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The Buffett Rule: Does it make sense?

What name flickers your mind when you think about a billionaire who lives a simple life? Who you think aspires generations dreaming to strike big in the stock market? I can’t fathom any other name than the legendary investor Warren Buffett.

Today,  Senate’s vote on the Buffett Rule underlines the fact that our politicians are handpicking winners and losers.

The Buffett Rule is a law proposed after Warren Buffett famously admitted to pay less in taxes than his secretary as a percentage of his annual gross income.

According to Warren Buffett, his effective tax rate is 17.7 percent while the effective tax rate for his secretary — who earns $60,000 — is 30 percent.

There are two primary reasons why Warren Buffet’s effective tax rate is lower than his secretary’s effective tax rate.

First, only the first $100,000 or so is subject to the payroll tax. For his secretary’s income, all is subject to this tax, while only a small portion of Buffett’s income is subject.

Second, most of Buffett’s income is taxed at the lower long-term capital gains rate of 15 percent rather than the tiered ordinary income rates that are in effect for his secretary’s income.

Income generated by working most jobs is taxed at higher rate, while income generated by investments — stocks, buying and selling a company — is taxed at a lower rate.

But this disparity ignores one major fact. Capital gains tax rate is lower to encourage hard-working people with entrepreneurial knack to take risk. Small businesses are the backbone of the growth engine of this great nation. It takes lots of courage, grunt work and persistence to start a small business and to grow it. These small businesses also create employment for people. And these employees pay taxes to our federal government.

The Buffett Rule is targeted for only a small fraction of tax payers — about 400,000 super wealthy — who make over $1 million annually.  They are paying 24.1% effective tax rate. The Rule proposes that these super wealthy individuals should pay 30% tax on their income. The Joint Committee on Taxation estimates that it would raise about $47 billion over the next decade.  It’s good to get more revenue for the federal government, but $47 billions is a drop in the bucket in comparison to over $1.2 trillion in the annual federal budget deficit. Clearly, the problem is not that our federal government needs more revenue, rather it is that the government spending is out of control.

Can $4 billion a year make any impact on the lives of average Americans when our government has gone on the spending binge without thinking about the long-term impact on our economy?

Municipal bond exemption

One glaring exemption in the Buffett Rule is the interest income exemption for those who invest in the municipal bonds. Municipal bonds are issued by the local governments to fund project like local highways, libraries, hospitals, schools and other community projects.  Municipal bonds are attractive to investors due to lower cost and interest tax exemption.

Case for a simpler tax system

Buffett Rule likely won’t pass in the Senate as Republicans are likely to use their filibuster right to strike it down. Nonetheless, it sheds light on an important issue our nation has to deal with — the need for a simpler tax code so that average Americans can keep more of the money they make, and — at the same time — fund our federal government.

Final thought:

My only goal — as a proud citizen of this great nation — is to think independently, and express my thoughts. Even if federal government can raise intended $4 billion a year, how is it going to make my life any better financially? On the contrary, it may get worst if these super rich start investing  heavily into other parts of the world where the tax system is conducive to those who take risk to invest their capital.

Those of us who believe in living within our means, we expect our government to do the same.

What do you think? I’d love to hear your thoughts.

 We contend that for a nation to try to tax itself into prosperity is like a man standing in a bucket and trying to lift himself up by the handle  — Winston Churchill

(Photo Courtesy: Serbasembillan)

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Comments (33)

I personally don’t think that investors should be forced to pay more taxes. The government is the one who makes the tax codes and they should have thought things through before hand.

If they made new tax codes that applied to everyone then that would be fair. But to just pick and choose who is going to pay more taxes is not right to me.

And like you said – even if they do make more money in income tax that doesn’t mean it will necessarily help the country. They need to stop worrying about collecting money and focus on how they are spending our money.

Katie, I agree with you that Congress passed this law in the first place. Again, problem is not that government needs more money, it is that our government is spending too much.

nicely done overview Shilpan.

For the past couple of years I’ve worked with VITA (Volunteer Income Tax Assistance) program preparing tax returns for our local poor and immigrant population.

It, and the training the IRS requires for certification, has given me an inside look.

