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Buffett Rule: Another Step Toward Fiscal Disaster in 2013?

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Senate Democrats are set to bring legislation on the Buffett Rule to a vote this Monday. Why now? For starters, it's just ahead of tax day in America, meaning the media will find the vote irresistible. More importantly, with Mitt Romney the presumptive Republican nominee, the game is afoot for the Presidential election. Taking a thinly veiled pot-shot at Romney's wealth will make for a nice opening salvo from the Democrats.

"It's the beginning of the political process and the Democrats and the Administration are putting their cards on class warfare, the politics of envy," says Hank Smith, chief investment officer at Haverford Trust. "They're going to play that out right into November."

If passed, the Buffett Rule —named after billionaire Warren Buffett, chairman & CEO of Berkshire Hathaway (BRK-A) and one of the wealthiest men on earth- would ensure that individuals and businesses earning over $1 million per year pay at least a 30 percent effective income tax rate. According to Congress' Joint Committee on Taxation, the measure would raise $47 billion over 10 years. For perspective, the incremental tax revenue is equivalent t0 0.5% of the current $1.2 trillion deficit.

From an economic perspective, the Buffett tax amounts to little more than political pandering of the highest order. It's the collective impact of all the pending tax hikes that pose the real threat to the economy, according to Smith.

"They call it the fiscal cliff in 2013. That can't be good for the markets because if all those tax increases are enacted simultaneously, you'll take out at least 2% of GDP growth right away," he states.

Which is precisely why President Obama isn't touting the Buffett rule for its economic benefits. He says it's about Americans paying their fair share and allowing "everybody the chance to do well." The symbol for the proposal isn't Warren himself but rather Buffett's secretary who reportedly pays a higher effective tax rate than her billionaire boss.

The reason for the different rates isn't quite as simple as the White House would like you to believe. It's all about how Buffett and many Americans earn their income. Wealthier investors earn normal income that is taxed. Once it's invested, any income generated is taxed up to 35%. But should investments made off that income pay off for fat cats such as Buffett, the paid rate falls to 15% capital gains and dividends.

In other words, Buffett's secretary lives off what Warren pays her. Buffett is able to pay himself a lower "income," then live like a king off what he earns off his investment portfolio.

If this sounds confusing, that's because it's supposed to be. Under the Buffett rule, the effective combined tax on profits must be above 30%. OR, the Administration may simply raise the 15% capital gains tax. Either way, the plan is to reap more money from investors.

Many Americans trying to generate income through dividend-paying stocks (SDY) would be hit by the Buffett Rule or a simple a dividend tax hike.

"Won't so-called defensive stocks get annihilated if they increase the dividend tax because that would mean that the dividend rate is wildly overstated?" questions Breakout's Jeff Macke. "Your 3% all the sudden becomes 2% after you pay your taxes on it."

Smith points out that dividend stocks have survived wildly higher tax rate environments in the past. Until 2003, dividends were taxed at the top marginal rate. A look back at some historical numbers show you just how frightening it could be. The top rate was 90% in the early 1960s and 70% in the early 1980s. It didn't begin dropping until Reagan.

Bottom line, Smith says the market is in disbelief, hoping that the Buffett Rule and ensuing tax hikes are just political posturing.

"Let's hope that is the case because I can't create a positive scenario around all those tax increases occurring in 2013," he says.

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