Tuesday, October 11, 2011

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.

Here goes.


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.


2. Inflation

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.

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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.

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39 Comments:

At Wednesday, October 12, 2011 10:49:00 AM, Anonymous Anonymous said...

You raise some interesting points, but your argument about double taxation is weak at best. Double taxation does not exist unless you choose to be extremely arbitrary and look at a very discrete period of time. Money is taxed repeatedly over time. If I take income from dividends, and use that money to buy something and pay sales tax, or if I employ someone and pay taxes on that, no one ever seems to consider that too terribly fair -- well, except for the people who think all taxation is unfair. Also, see this on the advantages corporations get from the government in return for paying corporate tax http://pragmatos.net/2008/09/07/the-myth-of-double-taxation/

 
At Thursday, October 13, 2011 7:50:00 PM, Anonymous Mike said...

"can we agree that he shouldn't have to pay tax on the inflation portion of his gain?"

I have to pay tax on the inflation portion of my gain in my savings account. How are capital gains different?

 
At Thursday, October 13, 2011 7:55:00 PM, Anonymous Mike said...

Also, in the US, I believe it's 500k for married couples, and there is no requirement for buying another house with the money. The only requirement is living in the house for 2 years, and it being your "primary" residence.

 
At Friday, October 14, 2011 11:12:00 AM, Blogger Phil Birnbaum said...

Mike,

I'm honestly not sure about exempting inflation from interest income. It seems like a good idea, but interest income on corporate bonds is also tax-deductible by the corporation, so you'd have to figure out how to make the tax deduction exclude inflation too, and also depreciation and such.

I'm not expert enough to figure out if that's a good idea or not.

Also, since interest rates are, to some extent, set by the market, the inflation tax disadvantage might be priced in (advantage lender, disadvantage borrower). I'm not sure about that. (It does seem like when inflation is 10% and interest rates are 12%, inflation isn't built in completely, because you lose money after tax at a 16% or higher tax rate. But is it built in a little bit? Not sure.)

Any economists reading who know about this stuff?

In any case, I agree that the inflation portion of interest isn't real income. I just don't know enough economics to follow through on what to do about it, if anything.

Thanks for the info about the US housing capital gain exemption. The "primary residence" thing is the same in Canada, but there's no limit on the amount.

 
At Saturday, October 15, 2011 1:10:00 AM, Blogger Tim Shipman said...

"the corporation has already been taxed on the profit that forms some or all of the gain."

The price of a stock is a function of its market. Stock prices don't rise or fall based off of profit or loss, they do so based off a market. If you buy a stock at $50 and sell it next week at $55, nothing happened in between but market forces. This argument is bogus and dishonest.

"I realize that if you didn't like that argument, you probably won't like this one either."

That argument was also bogus and dishonest.

"That probably shouldn't be taxed much either, since probably a lot of that is just inflation."

Wages aren't indexed for inflation. If I make 50K in 2008, and I make 50K in 2012, the government doesn't send me a check for the difference in real dollars I paid in taxes. Inflation is part of doing business. This argument is once again, bogus and dishonest.

 
At Monday, October 17, 2011 2:34:00 PM, Anonymous Anonymous said...

@tim shipman

i don't think you understand how stock prices are determined. they are determined by the market, correct, as just about everything is. but the market bases it's valuation on the company's future earnings discounted for the time value of money. this is the only way you can properly evaluate stocks, because your buying a claim of future profits. they aren't baseball cards. phil's aguement is neither bogus nor dishonest. your knowledge of the stock market, however, is blatantly lacking.

 
At Sunday, November 20, 2011 6:28:00 PM, Anonymous Matt said...

"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 tax environment was known and priced into the stock when you bought it. If the company were allowed to keep all $10, then you would have to pay more than $100 to buy the stock in the first place, since its expected future earnings would be higher.

So when you say

"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",

this is misleading. You paid the price for a company that will keep $7 for every $10 it earns.

It's inconsistent to treat the $3 as "tax you paid" without treating
the discounted share price you bought at as a credit in your favor.

Assuming the market is pricing the shares reasonably efficiently, that discounted share price should balance the 30% tax on corporate earnings.

 
At Sunday, November 20, 2011 10:26:00 PM, Anonymous Matt D said...

OK, having now read the comments on Tango's blog and thought about it a bit, let me restate my argument a different way:

When it comes to taxes, starting a company that's subject to a corporate tax is different than buying shares in an existing one.

Consider a hypothetical world in which all companies are taxed at 30%, except widget makers who pay 0%. Suppose, using our crystal ball, we know for sure that each year Acme drug company will make $100/share pre-tax, and ABC Widget company will make $70/share and pay no corporate tax.

All else being equal, which investment will cost you the investor more in taxes? I'd argue that in the most relevant sense they're the same.

Why? Your purchase price (all else being equal) should be the same for both, and in both cases your return is $70/(your price) per year.

