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The Dangers of Raising Taxes on Investment Income

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The Dangers of Raising Taxes on Investment Income

April 15, 2012

As Tax Day approaches, President Obama is traveling the country promoting his Buffett Rule, a 30 percent tax on millionaires. Yet, according to the Joint Tax Committee, this will raise only $47 billion over the next decade, a fraction of America’s $6.7 trillion 10-year deficit.

In addition, in its fiscal year 2013 budget proposal, the Obama administration has proposed a series of tax law changes designed to raise more revenue from higher-income earners. The administration has suggested increasing the tax rate on two major categories of investment income. Long-term capital gains tax rates would rise from 15 to 20 percent, and the tax rate on income from corporate dividends would rise from 15 percent to a top rate comparable to that of the highest “ordinary” income bracket, or 43.4 percent (including the 3.8 percent surtax to fund the new health care program).

These proposals follow the argument known as the “Buffett Rule,” advanced by the president in a series of speeches this month. Obama deems it “common sense” for the wealthiest Americans to pay tax rates at least comparable to those of their salaried employees—a reference to the observation by famed investor Warren Buffett that he pays taxes at a lower tax rate than his secretary.

It has been widely noted that passage of the “Buffett Rule” will not change Mr. Buffett’s tax rate. His company, Berkshire Hathaway, is set up as an insurance company, using insurance company reserve rules. Assets in Berkshire Hathaway build up free of tax, and Mr. Buffett gets his earnings from selling shares in the company. He generously gives away shares to charity, pays no tax on these shares’ capital gains, and legally writes off his charitable contributions against his income. Since he can give away approximately as many shares as he pays himself, he pays little tax.

Political posturing about a 30 percent tax rate for millionaires and proposals for higher taxes on capital serve the administration’s purpose of raising tax rates on investment income in the name of its view of tax fairness or justice. If, however, the administration is concerned that capital investment in U.S. firms continues at a time when economic recovery remains fragile, these proposals will harm the U.S. economy.

There is good reason to believe that higher rates on capital gains and dividend income would have negative effects on the U.S. economy by reducing the overall level of U.S. investment and by driving such investment to overseas markets. Higher tax rates would reduce economic activity and, thus, economic growth, by reducing available financing for private companies, innovators, and small firms just getting started.