This commentary helps shed some light onto some of my considerations when evaluating both the absolute and relative levels of capital gains vs. income tax rates in my proposal for tax reform.
Due to the large amount of money to be gained by an individual if a loophole exists, I have attempted to craft the proposal in a way which deeply considers not only a particular rate, but also the system as a whole.
One White House discussion of the proposed rule goes as such: wealthy folks like billionaire investor Warren Buffett should pay at least as high of a tax rate as one of his lower-income-earning employees (EE).
For simplicity’s sake, let’s say Buffett pays tax at a 20% effective rate because of current capital gains rates, whereas his EE pays a 30% effective rate because of income tax rates.
Therefore, folks might conclude Buffett should also pay tax at 30% rate in the name of fairness. But why have so few posited the alternative method of equalizing Buffett and his EE’s tax rates – that his EE should pay an income tax rate which is close to the capital gains rate?
A more efficient revenue raising system than high marginal ordinary income tax rates could be implemented, such as one including a national consumption tax (as included in my proposal for tax reform) coinciding with lower income tax rates. On the margin, this adjustment may seem to skew the overall tax burden from wealthier to less economically fortunate folks.
For those concerned about ensuring there is some correlation with ability to pay taxes and taxes owed (i.e. progressivity), this goal can still be maintained in the posited system as shown in my proposal which has multiple brackets for both income and capital gains rates.
Similar to the discussion regarding the second-layer tax of dividends, capital gains rates should be kept low to encourage capital formation through competitive investment tax rates. At the same time, a lower income tax rate not only deals with the issue of fairness that some folks are concerned about with the Buffett example, it also allows for more after-tax cash in the hands of hard-working individuals to be consumed or invested. As discussed, this efficiency goal can be achieved while maintaining some folks’ goal of fairness through progressivity.
I realize the key rebuttal to my alternative view is lowering the tax rate on the EE to Buffett’s rate would blow an even larger hole in the U.S.’ already-large deficit. While, all things equal, that might be true, it is not a sufficient rationale to conclude that the only way to enact the Buffett rule would be to raise the effective overall tax rate paid by wealthier individuals, rather than to lower the income tax rate paid by Buffett’s EE.
Would this adjustment potentially lead to an increase in the deficit in the short-run? Yes. Does that change my conclusion? No. Let’s all take a step back and assess what is optimal, rather than assuming the status quo is optimal and solely assessing the marginal change.
If combined with other complementary efficiency-enhancing adjustments, as posited in the reform proposal, my alternative view on the Buffett Rule execution may appear more optimal to most than at first glance.
Ultimately, a thorough economic analysis requires both an absolute and relative analysis of a proposed change in determining the optimality of a proposal. An appreciation for the powerful potential of lowering income tax rates closer to capital gains rates would lead to policy adjustments which would both increase the efficiency and maintain the fairness of our tax system.