Saturday, October 15, 2011

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.

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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."

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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?

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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.]

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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.]

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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.

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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.

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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.


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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.

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22 Comments:

At Sunday, October 16, 2011 11:12:00 AM, Blogger SportsGuy said...

Excellent post. A great illustration of why Bush's dividend tax cut was in essence a cap gains cut. I wasn't in favor at the time because I didn't think it transparent enough like a regular cap gains cut would be. But it had the same effect - a massive boost to the economy.

If Obama really wants another term a cap gains cut would be the way to get it. And repealing Obamacare too, of course.

 
At Monday, October 17, 2011 3:03:00 PM, Anonymous Mike said...

When you say that a stock's value is equal to its net future profits, what exactly does this mean? Is their some structural way in which this is guaranteed? I always hear this definition, but I don't really understand it in practice.

Because I sort of subscribe to the Mark Cuban philosophy of stocks, in which stocks are baseball cards that do nothing, are inherently worth nothing, and you buy them in the hopes that you can sell them for more money to some other sucker. In which case, the stocks are not the paper form of "net future profits", and thus nothing is being taxed twice.

(I also think the "double taxation" argument is silly. There are thousands of things that are taxed twice. If there was some proposal to eliminate double taxation on things, then your argument that capital gains tax is a double tax would be something worth considering. AFAIK this isn't the case though; it seems like most folks are accepting of the fact that many things get taxed twice)

 
At Monday, October 17, 2011 3:46:00 PM, Blogger Phil Birnbaum said...

To clarify about double taxation:

I don't know if there's an official definition of double taxation. How I've usually seen it used is to mean taxing the same thing more than once when the purpose of the tax is really to tax it only once.

So, first paying income tax and then sales tax is being taxed twice, but not truly "double taxation" in the sense of taxing the same thing twice. I don't think you'll see "double taxation" used in that context very often. It's a definition thing. Like, in baseball, not everything with two plays in it is a "double play".

The Yankees example is probably the clearest example of this kind of double taxation. You're taxing exactly the same money, at two different times.

It's like, your nuclear family from the 50s. Dad gets paid in cash, pays income tax. He then gives the money to his wife to take care of the finances. Do you tax the wife too? No, that would clearly be double taxation of the same money.

The intent behind income tax is that you tax changes in wealth, not transfers of money. If it's the same wealth, and you tax as two changes in wealth instead of one change in wealth, that's double taxation.

Double taxation isn't necessarily unfair: taxing corporate income, then dividends, isn't that bad, because the total tax is about the same as the regular tax. Being taxed twice at 10% each time is roughly the same as being taxed once at 20%. The bad part is where some people get taxed twice and some get taxed once, so they pay different amounts of tax even though they're in roughly the same situation.

 
At Tuesday, October 18, 2011 11:54:00 AM, Blogger Jeff Williams said...

So if I walk into a casino with $50, plunk it all down at the roulette table on RED, and the wheel lands on RED, I pick up a quick (approximately) $50 gain.

Are you saying that I should have to pay ZERO taxes on my gambling income? Because any money that I make at the casino is NOT gambling "income" - it is gambling "capital gains."

Because if so, I should have tried much harder to become a professional poker player instead of a statistician.

 
At Tuesday, October 18, 2011 11:59:00 AM, Blogger Jeff Williams said...

I think you're essentially confusing the taxes paid on the increase in value of the capital, and the taxes paid on the cash flows generated by that capital. They are two different things, both from an accounting and economic standpoint.

You pay a dividend tax on the cash flows generated by the capital (and if there is a double taxation - I would agree, why we tax an owner on profits and his share of the distributed profits makes no sense to me) and you pay a capital gains tax on the increase in value of your capital.

However, you only pay the capital gains tax when you realize the gain, which would be at the point of SALE of the capital...you don't pay capital gains taxes on unrealized or paper gains. If I buy General Electric at $50 and it rises to $100, I only pay taxes on the $50 gain if I sell it at $100. There is no "margin call" by the IRS on that gain, since the stock market or the individual stock could tank and go back to $50 a day later.

 
At Tuesday, October 18, 2011 12:06:00 PM, Blogger Jeff Williams said...

Also, a basic concept of finance is that the current value of any capital asset is a measure of the future cash flows that it can generate. If you buy a stock at $50, and they announce a new miracle product the next day that raises the price to $100, that $50 gain in the value of the capital reflects the anticipated future value of the upcoming future cash flows. Therefore, if you sell it at $100, the BUYER is purchasing it at that price anticipating the future cash flows.

