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Obama’s Shot Across the Bow to High Income Earners and their Tax Planners

September 28, 2011

Whatever criticisms might be raised about the politics of the tax reform proposal put forward recently by Barack Obama, lack of ambition not one of them.

As reported by The New York Times, President Obama’s new plan centers on the aptly named “Buffett Rule,” a policy change that would address the anomaly that apparently allows Warren Buffett, the second richest man in America, to pay an overall tax rate that is lower than that of his secretary.

Under current law, high net worth individuals like Mr. Buffett benefit from a large number of special tax rules and tax planning strategies that can limit their overall tax liabilities and, most significantly, put much of their income into special, lower tax rates or “brackets.”

One of the primary bases for limiting their tax liability stems from the differential treatment of investment income and income on wages – a policy most recently in place for more than two decades but that was greatly expanded under the administration of George W. Bush. While the marginal federal rate on individuals with earned income of as little as about US$34,000 per year is 25 percent – and rises to 35 percent on incomes roughly ten times that amount – the tax rate on investment income such as capital gain and dividends is never greater than 15 percent no matter what the amount. Moreover, the rate on interest from municipal bonds is zero. Thus an individual like Mr. Buffett whose income primarily comes from investments, whether in the form of long-term capital gains, dividends, or tax-exempt interest, may well end up paying tax at a significantly lower rate overall than someone (including his famous secretary) who makes significantly less money but all of which is earned income. With additional tax strategies, such as taking a carried interest with respect to management of an investment fund, a wealthy individual’s overall tax burden could decrease even more greatly relative to others whose income primarily comes from wages.

The President would have this all change. Under his proposal, individuals with annual incomes in excess of US$1 million – from any source, whether wages or investments – would be subject to a new minimum tax rate. Some details remain to be released, but the apparent goal of the policy would be to ensure that those earning more don’t pay significantly lower overall rates than those earning less but in the form of a different type of income.

This policy change could change radically certain areas of individual tax planning, at least for those few Americans whose incomes are of seven figures or larger. For example, one implication of the policy change is to limit the way in which the federal tax code now gives deference to investment income over earned income.

If these proposals are serious, they would reverse the trend to prioritize investment income over earned income for the first time since 1987, when the Reagan tax reforms equalized all federal tax rates for individuals. Moreover, President Obama’s proposals could finally put to rest the havoc wreaked by the Alternative Minimum Tax, which every year needs to be “patched” to avoid imposing a major tax increase on tens of millions of Americans.

The “Buffett Rule” may never become law. But if it is enacted, the Rule could fundamentally alter the way many Americans approach their taxes and the way the federal government is funded.