Is the 'Buffett rule' solution for the West?

As a measure of reform to the age old tax system, US President Mr Barack Obama, unveiled a dual taxation policy recently. The aim was to ensure that the rich are taxed at a higher rate than the less fortunate. While majority of the people seem to be supportive of this move one wonders whether such tax reforms would enable deficit cuts and fix government finances.

As the marginal utility of money for rich is low levying higher taxes on them would fill government lockers without much of a resistance. It is interesting to note that even in tax averse country like the USA, majority of the people have vouched for a higher tax regime for the rich. But what also needs to be understood here is the velocity effect that comes from lower taxation. As corporate profits and capital investments is a primary source of income for rich, higher taxation would mean that the capital that helps generates future growth effectively sits idle in the government lockers. This disrupts the capex cycle and the multiplier effect that comes through earnings plough-back.

Secondly, proponents of high tax regime for the rich also need to take into consideration the proportion of taxes that the rich contribute to the overall tax kitty of the government. A preliminary look at the statistics does suggest that the share is substantial. In fact, it has also risen as far as the developed world is concerned. So to that extent, it helps the government to manage their finances in a better way considering that the western world is soaked in debt.

However, as governments have yet to meet their fiscal targets they need to gauge the benefit arising from incremental tax levied on rich vis-a-vis creating a congenial business environment (taxes at par). A friendly business environment will help encourage capital investments and provide seed capital for future growth. This not only generates revenue for the government (through taxes; albeit at a slower pace) but also leads to a path of economic expansion. Take the case of 1970s. During that era higher marginal tax rates were a regular feature in many advanced economies. However, with growth slowing down, tax rates were lowered significantly. This encouraged private investments and created a buoyant environment for growth.

Further, one also needs to take into consideration the mobility factor associated with the rich. Rising tax rates may cause the rich to either move or re-locate to tax haven countries. Migration threat is typically large amongst corporates. If corporates shift their production base to a tax beneficial zone, the home country would not only lose tax revenue but will also suffer on GDP growth front.

Thus, while raising tax rates provides a temporary relief as far as the internal deficit targets are concerned it is not a universal remedy to meet the budgetary issues being faced by the western world.