Want to tax capital and income equally? Try the Buffett rule.

November 27, 2012

Warren Buffett (Daniel Acker -- Bloomberg)

Enthusiasm is building for a "minimum tax" for the wealthy, in which millionaires would have to pay, say, 30 percent of their income in taxes, no ifs or buts. Republicans in Congress have floated taxing the entire income of high-earners at 35 percent, while Warren Buffett has renewed his call for a minimum tax of 30 percent for millionaires.

The appeal of these proposals is fairly evident, as they would deny high earners the chance to use deductions and other tax breaks to lower their effective tax rates to levels far below what middle-class people pay. But there's one big problem. It's tough to implement a minimum tax without sharply raising marginal rates on capital gains.

Take the Buffett rule. Dan Baneman at the Tax Policy Center ran the numbers on the Pay Your Fair Share Act, Sen. Sheldon Whitehouse's version of the rule. Whitehouse's bill stops short of an actual minimum tax for all millionaires, as it phases in slowly as income goes from $1 million to $2 million.

As a consequence, marginal rates on wage income don't change that much. Compared to current policy, they're slightly higher between $1 million and $2 million (36.2 percent to 35.6 percent) but actually slightly lower above that (35.7 percent to 36.5 percent). So the lowest-earning millionaires pay more out of the next dollar they earn, whereas the highest-earning ones pay less.

But the story is dramatically different for capital gains income. There, marginal rates skyrocket as one goes from $500,000 to $1 million, reaching about 35 percent. That's above where the capital gains rate was in the 1940s and '50s, when the regular income tax rate was around 90 percent. Even then, capital gains rates were around 25 percent:

That's a problem for a number of reasons. Ideally, you don't want the capital gains tax to deter investment. But there's no good reason why we should encourage investments for earners making under $200,000 or so but discourage them for earners making above that. It makes sense on progressivity grounds, but not as a growth policy.

And that's assuming we want to tax capital at all. The consensus among most economists, including models from noted lefties like Oxford's Tony Atkinson and Columbia's Joseph Stiglitz, is that we shouldn't be taxing capital gains at any rate, let alone 35 percent. Thomas Piketty and Emmanuel Saez, in arguing for any taxation of capital, note that they're in the minority, and argue that the United States and Europe should be collecting less revenue from the taxes than they are currently.

One could structure a minimum tax such that capital gains are excluded, but that would raise much less revenue, as much of high earners' income comes in the form of capital. That would also lose some of the proposal's appeal as a fairness measure, and make it easy for professional investors like Buffett to evade. So supporters of minimum taxes have to ask themselves whether they can stomach imposing a sharp disincentive on investment for high earners.

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Dylan Matthews · November 27, 2012