How Would the Buffett Rule Affect Marginal Tax Rates?

By :: February 14th, 2012

The Paying a Fair Share Act of 2012 (PFSA) – Congress’ first crack at legislating the Buffett rule – would apply a broad-based 30 percent minimum tax for those earning more than $1 million a year. We have a pretty good idea of how this would affect people’s taxes: it would substantially raise them but only for relatively few high-income taxpayers.

Of course, economists don’t just want to know the total tax burden; we also care about incentives. So we looked at how PFSA would affect the amount of tax people pay on their next dollar of income – that is, their effective marginal tax rates.

We care about marginal rates because they measure the tax disincentive for earning additional income. High effective marginal rates on wages may discourage work effort, and high effective marginal rates on capital gains may distort investment decisions and discourage realizations of capital gains. Beyond generating efficiency loss, these reductions in realizations would mitigate the revenue pickup from raising capital gains rates.

Since effective marginal rates depend on all taxes applied to work effort and capital gains and include the effects of tax preferences, the statutory rate brackets in the income tax are only part of the story. Wages face an additional 7.65 percent payroll tax on both the employee and employer, so payroll taxes contribute an extra 14.2 percentage points to the marginal tax rate on pretax earnings (15.3 divided by 107.65, the gross wage including the employer tax). However, earnings above the Social Security wage threshold face only the Medicare Hospital Insurance (HI) tax, which is 1.45 percent on both employees and employers, for a total rate of 2.86 percent (2.9/101.45). And earnings above $125,000 (or $250,000 for joint filers) get hit with an additional 0.9% surtax starting in 2013.

Meanwhile, capital gains and qualified dividends face a top rate of only 15 percent – plus an additional 3.8 percent on net investment income for high earners beginning in 2013, courtesy of health reform. Various phase-ins and phase-outs in the tax code complicate things further; for example, taxpayers in the AMT exemption phase-out range face effective marginal rates several percentage points higher than their statutory rates on both earnings and capital gains.

Effect of PFSA on effective marginal tax rates against current policy

How would PFSA affect all of this? TPC estimates that the proposal would increase average effective marginal rates for high-income taxpayers – but not for all types of income. Effective marginal tax rates on capital gains would nearly double from 18 percent (under current policy) to 34 percent for taxpayers with incomes between $1 million and $2 million, and would climb to 29 percent for taxpayers with incomes over $2 million. That jump shouldn't come as a surprise. As Warren Buffett has been telling us, high-income taxpayers who face low tax rates tend to have lots of capital gains, which are currently taxed far below the fair share tax rate of 30 percent. (If you’re wondering, taxpayers with incomes between $1 million and $2 million face a higher effective marginal rate than taxpayers with incomes over $2 million because the fair share tax phases in over that range.) Capital gains realizations would fall dramatically in response to these high marginal rates, which – according to some estimates – would actually exceed the revenue-maximizing tax rate on capital gains.

The average effective marginal rate on wages actually decreases slightly for those with very high incomes. While this seems counterintuitive, it actually makes sense. Between income and payroll taxes, most high-income taxpayers already face a marginal rate above 30 percent on their wages. If they end up on PFSA – most likely because their capital gains pull their average tax rate down below 30 percent – their 30 percent marginal rate on earnings will actually be less than they were paying before.

Yes, raising taxes on a couple hundred thousand of the highest-income Americans sounds awfully appealing. But narrowly based tax increases often come at an efficiency cost. And in this case, the most likely source of efficiency loss comes from discouraging realizations of capital gains.

16Comments

  1. How Would the Buffett Rule would Affect Marginal Tax Rates? | Tax Information  ::  5:51 pm on February 14th, 2012:

    […] here to read the rest:  How Would the Buffett Rule would Affect Marginal Tax Rates? Posted in News Tags: buffett, capital-gains, congress, effective, employee, marginal-rate, […]

  2. Vivian Darkbloom  ::  7:45 am on February 15th, 2012:

    Thanks for pointing out the (dis)incentive effects of this type of legislation. The behavioral responses to this (and similar proposals in the Obama budget) will result in much less revenue than projected. Even though the PFSA is entitled “A bill to reduce the deficit…”, a few years down the road, the same folks will be back for more (Note well, Mr. Binder). In the meantime, we’ll be lulled into thinking we can keep up the spending.

