'Burden-Sharing' Basics

by Alan Reynolds at http://www.cato.org


This article appeared in The New York Post on September 20, 2011. 

Warren Buffett, the chairman of Berkshire Hathaway, has been complaining that he pays a lower tax rate than his secretary — and President Obama says he wants to fix this. Good luck.

Buffett is the second-wealthiest man in America, but he's way down the list when it comes to income reported to the IRS. What little income he reports from his wealth is long-term capital gains — which is why his average tax is closer to 15 percent (the cap-gains rate) than 35 percent.

What Obama and Buffett ignore is the fact that people like Buffett go to great lengths to keep much of their money "invisible" to the taxman.
In his New York Times oped last month, Buffett complains that his federal income tax last year was "only 17.4 percent of my taxable income" — less than $7 million on a taxable income of about $40 million. He claims that other "mega-rich pay income taxes at a rate of 15 percent on most of their earnings." That's just not true: The average income-tax rate of those earning between $1 million and $10 million was 29.5 percent in 2009, according the same IRS data that Buffett cites.

Now, raising income-tax rates, as both Obama and Buffett propose, would barely affect Buffett: His actual salary is only $100,000 (which also explains how he pays less than his employees do in payroll taxes for Social Security and Medicare).

What if we raise tax rates on dividends and capital gains, too? The Berkshire Hathaway holding company is itself a way to own dividend-paying stocks without paying taxes on the dividends. Buffett is famous for collecting stocks with a generous dividend yield without Berkshire itself paying any dividend; the holding company reinvests the dividends it receives in buying more stocks, so Berkshire ends up with more assets per share (which should result in capital gains, but more on that later).

And nobody with substantial wealth can be forced to actually sell an asset and so pay capital-gains tax — which is why the government can't afford to raise this tax, particularly on those most likely to pay it.

In 1977, the capital-gains tax was 39.9 percent — and realized gains amounted to less than 1.57 percent of GDP. From 1987 to 1996, when the tax was 28 percent, realized gains rose to 2.3 percent of GDP. Since 28 percent of 2.3 is larger than 39.9 percent of 1.57, the lower tax rate clearly raised more tax revenue.

From 2004 to 2007, when the cap-gains tax was 15 percent, realized gains amounted to 5.2 percent of GDP — so again, the lower tax rate raised more tax revenue.

What's going on? With the lower cap-gains rates, taxpayers are more willing to sell assets and pay the tax — so the government's getting to tax more income. So "the rich" are paying more total tax than they would have at a higher cap-gains tax rate.

Mind you, they're paying a lower average tax rate even as they pay more in taxes, because the cap-gains rate is lower than the tax rate on salaries. But they're still doing more of the "burden-sharing" that the president likes to talk about, because they're letting the tax man at more of their wealth.
It is easy to advocate a higher tax rate on capital gains, but it is even easier to avoid paying that higher tax rate. Choosing to pay tax on capital gains and dividends is usually voluntary — and when the rate gets too high we run short of volunteers.

In 1977, with super-high tax rates of 39.9 percent on capital gains and 70 percent on dividends and salaries, federal revenues were 18 percent of GDP. In 1992, revenues were only 17.5 percent of GDP. In 2007, thanks in large part to a 15 percent tax rate on capital gains and dividends, revenues were 18.5 percent of GDP.

To hold out the tax policies of 1977 or 1992 as examples of effective ways to raise more revenue is ludicrous. It didn't work then and it wouldn't work now.