The Buffet Rule: Good Politics, Bad Policy

President Barack Obama’s proposed “Buffett Rule,” which would impose a minimum 30 percent tax rate on individuals earning $1 million or more  a year certainly makes for good politics. It capitalizes on the envy, resentment and visceral anger that is so often aimed at the richest members of our society. But if there’s anything I’ve learned as a student of political economy, it’s that good politics almost invariably equals bad economics. The Buffett Rule is no exception.

First, let’s talk about the idea that rich people aren’t paying their “fair share” of taxes. According to the Congressional Budget Office, the richest 1 percent of Americans face an average tax rate of 29.5 percent and pay 28 percent of all federal taxes. Meanwhile, the bottom 40 percent of American households have averaged a federal income tax rate below zero since 2000, according to The Atlantic.

The fact is that rich people pay a lot of taxes. Nonetheless, there persists a widespread belief that they still aren’t paying enough. Much of the confusion in this respect stems from Warren Buffett’s proclamation that he pays a lower tax rate than his secretary, who, for the record, earns somewhere between $200,000 and $500,000 annually, according to Forbes.

It is true that the relatively few individuals in this country who earn income solely from long-term investments face a lower top rate than those who pay taxes on ordinary income streams. While individuals who pay taxes on ordinary income face a top marginal rate of 35 percent, those who pay taxes on long-term capital gains are taxed at a maximum rate of 15 percent.

At first glance, this may strike you as being tremendously unfair. After all, why should super-rich investors like Buffett pay a lower tax rate than many middle-income Americans? The only thing is … they don’t. For one thing, the capital gains tax is a tax on the present discounted value of a company’s future profits. This makes it a double tax because it is being applied to profits that, when earned, will also be subjected to the corporate income tax.

Additionally, long-term capital gains are unique in that they are not indexed to inflation. This means that investors can and often do end up paying taxes on income increases that are purely nominal, which means that they do not represent an increase in actual purchasing power. As former Federal Reserve Board member Alan Blinder once noted, “most capital gains … simply represented the maintenance of principal in an inflationary world.”

It is also important to bear in mind that investors like Buffett aren’t paying a 15 percent rate on income they picked from the money trees in their backyards. You generally have to earn income before you can invest it, which means Buffett and investors like him are paying a 15 percent tax rate on investment yields to income on which they already paid the top marginal rate.

Now that I’ve addressed Obama’s fairness claim, I’d like to address his argument that the Buffett Rule will help to reduce the federal government’s fiscal deficit. This cockamamie argument is utterly laughable on its face and ultimately highlights the fact that this policy proposal is nothing more than a cheap political ploy.

According to the Joint Committee on Taxation, if implemented, the Buffett Rule would increase federal revenues by roughly $47 billion over the next decade. This may sound like a pretty big number, but in actuality it’s not even a drop in the bucket. As the Wall Street Journal points out, this amount would barely cover 0.5 percent of the president’s proposed budget over the same time period.

President Obama has proposed a $3.8 trillion budget for 2013 alone. This means Warren Buffett’s entire net worth of $44 billion wouldn’t even get us through the first five days of the fiscal year! The fact is, if the federal government is serious about getting its fiscal house in order, it will need to drastically cut spending and reform our entitlement programs, not simply raise taxes on the 0.02 percent of filers to whom the Buffett Rule would apply.

If anything, history suggests that lowering the capital gains rate would help the federal government reduce its fiscal deficit. As Wall Street Journal Editor Stephen Moore points out, after the capital gains tax rate was cut by 8 percent in 1981, real federal revenues from the tax increased by more than $7 billion over the following two years. When the rate was cut again in 1997, revenues from the tax rose by nearly $50 billion over three years.

One final point I would like to make is that a low tax rate on long-term capital gains is beneficial not only for rich Americans but for middle-class and poor Americans as well. A high capital gains tax rate penalizes investment and risk-taking, thereby inhibiting long-run growth and job creation. By contrast, a low capital gains tax rate encourages higher levels of investment and risk-taking, thereby spurring innovation, real wealth creation and job growth.

It is a matter of fact that increasing taxes on a scant number of millionaires will do nothing to resolve Washington’s fiscal woes or stimulate our economy. If anything, the Buffett Rule would likely reduce real federal revenues while inhibiting long-run investment and job creation. Clearly this policy proposal was never really about reducing the deficit or stimulating economic growth, nor was it about achieving a greater degree of economic “fairness.”

The purpose of the Buffett Rule has always been to feed into the illusory notion that taxing the wealthy will solve all of our economic problems. It has been to divert our attention away from out-of-control government spending by redirecting that attention towards the investment yields of the risk-takers and job-creators on whom the future growth of our economy depends.

President Obama might think he can win your vote by convincing you that wealthy investors aren’t paying their fair share or that the Buffett Rule will somehow spectacularly manage to get our economy back on track. I implore you not to fall for this ruse and to instead put the pressure back on both political parties to reduce spending, reduce taxes and reform our entitlement programs. Mulcting the rich is easy; implementing smart and substantive reforms is tough. But ultimately, the latter is what’s needed to get our economy going strong.