The tax code is complex precisely because it provides goodies for everyone.

The rich get the favorable treatment of capital gains, dividends and munis. Not to mention the specific tax breaks for specific industries. This being the reason our corporate tax rate at 30% is one of the highest in the world but the effective corporate tax rate is only 12%, one of the very lowest.

The middle class get deductions for IRAs, 401ks,mortgage interest, RE taxes, children and dependents.

The poor also get exemptions for children and dependents, along with the child tax credit and earned income tax credit. (Tax credits provide refund dollars in excess of taxes withheld.)

To name just a few.

the problem is the tax code is only partially about raising revenue for the government to operate.

the other huge function is it provides congress Power: the power to create and distribute all these goodies. it is the power of social engineering and patronage.

Congress decides that homeownership is a national good and, oh by the way, all those mortgage holders will vote for me, so lets pass out a home mortgage deduction.

The challenge in achieving a simpler tax code is that its passing would require congress to give up this power. Not likely, and even if it comes to pass my bet is in a few short years they’ll start passing laws and adding back goodies.

My proposal:

1. the 1st 50k everybody earns is tax free.
2. everything above 50k is taxed at 20%.
3. no deductions. you want to start a business, have kids, take a mortgage you shouldn’t expect the rest of us to pay you for it.

If you don’t like my plan, don’t worry. It’s never gonna happen.

Thank you for sharing this information Jim. Since you are helping others, you have better understanding of our tax code. As you’ve mentioned, each class of earners has specific benefits given by the tax code. I personally like the fair tax plan as it requires everyone — including illegal immigrants and tourists — to pay to uncle Sam.

This is once again great insight Shilpan! I don’t think taxing the rich is the answer to our problems, but as you mentioned, any additional revenue is a good thing.

The issue that I see is our government is very much like the average American: we’re willing to increase income but we’re rarely willing to cut back our lifestyle.

Our country’s financial woes will always be here until we have a president that’s willing to cut programs and prioritize. That would of course also require that the citizens be on board as well (which most of us won’t be).

Our government has to live within its means to avoid major inflation down the road, and further erosion of the value of good ole’ US dollar. Europe is a great example for our country to learn from.

You are ABSOLUTELY correct on the (Which most of us won’t be).

We are a strange country – everyone wants to cut government spending BUT never any program that effects them!!!!!

David, that’s so true! thanks for stopping by.

I think the end goal is about fairness. Of course taxing the majority rakes in more than taxing the 1%.

But when Buffett says he pays less than his secretary in taxes (percentage-wise of course), there is something fundamentally wrong.

MC, I agree about the fairness doctrine. I think current tax system is heavily against wage earners, aka middle class. I think the fair tax plan brings fairness by taking away power from politicians to pick and choose winners and losers.

This seems to be a classic case of wealth envy. The government has this wild notion that in order to solve our national debt problem, we should make the rich pay more in taxes. Not only is this foolish, but it’s also dangerous. The rich are primarily the job creators. If we start taking more money from them in the form of taxes, what’s to say that many of these business owners won’t close their businesses and go elsewhere with their wealth? As you stated, Shilpan, the government has a spending problem. The answer is simply decrease spending, implement the Fair Tax, and allow the wealthy to continue building their wealth.

Well said Anthony. I like your concise analysis. Our government definitely has spending problem. And very little has been done to stop the bleeding.

I think some of your numbers on effective tax rates are a little skewed. The highest anyone would pay on $60k of income is 18.5% (filing single). And that is before any deductions. Also, it would be difficult to make $1 mil and pay a 24.1% effective tax rate. If you’re filing status was MFJ, then you would have to deduct almost 3/4 of your income. I calculated with no deductions, the lowest someone with $1 mil in ordinary income will pay ~32% effective tax rate. That is before FICA. FICA isn’t paid on LTCG & ordinary dividends.

Seems like, based on the numbers above, most millionaires with ordinary income would welcome the 30% straight across the board tax “increase.” Especially those who make significantly more than $1 mil.

I see your point, Bichon, but they won’t. Buffett isn’t the only one paying just over 17 percent in that income range. Because their income is usually not parsed as ordinary income, having their tax raised to 30 percent will be a shock. Mitt Romney’s effective tax rate, for example, is also well below 30 percent.

