The Other Side of the Social Contract

While our political conversation should be focused on the deficit and unemployment, or the size and role of the government in our lives, we have been distracted by rhetoric on fairness and the wealthy. We are mislead by extreme examples like Warren Buffet that most wealthy are not paying their fair share.  Warren Buffet decried the fact that he pays a lower percentage of his total income in taxes than his secretary.  The President has mirrored his statement saying that billionaires should not pay a lower tax rate than janitors.

Elizabeth Warren, running against Massachusetts  Senator Scott Brown for his seat, fired a volley in the class war claiming that “There is nobody in this country who got rich on his own — nobody.”  She clarified further:

You built a factory out there? Good for you. But I want to be clear: you moved your goods to market on the roads the rest of us paid for; you hired workers the rest of us paid to educate; you were safe in your factory because of police forces and fire forces that the rest of us paid for. You didn’t have to worry that marauding bands would come and seize everything at your factory, and hire someone to protect against this, because of the work the rest of us did.

Now look, you built a factory and it turned into something terrific, or a great idea.  God bless. Keep a big hunk of it.  But part of the underlying social contract is you take a hunk of it and pay forward for the next kid who comes along.

Ms. Warren’s comments reflects a juvenile understanding of our tax system and addresses only one side of the social contract.

There are many different kinds of taxes that carry different rates for various reasons.  A wealthy retired person could have all of his money in municipal bonds and pay no taxes?  Is that fair? Should we remove the tax break for municipal bond interest?  This will certainly raise the cost of financing your new sewer system or power plant and will raise your power and water bills?

Warren Buffet likely makes a much larger percentage of his income from capital gains.  There are already plans to raise the capital gains taxes embedded in the Health Care bill that was passed, but this curiously takes effect after the 2012 election.  Just the anticipation of it, however,  will have an effect of current capital investment.  Currently the capital gains tax rate is 15%. It was lowered by both Bill Clinton and George W. Bush.

Capital gains is distinct from income in a few ways.  Capital gains is often the income that accrues over many years but is actually realized in a single year.  When we recently sold a company that had been in the family for three generations the capital gains we paid reflected the growth of the company over 90 years. Over nearly a century we paid millions in income tax, sales tax, and property taxes.  All of that is incurred before the gain on the basis is taxed at a lower capital gains rate.

This is true with any company that grows over time and generates a capital gains tax if it’s stock is sold at a  profit.  The capital gains rate is lower because it reflects these realities.

There is also the reality that we compete with other nations for investment capital.  There may be advantages to investing in the United States that would merit a higher tax rate, but while the president is refuting the idea of American exceptionalism, he should also be aware that we have become a much less ‘exceptional’ place to invest. Our corporate taxes are relatively high and the capital gains rate in China is zero.

If we are using the example of Warren Buffet and the reason that he pays a lower percentage than his secretary is that he has a higher percent of his income in capital gains or tax free muni bonds then I must assume that the president is calling for a much higher tax rate on these two sorts of income.  If he is not then he is either being intentionally deceptive or monumentally naive and ignorant .

If he is talking about raising the rates on these taxes then he risks major damage to investments, and without more investment then there will not be more jobs.  I doubt such an idea would make it through either house.  So far his own party seems reluctant to push for his recent jobs bill because it is aimed more at higher taxes on the rich than it is about creating jobs.

Warren Buffet himself noted that even if they substantially raised the taxes on the rich that it would do very little for solving the debt crisis.  And even Obama has noted that higher rates may reduce the actual dollar revenues.  Would they pursue their distracting quest for fairness even if it makes the deficit worse and increases joblessness?

Elizabeth Warren speaks of a social contract when she suggests that the successful should pay higher taxes.  The current progressive tax structure accomplishes that, but that does not give the government carte blanc to spend whatever it wants on whoever it wants or to regulate the light bulbs we read by, the amount of water we flush or the type of wood used on my Gibson guitar.  We don’t mind spending for roads, police or schools, and even some welfare, but a contract means there is also some obligation of the other party to be prudent with the money they spend.  Few Americans feel that the government is upholding their end of the social contract.