Buffett misses mark

Posted on August 17, 2011 in Policy Context

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NationalPost.com – financialpost/fpcomment – Don’t hike income taxes — eliminate special preferences
Aug 16, 2011.    Jack M. Mintz

The United States, the world’s largest and arguably most innovative economy, is in trouble. With a stagnating economy, high unemployment, and now one of seven people on food stamps, what the U.S. needs most is growth. An essential part of a growth agenda should be tax reform, which is the best way to get onto a better economic footing.

Although a brilliant investor, Warren Buffett’s recent prognosis to hike taxes on the rich is off the mark and, frankly, naive public policy. He is right that tax reforms of some sort will be needed to deal with the U.S. deficit since the fiscal hole is just too large now. With federal-state-local government spending over 40% of GDP and all-government revenues at 30% of GDP, Americans are paying only for 75% of their 2011 public bills. Spending reforms alone won’t do the trick.

However, the Obama plan to simply increase personal income tax rates on the rich and hike capital gains and dividend taxes will hurt rather than help growth. Higher personal tax rates will reduce the incentive to invest by entrepreneurs, who are most responsible for growth.  Capital gains and dividends (subject to federal-state personal tax rate of 20%) are currently highly taxed at more than 50% once taking into account the 39% corporate income tax rate that reduces the amount of profits distributed to shareholders or reinvested by the company. More double taxation of dividends and capital gains hurts the economy.

Already the highest-income taxpayers — about 5% of taxpayers — pay almost 60% of U.S. income taxes. The bottom half of the population pays only 3%. So any tax increase imposed on high-income earners should be in areas where some, like Warren Buffett, are paying far less than other wealthy individuals. Warren Buffett’s 17% tax rate results only because he gets a large number of breaks that other wealthier Americans, like doctors, cannot use.

Which gets to the main point. The United States needs major tax reform, rather than playing at the edges to make the system more progressive than it is already. U.S. income taxes are complex, inefficient and highly unfair. The statutory rates, once taking into account federal and state income and payroll taxes, are already high, even with the Bush tax cuts.  The problem is that too many targeted preferences reduce the amount of taxes paid, undermining economic growth. Let me provide two examples.

On top of the list is mortgage-interest deductibility for home ownership, one of the sources of the U.S. mortgage-market failure. This policy is likely the most economically harmful policy ever to be adopted (and one that Canadian governments have thankfully avoided).  Since imputed income from owner-occupied housing is not taxed (except for capital gains in excess of US$500,000), interest deductibility is a pure subsidy for home ownership. The subsidy encourages Americans to invest in housing, rather than industrial capital. It also leads to excessive prices in the markets, as interest deductions are capitalized in housing values.

In fact, there are 13 tax subsidies for housing in the United States, including property tax deductibility, exclusion of interest on rental bonds, home tax credits, and accelerated depreciation for rental housing. Interest deductibility and property tax relief alone costs the federal and state budgets US$1.5-trillion over 10 years.

Tax reform should eliminate or at least blunt this excessive subsidy toward housing. Even if the United States adopted a Canadian approach that treats housing like any form of tax-free TFSA saving (no interest deduction and no tax on capital gains or imputed rental income), the United States would generate far more tax revenues from this item alone. It could maintain some tax deduction for lower-income Americans (although many don’t pay tax or itemize deductions, such as mortgage interest), but the overall impact would be to raise taxes on upper- and middle-income Americans.

Another example of needed reform involves the tax preference given to private-equity investors like Warren Buffett, which costs federal and state treasuries more than US$25-billion over 10 years. Typically, those engaged in financial trading as their main business would pay income taxes like any salaried worker. However, in the United States, private-equity investors can have a significant part of their earnings (carried interest) taxed at the capital gains tax rate on the presumption that this will encourage risk-taking. Given that governments share financial trading losses through mark-to-market rules, the risk-taking argument is poppycock.  Such earnings should be fully taxed like other sources of income — this would certainly double Warren Buffett’s low tax rate.

The list of special preferences in the United States is mindboggling and could fill a book on how not to run a tax system. A major tax reform that lowers rather than increases personal and corporate tax rates and eliminates a number of special preferences would make the tax system more efficient and fair, and it would grow revenue over time by growing the economy. Currently, favoured activities earn a lower return, so base-broadening and rate reductions would shift resources to activities with better returns. The Americans could also build in some extra revenues to help deal with the deficit, since a more efficient tax system would generate growth.

Even better, the adoption of a VAT to replace income tax revenues would help spur growth, since consumption taxes are far less harmful to the economy than income taxes. But don’t hold your breath on this one — both Democrats and Republicans oppose a VAT. They at least agree on one fiscal issue.

The United States needs to get out of its box of low growth. Current proposals for tax increases are the wrong medicine. Instead, a rate-reducing cum base-broadening tax reform would be more powerful by reducing the economic cost of taxation. Buffett pays too little tax, not because he’s so rich but because the U.S. tax system is so poor.

Financial Post
Jack M. Mintz is the Palmer Chair in Public Policy at the University of Calgary.

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