“Charge 'em for the lice, extra for the mice.
Two percent for looking in the mirror twice.
Here a little slice, there a little cut
Three percent for sleeping with the window shut.
When it comes to fixing prices
There are a lot of tricks I knows.
How it all increases, all them bits and pieces.
Jesus! It's amazing how it grows!”
--- Monsieur Thenardier
The popular musical Les Miserables is back. The film won three Oscars Sunday (including one for best supporting actress), and the show is now touring before it reopens in New York in 2014. But the influence of Les Miserables doesn’t just extend to the silver screen and stage. President Obama seems to be taking tax policy advice from the musical’s comical antagonist, Thenardier. Just like Thenardier hides the true cost of his services from customers by using surcharges and hidden fees, Obama would like to raise taxes on the rich by doing everything but attacking the problem head-on.
Obama and Democrats are convinced that the wealthy don’t pay enough in taxes. They frequently point to the low marginal rate paid by Warren Buffett and other superrich taxpayers. The “Buffett rule” came about because the billionaire supposedly pays a lower marginal rate than his secretary. The solution? A complex surtax that would essentially mimic the alternative minimum tax and force the rich to pay at least a 30 percent rate. But that’s only the beginning.
Just like Thenardier’s customers pay for using the mirror or keeping their window shut, upper-income taxpayers will now pay a 3.8 percent surtax on net investment income. Income tax rates on those making over $400,000 have risen to 39.6 percent. So-called “Pease” phaseouts (one of the most complicated provisions of the tax law) are also back. But that isn’t enough complexity for Obama. He would like to impose a 28 percent cap on deductions and eliminate or reform many tax incentives to exclude the wealthy.
Thenardier uses tricks to charge customers because he wants to conceal the true cost of staying at his inn (costs which also hide the fact that he is frequently stealing items from guests at the same time). But it is baffling why Obama and the Democrats come out so strongly in favor of higher taxes on the rich, yet fail to confront the true source of the problem: the preference for capital gains.
Capital gains are taxed at a much lower rate than ordinary income. Before January 1, the preferential rate was 15 percent. It rose to 20 percent for taxpayers in the highest income bracket when portions of the Bush tax cuts expired. Buffett, Mitt Romney, and many other wealthy taxpayers earn most of their income from capital gains. That is how they are able to pay lower marginal tax rates than many middle- and upper-middle-income wage earners. Even if the top income tax rate were to rise to 50 percent or more, taxpayers such as Buffett might continue to pay lower marginal tax rates than their secretaries (assuming, of course, that those secretaries earn six-figure incomes, which Buffett’s apparently does).
The capital gains tax preference has a long history, but the tax rate was 28 percent as recently as 1997, when President Clinton agreed with congressional Republicans on a rate cut. Democrats have been reluctant to directly propose higher capital gains rates since then, for a variety of reasons. They can’t even agree among themselves to change the tax treatment of carried interest, which allows very well-compensated fund managers to pay the preferential rate. (Cynics would suggest that is because of the increasing importance of the political donor class.) Instead they have played around at the edges of the tax, trying to find ways to nickel-and-dime the rich rather than seriously attacking the roots of inequitable marginal tax rates.
Thenardier would be proud of their theory, but he might not approve of the results. Despite all the increased complexity being layered onto the tax code to trap the rich, it really isn’t clear that they will be paying all that much more in taxes. And they probably won’t until the capital gains preference is eliminated or sharply reduced.
Figure 1. Effective Income Tax Rates By Income Category, 2007
Source: Martin A. Sullivan, "Is the Income Tax Really Progressive", using data from IRS Statistics of Income Division, Individual Complete Report (Publication 1304). Table 1.1, "Size and Accumulated Size of Adjusted Gross Income," for tax year 2007, available here.