Capital Gains and Warren Buffett: Part II
This is a continuation of the previous post about why capital gains taxes should be lower than regular taxes, and perhaps even zero.
3. More Double Taxation
One year, the New York Yankees draft Mickey, a player with star potential.
The team signs him to a five-year contract at $2 million a year. They figure that's a bargain. Mickey is good enough that he's expected to produce $15 million a year in revenue, so the Yankees figure, reasonably, that they're making $65 million on the deal.
The day after the draft, along comes the IRS. "Hey," they say to the Yankees. "You just signed a deal that's worth $65 million in profit. We want the corporate tax on that, $22 million. Pay up!"
The Yankees say, "Wait a second! Mickey hasn't played a single game for us yet, so we haven't made any profit! How can you be asking for the tax already?"
The IRS says, "We don't want to wait. We want the money now. But, don't worry, we know we're collecting the money in advance, so we're discounting the amount owed by the current interest rate."
The Yankees protest. "That's still not fair," they say. "You shouldn't tax us until we actually make the money. After all, Mickey just signed a contract for $10 million. You're not taxing *him* on that $10 million right away ... you're going to tax him only when he gets his paychecks. You're not going to his house and demanding $4 million from him right this second, are you?"
The government agent replies, "I don't know why you have a problem with this. I already told you we're adjusting for the time value of money. And we know you *have* enough cash to pay us now, because you're the Yankees. So why not?"
"What if Mickey doesn't perform and we don't make the expected profit?" the Yankees ask.
"No problem," replies the IRS. "We'll give you a partial refund. But, of course, if Mickey starts playing like Albert Pujols, and you clean up, we'll ask for more."
"Hmmm," the Yankees owner says. "I guess it doesn't really matter to the long-term bottom line. But it still seems like it's not right."
Is it unfair? Yeah, I think it is ... if the Yankees haven't made any profit yet, they shouldn't pay any tax on that profit.
Still, the present value of the tax paid is the same, whether the Yankees pay it in a lump sum, or whether they pay it on a year-by-year basis. So if paying in advance is unfair, it's unfair only from a timing standpoint. Either way, the Yankees pay the right amount of tax. It's just that one way, the IRS is in an ungodly hurry, that they have no business being in. But it's the same amount of money. You might even imagine a situation where the Yankees would *choose* to pay in advance.
So this is just slightly unfair. What would make it *really* unfair is if the IRS made the Yankees pay BOTH WAYS. First, if they made them pay $22 million on their projected $65 million profit, and then they also made them pay regular corporate tax on the annual $13 million profit. That would be pure double taxation, right?
It has to be one or the other. Either they pay the tax on the projected profit in advance, or they pay the tax as the profit comes in. If you make the Yankees pay both, you really are making them pay exactly twice as much tax. Instead of 35% tax, they'd be paying 70%.
Now, if you don't stop to think about it at all, it might not seem unfair that way. When they sign the contract, the accountants say, "Congratulations, Mr. Cashman, that deal you just made with Mickey is worth $65 million." And, at the end of the next five years, the accountants say, "Congratulations, Mr. Cashman, you made $13 million more this year because of Mickey." It may be tempting to add all those up to get $130 million in profit. But you can't do that. The $65 million is THE SAME MONEY as the five $13 millions.
Tax the profit in advance, or tax it when it comes in. Choose only one. If you do both, it's grossly unfair.
With me so far?
Now I'm going to argue that when you have a capital gain on a stock, this is almost exactly what happens: the profit gets taxed twice: once in advance, and once when it comes in.
You buy a stock in a drug company, Acme, for $1 a share. Acme is just barely breaking even. After you buy the stock, Acme discovers a new drug that prevents heart attacks. It's going to be a blockbuster. In fact, it's so good that it's going to produce annual earnings and dividends of $2 a share, indefinitely. But, first, the FDA has to approve the drug. It's so good, with no side effects, that FDA approval is assured, but it will still take two years.
Wall Street immediately calculates that $2 a share, indefinitely, starting in two years, makes the stock worth $31. Shareholders celebrate. You sell your share of Acme for $31, incurring a $30 capital gain. Should you pay tax on that capital gain?
Look what's happened. Acme hasn't actually made any profit yet. The $30 increase in the stock price represents *future earnings*, just like the $65 million contract with Mickey is future earnings. So if you tax the $30 increase -- which is what capital gains tax does -- and then you later tax the corporate profits -- which of course you will do -- that's exactly analogous to what happens if you tax the Yankees twice.
To make things fair, the IRS should pick one: either tax the capital gain right now, or tax the corporate profits later. One or the other.
Otherwise, the IRS is getting a lot more than the corporate tax on the profits. Because, the fact that I sold my share does not change the future tax bill of the corporation, or the new shareholder, at all. Whether I sell the share or not, the corporation will still pay the normal taxes on the profits. But, by me selling the share, I trigger an *extra* tax, a capital gains tax, on the value of the future profits. That's two taxes on the same money.
The only thing that makes this example different from the Yankees example is that the two taxes are paid by two separate people, instead of one. That kind of hides the unfairness. The original buyer pays the full, future corporate tax, which seems OK because he just made a big gain on his stock. And the new buyer pays the full, future corporate tax, which seems fair because he's the owner at the time the profit was made.
But, still, they're both paying tax on the *same money*. [See footnote 1.]