YOUR $50 increase in capital gains reflect the fact that you now hold a stock that is anticipated to generate a future value of $50 more in future cash flows.

Whoever holds that $100 stock going foward assumes the liability of the dividend taxes, but also gets the increased future dividend payouts. That's what the $50 increase in the value of the stock, your capital, reflects - AND the $50 value also includes the cash flow adjusted for dividends minus the dividend tax.

 
At Tuesday, October 18, 2011 12:17:00 PM, Blogger Jeff Williams said...

So, essentially, the flaw of your argument against capital gains taxes can be boiled down to a single question. And this was essentially Warren Buffet's point.

What if your ENTIRE income is based off not being reimbursed for your time/labor but rather by making money off making bets on the increase in value of capital that you invest?

If you are a professional gambler, 100% of your income will be in capital gains. The casinos do not pay you money, but rather you make money by finding smart ways to increase your capital. By your argument, professional gamblers should pay no taxes if they are lucky (and smart) enough to turn a profit.

If you are a CEO, you could ask to be paid $1 in income and the rest in stock options and dividend payments. Again, you'd argue that this CEO pay taxes only on their $1.

If your business was in "flipping" houses for a living, you'd buy a distressed property, pay to fix it up, sell it for a higher value and make a profit on the difference in the sell and buy price minus your expenses. You wouldn't make an income and your profit would essentially be your capital gain. Professional house flippers would pay no taxes under your logic.

Again, you're confusing the cash flow generated by a capital investment with the increase in VALUE of that investment. The increased value of the investment is a measure of the increased future cash flows from that investment.

I wish I had enough money to buy a professional football team in the NFL. I could buy it for $500 Million, make $5 million a year in profit, and watch the value of the franchise rise to $750 Million, sell it and only pay taxes on the $5 million a year in profit and pay no taxes on the $250 Million change in my investment. The $250 Million increase most likely occurred from a new TV deal with NBC and Fox, meaning I would expect additional revenue (and depending on how I picked players) additional cash flow each year. I haven't paid the taxes on my future cash flows YET, and I haven't paid the taxes on my capital gain YET either. If I sell the team, I pay the capital gains taxes but NOT my future dividend or profit taxes. if I keep the team, I pay the profit/dividends taxes but not the capital gain tax.

 
At Tuesday, October 18, 2011 7:48:00 PM, Blogger Phil Birnbaum said...

Hi, Jeff,

Thanks for the comments!

I agree with almost all of what you've said, and so I don't understand where you're disagreeing with my conclusion.

You say,

">Whoever holds that $100 stock going foward assumes the liability of the dividend taxes, but also gets the increased future dividend payouts. That's what the $50 increase in the value of the stock, your capital, reflects - AND the $50 value also includes the cash flow adjusted for dividends minus the dividend tax."

Exactly! The $50 increase reflects the future cash flow. And the future cash flow is going to be taxed. That's why you shouldn't tax both the $50 increase and the future cash flow. Because, then you're taxing the increase in future cash flow, and also the future cash flow! That's where the double taxation is.

 
At Tuesday, October 18, 2011 11:06:00 PM, Anonymous Mike said...

Phil - when you say a stock represents future cash flow, what does this mean? If I own a share of GOOG, can I turn in my share and get 0.000001% of their profits every year? I don't think that's possible.

In regards to dividend-bearing stocks, I follow your argument and am persuaded that paying capital gains tax on dividend checks is double taxation. A dividend-bearing stock is indeed bound by contract to some portion of future profits. But AFAIK, a non-dividend stock is not bound by such rules. So it seems impossible to state that a stock's value represents, solely and completely, the future cash flows of a company.

 
At Wednesday, October 19, 2011 12:56:00 AM, Blogger Phil Birnbaum said...

Hi, Mike,

There's no difference, really, between a dividend-bearing stock and a non-dividend-bearing stock. The company decides how much of a dividend to pay, if any, based on how much money it needs to grow, and the desires of the shareholders. Every company hopes to pay a dividend eventually.

Technically, the value of a share is the discounted future value of all dividends. That's hard to figure, though, because, for many stocks, who knows when they'll pay a dividend and how much? So you use earnings (or cash flow) instead. The idea being that even though the profit will be reinvested, it's your money and *could*, in theory, be paid out as dividends if the company chose to. And, the reason it's choosing not to is that it figures in the shareholders' best interest not to, right now.