When Acme sells shares to you they are essentially capitalizing their expected tax burden in the form of a discount to you. Acme will get the same price on the market as ABC, even though their earnings are higher. So they absorb the cost, not you.

Sure, technically a company you own is paying $30/year in taxes, but you got an offsetting $30/year credit at the time of purchase.

This is different from starting a company, and is why your "incorporate yourself" argument is misleading.

If I incorporate myself, upon doing so I make myself susceptible to corporate tax. Let's say it's 30%. Let's say I expect to make $100000/year pre-tax. My tax burden is then 0.30*$100000 (corporate tax) + 0.15*$70000 (15% capital gains) = $40500. So MY tax rate as founder is 40.5%.

BUT if I sell shares of myself to Warren Buffett, he has no reason to pay for my expected pre-tax earnings of $100000. He's going to pay for my expected post-tax earnings of $59500. I have to capitalize my expected tax exposure when I sell shares.

Sure, in one sense, Buffett would then be paying the 30% tax on my earnings (and then capital gains tax on that). But in that sense he has also received corresponding extra income, in the form of a discounted purchase price, for assuming my expected tax burden.

HIS effective tax burden in this scenario is 15%.

He'd get a return of $59500/(his price paid) per year as income. If the tax rate were higher, the numerator would get smaller, but so would the denominator.

I think Buffett's way of putting it is correct and more straightforward. But however you want to word it, I think the 17% tax he pays on investment income is indeed the relevant rate.

 
At Monday, November 21, 2011 9:30:00 AM, Blogger Phil Birnbaum said...

Matt,

If I've got your argument right, you're saying that Buffett is paying the 40.5% tax, but that he gets a discount on the share price to compensate.

OK, I'll buy that. But why does it follow that Buffett is therefore only paying 17%? It only follows that he got the stock cheaper than he would have if the corporate tax didn't exist!

And, more relevant to the argument, you've just debunked Buffett's actual claim: that he should be paying more than 17%, that 17% isn't fair. If you believe that the stock is priced to reflect the corporate tax, so that the previous buyer pays it ... and if you don't want to count that for Buffett (which I disagree with, but you don't) ... then all that's left is Buffett's 17%. So, if you ask Buffett to pay more than 17%, that would be unfair!

You can't have it both ways. Either Buffett pays the corporate tax, or someone else does. Whichever way you decide to account for it, the tax is 40.5% (or whatever). If you decide to tax Buffett more because he isn't really paying any corporate tax (a point on which I disagree), then you're taxing two people the same tax, which is still double taxation!

Remember my salary analogy. You have two choices: (a) you earn $80K and pay $30K tax. (b) you earn $50K and pay no tax, and your employer will pay all the tax for you.

In case (b), do you really want to argue that your tax rate is 0%? I think that's what you're doing in the Buffett case.

 
At Monday, November 21, 2011 3:02:00 PM, Anonymous Matt D said...

If I've got your argument right, you're saying that Buffett is paying the 40.5% tax, but that he gets a discount on the share price to compensate.

OK, I'll buy that. But why does it follow that Buffett is therefore only paying 17%?


Because the corporate tax was priced in. If things are priced reasonably efficiently, the size of the initial discount is precisely the expected future corporate taxes (i.e. the 30%). The 17% is what he pays on his actual investment return. Which is my point. (And his).

It only follows that he got the stock cheaper than he would have if the corporate tax didn't exist!

Yes, that's the point. And it supports my argument, not yours.

There are two ways to look at it:

--You can compare his real-world buying price to his real-world selling price and conclude he pays 17% on his real-world return. This is straightforward and it's what he is doing.

--Or you consider at what his return would be in an imaginary corporate tax-free world, but then you need to compare it to his cost basis in that world. That would be higher, and if this imaginary world prices things efficiently, it would be exactly as much higher as the market value of the (missing) expected corporate taxes. So in this imaginary world he would still be paying about 17%.

What you CAN'T do is subtract his real-world cost basis from his imaginary world selling price and call that his "effective tax". It's not apples-to-apples.

You can't have it both ways. Either Buffett pays the corporate tax, or someone else does.

Um ... I think you're the one trying to have it both ways.

I'm claiming specifically that, in effect, someone else does. It's whoever owns the company when it first becomes subject to corporate taxes.

That's one of the costs of incorporating. Your expected future taxes go up. (There are also benefits to incorporating, which is why people do it in spite of the expected tax burden.) And you capitalize that loss when you incorporate and then sell shares.

None of that has to do with Buffett, who is buying shares in companies where that loss of value has already been capitalized by someone else.

If you decide to tax Buffett more because he isn't really paying any corporate tax (a point on which I disagree), then you're taxing two people the same tax, which is still double taxation!

You could argue that the people who own shares at the time of incorporation are being double-taxed. But:

A) That's not what Buffett was talking about.

B) It ignores the benefits that come with incorporating.

If you want to make the argument anyway, be my guest. But that's not what your post says, and it's not relevant to what Buffett was talking about.