As I said, it should be one or the other. Since it's hard to discount the corporate tax by capital gains tax that's already been paid, the easiest solution is to just eliminate the capital gains tax. That way, the profit is only be taxed once, when the corporation earns it.
That may seem unfair, because, after all, when you earned your $30 capital gain on your $1 investment, that's a lot of money. Why shouldn't you pay tax on it?
One answer is: you already did, kind of.
When you sold the share at $31, that was the market price. That market price is based on after-tax profits. We said the corporation pays a $2 dividend. That means it will make $3 in profits and pay $1 in corporate tax, leaving a $2 dividend. The buyer of your share gets the $2 dividend, and pays 15% tax on it, leaving $1.70 in his pocket.
That $1.70 in his pocket, year after year, is why the new buyer was willing to pay $31 for your share. That means he's looking for an after-tax return of 5.48% on his money, which is what he's getting: $1.70 divided by $31.
Now, suppose there were no corporate tax or dividend tax. Then, instead of $1.70 a year, the new owner of the share would receive the full $3 profit. For the same yield of 5.48% after tax, he'd now be willing to pay $54.74. So, if there were no taxes, the shares would have been worth $54.74 instead of $31, and you would have made a capital gain of $53.74 instead of $30.
So the corporate tax actually did cost you money! It cost you almost exactly the same rate as the overall taxes on the profits -- in this case, about 45% -- because you received only $31 instead of $54.74. That is, in order to take over *your* obligation to pay all that future tax to the government, the new buyer demanded a discount of $23.74 to compensate him for taking over your obligation.
It may look like you're not paying any tax on your capital gain, but, you are, in a hidden kind of way.
Look at it this way. Suppose that while you owned Acme, the government decided to double the corporate tax on drug companies, forever into the future. What would happen? Well, because of the new tax, Acme would only be able to pay $1 in dividends, instead of $2. That means the new owner would receive only 85 cents a year.
But the new owner still wants his 5.48% after-tax yield. So, he's not going to pay $31 for the stock any more. He's only going to be willing to pay $15.50. So that's what you'll have to sell it to him for.
See? The extra corporate tax comes right out of your pocket, even if you're not the one writing the check. [See footnote 2.]
Here's another way to look at it: when you sell the company, you sell it for $54.74, its full value if there were no taxes, but you promise the buyer to pay all the taxes into the future. Instead of paying every year, though, you hand the buyer a cheque for $23.74, and say, "here, invest this and it'll pay your tax bill every year." The buyer says, "OK, that's a deal."
Instead of you actually physically paying the $23.74, you just take it off the price of the share, which is why you wind up with $31. It doesn't look like you paid any tax, but you actually paid all of the corporation's tax into the future!
And, again, that's WITHOUT a separate capital gains tax. With a full capital gains tax, you'd be paying double.
Here's a simpler case.
You grow apples. There's a 50% income tax on the apples you grow. There's also a 50% capital gains tax.
You take two apple seeds, plant them, nurture them, fertilize them, and grow them into two healthy trees. The apples start growing. You harvest them and send half the apples as your income tax. The government, therefore, gets one tree's worth of apples a year -- half the harvest of the two trees.
Now, you sell the two trees to your neighbor. Since you grew them from nothing, your capital gain is the entire two trees. So, at a 50% capital gains tax, you owe the government one tree. But you're out of trees, so you have to buy one tree back from your neighbor, which you now give to the government.
What's happened? The government used to get one tree's worth of apples a year. Now it gets 1.5 trees' worth! First, the tree that you just paid it in capital gains tax, which now belongs 100% to the government. Second, half the apples from the other tree the neighbor now owns.
So, effectively, the government is now taxing the apples not at 50%, but at 75%.
But it's hidden between the two of you. You pay the first 50%, and your neighbor pays 50% of what's left.
It may seem counterintuitive that Warren Buffett should get away with almost no tax on his capital gains. You have to look hard to see that even if the capital gains tax rate is zero, Warren Buffett, and the rest of us, are still, in a hidden way, paying the normal rate.
It may not be obvious, but I think it's true.
Footnote 1: This argument applies when the profit goes on indefinitely. If not, the double taxation isn't quite as bad. Suppose the patent on the drug runs out in 20 years. At that point, the stock will tank and the new buyer will have a capital loss, exactly offsetting the capital gain the old buyer had 20 years before.
However, the government will have earned interest on that capital gains tax for 20 years, before refunding it without interest. After 20 years, because of forgone interest, the refund might be worth, say, only 1/4 the original amount. So it's not double taxation, but only "1.75-ble" taxation.
Footnote 2: Actually, it's not quite that simple. We assumed the new buyer's demand for 5.48% after-tax was fixed. Really, it's in comparison to other investments of equal risk. And those other investments also have tax burdens associated with them. The reason the new buyer demands 5.48% is because that's what he could get, after tax, from a bond of similar risk.
But if there were no corporate taxes, the rate of return on bonds would also be higher. Therefore, the new buyer might be demanding, and receving, a higher rate. That shows that the overall investment tax rate affects the buyer, too.
So it's not really as clear-cut as saying the original owner, the one who gets the capital gain, pays all the tax. It's a complicated thing to figure out what proportion of the corporate tax is actually "paid" by the original owner, and what proportion is "paid" by the second owner. All we know is that the proportions add up to 100%, and the total tax paid is the corporate tax plus the dividend tax.
I might be wrong here ... economists, please correct me.