A better Buffett Rule

Recently American billionaire investor Warren Buffet wrote this article in the opinion pages of the New York Times arguing that the super-rich (top 400 personal incomes) have been molly-coddled by tax reforms of the past three decades.  Buffett noted that he only paid an average tax rate of 17.4%, while the tax burdens of his office staff averaged 36%.

Buffett made the following suggestions

…for those making more than $1 million — there were 236,883 such households in 2009 — I would raise rates immediately on taxable income in excess of $1 million, including, of course, dividends and capital gains. And for those who make $10 million or more — there were 8,274 in 2009 — I would suggest an additional increase in rate.

Buffett’s opinion is not taken lightly, and as a result of his musings President Obama has included the Buffett Rule in his budget plan being pushed through Congress.  Put simply, the rule aims to ensure that people with incomes greater than $1million will pay at least the average tax rates of the income earning middle class.

Like all grand promises, the devil is in the detail.  The rule may require different types of income to be taxed differently (that was Buffett’s reason the super-wealthy pay less tax on average), which could increase average tax rates for some middle-income earners.  Buffett himself is reserved about the application of ‘his’ rule, choosing to note that his main point was that the super-rich – the top 400 incomes – should be the target of reforms due to their astronomical ability to pay (and low relative impact on their wellbeing), rather than the normal-rich.

To my mind Buffet’s point is sound – the average rate of income tax paid should increase with income (progressive income taxation).  And with income inequality also increasing in Australia we should expect much more focus on this redistributive aspect of income taxation as the trend continues.

But the most important debate regarding income taxation is not the degree of progressiveness of income taxation, which is important due to perceptions of fairness (remember income is simply the incidence of a tax, and money not taxed by income tax continues to circulate in the economy to be taxed at other transactions). The important debate, regarding the way income taxes change behaviour, is over the effective marginal tax rate (EMTR) for low-income individuals and families. A well considered topic in the Henry Tax Review, and likely to be a topic of interest this week at Wayne Swan’s somewhat redundant Tax Forum.

EMTR is the reduction in take-home income from earning an extra dollar after due to the combined effects of income tax and reduced welfare payments.  So while marginal income tax rates may be lower at low incomes, as any welfare benefits are being phased out (which typically reduce by 20c for every extra dollar you earn) there is often the perverse situation in practice that low income earners have a higher effecting marginal tax rates than the highest income earners.   Economists call this perverse outcome a welfare trap.

There is clear evidence of high EMTRs, especially for families in Australia.

…families with children are more likely to face an EMTR of 50 to 70 per cent than other types of households, due to the accumulation of withdrawal rates for family related payments on top of income support withdrawal and income tax. This is observed even without including the withdrawal of childcare subsidies. On average, the EMTR is highest for couples with dependent children. (here)

In the Henry Review the below graph was shown to demonstrate the point, while many submissions from stakeholders also noting that this should be a key focus of reform.

Recommendations 99 and 100 from the Henry Tax Review did note the impact of childcare payments on the EMTR of working families (apologies for the use of Rudd’s favourite phrase).  80%+ EMTRs for families earning $35,000pa is not providing any incentive for these families to get ahead.

The variation between marginal tax rates of different types of income also distorts investment behaviour.

Very different effective tax rates on savings placed in bank deposits, owner occupied homes, other real estate, shares and superannuation distort the mix of investment and reduce the aggregate return to the nation’s scarce aggregate savings.

As the Henry Tax Review shows, bank deposits are the worst place to put savings in Australia.  This might explain the trend in savings rates observed prior to 2006.  It also explains why the wealthy, who earn most of their income from investment, can pay lower tax rates and lower marginal tax rates, than job-income earners.

After examining the Buffet Rule alongside the genuine problems of current income tax regimes, I am going to suggest an improvement on both Henry’s recommendations and the Buffet Rule itself.  Implement a ‘Rumple Rule’ that equalises marginal tax rates for different sources of income (as suggest in the Henry review), AND ensures that EMTRs are flat or rising with household income.  There are suggestions by some on this matter which warrant further investigation, but the focus probably needs to be on simplifying the welfare system first, and simplifying income taxation second (but keeping income taxes to ensure at least flat marginal tax rates).