 
At Monday, November 21, 2011 3:07:00 PM, Anonymous Matt D said...

And, to be clear, I'm just talking about what one should identify as Buffett's actual "effective tax", not about what is fair.

(Personally I'm a pragmatist and I don't particularly care about double-taxation per se. I care what the effective rates are, and what are the actual outcomes that they produce.)

 
At Monday, November 21, 2011 4:13:00 PM, Blogger Phil Birnbaum said...

Sorry, Matt, I can't really follow your argument.

Let me start by asking you this:

1. I make $100K a year, nominally. My employer sends $30K to the government, leaving me $70K. When I do my taxes, I pay $10K more.

2. Buffett's shares earn $100K in corporate profits. The corporation sends $30K to the IRS in corporate tax. It pays $70K to Buffett, who pays an additional $10K tax.

What is my effective tax rate? What is Buffett's? If they are different, why?

 
At Monday, November 21, 2011 7:18:00 PM, Anonymous Matt D said...

1). 40%.

2). Assuming Buffett bought an efficiently priced stock, ~14% (10 of 70K)

The difference is that Buffett bought shares on the market, after the tax expense was already priced in. (You conveniently left out any info about Buffett acquiring the shares.) The loss of value due to expected future tax exposure was already absorbed by whoever generated the exposure (presumably whoever incorporated the company).

On the other hand, you didn't purchase your labor from somewhere else. You acquired it by producing it. Since it's taxable, you also produced a tax liability. No one's going to pay you for your labor's value without discounting for the liability.

Your employer is not going to hire you for (pre-tax) $100K/yr unless they think you add at least $100K in value. They price your labor's tax liability into your pay. When they send 30K to the government, it's your loss, not theirs, since you had to produce 100K of value to get your 70K paycheck.

Your employer is the one analogous to Warren Buffett: they're investing in your labor after expected tax liabilities are priced in.

Or consider an example I mentioned earlier:

Consider a hypothetical world in which all corporations are taxed at 30%, except widget makers who pay 0%.

Suppose, using our crystal ball, we know for sure that each year Acme drug company will make $10/share pre-tax, and ABC Widget company will make $7/share and pay no corporate tax.

All else being equal, do you agree that shares of Acme and ABC should have the same price?

Suppose I buy a share of Acme for $100/share and you buy a share of ABC for $100/share.

Do you agree that after one year both our gains will be $7 ?

If so, then:
ABC: makes $7/share/yr, sells at $100/share
Acme: makes $10/share/yr, sells at $100/share
Me: Invests $100, gains $7/yr, ~$6 after taxes
You: Invests $100, gains $7/yr, ~$6 after taxes

1) Would you say that I'm being double-taxed in this scenario?

2) Who loses money as a result of the (non-widget) corporate tax, me or Acme?

3) Would it achieve horizontal parity to tax me less than you?

 
At Monday, November 21, 2011 11:03:00 PM, Blogger Phil Birnbaum said...

Matt,

Sorry I have to keep moderating your comments ... the original blog post is more than a month old, so it asks me every time.

Let me jump to the last part of your comment. I was going to pursue the employee/corporation thing, but I have a better example for a future comment. But, let me respond to you, first, as you were kind enough to respond to me:

Yes, I agree that Acme and ABC will sell for the same price per share.

As for your questions:

1. Yes, you are being double-taxed. You are paying 40% tax on your profits. The fact that you got a "discount" on those shares doesn't mean you're not paying 40%. It just means that the 40% rate isn't really hurting you personally.

Assuming that Acme is the only company paying corporate tax, the 40% rate is hurting whoever started the company and sold the shares the first time. This is in agreement with what you said before.

However, that's a different argument than the one I made. I didn't argue that Buffett's 16% was equivalent *in fairness* to his secretary's 40%. I argued that Buffett is actually paying 40%. I still argue that that's true.

2. Who loses money on the corporate tax? As you say, the founder of Acme lost all that money when he was forced to sell the shares at a discount.

That's why if you tax Buffett at more than 15%, you are double taxing. The founder pays the corporate tax, Buffett pays 15% more, *and then Buffett pays even more*. The double taxation is spread between the two parties. It's still double taxation.

3. On horizontal equity, the question is confused by the fact that it's unfair that Acme income is subject to more tax than ABC income. That's the inequity.

However: I do see what you're getting at. You're saying that Buffett is not being hurt by the corporate tax, because it's priced in.

But, if you want to argue that, then it's not just the corporate tax that's not meaningful in evaluating Buffett -- it's the 16% also!

Because, let's say the corporate tax stays the same, but the government decides to tax dividends at 32% instead of 16%. What happens? Well, now Buffett takes home $5 instead of $6: Acme makes $10. The corporation pays $3 corporate tax, and Buffett pays $2 additional.

But, if that's the case, Buffett wouldn't pay $100 for the shares anymore. To make them competitive with ABC, the original owner of Acme would have to sell the shares for $83. Right?

