Top Marginal Tax Rates Under The Buffett Rule Could Exceed 100%

Warren Buffett and Obama

President Obama’s Buffett Rule looks so simple on paper:

No household making over $1 million annually should pay a smaller share of its income in taxes than middle-class families pay. As Warren Buffett has pointed out, his effective tax rate is lower than his secretary’s. And, the President is now specifically proposing that in observance of the Buffett rule, those making over $1 million should pay no less than 30 per cent of their income in taxes.

The goal here is to raise taxes on wealthy Americans who get most of their income from investments. Investment income currently is taxed at a lower rate than labour income. But the Buffett Rule, according to the non-partisan Tax Foundation, creates a terrible, unintended consequence for some taxpayers: The marginal tax rate on investment income could plausibly exceed 100 per cent! “In other words, taxpayers … would have an incentive to lose money,” according to the research group.

See, the Buffett Rule almost certainly wouldn’t suddenly kick in once a taxpayer’s income hit $1 million. More than likely it would be gradually phased in over the $1 million to $2 million range. And this causes a huge problem for taxpayers inside this phase-in range:

For example, a taxpayer making $1.6 million dollars is 60%of the way from $1 million to $2 million, so his or her minimum rate would be 30% times 60%, or 18%. In practice, taxpayers in this income range tend to pay effective rates of around 25%, so the Buffett rule would typically affect only taxpayers whose incomes are high enough to require at least that minimum rate (about $1.8 million.) … Consider a taxpayer who earns exactly $1.8 million and is subject to the new minimum tax. In this case, the minimum is equal to 80% x 30% x $1.8M: $432,000. Next, assume he gets a $10,000 bonus, so that his income is now $1.81 million. The minimum is now 81% x 30% x $1.81M: $439,830. An income increase of $10,000 has led to a tax increase of $7,830 ($439,830 – $432,000) – in other words, the marginal rate on that additional $10,000 is 78.3%.

The rate gets as high as 90% at the upper end of the phase-in range before dropping back down to 30% for as long as the taxpayer is affected by the minimum tax. Combined this with state and local income taxes, as well as the new 3.8% tax on investment income beginning in 2013, and the marginal tax rate on investment income could plausibly exceed 100% within a narrow range. In other words, taxpayers in this range would have an incentive to lose money.

Amazingly, the Obama administration says its tax plan would increase fairness and simplicity. But what in the above example sounds either fair or simple? Then again, this is the kind of policy nonsense that can occur when a budget plan morphs into a political document.

This post originally appeared at The American Enterprise Institute.