Who Wants to Tax a Millionaire?

The "millionaire's tax" will affect more people than you think.

Supporters of health care reform need money—a lot of money—to pay for it. So it's not surprising that they would try to get it from the people with the most money to spare. Hence the so-called millionaire's tax, a levy embedded in the House health care bill. As the noted philanthropist (with other people's money) and House Ways and Means Committee chairman, Rep. Charles Rangel (D-N.Y.), explained, lawmakers are targeting big earners because it "causes the least amount of pain on the least amount of people." 

That's the theory, anyway. In fact, the millionaire's tax is a good example of how poorly some politicians understand the policies they propose.

At press time, the Senate was still debating the bill's details. But the health care bill that the House narrowly approved in November included a 5.4 percent tax on the portion of gross income (which includes capital gains and dividends) that exceeds $500,000 for individuals and $1 million for a couple. The surtax would apply to tax years that begin after December 31, 2010. So the first sign that the tax will hit more than millionaires is the fact that it targets half-millionaires from the get-go.

The idea's main selling point is that the in-crease would hit only 0.3 percent of tax filers —roughly 400,000 people—yet would raise $460.5 billion over the next 10 years. Congress' Joint Committee on Taxation estimated that the new rate would affect only 1.2 percent of relatively small business owners, including sole proprietorships (that is, businesses owned by just one person), partnerships (owned by a few people), and S corporations (which have up to 75 shareholders). But because the tax isn't indexed for inflation, over time it will apply to more taxpayers as inflation affects income levels.

Sound familiar? It should, because this is how the alternative minimum tax (AMT) became such a nightmare. The AMT was created in 1969 to prevent just 155 wealthy taxpayers from using deductions and credits to avoid paying any federal income taxes. Because it was not indexed for inflation, it came to affect an ever-growing share of the population, prompting Congress to pass a patch each year limiting its reach; next year, without the patch, it is projected to strike 27.4 million Americans—nearly 20 percent of the country's taxpayers. And even with the patch, the AMT hits far more than just millionaires: In 2009, it swept up 4 million families living in high-tax states who merely took multiple deductions for dependents and houses.

The same process would happen with the millionaire tax. According to the Tax Policy Center, a joint venture of the Urban Institute and the Brookings Institution (not exactly anti-tax organizations), by 2019 the number of taxpayers subjected to the health care bill's tax will have doubled. If inflation hits harder than the center's analysts assume, the number will be even higher. Either way, it will keep climbing, gradually assimilating more and more people who never thought they'd be considered super-rich. 

And many people classified as millionaires aren't millionaires at all. Out of the 300,000 or so joint tax filers earning more than $1 million, about 90 percent have small business income. That's because 75 percent of America's small businesses are structured as pass-through entities and pay their business taxes at the individual level. So the $1 million isn't going into those individuals' pockets; it's money they use to run their businesses. To avoid the new tax, those businesses would have to adopt a new structure and start paying the complicated corporate income tax. 

As income taxes increase on very productive people and small businesses, they will be less willing to hire or keep employees. The top tax rate on business owners who pay taxes as individuals, as opposed to corporations, is now 35 percent. It is already scheduled to rise to 39.6 percent on January 1, 2011, and under the House bill it would rise even higher, to 45 percent on taxable income of $500,000 for singles, $1 million for couples. With state taxes, some combined rates could exceed 55 percent. 

An acquaintance who manages a hedge fund told me, via email, "Economically, the play will disincentive folks like me to work—the tax now puts me well over the 50% tax bracket, will give me an incentive to find better tax strategies to protect my wealth and earnings and ultimately lead to a DECREASE in jobs for the U.S."

That's what has happened in states that have adopted their own millionaire taxes. In 2008, for instance, Maryland created a millionaire bracket subject to a 6.25 percent tax. When added to other state and local taxes, Marylanders could be hit with a rate as high as 9.45 percent. That didn't worry the state's governor, Martin O'Malley, who predicted that the 0.3 percent of filers affected would be "willing and able to pay their fair share." 

O'Malley was wrong. One year later, a third of the millionaires had disappeared from Maryland tax rolls. According to The Wall Street Journal, about 2,000 $1 million income tax returns were filed by the end of April 2009, down from 3,000 in April 2008. Where have these millionaires gone? Most likely to a state with no millionaire tax, such as neighboring Virginia. 

Would the same thing happen if the millionaire tax went federal? It isn't clear, the University of Michigan economist Joel B. Slemrod says in his 2000 book Does Atlas Shrug? The idea that heavy taxes on top incomes would entail huge economic distortions is somewhat ideological, he writes, and isn't rooted in serious empirical evidence. Unlike the conspirators in Ayn Rand's novel Atlas Shrugged, who escape government oppression by going on strike, real-world business leaders tend to keep on working and paying their taxes.

It's harder to move to another country than it is to move to another state within the same country. What's more, the U.S. tax code is extremely punitive toward wealthy taxpayers who move abroad. The United States is one of the few countries in the world that taxes its high-earning citizens on their income regardless of where they earn it or where they live. And because some Americans abroad have tried to renounce their citizenship to escape the worldwide tax treatment, in 2008 Uncle Sam imposes an exit tax on those who want to escape. 

This exit tax, worthy of authoritarian regimes, could very well dissuade Americans from leaving the U.S. This means they would be stuck with no choice but to pay the millionaire tax in the U.S.

Council of Economic Advisers Chairwoman Christina Romer is more pessimistic, or at least was. In a 2007 article written with her economist husband David, she concluded that tax changes—on millionaires or anyone else—"have very large effects: an exogenous tax increase of 1 percent of GDP lowers real GDP by roughly 2 to 3 percent." In other words, when you raise taxes, the economy shrinks. Weighing these factors, at the very least a millionaire tax is likely to be astonishingly inefficient.

It is also unfair, and it would be unfair even if it were indexed to inflation. According to the Congressional Budget Office, the top one-fifth of households already pay 69 percent of the costs of the federal government. Now the millionaire's tax is being tasked to pay for more than half the cost of the House bill. Is it really fair to place that much of the burden on just 0.3 percent of the taxpayers?

Contributing Editor Veronique de Rugy ([e-mail]) is a senior research fellow at the Mercatus Center at George Mason University.