In today’s News and Observer there was an op ed by a Professor David McAdams at Duke’s Fuqua School of Business which claims that Obama’s Buffett tax on millionaires would actually stimulate job creation. (The idea behind the Buffett tax is to make sure “millionaires and billionaires” pay no smaller a percentage of their income in taxes than a middle income family.) This, according to McAdams, would occur because, while forcing some millionaires and billionaires to pay more in taxes it may actually lower their marginal tax rate. The amazing thing is that this professor shows a level of understanding of tax analysis that is shockingly pedestrian if not sophomoric.
First let’s dispense with McAdam’s basic argument, that, by lowering marginal tax rates, the Buffett tax would stimulate investment and job creation. He illustrates this with the following example.
Consider, for example, a millionaire whose income consists of $1 million in capital gains and $100,000 from a chain of hot dog stands. This millionaire pays taxes of 15 percent on capital gains and 35 percent on net income from the hot dog stands, for a total of $185,000 ($150,000 plus $35,000). This amounts to an average tax rate of 16.8 percent, less than the 25 percent marginal rate paid by many middle earners.
Under the Buffett rule, he would have to pay 25 percent of all income in taxes, for a total of $275,000. However, he would be keeping 75 cents of every additional dollar generated by the hot dog stands, compared with 65 cents of every dollar without the Buffett rule. So this millionaire would have more incentive to expand his hot dog business, hire more workers, and so on.
So, for the millionaires it would apply to, the Buffett rule would effectively cut marginal tax rates 10 percentage points even as it raises the overall tax burden.
Let’s assume for the moment that his example is analytically correct–which it is not–and the millionaire’s marginal tax rate for the year in question is lowered from 35% to 25%. This result is completely an artifact of his particular situation during that particular tax year. It is a situation that he could not have known about in advance. In other words, he doesn’t know that his marginal tax rate will be 25% going into the tax year. It is only something that he discovers after the fact when he does his taxes or at best speculates might be the case as the year draws to a close. In order for him to be facing a meaningful marginal rate of 25% in term of economic incentives he would have had to have known in advance that his investments were going to generate a million dollars in capital gains before the market actually generated them. In fact he would need to know that this would continue to be the case for a considerable length of time into the future. Obviously if this was knowledge that we could obtain we would never lose money. This millionaire-for-a-year hot dog stand owner would never make expansion decisions based on the expectation of a continued marginal tax rate of 25%. In fact the only reasonable thing for him to do would be to base his future investment on the (presumed) statutory marginal rate of 35%. Professor McAdams seems not to understand the difference, in terms of incentives, between an ex ante marginal tax rate, which is all that matters from an incentives perspective, and an ex post marginal tax rate, which matters not at all. The fact that he convolutes these two does not bode well for students at the Fuqua School.
What is just as troublesome is that he seems to mix up the notions of marginal and average tax rate–unless he is assuming that the tax code has been changed to a bizarre combination of a flat and progressive rate system where average and marginal rates are the same and it is this rate that increases as income increases. Before giving the above example McAdams states the following:
…but suppose “middle-class families” pay 25 percent of their income in taxes, which is the marginal tax rate for many middle-income earners. If a “millionaire” already pays more than 25 percent of his income in taxes, the change won’t affect him. But a millionaire whose income derives from both capital gains, taxed at just 15 percent, and business income, taxed at a marginal rate of 35 percentmay well be paying less than 25 percent of his total income in taxes – and therefore would pay more under the Buffett rule.
While McAdams is correct in saying that the marginal tax rate for a middle class family is about 25% this does not mean that middle class families “pay 25 percent of their income in taxes.” The marginal rate, not the average rate, is 25%. The family will pay 0% on the first $12,150 of their income and then 15% on everything between $12,150 and $46,250. This family will only pay 25% on any taxable income between this amount and $119,400, when the marginal rate would go to 28%. The point is that a family facing a 25% marginal rate would not pay anything like 25% of its income in taxes, as asserted by McAdams. This is a sophomoric mistake. The same would be true for the hot dog salesman earning $100,000. McAdams claims that he would face a 35% marginal tax rate–wrong again–and pay $35,000 in taxes on the $100,000. For the same reason as noted for the middle class family, the hot dog stand owner would not be paying 35% of his non-passive income in taxes. But not only would McAdams be wrong about the amount paid by the hot dog stand owner he also gets his marginal rate–on the $100,000–wrong. In fact he’s off by two whole tax brackets and possibly three. A single person earning $100,000 in taxable income faces a marginal tax rate of 28% not 35% and if that hot dog salesman was a family man, making it a true apples to apples comparison with the “middle class family,” his marginal rate would be 25%. It is impossible to go back to McAdams example and plug in the actual rates to see just how off his numbers really are for two reasons. First we do not have precise income figures for the middle class family and furthermore in his example he makes no distinctions between marginal and average.
First of all, if the News and Observer was not blinded by its ideology it would have, or at least should have, caught all this. As for what this says about the Fuqua School…
