Much has been made of the “Buffett Rule” when the sage of Omaha skewered the nation’s tax code for giving him a lower effective tax rate than that of his secretary. Since then the President has cited this numerous times in his speeches and public utterances for taxing upper income earners more in order to pay “their fair share.” The Buffett Rule would require households with more than $1 million in adjusted gross income to pay at least 30 percent of it in taxes. But is this really an equitable way for the government to raise revenue? And aside from the class warfare politics what does this approach do for our economy?
Writing in Tuck Today, the journal of Dartmouth College’s Tuck School of Business, Richard Sansing, professor of accounting, says, “not so fast.” While he agrees that framing the analysis in terms of effective tax rates—the ratio of individual income tax to taxable income—is simple and convenient when looking at a single individual tax return, it is highly misleading when one looks at the larger picture.
Warren Buffett, Sansing argues, has a low individual effective rate because dividends and realized long-term capital gains face a 15 percent tax rate, even though other forms of income are taxed at rates up to 35 percent. However, what this fails to acknowledge and which media reports rarely if ever mention, is that the dividend income eligible for the 15 percent tax rate has already been taxed at the corporate level. Hence the individual tax on such dividend is the second tax on the income not the total tax.
Tuck’s professor uses a hypothetical example of a business owner who invests in a “manufacturing plant that generates annual pretax cash flow of $20 million and is depreciated for tax purposes at the same rate that it decays economically. The government collects $7 million annually in tax, and the remaining $13 million is distributed to the owner. A very different picture of the taxes associated emerges if we consider all the income and all the taxes. The pretax income is really $22 million: $2 million ordinary income and $20 million of pretax corporate earnings. The tax on this income in $9.61 million: $7 million paid by the corporation and $2.61 million paid by the owner.” This gives the owner a combined effective tax rate of 43.7 percent. The Buffett Rule would raise this figure even further.
Unfortunately this nuance doesn’t fit the convenient narrative of getting the so-called undertaxed rich to pay their fair share. Regardless of the rate one thinks upper income earners and business owner’s should pay it is dishonest to frame the issue in a way that focuses only on the shareholder tax on dividends while ignoring the corporate tax on the income that made that dividend possible in the first place.
Read: Not So Fast