In his State of the Union address, President Obama defined the Buffett Rule aggressively: "If you make more than $1 million a year, you should not pay less than 30 percent in taxes." The Buffett Rule, of course, was inspired by Warren Buffett urging policymakers to "stop coddling the super-rich" with a tax code that favors capital income over labor income in ways that can lower a certain billionaire's effective tax rate (17.4 percent of taxable income in 2010) below that of his secretary. Just hours before Obama's speech, presidential candidate Mitt Romney released his 2010 tax returns and unveiled a 13.9 percent effective tax rate paid on $21.7 million of income, epitomizing the need for the Buffett Romney Rule.
The administration's previously floated rule that "no household making over $1 million annually should pay a lower share of its income in taxes than middle-class families pay" left some ambiguity as to how much progressivity should be restored by comprehensive tax reform. (Progressivity has declined markedly since the 1960s, as demonstrated by economists Emmanuel Saez and Thomas Piketty.) There's the trick of defining the middle class. More contentiously, would millionaires have to pay a higher effective tax rate than the average middle class tax rate or the highest middle class tax rate? Effective tax rates vary widely across all cash income levels. A professional athlete with tens of millions of dollars in annual wage and salary income pays the top marginal 35 percent tax rate plus the 1.45 percent Medicare payroll tax on most of their earnings. Not so for Mr. Romney or Mr. Buffett.
As a co-founder of private equity firm Bain Capital, Romney's work income was reclassified as "carried interest," which is treated as investment income and taxed at the preferential 15 percent long-term capital gains rate. (See Howard Gleckman's overview of this insidious tax preference.) The carried interest loophole helped Romney accrue his fortune, currently estimated somewhere between $190 million to $250 million. The vast majority of his current income is in the form of capital gains and dividends (including $7.4 million reclassified as such through the carried interest loophole in 2010) and taxed at the preferential 15 percent rate. The tax code favors capital income over work income in other ways, too: Capital income is not part of the income base for payroll taxes, the biggest component of which -- the Social Security payroll tax -- is only charged on the first $110,100 in wages and salaries. (About 94 percent of households' entire earnings fall under this taxable maximum.) Hence the 13.9 percent tax rate that many find so infuriating.
As my colleague Ethan Pollack depicts in this post, it didn't always work this way -- the long-term capital gains rate sits at a rock-bottom historical low. The 1986 Tax Reform Act enacted by President Reagan equalized the tax rates for capital income and work income at a 28 percent rate. In horse-trading with the House GOP, President Clinton agreed to lower the capital gains rate to 20 percent in 1997, although dividends were taxed as ordinary income up to the top rate of 39.6 percent. Then the Bush-era tax cuts undermined tax progressivity in a myriad of ways, including dropping the capital gains and qualified dividends rates to 15 percent, thereby making the carried interest loophole oh so much more valuable. (The estate tax -- the most progressive federal tax -- was also thoroughly gutted and even repealed for a year, with the hopes it would never return.) It could be worse: Under Newt Gingrich's budget-busting tax plan, these investments would be tax free, leaving Mr. Romney with an effective tax rate closer to zilch.
Unfortunately, reversing the unaffordable and unfair Bush-era tax cuts is proving devilishly hard. President Obama has proposed eliminating the carried interest loophole and returning the top capital gains rate to 20 percent in every one of his budget requests. (The administration would, however, keep the dividends rate at 20 percent instead of taxing it as ordinary income, at a loss of $96 billion over a decade.) Senate Democrats have repeatedly proposed repealing the carried interest loophole to finance job creation bills (most recently as an offset for the American Jobs Act), but all have been blocked by Senate Republicans. Sadly, the pocketbook interests of the 1 percent are much better entrenched by Senate procedural rules than those of the vast majority.
Romney's outlandish tax rate, however, makes the plutocratic interests vested in the tax code much more difficult to defend, particularly for Romney. According to Romney's policy adviser Lanhee Chen, the candidate would consider scrapping the carried interest loophole as part of comprehensive tax reform. That represents incremental progress, but scrapping wouldn't come close to adequately restoring progressivity or meeting the Romney Rule.
In recent testimony before the Senate Finance Committee, tax expert Leonard Burman rightly identified that "treating carried interest like other wage and salary income is one approach to diminishing this inequity, but a better and more consistent one would be to tax all capital gains the same as other income." Tax neutrality across income types is at the core of meeting the Romney Rule because capital income is so heavily concentrated at the top of the earnings distribution and because those at the top can easily reclassify work income as capital income. As my colleague Greg Anrig at The Century Foundation points out, the distribution of capital income is so skewed that 72 percent of the revenue collected by taxing capital gains as ordinary income would come from millionaires (those above the Romney Rule threshold).
Inseparable from questions of tax fairness and revenue collections are income inequality trends. A recent Congressional Research Service report noted that "changes in capital gains and dividends were the largest contributor to the increase in the overall income inequality [between 1996 and 2006]. Taxes were less progressive in 2006 than in 1996, and consequently, tax policy also contributed to the increase in income inequality between 1996 and 2006." The capital gains rate was lowered twice in this period. With inequality returning to Gilded Age-levels, tax policy should temper rather than exacerbate inequality.
The most fitting way to fulfill the Romney Rule would be once again equalizing the tax treatment of capital income and work income, and correspondingly physical capital and human capital. Doing so would restore fairness to the tax code, temper income inequality, and raise much needed revenue from those who can best afford it. Romney's income could easily be restructured to keep his tax rate in the ballpark of 15 percent even without the carried interest loophole; his tax rate would unequivocally rise, however, if capital gains and dividends tax rates increased. In my book, annual income of $21.7 million and net worth close to a quarter-billion dollars lands anyone squarely in the super-rich category. For those truly lucky duckies, a 30 percent tax rate seems much more appropriate than the tax code coddling lavished upon them over the last decade. For the sake of an equitable society and an adequately funded social contract, it's time for Congress to implement President Obama's Buffett Romney Rule.