So now Buffett buys 1.16 shares for his $100, and still takes home $6.

But, by your argument, Buffett is now paying 30%, instead of 16%!

See what I mean? Buffett's nominal tax rate is irrelevant. He's always going to make the same after-tax return on investment as ABC. No matter what the tax rate on dividends is, it doesn't affect Buffett at all. It only affects the original owner of Acme.

Bottom line: I agree with much of your argument, and what you say about the tax incidence is relevant. But your conclusion that Buffett's *true* rate is 16% isn't right, because that rate isn't meaningful AT ALL if you're looking at horizontal equity rather than tax actually paid.

 
At Monday, November 21, 2011 11:08:00 PM, Blogger Phil Birnbaum said...

Here's the other argument, as promised.

Two countries, USA and Elbonia. Exactly the same countries, except that the USA has a 30% corporate tax and 15% dividend tax, for an overall tax rate of 40.5%. Elbonia has a 40.5% corporate tax and no dividend tax, also for an overall tax rate of 40.5%.

Shares of Acme go for the same price in both countries, since the after-tax return is the same.

Warren Buffett buys shares in Acme USA. He pays $100 for the shares. Acme pays $30 in tax. Buffett pays 15% of his dividends, or $10.50. Overall tax: $40.50. Buffett keeps $59.50.

In Elbonia, Boron Wuffett buys shares in Acme Elbonia. He pays $100 for the shares. Acme pays $40.50 in tax. Wuffett receives $59.50 in dividends, and pays no tax on that.

By your logic, Buffett pays 16% in taxes. Wuffett pays 0%. But both investments are exactly the same price, pay the same after-tax return, and, both companies' profits result in exactly the same tax revenue to their respective governments.

So how can Buffett's and Wuffett's nominal dividend tax rates -- 15% and 0%, respectively -- be meaningful at all? The numbers make NO DIFFERENCE to horizontal equity.

 
At Tuesday, November 22, 2011 11:43:00 AM, Anonymous Matt D said...

The fact that you got a "discount" on those shares doesn't mean you're not paying 40%. It just means that the 40% rate isn't really hurting you personally.

OK, then I think we need to define what is an "effective tax rate" before we go any further.

If I lose $1 as a result of the capital gains tax, and $0 as a result of the corporate tax, I would define my "effective tax" as $1.

If you define your "effective tax" as something else, then I fail to see why your "effective tax" is important in any real way.

 
At Tuesday, November 22, 2011 11:52:00 AM, Blogger Phil Birnbaum said...

I'm defining the effective tax as the amount of money the government gets out of each $1 in income (profits, or employment income). In our mutual example, the effective tax (by my definition) is 40.5%, after the corporate tax and dividend tax.

Then, there's another question -- WHO PAYS that tax? In one sense, it's Buffett. If all taxes were eliminated, Buffett would get 100% instead of 59.5%. So, Buffett is paying the tax.

That is a variation of what you just said: if Buffett loses 40.5% as a result of all the taxes on his property, his effective tax rate is 40.5%.

Then there's a third question: who is hurt by the tax? I'm not really addressing that question (although I perhaps addressed it a bit in the previous comments). I think that's the question you're thinking of ... and your comments are relevant to that question. I see kind of where you're going, although I didn't follow the full argument a few comments ago.

But my argument is: even if you're looking at this last question, the "16%" nominal dividend tax is still not a meaningful answer. In fact, I would argue, it's not a meaningful answer to any of the three questions.

On the other hand, the "40.5%" figure IS a meaningful answer to question #2. And, with certain reasonable assumptions, it's also a meaningful answer to question #3 (although I haven't really made that argument explicit yet, but I can if you like).

 
At Tuesday, November 22, 2011 12:01:00 PM, Anonymous Matt D said...

Who loses money on the corporate tax? As you say, the founder of Acme lost all that money when he was forced to sell the shares at a discount.

That's why if you tax Buffett at more than 15%, you are double taxing.


I'm still not sure if I disagree with your logic or semantics, but one of them is flawed.

If Buffett is losing $0 as a result of the corporate tax, he is effectively not paying corporate tax.

His effective tax rate is 15%. That is the point I was disputing all along. I wasn't discussing fairness, and I don't care about "double-taxation" (which I think is not well-defined, quite frankly).

Are you agreeing with me that Buffett's effective tax rate is 15%, not 40% ? If not, please define "effective tax rate".

 
At Tuesday, November 22, 2011 12:17:00 PM, Anonymous Matt D said...

I'm defining the effective tax as the amount of money the government gets out of each $1 in income (profits, or employment income).

No, no. I mean what are you defining as Warren Buffett's effective tax rate?

 
At Tuesday, November 22, 2011 12:23:00 PM, Blogger Phil Birnbaum said...

You can define it two ways. You can define it to be 16%, or 40.5%.

