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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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.

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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.

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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.

Why Warren Buffett is wrong about tax rates

Note: non-sports post. Lots of numbers, though!

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As you've probably heard by now, Warren Buffett thinks the rich should pay more taxes. Much of his argument is based on the fact that wealthy people pay a lower percentage of their income to the government. Buffett writes,

"Last year my federal tax bill — the income tax I paid, as well as payroll taxes paid by me and on my behalf — was $6,938,744. That sounds like a lot of money. But what I paid was only 17.4 percent of my taxable income — and that’s actually a lower percentage than was paid by any of the other 20 people in our office. Their tax burdens ranged from 33 percent to 41 percent and averaged 36 percent."

But, like a lot of numbers that get thrown around, this "percent of taxable income" is misleading. Yes, the number 17.4 is lower than the number 36. But if you look more closely, Buffett is actually paying at a comparable rate to that of his employees.

The issue that confuses things is that Buffett earns most of his income through corporate dividends (some of it also comes from capital gains, but I'll ignore those for now). Dividends are paid out of after-tax profits of corporations. That means, effectively, that the corporation has already paid most of Buffett's tax.

Suppose Buffett's employee earns $50,000, and pays $18,000 in taxes, which is 36 percent. As for Buffett himself, suppose he owns shares of McDonald's. Let's say he owns 7,609 of those shares, which correspond to the same $50,000 in McDonald's pre-tax profits. (My figures are approximate, all rounded from this Value Line summary.)

So, what happens? Well, McDonald's gets taxed at about a 30% rate. So that leaves only $35,000 in after-tax profits. Then, the company pays Buffett a dividend. It doesn't pay the entire $35,000, because it keeps some to reinvest. It pays Buffett only about half of that, maybe $17,000. Then, Buffett pays an additional 15% tax on that $17,000.

So: on his $50,000 in profits, Buffett pays $15,000 through the corporation, and then an extra $2,550 in dividend tax. That's a total of $17,550 out of $50,000, which is ... about 35%, approximately the same as his employee.

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Actually, that's not quite right. It actually understates Buffett's tax rate.

As we saw, McDonald's makes $50,000, pays $15,000 in taxes, sends $17,000 to Warren Buffett, and reinvests the remaining $18,000. But our calculation assumed that the $18,000 part is still Buffett's, but is fully tax paid. It's not. Eventually, Buffett will claim that $18,000 personally, either through another dividend, or through a capital gain when he sells his stock. At that point, he'll pay another 15%.

So, really, the bottom line is: Of every dollar Buffett earns through McDonald's, he gets to keep 85% of 70% of it. That's 59.5%. So his effective tax rate is 40.5%.

You can argue that 40.5% is too high, or you can argue that 40.5% is too low. But you CANNOT argue that Buffett's tax rate is only 17%. That simply isn't true in any real sense. It's true only in a misleading technical sense, in that McDonald's pays some of Buffett's tax for him. The fact that the corporation makes the payment doesn't mean that it doesn't actually come out of Buffett's pocket.

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This is actually a standard explanation of why taxes on dividends are lower than taxes on "work" income. In fact, it's actually the stated rationale. Canada has a complicated method of calculating taxes on dividends, a method that actually takes into account how much corporate tax was already paid. The explicit idea is that the overall tax rate should be the same, no matter if you earned the income through a direct investment, through an investment in a corporation, or through employment. It doesn't always work out perfectly, according to my accountant (who tells me it's a little higher through a corporation), but it's close.

It's well-enough known to economists and accountants and people who work in corporate finance that, like other bloggers who have written about this, I'm surprised Warren Buffett didn't know it.

Now, it could be that he knows it, but doesn't believe that the corporate taxes should "count". A lot of people somehow believe that corporations should count as separate "people," and so it's fair for both McDonald's and Buffett to pay taxes separately, where the total adds up to more than if Buffett made the money directly.

But that really doesn't make sense. The fact is that if Buffett owns McDonald's, and McDonald's earns $50,000 from his investment, that $50,000 *belongs to Buffett*, even if, right now, it's classified as corporate earnings. Corporations, and their earnings, are the property of their owner, and Buffett is that owner. The fact that the first $15,000 of taxes appears on the corporate tax return instead of Buffett's absoutely does not change the fact that Buffett is paying that tax.

