Posted by: bmeverett | September 22, 2011

The Buffett Rule

I have devoted most of the space in this blog to energy issues, but I have also tried to dispel some of the economic myths that pervade our public debates on energy and everything else. President Obama’s new jobs bill is based on several such myths. In his September 21 speech, President Obama called said about his tax proposals, “It’s not class warfare. It’s math.” I agree, let’s do the math. My first attempt at this piece took on too many issues, so I will offer three different postings over the coming weeks on: (1) The Buffett Rule, (2) capital gains taxes and (3) income tax equity.

Democrats have been popping champagne corks ever since multi-billionaire Warren Buffett complained that his tax rate was lower than his secretary’s. What more proof do we need that our tax system soaks the middle class for the benefit of the rich? On examination, however, Mr. Buffet’s claim makes no sense. Here’s the math. Mr. Buffett derives most of his income from Berkshire-Hathaway (BH), a publicly traded investment company whose primary business is insurance. According to the company’s proxy statement, Mr. Buffett owns roughly 40% of the shares in this company and is thus entitled to 40% of its profits. Page 31 of BH’s annual report states that the company had roughly $19 billion in profits in 2010. If there were no income taxes of any kind, Mr. Buffett would be entitled to 40% of BH’s earnings or $7.6 billion. The BH annual report also states, however, that in 2010 the company paid $5.6 billion in corporate income tax – a rate of 29½%. Although BH wrote the check to the IRS, the burden fell on the shareholders, including Mr. Buffett, whose share of earnings was therefore reduced from $7.6 billion to $5.4 billion. If Mr. Buffett had decided to take all his BH earnings in the form of dividends, he would have paid an additional 15% income tax or $0.8 billion on his own IRS Form 1040. Starting from his $7.6 billion share of BH earnings, Mr. Buffett would end up with $4.6 billion – an effective tax rate of roughly 40%, not counting any state income taxes he would owe on this amount.

Berkshire-Hathaway management has in fact decided to retain all its earnings for future investments rather than to pay out a dividend. The dividend tax on Mr. Buffett’s share of earnings has therefore been deferred to some later time. Even so, he still must pay the corporate tax rate of 29½%, so let’s call that his real tax rate.

Now, let’s assume that last year Mr. Buffett’s secretary earned $100,000 – a pretty good salary for a secretary, particularly in a low-cost state like Nebraska. Let’s further assume that his secretary is single, rents her home, has no dependents, no IRA or 401(k) and no itemizable tax deductions. In other words, she gets hit with the full force of the tax code. She would be entitled to a personal exemption of $3,650 and a standard deduction of $5,700, so her taxable income would be $90,650. At 2010 tax rates, her federal tax liability would have been $19,098 or 19.1% of her salary.

These are average tax rates. What about marginal rates? The marginal corporate income tax rate for BH is 35%. His secretary’s marginal tax rate of 28%.

So far, it looks like Mr. Buffett’s average and marginal tax rates are well above his secretary’s, but what about payroll taxes? Both Social Security and Medicare taxes are deducted from compensation income only (wages, tips and salaries). Currently, employees pay 4.2% of their wages, tips and salaries to Social Security and another 1.45% to Medicare. In addition, however, each employer must contribute 6.2% to Social Security and 1.45% to Medicare. Social Security (but not Medicare) taxes are subject to an income ceiling, currently $106,800. Thus, wealthier people, who derive much of their income from dividends, interest and capital gains, pay a smaller share of their income in payroll taxes. How does this affect the comparison of Mr. Buffett and his secretary?

Warren Buffett’s Social Security and Medicare taxes are negligible since he receives almost no compensation income. His Secretary’s total compensation, including employer payroll tax contributions, is $107,650 ($100,000 salary plus employer contributions of $6,200 to Social Security and $1,450 to Medicare), and she gets to keep $75,252 ($107,650 minus $10,400 to Social Security, $2,900 to Medicare and $19,098 to the IRS. Her average tax rate therefore is just about 30%. (Her tax rate will increase to 32% if the temporary payroll tax reduction from 6.2% to 4.2% expires.)

Workers’ payments to Social Security, however, are not true taxes, since they are accompanied by a right to get the money back in retirement. In other words, Social Security taxes are both an asset and a liability to government. If Social Security is not reformed, virtually every worker will receive retirement income with a net present value higher than that of the taxes they paid in to the system. This problem is even more severe for Medicare – retirees will receive medical benefits with a value much higher than the taxes they paid. Therefore, it’s incorrect to include Social Security and Medicare in calculating an individual’s tax burden. We don’t count IRA and 401(k) contributions as part of our tax burden, and we should not count Social Security/Medicare payments just because these programs are run by the government.

I should also note that the payout of promised Social Security and Medicare benefits is unlikely since would place a horrendous tax burden on future generations. Someone is going to get a bad deal here when the system finally hits a brick wall, but it’s probably not going to be Mr. Buffett’s secretary.

So what do we conclude? If we make a correct comparison of average taxes paid, Mr. Buffett pays at least 29½% and his secretary 19% or less. Mr. Buffett’s marginal tax rate is 35% and his secretary’s is 28%. If we include payroll taxes, the two tax burdens are roughly the same. As noted, however, payroll taxes are not a real burden. President Obama’s claim that the secretary pays less than Mr. Buffett is only true if we don’t count corporate income taxes as part of Mr. Buffett’s tax burden.

The real problem with the Buffett Rule is the complexity and lack of transparency in the tax system. When a single income stream such as corporate earnings is taxed at several points and times, it’s easy for politicians to craft a logically incorrect and misleading narrative by including some parts of the tax structure and not others. One can only wonder what prompted Mr. Buffett to make his remarks. Perhaps he was helping out his political friends in the Democratic Party. Perhaps he cynically concluded that higher taxes would give him an edge versus his competitors. Mr. Buffett is a very smart man, and I very much doubt that his comments were simply thoughtless or poorly considered. Regardless, he has made an important and destructive contribution to American economic mythology and done some real damage to the 299,999,997 Americans who are not as rich as he is.


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