By Edward Zelinsky
As the American public debated the legislation ultimately enacted into law as the American Taxpayer Relief Act of 2012, no person was more influential than the Oracle of Omaha, Warren Buffett. Much attention was given to billionaire Buffett’s complaint that his federal income tax bracket was lower than his secretary’s tax rate. President Obama invoked “the Buffett Rule” to bolster the President’s successful effort for the Act to raise income tax brackets for high income taxpayers.
In his most recent letter to the shareholders of Berkshire Hathaway, Buffett issued another oracular pronouncement about America’s fiscal health. Buffett warned that many public pension plans are dangerously underfunded:
Local and state financial problems are accelerating, in large part because public entities promised pensions they couldn’t afford….[A] gigantic financial tapeworm…was born when promises were made that conflicted with a willingness to fund them….During the next decade, you will read a lot of news –- bad news – about public pension plans.
Many of those who heeded Buffett’s call for higher tax brackets for the wealthy ignore his current warning about the parlous financial condition of public pension plans. One of the problems of being an oracle is that your listeners will pick and choose which prophecies to follow.
Attached to Buffett’s most recent shareholders’ letter was a 1975 memo on pensions Buffett sent to Katharine Graham, then chair of The Washington Post Company. Buffett’s observations in this now released memo are as compelling today as they were forty years ago. It is easy to grant pension benefits payable in the future while failing to fund that pension promise today as “making promises never quite triggers the visceral response evoked by writing a check.” Typical defined benefit formulas, which gear pensions to an employee’s final salary before retirement, are particularly expensive for the employer to finance since higher final salaries will, at the end of an employee’s career, escalate his pension entitlement. It is tempting, but futile, to assume that the underfunding of defined benefit plans can be remedied by every plan continuously earning above average returns on pension assets: “yes, Virginia, maybe every football team can have a winning season this year.”
All of this explains why many of the nation’s public pension plans are today seriously underfunded: Elected officials promise pension benefits without properly funding them and rely on unrealistic assumptions about future rates of return to deny the reality of underfunding.
Buffett’s observations resonate with particular force in Connecticut where I live. Connecticut competes with Illinois for the distinction of being ground zero in the public pensions crisis. In this election year, neither the Governor nor the legislature will acknowledge that the Nutmeg State’s public pensions are seriously underfunded.
Consider in this context Buffett’s warning that pension plans should not assume that they will earn superior investment returns. Connecticut contends that its pension plans will earn 8% annually. Most other states make similarly optimistic assumptions. The National Association of State Retirement Administrators has recently determined that the average state public pension plan currently assumes that its investments will earn an annual rate of return of 7.72%.
More realistic assumptions about rates of return would expose the underfunding of public pensions described by Buffett. Under the Internal Revenue Code, private sector pensions this month must calculate their obligations to pay retirement benefits using interest rates ranging from 1.19% (for pension benefits payable soon) to 6.76% (for pension benefits payable furthest down the road). If Connecticut or any other state with similarly underfunded pensions assumed these more sobering rates of return (as they should), Buffett’s dire assessment of pension underfunding would be dramatically confirmed.
Equally instructive is the recent contract settlement brokered by New York Governor Andrew Cuomo between the Metropolitan Transportation Authority (MTA) and Local 100 of the Transport Workers Union (TWU). With much fanfare, Governor Cuomo announced that TWU workers will receive increased wages but that the MTA will not elevate fares to cover these increased wages. Only after the cheering stopped did we learn how this alchemy is to be accomplished: by reducing the MTA’s scheduled contributions for pensions and retiree health care costs. Governor Cuomo, the MTA, and the TWU have decided to underfund pensions for MTA workers. No doubt, they will justify this underfunding by predicting superior investment returns on the pension’s investments.
The Oracle of Omaha is, unfortunately, right. Many states and localities will soon have to choose whether to pay pensions promised to retired workers, or whether to put police on the streets and teachers into classrooms, or whether to increase taxes significantly to pay pensions and maintain public services.
It is regrettable that many who marched under Buffett’s banner when he favored higher taxes on the rich ignore his message about the troubled state of public pensions.
Edward A. Zelinsky is the Morris and Annie Trachman Professor of Law at the Benjamin N. Cardozo School of Law of Yeshiva University. He is the author of The Origins of the Ownership Society: How The Defined Contribution Paradigm Changed America. His monthly column appears on the OUPblog.
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Image credit: Pension pension or retirement concept with word on business office folder index. Photo by gunnar3000, iStockphoto.
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By Edward Zelinsky
Like many of us, President Obama is a Warren Buffett fan. Most prominently, the president advocates, as a matter of tax policy, the so-called “Buffett Rule.” This rule responds to Mr. Buffett’s observation that his effective federal income tax rate is lower than the tax rate of Mr. Buffett’s secretary. In President Obama’s formulation, the Buffett Rule calls for taxpayers making at least $1,000,000 annually to pay federal income tax at a 30% bracket.
