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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By Edward Zelinsky
One widely-discussed possibility for reforming the federal income tax is limiting the deduction for charitable contributions. Whether or not Congress amends the Code to restrict the income tax deduction for charitable contributions, Congress should limit the charitable contribution deduction under the federal estate and gift taxes. Such a limit would balance the need for federal revenues with the desirability of encouraging charitable giving.
On December 11th, the advocacy group Responsible Wealth called for the federal government to tax estates over $4,000,000 at rates starting at 45%. Among those joining this call were heirs to old fortunes such as Abigail Disney and Richard Rockefeller and owners of new wealth such as Bill Gates, Sr. Most notably, Warren Buffett agreed (as he has in the past) with this recent plea for higher estate taxes.
I am a fan of my fellow Nebraskan and agree with him that the federal government should impose estate taxes, particularly on large fortunes. I also admire Mr. Buffett for the Giving Pledge which he has promoted with the younger Mr. Gates. Under that Pledge, wealthy individuals commit to giving at least half of their wealth to philanthropy.
There is, however, considerable tension between the Buffett commitment to federal estate taxation and the Buffett commitment to philanthropy. By virtue of the estate tax charitable deduction, when a wealthy decedent leaves part or all of his estate to charity, no estate tax is paid on these contributed amounts.
It is perfectly plausible to call for estate taxation only for those who don’t distribute their wealth to philanthropy. It is, however, hard to reconcile that position with Responsible Wealth’s advocacy of strong estate taxation. Mr. Gates, Sr., for example, declared that “it would be shameful to leave potential revenue on the table from those most able to pay.” However, that is precisely what happens when large estates go to charity, namely, estate tax revenue which would otherwise flow to the federal government is instead diverted to charity. Such charity may be worthwhile but it does nothing to reduce the federal deficit.
Similarly, Ms. Disney argued that “a weak estate tax” falls “on the backs of the middle class,” presumably because the federal government will respond to reduced estate tax revenues by deficit financing, by raising other taxes on the middle class or by reducing government spending. However, when an estate is distributed to charity free of estate taxation, the government confronts these same choices.
A compromise could preserve the incentive for charitable giving while also generating some estate tax revenues for the federal government: Limit the estate (and gift) tax charitable deduction.
Many, including President Obama, have suggested such limitations on the income tax charitable deduction. If, for example, an individual is in the 35% federal income tax bracket, the President has proposed that the donor receive a deduction as if he or she were in the 28% bracket. In a similar fashion, the estate tax charitable deduction could be curbed, thereby generating some additional revenues for the federal fisc while also keeping a tax-incentive for charitable giving.
Consider, for example, a billionaire who leaves his entire estate of $1,000,000,000 to charity. To simplify the math, let’s assume that this billionaire would pay estate tax at the 40% rate if he did not bequeath all his assets to philanthropy. Because this $1,000,000,000 bequest is fully deductible for federal estate tax purposes, no tax is paid in this example. If this billionaire had not made this charitable bequest but had instead left his money to his children, the federal government would have received estate tax revenues of $400,000,000.
Suppose now that Congress limits the federal estate tax deduction to 70% of the amount donated to charity. In this case, the billionaire would leave a taxable estate of $300,000,000. At a 40% rate, this would require a federal estate tax payment of $120,000,000.
To provide the cash to pay this tax, this billionaire would probably reduce his charitable bequest to retain cash to pay this estate tax. However, at the end of the day, charity would receive the bulk of this billionaire’s assets while the federal government would receive some estate tax.
A limit on the estate tax charitable deduction could be constructed to fall only on relatively larger estates. For example, the first $10 million of charitable bequests could be fully deductible for estate tax purposes and only the amount gifted over that threshold would be deductible in part.
Alternatively, the limit could be phased in as charitable contributions increase. For example, the first $10 million of charitable bequests could be fully deductible for estate tax purposes. Then the next $50 million of philanthropic gifts could be 90% deductible and any further gifts would be 70% deductible for federal estate tax purposes.
The details are less important than the basic policy: By limiting the estate tax charitable deduction, all large estates donated to philanthropy would pay some federal estate tax revenues at a reduced rate. This would balance the need for federal revenues with the encouragement of the kind of charitable bequests quite commendably encouraged by Mr. Buffett and the Giving Pledge.
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 here.
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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
