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"Buffett Rule" Is a Sorry Excuse for Tax Reform

Author: Sebastian Mallaby, Paul A. Volcker Senior Fellow for International Economics
April 13, 2012
Financial Times

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No reasonable person can doubt that the US must eventually raise taxes. The country is running an unsustainable budget deficit. Its tax take, measured as a share of gross domestic product, is the lowest in the OECD. The 1990s suggest the US can raise revenues without damaging growth. Other countries have also managed similar feats. Sweden, for example, which collects 53 per cent of GDP in taxes, has grown faster over the past decade than the US, which collects 32 per cent, counting state and local government. From all this it follows that a distressingly large slice of the Republican party is unreasonable.

Equally, no reasonable person can doubt that the tax system must be used to soften inequality. Some inequality is good: it is a spur to enterprise and effort. But too much is clearly bad: it punctures meritocracy. As gaps in wealth and income have widened, it has become steadily harder for talented poor kids to compete against lavishly tutored rich kids armed with iPhones full of contacts. This is politically corrosive, morally unjust, and a shocking waste of human capital.

All this suggests Barack Obama is right to call for a "Buffett tax". Yet in doing so, the president reminds us of why he is a disappointment.

How so? After all, the tax would raise welcome revenue by ensuring that Americans with incomes of more than $1m pay a federal tax rate of at least 30 per cent – hardly onerous by historical or international standards. The Buffett tax is also politically clever: not even the most avid anti-tax Republican will defend a system in which a billionaire pays a lower rate than his secretary. Coming in the week that Mitt Romney has all but sewn up the Republican presidential nomination, Mr Obama's focus on the Buffett tax serves to remind voters of his opponent's embarrassingly low tax rate. One marvels at the hubris of a candidate who imagined he could run without this becoming an issue.

But the larger point is this: a clever campaign gambit is a poor substitute for a serious proposal. By focusing his rhetoric on the Buffett tax, Mr Obama is fumbling his best chance to win a mandate for intelligent reform – reform, moreover, that ought to be the centrepiece of a second term.

Millionaires enjoy tax rates below 20 per cent because the tax code is littered with complex distortions. The Buffett answer to this problem is, paradoxically, more distortion. The idea is that the rich should calculate (or pay their accountants to calculate) their tax liability. Then, if it comes to less than 30 per cent of their incomes, they should comply with the alternative Buffett minimum. This creates interesting incentives for families earning $950,000 and paying 15 per cent to the Feds. Presumably they will not want to earn an extra $50,000.

Rather than buffeting the rich this way, it would be better to close their tax loopholes. The most obvious is the scandalous mortgage-interest deduction, which is as regressive as it is costly. Americans are allowed to deduct interest payments on mortgages up to $1m from their taxable income. Clearly, only the rich have mortgages that size. Equally clearly, the value of the deduction goes up when you are rich enough to fall into the top tax bracket. You might have thought that in the wake of the financial crisis, Mr Obama could summon up the courage to end subsidies for leverage. Apparently he is scared of the mortgage-industrial complex.

Next, Mr Obama could back the equalisation of tax on investment income and ordinary income. Again, this could raise revenues and be more progressive at the same time; most investment income flows to the rich, and goes a long way to account for the low rates paid by Messrs Buffett and Romney. To avoid the double taxation of dividends, Mr Obama could also abolish corporate tax, which is cumbersome and ineffective. The equalisation of taxes on capital gains and salaries is not some kooky leftist scheme. It was embraced by Ronald Reagan.

One could go on: the US tax code has more crazy kinks than a Broadway performer's hairdo. Assorted credits, exemptions and deductions deprive the government of an astonishing $1tn per year, dwarfing the $5bn or so that the Buffett tax would raise. If Mr Obama had the mettle to tackle these distortions, he could fix the budget deficit, curb inequality, and even boost incentives by cutting marginal tax rates. The president has the eloquence to explain this to voters. But he lets himself be imprisoned by political aides, whose job is to win the election, not serve their country.

The writer is Paul A. Volcker senior fellow at the Council on Foreign Relations.

This article appears in full on CFR.org by permission of its original publisher. It was originally available here (Subscription required).

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