Bichon, I agree with Joe that because capital gains tax rate is lower than ordinary income tax rate, wealthy pay less in taxes as percentage of their AGI.

The Buffett Rule is already DIA as I write this, but I want to comment on the capital gains rate comment. I don’t see how raising the capital gains rate affects an entrepreneur’s ability to take a risk.

I understand how it encourages investors not to sell their investments (or to move funds at a slower rate to avoid higher taxation), but how does it help entrepreneurs take more risk? It seems lowering corporate tax rates would effectively do this.

Don’t mistake my comment for a political statement. It isn’t. I just don’t understand the logic.

Joe, If I have several million dollars to invest, and if my financial adviser tells me that it is better to incorporate my company in Germany, just for the sake of example, due to its lower capital gains tax, I will move my corporate HQ to Germany. So capital gains itself won’t deter me from taking risk, but the tax revenue will go to other country. Also, by lowering capital gains tax, our country can attract foreign investors to do business in America. The end result is more tax revenue for our government.

I don’t think raising taxes on the rich is going to solve any problems today. I work hard for my millions, darn it! Okay, only kidding….I’m definitely not rich. However, I do see the importance in having the top 1%’s support of our economy. Raising their taxes might actually lower the extravagant spending that’s fueling our economy today and could be very bad. I know I know….fear mongering. But I have young children and am terrified of the future of our economy if we don’t get this national debt under control.

Absolutely. For the sake of future generations, leaders in Washington ought to think like average American household. Our government is on spending binge. And that’s very scary.

I agree with Michelle on this! I think the government needs to control costs before trying to raise taxes.

Absolutely. Raising taxes won’t help since our economy is in tailspin. Our government has to live within its means or we all will face rude awakening.

Poor rich people… I mean they get backlash for being financially successful. To raise their taxes would just piss them off and make them seek options to work around it. If WB wants to pay more than become more philanthropic. I say taxing the rich will have an adverse affect.

Jai, I never understood that how taxing a small universe of rich people can fix our out of control budget deficit.

I’ve never fully understood why most economically developed nations have had a budget deficit since WW2. Why doesn’t a government act like any other sensible economic agent and spend less than it earns? Seems to me that you’re always going to end in trouble if you take on debt because one day it HAS to be paid off. Where’s the sense!?

Agreed. Ironically, our government never learned to live within its means. We all will pay price for it.

Well laid out Shilpan. I agree with you that the Buffett Rule will have little effect on my life or the people I know. It seems like it is merely a token effort to show the common people that the government is doing something about cracking down on the “unfairness” of the rich. But we should wake up. The richest people in America are in control and they will find another loop hole to again hide their money and avoid taxes. I unfortunately feel as though this is all just a show.

$4 billion in additional federal income tax revenue can’t do much to offset $1.2 trillion budget deficit. :)

Yes Shilpan, you make some great points. It does seem that the effect will be insignificant.

Here’s what most people fail to understand. The system is set up so the government never has to pay off its debt. That’s the genius of having petro-dollar fiat “money” that is the Reserve currency of the world (for now). The Fed will print to infinity, inflate away the debt with counterfeit currency (according to the constitution Federal Reserve Notes are not legal tender), while the banking-elite skim trillions off the top. Hyper-inflation will result, and a massive debt collapse that will make the great depression look like an entree will be the result.

Jim, I can’t agree with you more. Until spending restraint is in place, federal government can either tax everyone more or keep printing money to satisfy out of control spending. Neither is a good solution for the long-term implications.

I’ve struggled to wrap my head (and heart) around the issue. For folks who rely on technicalities to characterize money they make from their job then I think it’s not consistent with the spirit of capital gains to allow them to reduce their taxes. But it’s also tough to penalize people who spend less than they make for a long time, investing the rest to a point where they can “retire” young and live off of capital gains. Tough one – way too many thoughts running through my brain for a comment!

Nick, Keep in mind that tax on capital — at 15 percent — is lower than income tax, but that capital was earned by the person who invested and risked it entirely. So, in reality, he has paid income + capital gain on his initial capital unless he or she inherited the wealth.

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