What's Wrong With the Buffett Rule

It appears that Senator Sheldon Whitehouse (D-R.I.) intends to introduce a "Buffett Rule" bill in the Senate, in line with President Obama's State of the Union call that anybody making over $1 million should be paying at least a 30 percent tax rate. Essentially, it's a proposal for a second Alternative Minimum Tax, though unlike the current AMT, this one would not make provision for lower taxes on capital gains.

It's important to note that this proposal effectively eliminates the tax preference for capital income for very high earners, even though 30 percent is lower than the top tax rate of 35 percent. Essentially any high earner with substantial capital income will end up being subject to the alternative tax; that means he'll face a 30 percent marginal rate not only on capital gains, but also on additional ordinary income, whether from wages or interest.

This is sure to be a powerful wedge issue for Democrats in the campaign. It's also a terrible policy idea. Here's why.

First, the proposal will significantly exacerbate a negative feature of our tax code: the preference for corporate debt finance over equity finance.

A corporation deducts interest payments before calculating its taxable income, and then an individual owner of corporate debt pays tax on interest payments at ordinary income rates. On the other hand, a corporation pays tax on profits after interest expense. These after-tax profits are either distributed to shareholders, who pay tax on the dividends; or they are retained, in which case the stock price rises and shareholders pay tax on capital gains.

Because interest is taxed only once and profits are taxed twice, corporations take on more debt than they would in absence of the tax distortion. The distortion is mitigated by the fact that dividends and capital gains are taxed at lower rates than interest income. Because the Buffett Rule would raise capital gains and dividend tax rates and, in many cases, lower the effective tax rate on interest, corporations would face even more incentive to overleverage themselves.

There is an irony here: one of the criticisms of Mitt Romney's record at Bain Capital is that private equity firms put unhealthy amounts of leverage on the firms they acquire in order to exploit the favorable tax treatment of debt. The Buffett Rule would make that strategy even more attractive.

Second, the rule would also make the United States a significant outlier. Preferential treatment for capital gains isn't an idea that the Republican congress invented in the 1990s. It has been a feature of the United States tax code for more than eight decades and is also present in substantially every other advanced country's tax code. In every G7 country, even the taxpayers with the highest incomes pay capital gains tax at a significantly lower rate than on ordinary income.

The United States has had a preferential rate on capital gains almost continuously since 1922, when it was determined that a top rate of 73 percent was discouraging gains realizations. (The sole exception was for three years from 1988 to 1990, when the top rate on both ordinary income and capital gains was 28 percent.) For most of the last nine decades, the top rate on capital gains has been around 25 percent; but because tax rates on ordinary income and corporate income used to be much higher, this represented a very large tax preference, even when the maximum capital gains rate topped out at 39.9 percent in 1977.

So, a Buffett Rule would not simply mark a return to a time when tax burdens were higher on people with high incomes. It would entail enacting a new form of tax policy not used in other major countries and not used for any sustained period in the United States. It is very cavalier to contend that such a policy would not discourage investment.

Third, the rule is missing an important characteristic: indexation to inflation. Part of a capital gain is not real income at all, but an inflationary return. Let's say that you bought an asset last year for $100 and sold it today for $104, but there was 2 percent inflation. Your real gain was only $2, but you paid taxes of 60 cents (15 percent of $4), for a real tax rate of 30 percent.

This has a couple of upshots. One is that capital gains tax rates are higher than they appear on paper. But another, as I wrote in 2010, is that higher capital gains taxes are likely to entrench opposition to dovish monetary policies. When higher inflation means a higher real capital gains tax rate, investors are likely to fight for lower inflation rates, even if their investment portfolios are not inherently geared toward benefitting from a low-inflation environment.

Of course, this is also a problem with the existing tax code. But raising the capital gains tax rate increases the importance of non-indexation. A Buffett Rule could include indexation—some other countries that tax capital gains do index those gains—but an indexed capital gains tax would not raise as much revenue at any given rate.

So, if we shouldn't enact a Buffett Rule, what can be done to improve equity in the tax code? My City Journal article from the fall provides a good overview of my views. Broadly, I think we should move toward a system of corporate taxation that treats debt and equity investment equally, by taxing corporations on their income before interest expenses. Then, individuals should pay a progressive income tax on wages, with many fewer deductions than are currently available.

I don't see a compelling reason to tax capital income twice (at the corporate level and again at the individual level.) But if it is to be taxed twice, debt and equity should be taxed at the same rates, and capital gains should only be taxed to the extent they exceed inflation.

I am not wedded to a particular top rate on wage income; indeed, I think many of the tax reform plans being discussed today (such as Bowles-Simpson) unwisely fetishize top rates below 30 percent. Such plans only achieve much lower rates on wage income by subjecting capital to markedly worse tax treatment than it gets today. If the top rate stays at 35 percent, or even rises, that is fine with me so long as the tax base is reasonably broad and capital income is not double-taxed.

This piece originally appeared in Forbes

This piece originally appeared in Forbes