 
At Thursday, October 20, 2011 11:06:00 PM, Anonymous Mike said...

"*could*, in theory, be paid out as dividends if the company chose to"

Got it. So let's say Larry and Sergey and Eric, who are majority holders of GOOG, issue a statement that Google will never give dividends, will never sell itself, and will never buy back GOOG shares. And lets say they somehow make this guarantee in writing, in some enforceable way.

Is GOOG stock then worth $0?

This is what I have a hard time with. Because it seems to me that in most cases, the odds of a company I invest in turning around and giving dividends, or buying their shares back for acquisition reasons, is pretty small. So the value of the stock shouldn't be the net future cash flows, it should be the net future cash flows times the likelihood of stockholders actually getting those net future cash flows.

 
At Thursday, October 20, 2011 11:23:00 PM, Blogger Phil Birnbaum said...

> " ... issue a statement that Google will never give dividends, will never sell itself, and will never buy back GOOG shares. And lets say they somehow make this guarantee in writing, in some enforceable way. Is GOOG stock then worth $0?"

Yes, exactly! Actually, I think I saw that exact question (except for the mention of Google) as an exercise in a finance textbook once.

Usually, when a company is profitable and has cash it doesn't know what to do with, shareholders will start agitating for a dividend. Microsoft, for example:

http://www.seattlepi.com/business/article/Microsoft-surprises-will-issue-first-ever-1105495.php

 
At Saturday, October 22, 2011 11:01:00 PM, Anonymous Mike said...

I mention Google specifically because I happen to know that those 3 have majority control over the company, and the company has craploads of money, and no dividends.

Anyways thanks for clarifying. I've never read a finance textbook, as you may have guessed :-)

Final question then:
In this scenario above... if I buy a share for $500 and sell it for $600, and pay capital gains on my $100 profit... is money being taxed twice?

I'd argue no, because the value of the stock is in no way related to or representing the future cash flow of GOOG.

And so this was my initial rebuttal to your argument in the original post. What portion of non-dividend stocks go on to sell themselves and/or give dividends? I feel like it's the minority of them. So that's why I felt like, even if I believed double-taxation in this sense was "bad", there might not even be a case of double-taxation here.

 
At Sunday, October 23, 2011 12:03:00 AM, Blogger Phil Birnbaum said...

Mike,

I would say that if there's capital gains tax, the profit is being taxed twice. Once you're paying, and once the future owner will pay.

The price of the stock, in theory (and, IMO, in practice), does represent the present value of future dividends (or future cash flow, some say, which can work out to the same thing). So when the stock rises $100, it's probably because expectation of future dividends rose $100.

You pay tax on that $100 now, and then when the dividends actually occur, the future owner will pay tax on them too.

 
At Monday, October 24, 2011 10:47:00 PM, Anonymous Mike said...

Thanks again, this has been a big help to me.

 
At Wednesday, November 02, 2011 6:47:00 PM, Anonymous dana said...

you clearly dont understand how capital gains tax works. you dont get taxed until you realize that gain, ie make money by selling the stock. to put in baseball terms, yankees buy a player for $10m, the next day they sell the player for $15m, the capital gain is $5m (15-10). until they sell the player (realize the gain), there is no capital gains tax due.

 
At Sunday, November 20, 2011 8:01:00 PM, Anonymous Matt D said...

As with Part I, I think you're being inconsistent by including the effect of corporate taxes on your selling price but not on your buying price.

e.g.

"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."

When you bought Acme stock, the corporate tax was priced in. You didn't pay for a company that would be able to keep 100% of its earnings. For such a company you would have had to pay more.

Your capital gain in the imaginary tax-free world would be

$54.74 - (price of Acme in imaginary tax-free world)

not

$54.74 - $1

In the case of Acme it may not seem like a big deal since Acme started so cheap. But few stocks appreciate like Acme; many cheap stocks fizzle. Buying a portfolio full of Acme-like stocks in a corporate-tax-free world would be more expensive than in the real world. (If those stocks were efficiently priced, and all else being equal) the additional expense would balance the lack of corporate taxation.

Bottom line, the double taxation is an illusion. By subtracting the real-world buying price from the tax-free-world selling price you are overstating how much investors* are taxed.


*I think a different analysis is necessary for entrepreneurs like your apple-grower who start a business from scratch. But that's not what Buffett was talking about; he invested in Coca-Cola, he didn't start it.

 
At Monday, November 28, 2011 10:19:00 AM, Anonymous Guy said...