My argument is that the 16% figure is meaningless, and is itself a result of semantics, of not including corporate tax as income tax.

To be clear: there is a sense in which "Buffett pays only 16% tax on his dividends" is true. However, because of the existence of corporate tax, that 16% is misleading when trying to judge his overall tax burden.

That is: "Buffett pays 16% tax but his secretary pays 33%" is not a valid comparison, because Buffett's rate does not include consideration of dividend tax.

If your entire question is about how to define it, my answer is: I don't care. Define it as 16%, or 40.5%, whichever you like. But if you define it as 16%, as a percentage of "cash received", then you can't validly compare it to employment income tax -- because "percentage of cash received" is a misleading measurement.

Does that help? I am willing to concede the sentence "Buffett pays 16%", but would argue that the definition that makes that true is not in accord with how it's being used in arguments.

For instance: define "tax paid on cash received." Buffett pays 16%. His secretary pays 0%, because all her tax is withheld from her paycheck.

It is true that "tax paid on cash received" is 16% for Buffett and 0% for his secretary. But that can't be used to decide if Buffett is being taxed unfairly, because "tax paid on cash received" is not an accurate reflection of the true tax burden.

The same is true, in reverse, for "effective tax rate" that's defined as 16% for Buffett and 33% for the secretary.

 
At Tuesday, November 22, 2011 12:27:00 PM, Blogger Phil Birnbaum said...

To more clearly answer your question, I don't have an answer because I don't care how you define "effective tax rate". I honestly think of Buffett as paying 40.5%, and that that is the meaningful number.

My criterion is: in the absence of income taxes, what would Buffett take home? The answer: $100 instead of $59.50. What would his secretary take home in the absence of income taxes? $100 instead of $67. That's the more meaningful number, whatever you want to call it.

 
At Tuesday, November 22, 2011 2:48:00 PM, Anonymous Matt D said...

Oh wait, there's a missing ingredient here, and it's important.

Dividend taxes are progressive.

So your example of Elbonia is good, and instructive: a flat dividend tax is also priced into shares. Wuffett and Buffett pay the same effective tax (by my reckoning, 0%).

My ABC example was flawed in this regard. The flat rate of the dividend tax is priced into shares too.

But actual dividend taxes are progressive, and this is important.

I need to correct myself and say that I think the "effective tax" is based on the difference between the investor's rate and the lower bracket rates. (I would guess a decent estimate would be something like: effective tax ~ investor's dividend tax rate - lowest bracket dividend tax rate).

Currently that bottom rate is 0%, but it wasn't in our examples.

So: in your example, as long as there are some investors in the US who pay a dividend tax rate lower than the 15%, the price of Acme USA will be higher than Acme Elbonia.

The difference is that corporate tax is priced in for all buyers. Dividend tax is priced in for the individual buyer.

If I can get a $7 after-coprporate-tax return for a share of Acme USA and pay 0% dividend tax, I'll pay the market rate for a $7 return. If Warren Buffett wants to outbid me for that share, he'll be paying >= market rate for a $7 return, then get taxed ~$1. That's why I think the dividend rate is a tax on him, and the corporate tax is not.

Sorry, I feel silly for having missed that.

Responding to your last post:

My criterion is: in the absence of income taxes, what would Buffett take home? The answer: $100 instead of $59.50.

This is the part that I think is wrong, not just semantically different.

The absence of income taxes would have affected his cost basis. He wouldn't get a full $100 because he wouldn't have as many shares in the first place.

$100 is what he takes home if he buys stock in a world *with* income taxes, then unexpectedly all taxes are eliminated the moment after he buys.

This world is not relevant to his secretary's taxes.

 
At Tuesday, November 22, 2011 2:54:00 PM, Blogger Phil Birnbaum said...

Matt,

I was assuming that dividend taxes were progressive, like they are in Canada. So, no big deal.

As I said before, my argument is that if you're going to take Buffett's cost base into account, to see how much he's actually hurt by the tax, that's fine. But then it's not just the 40.5% that's irrelevant, but the 16% is also irrelevant. I illustrated that in the Elbonian post, where Buffett pays different amounts of dividend tax, but is treated exactly the same way, even on the cost base.

 
At Tuesday, November 22, 2011 4:47:00 PM, Anonymous Matt D said...

First, let me be clear: by Buffett's "effective tax" I mean a number that could be compared to the tax rate of his secretary.

But then it's not just the 40.5% that's irrelevant, but the 16% is also irrelevant.

Not if the market includes people who are paying dividend tax rates other than 16%.

That's why I'm saying progressivity was an important ingredient I forgot.

I illustrated that in the Elbonian post, where Buffett pays different amounts of dividend tax, but is treated exactly the same way, even on the cost base.

Right, hence the correction about progressive rates: In the Elbonian post his dividend rate doesn't matter -- BUT: that's because he's paying the base rate. His rate = bottom rate = top rate = flat rate, which is priced in. There's no effective tax because his rate is exactly 0% above the base rate. It DOES NOT mean that dividend tax rates never matter.

