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It’s time for an honest tax debate

In his State of the Union address last night, President Obama reiterated his vision for a tax code in which the wealthy — “people like me and an awful lot of members of Congress” — pay their fair share.

It’s a conversation worth engaging: In this charged political season, who pays what in taxes has emerged as a stand-in for widespread worries about the growing concentration of wealth in America. But first let’s inject some honesty into the debate.

Most people that Obama deems “wealthy” — including the President himself and most members of Congress — pay the highest tax rates of anyone around. Even most “millionaires,” with all their deductions, pay higher rates than the middle class. And the top 120,000 households — the 0.1% of earners — pay 30%, twice the middle-class rate. As Roberton Williams of the nonpartisan Tax Policy Center remarked in my Dec. 7 column, Why the GOP should hike taxes on the super rich: “The tax code is actually very progressive.”

President Obama, a millionaire from his book sales, paid a 2010 tax rate of 25%; the 271 non-millionaire members of Congress — those who rely on salaries ranging from $174,000 to $193,000-plus for House and Senate leaders — pay just under 23%. By contrast, middle class households pay average rates in the teens.

But, as I noted in that Dec. 7 column:

There is one class of wealthy people who arguably don’t pay their fair share — a relatively small class of investors that Warren Buffett has labeled the “super rich.” Their incomes have more than quadrupled in the past two decades, while their effective rates have plummeted to below what many in the middle class pay. They make most of their money from dividends and capital gains on investments, which are taxed at much lower rates. Contrast a capital gains rate of 15% with the top individual rate of 35%.

The higher you move up the income chain, the more likely you are to earn your income from investments rather than salary. The average taxpayer earns three-quarters of his income from a salary; for the top 400, it’s 8%, according to IRS numbers crunched by the Tax Policy Center.

Williams calculates that the 400 richest Americans, averaging $270 million a year, paid an average 18% tax rate in 2008. Even worse, these big time investors aren’t subject to payroll tax, which everyone else has to pay until their salary hits $106,800. Neither are their investment gains subject to the 1.45% Medicare tax that the rest of us pay.

But for others that President Obama has labeled wealthy, it’s a different story. The system is actually quite progressive — and fair. “It’s really about investors versus workers,” Williams notes.

The White House tries to spin its case for higher taxes on all rich by advertising facts like this: “165,000 households making over $1 million paid less than 30% of their income in taxes.” But 30% compared to what? That’s far higher than average rates paid by much of the middle class—which is how our progressive tax code is designed.

Super-rich investors are the biggest income winners over the past two decades, even as their tax rates have dropped. Williams says the IRS numbers on the Forbes 400 show that their incomes have quadrupled since 1995, even as their tax rates have dropped to 18%. The average earner has seen his income rise by only 77% while tax rates have gone up.

GOP candidate Mitt Romney stepped into this morass when he released tax returns showing that he paid just under 14% in taxes. (Full disclosure: My husband is a Romney adviser.) But it’s up to Congress and the President to change the law if Americans deem the system unfair.

There are arguments on all sides worth airing. Raise rates on investment income? Maybe, but that could also discourage investment and risk-taking, and supporters of a low rate argue that investment income has already been taxed at the 35% corporate tax rate before being paid out to individuals.

A narrowly tailored Buffett Rule — in the form of a minimum tax that acknowledges that the “millionaires-escaping-taxes” story is really an exception to the rule – may make sense. So too would a simpler, lower-rate tax code that doesn’t pick winners and losers. When the Harvard Business School asked 10,000 alumni for policy suggestions to make American more competitive, the most popular was “simplify tax code.”

Let’s have the discussion—but without the politically-opportune myths.

Washington Columnist Nina Easton is currently a fellow at the Harvard Kennedy School’s Shorenstein Center on the Press, Politics and Public Policy.