If you still don't agree with that, if you think that Buffett really isn't paying that 30%, then you might like these two options I'm about to show you. Those could reduce personal taxes substantially, while still providing the same amount of money to the government!

Here's number 1. As of tomorrow, ever person in the country has to start up a corporation, of which he/she is the sole shareholder and CEO. Also, all employers now have to pay any salary to the corporation.

So, what happens is this: your corporation now pays 30% of its income -- your salary -- in corporate tax. It then pays you the rest as a dividend. Like Warren Buffett, you now pay only 15% in taxes. Indeed, you might pay zero in taxes -- according to this Wikipedia page, low-income Americans pay 0% tax on dividends!

That means that Warren Buffett's employees will now definitely have a lower tax rate than he does -- or at worst, the same rate -- because they are taxed exactly the same way!

Would you support that new law? You probably wouldn't. You'd see that that was just a sneaky way of taxing people the same rate as always, but making it look like they're not paying much tax. That's exactly what I'm arguing in the case of McDonald's.

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Here's number 2. Right now, people take home a lot less than their salary, because of payroll deductions for income tax. Someone making $50,000 might actually take home only $35,000.

So here's what we do. We eliminate payroll deductions and personal income tax completely. Instead, we implement a corporate payroll tax, which works out to exactly the same as the income tax used to. So, now, your employer still gives you $35,000 to take home, but pays an extra corporate tax of $15,000. You pay zero percent tax on the $35,000.

Perfect, right? Now the income tax on "work" is zero percent. Warren Buffett is still paying 17.4% on his investments. Situation resolved!

I bet you think that's ridiculous. You probably should. Whether you pay the tax, or your employer pays the tax, it's the same thing: you do $50,000 of work, and the government gets 30% of it.

Well, it's the same thing for McDonald's profits. Whether McDonald's pays the tax, or Warren Buffett does, or they both do, the fact remains: McDonald's makes $50,000 of profit, and the government gets 40.5% of it. How much of that 40.5% comes from a cheque from Buffett, and how much comes from a cheque from McDonald's, doesn't matter.

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OK, here's one more suggestion that's less ridiculous.

Change the law a bit, so that when McDonald's pays a dividend to an American taxpayer, they don't pay tax on that part of their profit. That sounds kind of fair, right? If McDonald's doesn't get to keep it, they don't pay tax on it. Just like they can deduct interest that they pay to a bondholder, they can deduct interest that they pay to a shareholder.

Then, when the shareholder receives the dividends, tax them at the normal rate, as if they were "work" income.

Sounds reasonable, right? Well, it works out to almost same amount of tax collected. Actually, if Buffett's personal tax rate is around 33%, you can leave out the "almost" -- it's exactly identical.

McDonald's makes $50K. They send Warren Buffett $21,428.57. Buffett pays about 33% of that in taxes, or $6,978, leaving him $14,450. After paying Buffett, McDonald's has $28,571.43 left. They pay the government 30% of that, or $8,571.43. That leaves them $20,000 to reinvest.

That's EXACTLY what's already happening, in today's system where Buffett *appears* to be only paying 15%:

-- McDonald's makes $50,000
-- Buffett keeps $14,450 after taxes
-- McDonald's keeps $20,000 after taxes
-- The government gets $15,550.

One way you look at it, it looks like Warren Buffett pays only 15% in taxes. Another way, it looks like he pays 40.5% in taxes. A third way, it looks like he pays 33% in taxes. But the results, all three ways, are exactly the same!

No matter how you figure it, the bottom line is the same. Buffett gets 28.9% of the profit, McDonald's keeps 40% of the profit, and the government gets 31.1% of the profit. The difference is how you do the accounting. If you're a government that wants to make it look like the rich have it too good, you levy the entire 31.1% on the corporation, so that it looks like Buffett pays zero. If you're a government that wants to make it look like corporations aren't taxed enough, you levy the entire 31.1% on Buffett, so that it looks like McDonald's pays zero.

In a vacuum, Warren Buffett's supposed 17% tax rate doesn't mean anything. It's an artifact of how you do the accounting. To really see what's happening, you have to look at the end result. And that end result, in this example, is that the government winds up with 31.1% of the money that would otherwise have been Buffett's.

You may think that's too low. You might think that's too high. That's fine. But either way, the "17%" figure is not relevant, even if Warren Buffett thinks it is.