How the 'Buffett Rule' Has Already Hurt the Economy

When individuals anticipate a tax increase they will accelerate their income so that is taxed at the prior (lower) tax rate.

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Joseph Mason is the Moyse/LBA Chair of Banking at the Ourso School of Business at Louisiana State University and a senior fellow at the Wharton School of the University of Pennsylvania.

One topic of concern in the recent news is whether President Obama will succeed in raising U.S. income tax rates. (In fact, one of the first tests of that agenda will take place Monday with the Senate scheduled to vote on the so-called "Buffett Rule.") Of course, it is still too soon to tell, but as tax season rolls around we can look to coming tax collections to get some insight.

In a superb review article in the most recent Journal of Economic Perspectives, Emmanuel Saez, Joel Slemrod, and Seth Giertz point out that when individuals anticipate a tax increase they will accelerate their income so that is taxed at the prior (lower) tax rate. The authors make the case that such patterns are common in historical tax collections, such as when President Clinton was elected in 1992 with a promise of raising taxes, which was implemented in 1993. Taxable income reported in those tax years spiked in 1992 and fell dramatically in 1993, as individuals subject to the higher taxes accelerated income where they could do so.

[Read the U.S. News debate: Should the 'Buffett Rule' Become Law?]

Of course, such strategies work best for realized capital gains and stock option exercises, which can be conveniently timed. In other words, such strategies work well for people like Warren Buffett.

But there's more. When large numbers of market participants do the same thing at once, markets react. In particular, when a large number of investors sell at once, prices go down. If markets anticipate tax increases and the timing that results, they may decline at the policy announcement.

In his first address to the nation on February 15, 1993, Clinton announced his intention to raise taxes to cap the budget deficit. Just two days later in a nationally televised address to a joint session of Congress, Clinton unveiled his economic plan focusing on deficit reduction rather than a middle class tax cut, which had been high on his campaign agenda. After falling somewhat in anticipation of the speech, from February 15 to February 17, the S&P 500 lost 2.54 percent, the Dow lost 2.37 percent, and the Nasdaq lost 4.51 percent.

[See a collection of political cartoons on the economy.]

Of course, any time you can predict a market movement you can make money. That, in fact, is part of the congressional inside trading issue that led to the Stop Trading on Congressional Knowledge Act, known as the STOCK Act. Clinton was reportedly pressured by his advisers, including Robert Rubin formerly of Goldman Sachs, to raise taxes on the theory that a smaller federal budget deficit would reduce bond interest rates.

While Rubin kept his motivations somewhat under wraps, in the recent episode Warren Buffett has been boldly comfortable basking in the media limelight for pushing the tax increase. It would make sense for an astute investor such as Buffett to place investments that would gain from the market reversal such policy announcements would inevitably cause. Of course, I cannot say for sure that Buffett knew the timing of the announcement or prepared his portfolio appropriately. President Obama, however, squarely situated the Buffett rule in his platform on April 7. By April 14, it was reported that the Standard & Poor's 500 Index just experienced its biggest weekly decline in 2012.

Thanks Warren. Nice trade.

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