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Sunday Pearlstein: On billionaires, secretaries and taxes

at 08:00 AM ET, 11/27/2011

This past summer, billionaire Warren Buffett dusted off an old line about how his secretary pays a higher tax rate than he does, and ever since there’s been a running debate over tax fairness.

The reason Buffett’s overall tax rate may be lower than his secretary’s
Berkshire Hathaway Chairman Warren Buffett helped stoke a broader debate about tax fairness. (RICK WILKING/REUTERS)
is because nearly all of his income comes in interest payments, dividends and profits on the sale of stocks and bonds known as capital gains. Under the George W. Bush tax cuts, the tax rate on this “unearned” income was reduced to a flat 15 percent, a level below the effective tax rate for most households earning more than $100,000 a year (Buffett’s is no ordinary secretary!).

From one angle of view, this seems absurd, particularly in a country that boasts of a progressive tax code. With that in mind, President Obama has weighed in with what he called the “Buffett rule,” proposing a minimum effective tax rate on all income, irrespective of its source. Subsequent proposals have taken the form of a surtax of about 5 percent on income of over $1 million.

But from another angle, the “Buffett Pays Lower Tax Rate Than Secretary” story looks to be something of a statistical mirage.

For it turns out that those dividends and capital gains for which the billionaire is taxed at the 15 percent rate are already taxed at the corporate level by way of the federal tax on corporate profit.

The official tax rate for most corporate profit in the United States is 35 percent, but because of the myriad deductions and credits written into the tax code, the average effective rate is about 27 percent. Once the tax is paid, the profits can go in either of two directions. The company can distribute them to shareholders as dividends. Or they can retain the profits in the company, which has the effect of increasing the value of the company’s stock and thereby generating higher capital gains when the shares are sold. Either way, the profits eventually make their way to the tax returns of the shareholders, where they are taxed again at the special 15 percent rate. The two add up to what looks like an effective federal tax on investment income of 42 percent, several times the tax rate paid by middle-class secretaries.

This “double taxation,” as you might imagine, is a cause celebre among anti-tax conservatives, but it is not quite the problem they make it out to be. While it is true that the check for the corporate tax comes from the company -- and thus from its shareholders -- economic theory and empirical studies suggest that at least a portion of corporate taxes are eventually passed on to workers in the form of lower wages or consumers in the form of higher prices.

I won’t bore you with the details of these studies, other than to report that there is no clear consensus among economists on the “incidence” of the corporate tax burden. The reality of who actually pays depends on the relative competitiveness of the industry involved, the tightness of the labor markets and the level of competition for investment dollars at any point in time. Making certain unrealistic assumptions, it is possible to show that workers and consumers pay all of the corporate tax. Making other unrealistic assumptions, you can reasonably conclude that the full burden of the corporate tax falls on shareholders. But by making more reasonable assumptions about less than perfectly efficient and competitive markets, it would appear that shareholders typically pay about half of the corporate tax.

So where does all this leave us in terms of tax fairness? Well, if you take an effective tax rate on corporate profits of 14 percent for the shareholders (about half of the effective 27 percent corporate rate), and add to that a 15 percent tax on the shareholder’s dividends and capital gains, you wind up with a combined tax on investment income of 29 percent. By contrast, a household earning $150,000, for example, typically has an effective federal tax burden of about 17 percent of income.

Even liberal tax reformers concede double taxation of corporate profits is not fair or economically desirable. They prefer proposals to “integrate” the corporate and individual income taxes. These usually involve passing through to shareholders their share of the taxes on corporate profits, as partnerships now do, or giving each shareholder a tax credit equal to her share of the taxes paid by the company. My back-of-the-envelope calculations suggest that these would largely have the same effect as the lower rate on investment income, only with a lot more complication and a lot more political pushback about eliminating the corporate profits tax.

Rather, if your aim is to raise additional tax revenue, why not do it by eliminating or reducing the impact of all those deductions and credits, which are used disproportionately by the wealthy to lower the taxes on their “earned” income? This would make the tax code fairer, simpler and more progressive. And as part of the same reform, it would certainly make sense to slightly raise the tax on “unearned” income as well -- say from 15 to 20 percent, as Obama has proposed.

To my mind, however, the better way to reform the tax code, and make it a bit more progressive, is to go back to an old idea -- a progressive consumption tax - first proposed by Sens. Sam Nunn and Pete Domenici two decades ago and recently revived by Cornell University economist Robert Frank in his new book, “The Darwin Economy.”

A progressive consumption tax would work like the current income tax, with one big exception: Any income earned from investments would be taxed only if and when it is used to buy goods and services; investment income that is reinvested would not be taxed at all. Under such a tax regime, it would be as if all your savings were put into one big tax-free investment account, with taxes paid only when money is withdrawn. Money borrowed for purposes of consumption would also be taxed.

A progressive consumption tax would be a big step forward for a country where household savings has been woefully inadequate and borrowing for current consumption has risen to dangerous levels. And as Frank likes to point out, such a tax would also discourage the unproductive “arms races” in which the wealthy now use their money to bid up the price of scarce “positional” goods such as houses in the Hamptons, luxury cars and tuitions at elite private schools and colleges.

Of course, it’s perfectly possible under a progressive consumption tax that Warren Buffett could pay less in taxes than his secretary - but only if he were willing to live a lifestyle as modest as hers.

 
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