Capital Gains and Warren Buffett: Part I
Recently, Warren Buffett noted that the rate of tax he pays on investment income (around 17%) is much less than the rate his employees pay on their earned income (around 36%). In a previous post, I argued that the comparison is meaningless, at least in the case of dividends.
Some commenters, here and at Tango's blog, criticized me for not dealing with capital gains, which they say is where most of Buffett's income arises.
Capital gains come from many different sources, which bring up different issues of fairness. So, I'll have several things to say instead of just one. My conclusion will be that there's an argument to be made for taxing capital gains at a very, very low rate, perhaps even zero.
I will argue that position is true even if you believe that tax rates on the rich are too low. I believe that even if you think the rich should be taxed, at, say, 60%, or 70%, or 80%, you should STILL favor a system where their "regular" income is taxed at a higher rate and capital gains are taxed at a lower rate.
1. Double taxation inside a corporation
If you buy a stock, and then sell it at a higher price, your profit is a capital gain. But, in many cases, the corporation has already been taxed on the profit that forms some or all of the gain. To tax it again at the full rate is unfair double taxation.
Suppose you buy a share of a company at $100. This year, they earn $10 in profits. They pay $3 corporate tax on the profit, and keep the other $7.
So, a year later, and all things being equal, the company is worth $107 a share. You sell your share for a $7 capital gain.
But, the piece of the company you owned actually earned $10 in profits, not $7. At a 30% tax rate, you already paid $3 in corporate tax on the profit. To tax you another 30% on the remaining $7 would be unfair. That would mean you'd only keep $4.90, and your effective tax rate would be 51%.
The concept of "horizontal equity" says that people who have the same income should pay the same amount of tax, regardless of where the income came from. If the top tax rate on employment income is, say, 40%, then the effective tax on income earned through a corporation, when you combine all the taxes, should also be 40%.
As I described in more detail in the previous post, a personal capital gains tax rate of around 15% gives the result we're looking for: you keep 85% of 70% of corporate earnings, which works out to a tax rate of 40.5%.
This is exactly the same argument as in the other post, just for capital gains instead of dividends. I realize that if you didn't like that argument, you probably won't like this one either.
Want a real-life example? Suppose you owned one share of Chevron.
Over the 16 years from 1995 to 2010 (.pdf), Chevron made a total profit for you of about $123. It had around a 40% corporate tax rate (I'm not sure why so high -- other companies seem to be around 30%). That means it paid around $50 in taxes, leaving $73 in after-tax earnings. It paid around $27 in dividends over that stretch, leaving $45 inside the company.
In that time, the stock went from around $25 to around $100, a $75 capital gain. More than half of that capital gain -- $45 -- is from the profit on which the corporation has already paid tax for you.
To fully tax you again on that $45 profit is not particularly fair.
What about the rest of the capital gain, the remaining $30 out of the $75? That probably shouldn't be taxed much either, since probably a lot of that is just inflation. Which brings us to number two.
The idea behind income tax is that when you become wealthier, you give some of it to the government to provide public services. But when the nominal value of your assets goes up only because of inflation, you're not wealthier, are you?
In 1980, you bought a house for $100,000. Today, you sell it for $300,000. Are you really $200,000 wealthier? Of course not. That's just inflation increasing the price of your house. In non-monetary terms, you might have paid 200,000 loaves of bread for it in 1980 (at 50 cents a loaf). In 2011, you sell it again for 200,000 loaves of bread (at $1.50 a loaf). Really, you've broken even.
This is pretty obvious, and I think almost everyone understands this already. That's why, in both Canada and the US, they offer tax relief for capital gains on houses you live in. In Canada, you pay absolutely zero capital gains tax when you sell your primary residence. In the USA, I once read, your first $400,000 in gains is tax-free if you buy another house with it. (Is that still true?)
If the government didn't do that, there would be riots in the streets. You wouldn't be able to move! If you're living in a $500,000 house with $200,000 worth of taxes due when you sell it, you'd have to downsize substantially. That would obviously be unfair. In most cases, the profit you made on the house is artificial, just an artifact of inflation.
The same is true for, say, stocks and mutual funds. Suppose you bought a share twenty years ago for $10. It never paid dividends. Today, you sell it at $20, but because of inflation, the $20 buys only what $10 bought then.
You really haven't made a profit. Yes, you got more dollar bills now then you paid in the past, but in terms of actual wealth -- the number of loaves of bread it would buy -- you just barely got your investment back.
That's part of the reason why the capital gains tax rate is lower than the regular tax rate: to compensate for the fact that a significant portion of a capital gain isn't really an increase in wealth.
Perhaps the best policy would be that when you sell an asset, you adjust for inflation when figuring your gain, and then you pay tax on that adjusted gain. The problem with that is that it's complicated and involves lots of arithmetic. I'd support implementing it anyway.
Now, you might be saying, that's fine if your capital gain just keeps pace with inflation. But Warren Buffett is famous for his investing prowess, where he makes capital gains that far outstrip inflation!
To which my response is: OK, but first, can we agree that he shouldn't have to pay tax on the inflation portion of his gain? (And if we agree on that, then at least we agree on at least one reason that Buffett's capital gains rate should be less than his employment income rate, right?)
But, yes, that still leaves the non-inflation portion of Buffett's gain, which is probably still substantial. That'll be in Part II.