    I can also see why the PFSA is billed “The Buffett Rule”. The minimum tax of 30 percent is generally based on adjusted gross income (AGI). But, careful reading of the bill reveals that there is an adjustment for charitable contributions taken as itemized deductions. This seems tailor-made for Mr. Buffett, indeed.

  3. Michael Bindner  ::  11:56 am on February 15th, 2012:

    Discouraging realization in capital gains might be a good thing, if dividend and capital gains incentives lead to both unsound investments (like the tech boom) and efforts to reduce labor costs and increase profit. I suspect this proposal is political window dressing rather than something to be taken seriously, however costing it out is useful.

    Aside from low capital gains and dividend rates, the real reason for a Buffett rule is the income caps on Social Security. Dealing with that, which has some consensus on both sides of the aisle, seems the wiser course.

    I am not necessarily in agreement with raising the cap on the employee contribution. I would rather lower the cap, which lowers benefits for higher income retirees, while converting the employer payroll tax to an uncapped VAT or VAT-like Net Business Receipts Tax (if personal accounts holding employer voting stock are included), with the employer contribution being credited equally to each worker – regardless of income level – so that workers with similar longevity have the same voting strength.

  4. Michael Bindner  ::  12:06 pm on February 15th, 2012:

    At least spell my name correctly. And use yours so we may know what skin you have in the game. The point of a rule like this should not be raising revenue at all, but to reduce incentives to cut costs and increase profits at the expense of workers. In the long run, this makes the economy more sustainable and less reliant on consumer debt (and the need for the Central Bank to accomodate it). Had Clinton not been talked into Gingrich’s capital gains cut in the first place (by Larry Summers), the tech boom would have been more muted, if it happened at all, and there would have been no boom in tax revenue for IPO realizations, which skewed projections that led to unsustainable state and federal tax cuts. Comprehensive tax reform that bumps the capital gains rate to more reasonable levels is desireable to this end – say 28% – while lowering marginal and corporate top rates to the same level. Sounds like Simpson-Bowles to me.

  5. AMTbuff  ::  3:11 pm on February 15th, 2012:

    Dan, can TPC please explain why its marginal rate estimates of the Whitehouse bill differ so dramatically from the 90% maximum marginal rate calculated at http://www.taxfoundation.org/blog/show/27972.html ?

    Is the TPC saying that the 90% is not a problem for the $1.8M income taxpayer because a $1.2M taxpayer has a much lower rate, so it averages out? If so, I call that highly misleading, bordering on deceptive.

    There is no way that the TPC experts could have missed this structural defect in the Whitehouse bill. It needs to be corrected. It can and will be corrected if the bill advances. TPC had better publish a clarification or risk its hard-earned reputation for playing it straight.

  6. Vivian Darkbloom  ::  3:12 pm on February 15th, 2012:

    Mr. Bindner,

    The misspelling of your name was not intentional. It was a typo. Sorry about dropping the second “n”. Stuff like that happens, but I”m sorry anyway. As for mine, rest assured that I have as much skin in the game as you do (or as little, however you want to interpret that). Base your criticisms on the substance of my comments; I’ll do the same with yours. And, you can call me Viv, Vivian, Darkbloom, Ms Darkbloom, or Ms Darkboo, or anything else if you like (so long as it does not get creepy). I’m primarily interested in whatever substance your comments might have.

    As to the substance of your remark, as I noted, the express purpose of the proposed legislation is to “reduce the deficit” as prominently advertised in the preamble and that is how it is being marketed and sold. We indeed have a deficit problem; however, your explanation of the link between the lowering of the capital gains tax rate, the IPO boom, subsequent tax rate cuts, the Federal Reserve actions and the current deficit problem rather reminds me of the nursery tale “The House that Jack Built”. In other words, the link between that rate cut and the successive results you attribute to it seems rather tenuous, at best. Many developed countries do not have any tax on capital gains at all. Yet, they managed to avoid an IPO bubble. I don’t think you can attribute all that you claim to an 8 percent reduction in the long-term capital gains tax rate that happened *in the middle* of that bull market.

