Real Clear Markets

The Buffett Rule: It's about Perceptions of Fairness, Not Policy

In a speech last fall, President Obama talked about restoring an economy "where everyone gets a fair shot and everyone does their fair share and everyone plays by the same set of rules." Now he has proposed what he views as one small step toward achieving that objective: the so-called Buffet Rule in which those with annual incomes over $1 million will be subject to a new alternative minimum tax of 30 percent.

The rule is named after Warren Buffet who, as everyone now knows, pays a lower effective tax rate than his secretary. But how many Warren Buffet's are there? Not many. If you visit the White House website, you will be told that there are 22,000 people with incomes over $1 million who paid less than 15 percent of their income in taxes. There are a total of 217,000 wealthy people, who though they may not be paying the low rates attributed to Warren Buffet would still be hit by the rule, according to the Tax Policy Center. They would end up paying an average of $190,000 in additional taxes. That sounds like a lot of money but it's not a lot of people. In fact, the Buffet rule will not bring in much new revenue or do much to reduce the deficit (although it brings in more money than such steps as raising the eligibility age for Medicare to 67 when measured against a realistic, current policy baseline).

If the Buffet rule affects very few people, does little to reduce the deficit, and adds a new layer of complexity to the tax system, why bother with it? The answer is that it affects the perceived fairness of the system which, in turn, affects the willingness of the middle class to pay their fair share. Eventually, to plug a gargantuan deficit hole, we are going to need major sacrifices from the middle class as well as from the wealthy as part of a comprehensive overhaul of the tax system and restrained growth of entitlements. But a precondition for that broader sacrifice is some sense on the part of the public that the deck is not stacked against them, that everyone does play by the same rules, that millionaires don't receive favored treatment while programs for the middle class and the poor are being slashed.

More relevant than the number of people who look like Warren Buffet is what has happened to the overall progressivity of the tax system. Back in the 1940s and 1950s the top marginal rate was above 90 percent. To be sure, very few people paid the top rate in practice but it symbolized a nation in which the very rich were expected to give back to a nation engaged in large collective projects such as fighting and winning the second World War and rebuilding the economy after the war with such things as the interstate highway system and the GI education bill. Even the Vietnam War, clearly less popular than World War II, produced a surtax on incomes to help pay for it.

Contrast these periods to the post 9-11 world in which both the war in Iraq and the one in Afghanistan have been put on the national credit card. In the meantime, average tax rates on the top 0.1 percent have fallen from roughly 50 percent to about 25 percent over the past 50 years while income inequality has soared.

Although changes in the tax system are only one, and a relatively minor, reason for the more robust growth of after-tax incomes at the top of the distribution, they are at least something we know how to change. Most important of all, perceptions of fairness matter. In a system in which tax compliance is largely voluntary, in which austerity for the middle class is a prerequisite to getting deficits under control, what happens if people lose faith in the reasonableness of the rules?

As a matter of policy, we need to make the entire tax system less complex and more growth-oriented as well as fair. We need to broaden the tax base, lower rates, and reduce the deficit. We also need to consider a Value Added Tax as a partial replacement for income taxes on the middle class. It would not only relieve most people from ever having to file a tax return, it would also encourage saving and growth, and if refunded at the border, encourage exports. European countries rely much less heavily than the U.S. on income taxes because they all use the VAT as their major revenue-raising measure. But fairness matters, too. Behavioral experiments done by academic economists have shown that most people will choose a more rather than a less equal distribution of money when given a choice. This preference for fair outcomes is an outgrowth of our evolutionary history that rewarded cooperation and sharing because they led to survival.

The Buffet Rule is unlikely to be enacted. Its significance is more political or symbolic than substantive. It draws attention to the way in which the average citizen fares at the hands of a government that seems increasingly out of touch with their needs and overly influenced by the monies class. How this theme plays out over the coming year will help to determine who wins in November. That's why the debate about the Buffet Rule is important.