Buffett Rule might be fair, but it’s not the answer

The “Buffett rule” tax bill failed in the Senate by a vote of 51-45.

Mark Twain once described composer Richard Wagner’s music as “better than it sounds.” The Buffett Rule legislation is just the opposite: It sounds better than it really is.

It sounded both reasonable and fair. Individuals with over a million dollars of income in any year would have to pay a minimum tax on their income that would equalize their tax rates with those of middle-class Americans.

What it boils down to, though, is the abandonment of what is called “long-term capital gains” treatment of income from investments. Short-term capital gains, for investments held for one year or less, are taxed as ordinary income. Long-term capital gains are currently taxed at a fixed percentage — 15 percent — of income earned when an investment held for longer than a year is sold at a higher market value than when you bought it.

The highest marginal tax rate for ordinary income is currently 35 percent, and the difference between that and the long-term capital gains rate of 15 percent is why, for example, Warren Buffett reportedly pays a lower average tax rate than his secretary. Most of his income comes from increases in the market value of his long-term investments and is taxed at the lower rate.

Maybe getting rid of the capital gains tax would end up being a good thing for the U.S. economy. We don’t know that, but it’s theoretically possible.

What we do know with certainty, though, is that suddenly dumping the capital gains tax rate is not a small matter. Capital gains tax rates have been with us almost as long as the income tax itself and tossing them out would be a major structural change to our financial markets. Our already disappointing economic recovery is fragile enough as it is. It doesn’t need this kind of grief.

Expecting the markets to digest this radical change without discomfort would be unrealistic at best — a bit like encouraging Grandpa to have a huge chilidog before launching him on the latest thrill ride at Six Flags.

The concept of treating capital gains differently from other income was first introduced in the 1920s, less than a decade after the Sixteenth Amendment had made our federal income tax legal. In the 1930s, a sliding scale of rates was introduced to the capital gains calculations in order to encourage even longer-term investments. The lowest rates applied to investments held longer than ten years, for example.

There is no doubt that our capital gains tax policy deserves a thorough examination for its effectiveness in its original purpose of encouraging investment, employment and economic growth. Its current rate structure should also be reviewed to see if it is functioning correctly or needs adjustment to meet the changes in our financial markets and our economy. Lastly, its history should be examined for signs of unintended consequences such as unwanted effects on income distribution.

It’s a pretty sure bet that this review will never happen, at least not until there are major changes in American political thinking. Economic policy decisions are made by our political representatives, and right now they are divided into two hostile camps.

The separation between Republicans and Democrats, liberals and conservatives, has a long history in the United States, but there was often a substantial area of common interest and common ground. The growing intensity of the differences has been accompanied by the shrinking of that common area, though, with negative effects on the development and the effectiveness of economic policy.

Economic issues must now be viewed through the prism of a political dualism where everything is either good or it is evil. If an issue or idea is neither one, it essentially ceases to exist.

Political dualism limits our economic policy options, which is why we are reduced to talking about capital gains taxes in terms of income distribution or “fairness,” its currently favored codeword.

There is no doubt that we have an income distribution problem in the U.S. economy. Unfortunately, there is no sound evidence that adjusting income tax rates has ever had a significant effect on income distribution here or in any other country. And we would expect that to be doubly true when the government’s financial structure is so dependent on support from borrowed funds and any new revenue would just get thrown into the jaws of the debt monster.

The roots of our income distribution problem are not to be found in the tax code but in the costs of education. Our failure to address that issue, along with the costs of medical care, is forcing both individuals and our federal government to accumulate debt at unprecedented levels. Those are real problems. The Buffett rule is a solution to a situation that is not.

James McCusker is a Bothell economist, educator and consultant. He also writes a monthly column for the Snohomish County Business Journal.