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Comments

  1. Is it just me or does that post-tax earnings gradient look pretty linear already? For all the discussion about marginal tax rates, the average “working family” is only going to look at the post-tax income. my guess from that graph is that the cut-out rate of subsidies and the tax bands looks like it’s designed to make that current slope.

    Also, it would change when/if the mooted realignment of tax-free threshold due to take place with the carbon tax takes place.

  2. Hi Cameron,

    I think this is a very worthwhile debate, but it could be just a subset within a much larger debate on the redistribution of wealth.

    A topic much out of favour within the current economic enviroment. The value and contribution of our successful entrepreneurs has never been more apparent than now, but does that mean we can allow our rich to become mega rich, and eventually produce an economic ‘upper class” that we haven’t quite managed to do in Australia. Another 5 decades will do it though.

    • Hi Peter – I disagree – there is definitely an economic upper class, the so-called 0.1% in Australia.

      We do not have the extent of crony capitalism as say the US or Euro, but its getting there, particularly the mining and RE development industry (especially at local level).

      There is a huge gap between the small scale entrepreneur/high wage earner (e.g doctors, lawyers, business owners) who are slugged with very high income tax and the financially connected (e.g bankers, miners, financiers, developers) who pay smaller taxes, usually through capital gains or very minor land taxes and can afford to spend a motza on financial engineering to hide income, unlike the “high income” earners, who just get slugged.

      On top of that, the lower class welfare has morphed into middle class welfare – so there is a huge pressure on the “high income” earners, who are getting assaulted from all sides to fund this…..

      And people wonder why are best and brightest go overseas?

      • Hi Prince,

        I don’t think we are greatly in disagreement. I said that “we haven’t quite managed to produce an economic upper class” whilst you say that we have but it is only 0.1% and not as pronounced as the USA or Europe.

        Two glasses of red would bridge that small gap.

        Cheers…

      • Mixed metaphors!

        I agree with you, its just that like the USA, we have 4 classes:

        1. the top 0.1% (USA) or more likely, 1% here
        2. the high income (approx. $200-500K pa) non-finance/RE earners
        3. the middle class ($50K to $150K household income)
        4. the rest

        I think only 2% of Australians earn (report) more than $200K income per year. There is a HUGE gap to the next pay level, where most of the “income” is unearned, i.e through capital gains and speculation. In the USA, that’s the 0.1% – I haven’t seen similar stats for Australia, but the implication is the same.

  3. Diogenes the Cynic

    A very important article. Effective marginal tax rates drive a lot of economic behaviour but they get little recognition amongst the mainstream media.

    A simpler system with less rebates, payments and transfers makes sense but then politicians will always want to tinker with the system to get elected. Recent examples – education rebate and changes to FTB for parents with 16 year olds.

    When I was based in Hong Kong my tax return used to take an hour to complete. There were very few things to worry about, your salary tax was 15%, less if you earned below the top band (capital gains, dividends and interest income taxes were 0%). My last return here took four days. A productive use of my valuable time…

    Go overseas bright, young people!

  4. Diogenes +1
    our current tax system makes our politicians lazy. Despite the inefiiciencies of the tax systems, it takes in a lot more than necesary, which allows the politicians to redistribute through middle class welfare . Hence Rather than coming up with good policies, they focus on a ” targeted vote buying” approach to win/retain power. This is why tax reform is so difficult as all the political parties are in cahoots. We are making it too easy for our politicians, we should be demanding more.
    We should simplify the tax system, provide less rebates and make the pollies earn their keep by envisioning, debating policies that are in the interest of this nation.
    Like you I lived in Singapore for 10 years. Very low income tax, not much rebates and my tax returns took 30 minutes to do every year. It was fabulous.

  5. Buffet’s article would at first glance seem to contradict Director’s Law http://en.wikipedia.org/wiki/Director%27s_Law.

    However, it is just as likely that measures designed to benefit the middle class (lower taxes on capital gains, etc) have the (unintended?) effect of benefiting the super rich even more.

    The question then becomes how is it possible to soak the super rich without collateral damage to the middle class, who form the bulk of voters.

    The evidence that this has not been achieved suggests that it can’t be achieved. One of the main problems being that if you try to soak the super rich, they simply leave to a more tax-friendly regime.