The Elbonian example shows only that a FLAT dividend tax rate doesn't matter. (Which is instructive, but misses an essential feature of actual taxation).

Consider:
Widgetland:
--30% corporate tax rate
--15% dividend tax rate on everyone
--ABC Corp makes $10/share

Taxlessland:
--No taxes on anyone
--ABC Corp makes $5.95/share

Fudgitland:
--30% corporate tax rate
--0% dividend tax rate on everyone except Baron Wuffett, who pays 15%
--ABC Corp makes $8.50/share
All else is the same in the three worlds.

--In Widgetland and Taxlessland, shares of ABC yield $5.95 after taxes for all investors, including Wuffett

--In Fudgitland, shares of ABC yield $5.95 for all investors other than Wuffett
For Wuffett, shares of ABC yield $5.06

Do you agree that the price of ABC should be close to the same in the three worlds?

If so then
--Widgetland Wuffett makes ~$5.95
--Taxlessland Wuffett makes ~$5.95
--Fudgitland Wuffett makes ~$5.06

I would call Wuffett's effective tax (by that I mean a number we could compare to his secretary's tax rate) to be the difference between what he makes and what he would make in Taxlessland.

For the Fudgitland scenario that would be ~$0.89 (~15%, since his rate is 15% above base) and for the Widgetland scenario it would be ~$0.

You're saying that you would call his effective tax in Widgetland and Fudgitland both $5.95 ? Even though the tax code caused him to lose more money in the one than the other?

Or that acquiring an income stream for the same price and after-tax yield as you could in a world without taxes still amounts to being taxed 40.5% ?

That's certainly not a number I would compare to his secretary's, who loses ~33% by being in the real world rather than the taxless one.

 
At Tuesday, November 22, 2011 8:33:00 PM, Blogger Phil Birnbaum said...

1. If you're saying that Buffett benefits from the fact that the corporate tax and dividend tax are flat and not graduated, then, OK, that's a point. But it's a side point.

2. The problem is that you have a solid explanation of why the corporate tax doesn't affect Buffett, but you're contriving to explain why the dividend tax DOES affect Buffett. Neither affects him, really. Let me think of how to explain why.

 
At Tuesday, November 22, 2011 8:41:00 PM, Anonymous Matt D said...

OK. Could you also clarify:

In some places you seem to be saying that the 40.5% really is Buffett's effective tax rate (again, "effective tax rate" = number we compare to his secretary's 33% rate).

In other places you seem to be saying that neither 40.5% nor 16% are Buffett's effective tax rate.

Which one are you claiming?

 
At Tuesday, November 22, 2011 9:01:00 PM, Anonymous Matt D said...

If you're saying that Buffett benefits from the fact that the corporate tax and dividend tax are flat and not graduated, then, OK, that's a point. But it's a side point.

It's not a side point. I'm computing "effective tax rate" as

[return Buffett would get in a tax-free world from buying and selling stocks] - [after-tax return Buffett gets in real life from buying and selling stocks]

You seem to want to call any tax effects that reduce Buffett's return as a "tax" but none of the tax effects that increase Buffett's return as "tax credit".

This will always overstate the tax burden of an investor.

Part of investing is exchanging debts, some of which happen to be called a "tax", for other things of comparable (negative) value which may not happen to be called a "tax". Tallying these ostensible "side points" is precisely what needs to be done to evaluate effective tax rates. You can't just glom together the things that happen to have the word "tax" in them. (This is what I think the 40.5% number is. If you're claiming his tax rate is something else entirely, please say what.)

 
At Wednesday, November 23, 2011 9:45:00 AM, Blogger Phil Birnbaum said...

OK, Matt ... I'm not sure, but I think the problem is that your examples compare corporations with different earnings.

When comparing tax rates, you want to compare rates on the *same gross income*. That's the income Buffett's secretary makes, and also the income Buffett's corporation makes.

 
At Wednesday, November 23, 2011 9:47:00 AM, Blogger Phil Birnbaum said...

I think part of the problem, too, is focusing on Buffett, and not on the tax.

We both agree that Buffett's corporation pays 40.5% tax, right? That is, of the wealth created, the government gets 40.5% of it.

If you argue that Buffett only pays 16%, then someone else pays the rest. Fine. But, then, if you think Buffett should pay more, then that other entity should pay less, right? Otherwise, you'd be taxing the corporate income at a huge overall rate.

Maybe focus on how the 40.5% is being split first, rather than how much Buffett himself is or is not paying.

 
At Wednesday, November 23, 2011 9:54:00 AM, Blogger Phil Birnbaum said...

To answer one of your questions:

If you want to measure how much tax Buffett is actually paying, I argue that 40.5% is the right number and 16% is the wrong number.

If you want to measure how much the corporate and dividend tax affect Buffett's earnings, both the 40.5% and the 16% numbers are probably not correct, and you have to look deeper to get the right answer.

