Ottawa Citizen: The trouble with the Buffett Rule

If you are Rip Van Winkle awakening from 20 years’ slumber, you might not know about the Buffett Rule. But almost everyone else does. Named after billionaire investor Warren Buffett, it would establish a minimum tax rate of 30 per cent on people earning over a million dollars.

Buffett proposed the rule to remedy what he sees as the inequity of his effective tax rate being lower than his secretary’s, despite her income being, ahem, somewhat lower.

Is the Buffett Rule a good idea? This is a question that is relevant in Canada as much as in the United States. Tax policy is one of the things that is increasingly marking out the policies of the tax resistant Tories vs. the tax-friendlier NDP and the schizophrenic Liberals.

On the surface there is something pleasingly simple about the Buffett Rule. Taxes should be based on ability to pay, and people who make a lot of money should pay a bigger share of it than people on low incomes. Hence a rule that sets a high minimum tax for the biggest earners to ensure that they don’t use the tax rules to escape paying their “fair share.”

The concept of fair shares, however, is itself not simple. The top fifth of U.S. earners earn nearly 55 per cent of the income, but pay nearly 70 per cent of all federal taxes. In other words, the U.S. already has a quite progressive tax system, Mr. Buffett notwithstanding.

In thinking through the desirability of the Buffett Rule, you might want to start by asking why Buffett pays a lower tax rate than his secretary. Sure, some tax provisions disproportionately benefit the rich (like mortgage interest deductibility and tax-free municipal bonds) and perhaps should be changed. But his tax rate has more to do with the fact that there are different kinds of income (chiefly wages, dividends and capital gains) and the tax system treats them, well, differently.

Take dividends. Dividends are the profits distributed to a company’s owners, its stockholders. But before the company can distribute its profits it has to pay corporate income tax.

In other words the profits, which belong to the shareholders, have already been taxed before they reach their rightful owners. If, once received, they were then subject to the taxpayer’s full personal income tax rate, the effect would be double taxation of the same corporate profits — once in the hands of the company, and once in the hands of the taxpayer to whom they belong.

Double taxation is unfair and we try hard to avoid it. In Canada, for example, dividend income in the hands of the individual is adjusted to reflect the corporate tax already paid.

But then if you compare the direct tax bill of an individual who earned $50,000 in dividends and one who earned $50,000 in wages, they’d be different. Hence the superficial appeal of the Buffett Rule. It depends on a demagogic sleight of hand: comparing the tax rate on pre-tax wages vs. the rate on dividends already taxed once.

Now consider another source of income for the Warren Buffetts of this world: capital gains. Capital gains are taxed at a lower rate than employment income. Again, there are good reasons for this.

Capital gains are earned when people take risks investing their money. Such risk-taking and innovation play an absolutely central role in our economy. We are constantly lamenting that there aren’t more risk takers and innovators in Canada. But we can’t have it both ways. One of the ways we recognize both the risky nature of such investment, and the hugely useful social role it plays, is by using the tax system to encourage people to use their capital to create investment, jobs and profits. Capital gains are therefore usually taxed at favourable rates compared to employment income.

There is another reason to tax capital gains relatively lightly. When in 1981 U.S. president Ronald Reagan cut the capital gains tax from 28 to 20 per cent, revenues rose by a third. When he later put the rate back up to 28 per cent, revenues fell from $328 billion to $112 billion. In 1996, Bill Clinton went back down to 20 per cent; investment and revenues again rose handsomely.

There is nothing unique about this. When you tax something more heavily, you get less of it. If we as a society want more risk-taking, more investment, and more tax revenues those activities generate, then we are smart to use the tax system to encourage them. The Buffett Rule does the opposite. Warren Buffett is therefore only the latest example of someone who understands how to make money, but not the system that allows him to do so. If he invested with the care he gives his tax proposals, his secretary’s income might look good to him.

Brian Lee Crowley is managing director of the Macdonald-Laurier Institute, an independent non-partisan public policy think-tank in Ottawa: (macdonaldlaurier.ca).