    And, I would be interested in your reaction to the following:

    1. If the capital gains tax rate is increased, how does that *reduce* the incentive (of managers of capital) to cut costs? I suppose you are thinking that if capital gains rates are increased, this would decrease the marginal return of reducing (labor) costs because each dollar of reduced costs provides a lower after-tax return to investors. On the other hand, have you considered that it might encourage increased cost cutting in order that investors might acheive a more reasonable after-tax return? And, would not lower capital gains rates increase investment and therefore employment? This seems the consensus among most economists. If we increase the capital gains tax rate to 100 percent, what effect do you think that would have on employment? Why should the allocation of capital andinvestment be affected at all by tax rates, unless you are talking about” Pigovian taxes”? And, If the incentive runs in the direction you claim, would not decreasing the rate of tax on corporate income (as you recommend) have the same negative effect on labor, but even more directly so?

    2. How does “increasing profits” necessarily come at the expense of workers? I would think that increased corporate profits (caused by lower tax rates) allow higher wages to workers (this is the argument of those who claim corporate taxes are borne, at least in part, by labor).

    3. Finally, how about that scoring issue? I’ve fairly challenged you, which frankly should be done when someone makes unsubstantiated assertions, as you have in response to my earlier comment. Don’t take this personally, but are you going to give me the courtesy of a reply?

    Best,

    Viv

  7. Tai Shan  ::  4:17 pm on February 15th, 2012:

    The Tax Foundation’s calculation differs from the way the tax is calculated in the actual legislation. TF just multiplied the phase in percentage by 30% of AGI, while the bill multiplies the phase in percentage by [30% of AGI *minus regular tax, payroll tax and AMT*]. It makes a difference.

    In other words, TF got their 90% marginal rate the old-fashioned way — by a mistake in arithmetic.

  8. Nick Kasprak  ::  5:04 pm on February 15th, 2012:

    Hello – as the author of the Tax Foundation’s analysis I’d love to hear more about this, because if it’s the case I’ve read the bill wrong then I’ll certainly change it. I don’t think this is right, though – the PFSA tax is calculated as:
    [phase-in %]*[30%]*[modified AGI] (where modified AGI is basically just AGI minus charitable contributions).

    The reference to subtracting out regular tax, payroll tax, AMT and so forth means is just the bill’s way of defining the excess of the new minimum tax over what the taxpayer’s liability would otherwise be – in other words, total tax liability is your normal tax plus the amount you need to get to the PFSA minimum.

    The high marginal rates I describe in my blog post obviously only apply if you’re subject to the PFSA minimum, and there are a significant number of taxpayers in the $1 to $2 million range who wouldn’t be. That is why TPC’s average effective marginal rate is much lower. I don’t think there’s a contradiction here – my analysis shows the maximum possible marginal rate, where TPC’s shows an average.

    Again, if I’ve misread the bill somehow then I’d love to know, but at the present I stand behind my analysis – PFSA makes a 90% effective marginal rate possible under specific circumstances.

  9. Tai Shan  ::  8:25 pm on February 15th, 2012:

    Let’s parse the bill text linked on the TF website:

    (a)(1): additional tax equals phase-in times the (a)(2)amount

    (a)(2) ‘amount’ equals ‘tentative fair share tax’ defined in (b) minus [regular income tax + AMT tax + payroll taxes]

    (b) ‘tentative fair share tax’ = 30% * [AGI – charity (as modified)]

    Try an example. Suppose AGI is $1.8 million and no charitable contribs. Suppose tax liability under regular tax, AMT etc. is $400K. TFST = $540K, the (a)(2)’amount’ = [$540K – $400K] = $140K and phase -in percentage is 80%. Additional tax = .8 * $140K = $112K.

    Now, try adding another $10K of income with a regular tax rate of 35%. TFST is now $543K, ‘amount’ becomes $543K – $403.5K = $139.5K and phase-in % becomes 81%, for an additional tax of $112,995. The effective marginal rate is [$3,500 + $995]/$10,000 = 44.95%. If the additional $10K is a capital gain taxed at a 15% regular rate, the effective marginal rate under the bill becomes 41.15%.