----

What I think your argument does is prove that Buffett is not necessarily negatively affected by the fact that his rate is 40.5% and his secretary's is 33%, because of what he paid for the stock on the open market. That's absolutely true. But if "extent of negatively affected" is your criterion, then the overall question is very hard to answer, and (I argue) "16%" is also incorrect.

 
At Thursday, November 24, 2011 12:07:00 AM, Anonymous Matt D said...

OK, Matt ... I'm not sure, but I think the problem is that your examples compare corporations with different earnings.

I'm pretty sure it's not a problem.

If you like, suppose the ABC company has the same $10/share earnings in each scenario.

Suppose ABC Taxlessland costs $100/share, yielding 10%.

Then (all else being equal)

ABC Widgetland (30% corporate tax, 15% flax dividend tax) will cost about $59.5/share

ABC Fidgitland (30% corporate tax, 0% dividend rate for everyone but Wuffett) will cost $70/share

Yes? (Please do check my arithmetic.)

So if Wuffett invests $100 in each world he gets back:

--Taxlessland: 1 share, $10
--Widgetland: ~1.68 shares, ~$11.76 before div tax, ~$10 after tax
--Fidgetland: ~1.43 shares, ~$10 before div tax, ~$8.50 after div tax
(everybody else gets ~$10 post-tax, since their div tax rate is 0)

His after-tax return in the flat dividend tax world is the same as in the taxless one.

His after-tax return in the progressively taxed one is 15% lower.

(I've assumed the investor pool is sufficiently larger than Wuffett himself, so that the dividend rate that's priced in is close to the 0% that belongs to everybody else. If Wuffett possesses a gigantic portion of all the investment capital in that world, then it's more complicated.)

Real life is also more complicated because there are many people in the market with different amounts of capital to invest and paying different dividend tax rates.

But (Buffett's dividend rate) - (lowest bracket rate) gives an upper bound on what he pays, and I'd guess that it's close to the real value. That real value should actually look something like (Buffett's dividend rate) - (some weighted avg of the different rates), but determining exactly what that second term is would be a pain.

In the US the lowest bracket rate is currently 0%, so right now Buffett's nominal rate happens to match (his rate) - (lowest bracket rate).

So I'd say 16% is probably a decent estimate, but not exact. If you want to criticize him for stating it like an exact thing, I won't disagree.

We both agree that Buffett's corporation pays 40.5% tax, right? That is, of the wealth created, the government gets 40.5% of it.

Yes, in the case of flat dividend tax.

In the case of progressive dividend tax, no.

Again, it's more like (corporate rate)&(lowest bracket capital gains rate). In the US that's around 30%.

The exact value should look like (corporate rate)&(some weighted average of capital gains rates). Again, I'd guess that this should be only a bit higher than 30%, but I'd have to look into it more.

But, then, if you think Buffett should pay more, then that other entity should pay less, right? Otherwise, you'd be taxing the corporate income at a huge overall rate.

Not necessarily.

To answer it I think one would have to also consider the benefits of incorporating.

When Coca-Cola incorporates, they take a value hit in terms of expected taxes. But they also gain advantages by being a corporation, which add value. (e.g. from what I understand, public shareholders have less liability if someone gets hurt by a Coca-Cola product than if Coca-Cola were privately held.)

Think: why would any company incorporate and expose themselves to additional taxes unless they expected countervailing benefits?

Whether or not the effective rate on corporations is "huge" depends on how one values those benefits. I'm not knowledgeable enough to have an opinion on that matter. But I do know that those benefits exist and should be taken into account.

 
At Thursday, November 24, 2011 12:33:00 AM, Anonymous Matt D said...

If you want to measure how much tax Buffett is actually paying, I argue that 40.5% is the right number[...]

But if "extent of negatively affected" is your criterion[...]

You make my criterion sound abstract and arbitrary when it's neither.

Suppose my income tax this year is $1000. Suppose I give you $1000 in cash and you write a check to pay my taxes for me.

By your reckoning the "tax [I] am actually paying" is $0.

That's true only in the most useless of senses.

By my criterion, I am still losing $1000 as a result of taxes, so my effective tax is $1000.

It doesn't require abstract language like "extent of negatively affected". "How much it actually costs" will suffice.

 
At Thursday, November 24, 2011 11:01:00 AM, Blogger Phil Birnbaum said...

Matt: all your argument proves is that if a progressive tax costs Buffett 15% more than someone else who pays 0%, then Buffett is paying an extra 15% more than someone who pays 0%. That's not in dispute.

Also, you object to me bringing up the effects of the tax, but then you defend a "higher than 40.5%" tax because of the benefits of incorporating. By your own argument, that's not an issue.

The bottom line is: a corporation Buffett owes creates wealth, and the government takes 40.5% of that wealth. You want to argue that the tax costs Buffett 16%, not 40.5%. I argue that you haven't made that case, except in comparison to a non-Buffett who pays 0%.

