the government is a poor allocator of capital. Buffett would like me to pay higher taxes to the very government he's opting to stiff.

Mr. Buffett has never met a preferential deal he didn't like and has 56,000 times as much money as someone with $1 million. The only reason the White House is using Buffett to promote this tax hike is because the administration thinks voters are ignorant regarding who Buffett really is. Buffett has no more place in a Jobs Act conversation than does the ghost of Cornelius Vanderbilt.

Buffett is a legendary investor and has created fantastic wealth for thousands of his shareholders. However, Macke hits the nail on the head. Buffett's proclamation that millionaires and billionaires should pay higher taxes reeks of hypocrisy. And somehow, the hypocritical mega-billionaire has taken center stage in the debate over the President's second stimulus proposal (ahem, "jobs plan").

Next time, why not link class warfare tax policy to someone with more historical gravitas? Personally, I think the "Vanderbilt Rule" has a much nicer ring than the "Buffett Rule." And after all, Vanderbilt was one of the richest Americans in history.

Meanwhile, Halloween is just around the corner. Would it be difficult to pull off the Ghost of Cornelius Vanderbilt?