    It turns out that the effective marginal rate under the proposal is a function of each taxpayer’s current *average* rate on all income as well as their marginal regular/AMT rate on the additional income. The only time one gets near an 80% or 90% rate under the proposal is if a taxpayer now has an average rate near zero. It would have to be a pretty odd shaped return — maybe lots of investment interest — to pay zero tax on an AGI near $2 million.

  10. Vivian Darkbloom  ::  11:37 pm on February 15th, 2012:

    This seems to be correct—and at the same time an admission that it is possible to have a maximum effective marginal rate of 90 percent “under specific”, albeit rare, circumstances.

    One of the reasons those circumstances should be rare is the assumption made in the bill that the Pease limitations under section 68 will again enter into force. If it were not for the Pease limitations, the instances in which there would be a wide gulf between regular/AMT taxable income and AGI would be much more common. In other words, the Pease limtations should bite first. And, are we to layer this on to the proposal to limit the benefit of itemized deductions to 28 percent? This is not tax code simplification.

    In this respect, it is again relevant to return to Mr. Buffett. The modification to AGI for charitable contributions to arrive at the “tentative fair share tax” is *before* the section 68 (Pease) limitation. This reduces even further the chance that Mr. Buffett will ever be affected by the rule that bears his name.

    And, a jump to an effective marginal rate of, say, 41.15 percent on capital gains is nearly triple the current rate. The regular marginal rate on dividends is proposed to be increased to 43.4 percent (39.6 + 3.8) which is even closer to triple the current rate. If this is to be taken seriously, Mr. Obama will be very lucky if the sell-off does not occur before the third week of November.

  11. Vivian Darkbloom  ::  12:43 am on February 16th, 2012:

    “Discouraging realization in capital gains might be a good thing, if dividend and capital gains incentives lead to both unsound investments (like the tech boom) and efforts to reduce labor costs and increase profit. ”

    Mr. Bindner,

    I have addressed this issue somewhat in my comment to you below; however, the specific notion outlined above bears further inquiry because I’m interested in your thought process. A lower rate of tax on dividends and capital gains does not, per se, “encourage unsound investments”, although it does encourage investment generally. It also comensates somewhat for the lack of integration between our corporate and individual tax systems. The rates are neutral, as they should be, as to whether one invests in a tech company, a home builder, an industrial manufacturer, a public utility, etc (I do note here, however, that the administration proposes a lower rate for relatively more speculative “small business stock”).

    If your thinking is that a higher rate of tax on CG and dividends would encourage “safer” investments, what type of investments are you thinking of? Municipal bonds that are not subject to federal tax at all? Corporate bonds which reduce the corporate income tax base and which are equally susceptible to capital gains and losses (and which Mr. Buffett recently commented are currently much more “dangerous” than equities)? Or, are you suggesting that we simply lend our money to the US federal government so that they can spend it? (Never mind that those bonds, too, are speculative and generate capital gains and losses). Preferring debt to equity sounds like an unsafe proposition to me. Or, are you suggesting that we not save and invest our money at all?

  12. How Would the Buffett Rule Affect Marginal Tax Rates? « Donald Marron  ::  8:28 am on February 16th, 2012:

    […] Daniel Baneman has examined how the PFSA would affect marginal tax rates — i.e., the effective tax rate that would apply […]

  13. Nick Kasprak  ::  9:59 am on February 16th, 2012:

    You’re right. I screwed up and misread how the phase-in works – the quantity that is phased in is the excess of the PFSA minimum over regular tax liability, not the PFSA minimum itself. I’ve put out a retraction and correction on TF’s blog. Thanks for pointing this out.

  14. Analysis of The Buffett Rule | Crowhill Weblog  ::  8:22 am on April 10th, 2012:

    […] I was reading a little on the so-called “Buffett Rule” and came across a bit of analysis from The Tax Policy Center. See How Would the Buffett Rule Affect Marginal Tax Rates? […]

  15. Want to tax capital and income equally? Try the Buffett rule.  ::  10:09 am on November 27th, 2012:

    […] 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. […]

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