I agree that Buffett pays 16% more than someone who pays 0%, but that's not the point.

 
At Friday, November 25, 2011 3:08:00 AM, Anonymous Matt D said...

all your argument proves is that if a progressive tax costs Buffett 15% more than someone else who pays 0%, then Buffett is paying an extra 15% more than someone who pays 0%. That's not in dispute.

I agree that Buffett pays 16% more than someone who pays 0%, but that's not the point.

Correct. You missed the point. The example was intended to address this comment:

you're contriving to explain why the dividend tax DOES affect Buffett. Neither affects him, really.

The example shows that he's affected by how much his dividend tax rate exceeds the base rate.

The point of the example is *not* that Buffett pays more than the people paying 0% on dividends (although that's already a bit hard to reconcile with your "neither affects him, really" claim; if Buffett pays more than the 0%ers, at least one of them is affected by the tax, right?).

The idea is to compare Buffett paying 15% in flat rate environment to Buffett
paying 15% when the base rate is 0%:

--Flat 15% dividend taxes --> Buffett's effective rate = 0%
--Progressive, w/ Base rate 0% and Buffett's rate 15% --> Buffett's effective rate = ~15%

General idea illustrated:
Buffett's effective rate ~ [his rate] - [base rate]

Try it again with different base rates if you like -- each time the tax that's priced into the stock should be close to the base rate, not Buffett's (assuming sufficiently many base rate investors).

The example also shows how your claim of Buffett being always unaffected by a dividend tax does not work in general. He's only unaffected in the special case of a flat rate, which isn't the case in real life.

 
At Friday, November 25, 2011 5:18:00 AM, Anonymous Matt D said...

Also, you object to me bringing up the effects of the tax, but then you defend a "higher than 40.5%" tax because of the benefits of incorporating. By your own argument, that's not an issue.

?

A) What's this "[my] own argument" you're referencing?
B) When did I object to you "bringing up the effects" of a tax?

You've discussed two questions:
1) What is Buffett's effective tax rate?
2) What tax rates are fair?

I wasn't really addressing #2, until you specifically asked

if you think Buffett should pay more, then that other entity should pay less, right? Otherwise, you'd be taxing the corporate income at a huge overall rate.

When you asked me to call a corporate tax burden "huge", then you're really asking about question #2. Numbers aren't intrinsically "huge" or "not huge".

Again, I don't know the answer to #2. I know some of the factors I would try to take into account before venturing an answer. Corporate limited liability is an important one. Since your argument (40.5>33=unfair) doesn't take anything like that into account, I don't find your argument persuasive. I also think 40.5 is the incorrect value under a progressive capital gains tax (using the formula in C it's about ~30% in our 0% base rate environment). This makes your argument extra unpersuasive.

So on question #2 I'm voting "no" on your argument, and "I don't know" on the conclusion.

 
At Saturday, November 26, 2011 12:46:00 PM, Blogger Phil Birnbaum said...

Ah, OK, I think I understand your argument now.

You're saying something like:

Because most investments are bought on an open market, the price adjusts for the tax burden. Therefore, the tax is irrelevant, because the price adjusts for it.

However, the price is based on the tax burden that *most* people pay. Because of progressive taxation, if Buffett pays 15% more dividend tax than most (who pay 0%), then that 15% really costs him, because it's not built in to the price. Therefore, Buffett's tax rate is really 15%.

Is that close? Rephrase if you like.

 
At Saturday, November 26, 2011 1:59:00 PM, Anonymous Matt D said...

Yes, that's a fair way to put it.

 
At Sunday, November 27, 2011 12:54:00 PM, Blogger Phil Birnbaum said...

Excellent!

I agree with your argument on all points except one: I don't agree that the baseline non-Buffett tax rate (that determines the market price of the investment) should be 0%. It should be something similar to the tax rate on other competing investments, like bonds.

The tax rate on interest is the same as on employment income, right? (It is in Canada.) So if you choose to buy a stock, the seller has to compete with bonds. If the typical tax rate on bond interest is, say, around 30%, then the stock is priced for a tax rate of around 30%.

(Add in Buffett's extra 15%, and you get the 40.5% I argue he's paying.)

I'm trying to think of a way to "prove" that to you ... the fact that tax-free Muni bonds are more expensive then normal bonds is one think that gives it away. If "regular" bonds were priced mostly for a tax rate of zero, then munis would yield about the same.

 
At Saturday, September 28, 2013 5:04:00 AM, Anonymous Anonymous said...

You are over analyzing what Buffett is saying. All he is stating is that his secretary will be effected a lot more by her INCOME tax rate than he will be from his. Even if Buffett were to be taxed at 90% on INCOME his life wouldn't be effected as much as his secretary with a 30% rate. There is absolutely no rational argument against his statement. Don't make it sound like he is fudging the numbers just to prove his point. This is a weak attempt to make Mr Buffett look bad. Try harder next time.

 

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