President Barack Obama and Warren Buffett in the Oval Office, July 14, 2010. Photo by Pete Souza. Source: Executive Office of the President of the United States.
In his most recent letter to the shareholders of Berkshire Hathaway, Mr. Buffett makes another provocative observation. However, Mr. Obama has so far ignored this most recent observation from the Oracle of Omaha. Addressing the nation’s continuing housing malaise, Mr. Buffett wrote:
A largely unnoted fact: Large numbers of people who have “lost” their house through foreclosure have actually realized a profit because they carried out refinancings earlier that gave them cash in excess of their cost. In these cases, the evicted homeowner was the winner, and the victim was the lender.
In contrast, the dominant narrative about the national mortgage crisis focuses upon the banks which, the narrative goes, knowingly induced homeowners to borrow money the banks knew the borrowers could not repay. The banks then sold the resulting mortgages to unsuspecting investors who were misled by the banks and by the rating agencies which put their respective seals of approval on these unsound mortgages. Banks subsequently compounded their misdeeds by engaging in widespread abuse while foreclosing on the homes subject to these mortgages.
This anti-bank narrative underpins the recent settlement among the federal government, the states and five major lending institutions (Bank of American, JP Morgan Chase, Citibank, Wells Fargo and Ally Financial, previously known as GMAC). Under this settlement, the banks will give a total of $25 billion to homeowners who have been foreclosed upon or who are in danger of being foreclosed upon.
This anti-bank narrative has had legs because there is much truth to it. We now know, for example, that many banks lent money with optimistic public faces at the same time that bank executives knew the loans were unsound and overly-risky.
However, Mr. Buffett’s comments reveal the incompleteness of the anti-bank narrative; many borrowers were culpable along with the banks. It takes two parties — a lender and a borrower — to make a bad loan. Most Americans know a friend, relative, or neighbor who opportunistically gamed the mortgage system during the pre-recession bubble, borrowing against the bubble’s continuation and spending the borrowed funds for personal consumption. As Mr. Buffett suggests, to declare that borrower a victim is to mislabel a willing player in the nation�
By Edward Zelinsky
Although he had said it before, Warren Buffett struck a nerve with his most recent observation that his effective federal tax rate is lower than or equal to the effective federal tax rates of the other employees who work at Berkshire Hathaway’s Omaha office. Mr. Buffett’s observations have provoked extensive comments both from those supporting his position (e.g., President Obama) and those critical (e.g., the editorial writers of the Wall Street Journal).
In response to Mr. Buffett’s remarks, President Obama has promulgated what he calls “the Buffett Rule,” namely, that those making $1,000,000 or more per year should pay an effective federal tax rate higher than the effective rate paid by moderate income taxpayers. To implement this rule, Senate Majority Leader Harry Reid has proposed a 5.6% federal surtax on annual incomes over $1,000,000. The Congressional Research Service (CRS) has issued a report on the Buffett Rule. Deviating from Mr. Obama’s formulation of the Buffett rule, Mr. Buffett himself has indicated that he only favors higher income taxation for “the ultra rich,” a group which apparently consists of individuals earning substantially more than $1,000,000 annually.
The debate following Mr. Buffett’s comments has been spirited, but, for many, confusing. Here is my effort to clarify the facts and arguments.
1) FICA taxes are the predominant tax burden on most working Americans. As I discussed in last month’s blog, many working Americans pay little or no federal income taxes, but do pay significant FICA taxes to finance Social Security and Medicare. Democrats and Republicans alike have ignored this reality. Democrats prefer to ignore the heavy FICA tax burden on lower income Americans to preclude an honest discussion about the fairness of those taxes to younger Americans, even after considering the Social Security and Medicare benefits younger Americans may receive in the future. Republicans avoid the reality of FICA taxation because it undermines the mantra that half of all Americans pay no federal income tax. That statement is true but incomplete. Working Americans who don’t pay income taxes do pay significant FICA taxes. When Mr. Buffett compares his federal taxes to those paid by his secretary, it is the secretary’s FICA taxation which constitute much of the secretary’s obligation to the federal Treasury.
2) As to the taxation of the affluent, the real issue is the lower rates applicable to capital gains. The CRS estimates that approximately 1/4 of those with annual incomes over $1,000,000 violate the Buffett rule by paying federal taxes at effective rates equal to or lower than the effective tax rates of Americans of modest incomes. Besides the FICA taxes borne by working Americans, this phenomenon is caused by lower federal taxes on capital gains. Today, capital gains (including dividends) are generally taxed at a maximum federal tax rate of 15%. This is essentially the same as the combined employer-employee tax rate which applies under FICA to the first dollar of a working American’s wage income.
3) Millionaires pay higher taxes on their ordinary incomes. Mr. Buffett is evidently one of the millionaires whose income largely consists of lightly-taxed capital gains (including dividends). However, the bulk of those making more than $1,000,000 pay taxes at much higher rates than does Mr. Buffett because they earn ordinary incomes such as salaries and other business profits. These millionaires generally do not violate the Buffett rule since the federal inco