Phil: Steven Pearlstein has an interesting analysis of Buffett's claim here: http://www.washingtonpost.com/blogs/ezra-klein/post/on-billionaires-secretaries-and-taxes/2011/11/27/gIQApdeZ0N_blog.html#pagebreak. He suggests that the best analyses of corporate taxes show that investors pay about half of these taxes (while workers and consumers pay the other half), resulting in an effective tax rate on unearned income of about 29%. That is a higher rate than Buffett acknowledges, but also lower than your analysis indicated.

 
At Monday, November 28, 2011 10:54:00 AM, Blogger Phil Birnbaum said...

Guy,

Right, that's an analysis of "tax incidence," which is defined (I think) as trying to figure out who actually benefits/suffers from the tax, as opposed to who actually appears to pay it. For instance, if the government forces cigarette makers to pay a per-cigarette tax, and they just raise the price of cigarettes, it's the smoker that effectively pays the tax, even though it's in higher prices rather than tax payments.

That is, the manufacturer pays the tax, but the "tax incidence" falls on the smoker.

It seems plausible to me that some of the incidence of the corporate tax falls on employees and consumers. (I won't endorse that particular number without reading the study, but it seems plausible.)

But ... if you're going to try to figure the tax incidence for corporate tax, you have to do the same for income tax too!

For instance, suppose Buffett's secretary earns $80K but pays $30K in income tax. That means she produces at least $80K in value for Buffett, but she's willing to work for only $50K in her pocket.

If the income tax is repealed, what happens? It doesn't necessarily follow that she (or he, but assume a she) takes home 80K. It could be that she and Buffett split the difference, and she settles for $65K untaxed.

If that's the case, if that's what winds up happening in equilibrium, it means that, right now, Buffett is paying half of his secretary's taxes.

I'm not making this up ... this is actual standard economics. It turns out that the incidence of the tax falls proportionally on the party with the least elastic supply/demand curve. That's probably the secretary, in this case, so Buffett is probably paying less than half her income taxes. But he's paying some nonetheless.

So, if you're comparing tax incidence, you have to do corporate tax AND income tax. You can't just do corporate tax, but not also do income tax, and seeing that employers and consumers are paying part of that, too.

So you have two choices: you can look at actual tax paid, in terms of cheques written. In that case, Buffett pays 40%, employee pays maybe 30%.

Or, you can look at tax incidence. Buffett pays 29 percent (according to the article you linked), employee pays ... we don't know.

For what it's worth, I suspect that the first way is a reasonable first approximation to what their respective burdens are. (That's if you consider Buffett's corporate tax, too.) My gut is that the side effects reduce their tax incidence roughly equally. I could be wrong.

 
At Monday, November 28, 2011 10:54:00 AM, Blogger Phil Birnbaum said...

A couple of other points brought up by Guy's comment:

1. Also, nobody has mentioned this, but I think you can add in the payroll taxes Buffett has to pay for employing his secretary ... I think they're close enough to income tax to be added directly to the secretary's tax burden.

2. On the subject of tax incidence, the total "burden" on consumers can be much, much more than the amount of the tax. ("Deadweight loss".) Suppose the government puts a surtax on doctors that raises their overall income tax to 99%. Most doctors quit. The one or two that remain raise their fees by a factor of maybe 30.

The surtax raises almost $0, because almost all doctors quit rather than pay it. But the deadweight loss is huge, much huger than the tax the two remaining doctors pay. There are now 300 million people who can't get health care, and that goes uncounted if you just look at tax revenues.

Of course, the few people who DO get health care have to pay 30x as much. Effectively, consumers are paying a lot of the doctor tax, even though it's the doctors who are "supposed" to pay it.

But, even that burden is tiny, compared to the burden of the 300 million people who now don't get healthcare, or have to pay a lot more for it by travelling abroad.

So, just because consumers pay $X more because of corporate tax (or doctor tax) doesn't mean investors are paying less. It could be that what the consumers are paying is the cost of the deadweight loss.

 
At Monday, November 28, 2011 11:04:00 AM, Blogger Phil Birnbaum said...

BTW, Guy, thanks for that link! It's a good one. I was estimating corporate tax was 30%, but that article says 28%, which I'll use from now on.

 
At Saturday, September 28, 2013 3:24:00 AM, Anonymous Anonymous said...

Actually that cap gains decrease didn't do anything for the economy except hurt it. Money needs to be circulated to have a positive effect not put into a wealthy persons savings or personal portfolio.

 

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