The Oracle of Omaha Falls Short on Economics

There are lots of reasons to listen to Warren Buffet.  His track record of building a team that can effectively evaluate companies and individual stocks to find those with value yet to be appreciated by the markets is unparalleled.  The candor reflected in his annual investment letters—admitting errors and mis-steps on a plain equal to that with which his states his successes—is refreshing and to be admired.   But not everything he says should be taken as financial gospel.

I live in Omaha now—the land of Buffet and the center of the Berkshire Hathaway universe—so I risk the appearance of pitchforks and angry villagers at my door in calling out this local luminary.  But under the vain pretension that Warren Buffet might hear about this article and give it a read, let’s try to correct his thinking on tax policy.

The Heart of the Matter

Much has been made in the media regarding “The Buffet Plan” or “The Buffet Rule.”  It is easy to get lost in the details.  Basically, he believes that the tax rates on capital gains and dividends should be raised for high income earners—he arbitrarily picks the $1 million dollar per year mark.  Sure, that sounds good.  It’s a number that has no basis in demographics or actual math to measure its impact other than it is a nice round number and sounds like a lot.  In other words, it is a “marketing” number as opposed to an analytical one (always check the math on “nice round numbers” … twice).

The Buffet Rule suggests that everyone who earns less than $1 million dollars can keep the current rates of 15% taxation on both capital gains (the amount of increase in value that you get when you sell an asset like a stock) and dividends (the income that a stock might have paid you along the way from the company’s profits).  However the rule asserts that those making $1 million or more should pay an even greater amount, effectively doubling the tax rate on capital gains and dividends to 30% (hmmm …. doubled to 30% … another nice round number).

It is worth stating that low income investors today already pay less on any dividends and capital gains that they receive (the rates start at 5%).  15% is the “top rate” on dividends and capital gains paid by the highest earners.  But it is also true that lower income individuals are less likely to have assets subject to these taxes outside of their 401k or other retirement accounts.

Sounds Good on Paper

Sure.  Get the rich to pay even more in taxes.  Who would argue with that, right?

There are some very important concepts to cover here, so for the sake of clarity let’s set aside that this plan, if implemented, is forecast to only add $35 billion to the tax collected each year (less than 5 days’ worth of government spending / 9 days of debt)—a literal drop in the metaphorical budget bucket—reflecting more “feel good” policy than actual progress.  That plan and forecast completely miss or ignore important things that we all need to understand before we should make any changes at all.  These are:

• The difference between income types
• Men are not mountains
• The Laffer Curve Lives

Income Types

Some people are trying to make the case that where people get their income doesn’t matter.  In truth—it matters a lot.  Most of us think about income in the context of our paychecks.  We work so that on payday we are paid via direct deposit or—for old school types like me—a physical paycheck.  Sometimes we have investments or additional deductions for our 401k.  But most of us do not “see” the impact of investments or investment income in our day-to-day lives.

But an individual can get to the point where he is managing investments himself, or even paying a professional to do it for him.  It is these people that would be affected by changes in tax policy now.  These folks might earn a high salary and, after several years, have built up enough extra funds that they start investing on their own.  They likely already pay far higher tax rates on the income that they get from their jobs than most people.  The money that they are investing has already been taxed at a higher rate when they earned the money.  No investment pays a return without some amount of risk.  So they are taking a risk and investing in the hopes of earning some more.

Men Are Not Mountains

People change their behavior.  They do so for any number of reasons.  This is a fundamental characteristic of all free people.  There is a great Russian expression (there are many of them) that says “A man is not a mountain.”  The expression means that men move about of their own free will and implies that you should treat them reasonably because you cannot be certain whether or not you will meet that man again in a different time or place.  People tend to act in a manner in what they perceive to be their own best interests.  They will change course, make decisions, move about, and reorganize their lives in response to conditions and the vagaries of their choices and respective condition.

All of us do this.  It should be axiomatic.

The Laffer Curve Lives

Some (lesser) economists and media pundits mock the concept of the Laffer Curve these days.  They do so at their own peril.  You can follow the link to read more about it if you wish, but the gist of it is that increasing tax rates does not always increase the amount of taxes paid because … drum-roll please … people will change their behavior based upon the conditions around them.  Sometimes you can increase the amount of taxes collected by actually decreasing tax rates.

Generally speaking I am always in favor of lower tax rates by reflex.  But I am also always willing to do the math and yield to economic reality.  But the concept that increasing rates might result in lower actual taxes paid is counter intuitive to most people.  Let me prove it to you.

I created a dynamic spreadsheet to prove the point.  Let’s start by saying that I did my level best to be fair and my sources are cited in the spreadsheet.  No doubt someone will get picky about an amount or reference, but this is not a dissertation.  The information proves the points at hand well.  I created a hypothetical investment case using current tax rates and various long-term return trends using the longest time-frame references at hand.

You can see the results in Example 1, where I allocated a $4 million investment portfolio across four investment types.  Hard data sets are shaded in red, investment variables and tax rates are shaded in green, and real results are shaded in blue and adjusted for inflation.  You may note that the base tax rate that I chose for normal income is 28%–covering the large swath of those earning over $100 thousand per year in income (the end results are even more dramatic if adjusted to “top rates”).

Investment Tax Analysis Example 1

In Example 1, note importantly that the amount invested is distributed across the four investment types for yield while maintaining some risk diversity and emergency cash reserves in the form of a CD.  This is a very common type of allocation for a working individual who is still a decade or more away from retirement–it is geared for growth.  The amount of real yield is just over $134 thousand dollars (3.84%) and the amount of taxes paid is just over $42 thousand (real current tax rates).

You will also see a series of numbers labeled “Risk Premium.”  These numbers will be important to us going forward.  Since some investments are inherently more risky than others, these are some standard amounts that investors require as an additional return on their investments to compensate them for the risk of the investment when compared to others (a company can go belly-up and its stock become worthless, but government bonds are more secure).  Note that the return on stocks after taxes and inflation is just a bit higher than the risk premium–about 0.9% higher.  This difference is the reason that people take chances on stocks at all–because they believe that in the long run they will benefit a little more than taking a safer route.  This applies to all kinds of people.  In fact, it applies to everyone who invests in the markets at all.

There is another fascinating tidbit.  Note that after taxes and inflation–federal bonds have nearly a “0″ yield over the long term (actually a shade negative).  Federal bonds–when not used for speculation–are generally accepted to have the lowest risk possible of all the world’s investment options.  Since there is no real return without risk, it should be no surprise that the long term return is, in fact, just about zero.  But let’s move on.

Let’s say that we implement the so-called Buffet Rule and raised the tax on capital gains and dividends to 30%.  What happens to our simple, but elegant scenario?

Investment Tax Analysis Example 2

Now we see what we hoped for, right?  The amount of tax paid is now nearly $84 thousand and the grubby rich guy still gets almost $93 thousand in real return.  This is the rosy scenario on which media forecasters pin their glowing endorsements of the Buffet Rule.  So, what’s the problem?  Note how the average return of all those stocks is less than the amount allocated for risk premium?  This is very important.  When you take risk into account, the actual return is less than municipal bonds, and municipal bonds generally have much less risk.  In fact, it should be expected at this point that a few stocks would under-perform to the point that the investor would start to lose money.  The real net return would fall below zero more often than not.

The issue is that people move and change … a man is not a mountain.  The reason that the money was invested in the first place was to get the best yield possible for the investor relative to the amount of risk he takes on.  If he was not looking for a higher yield he might have left all that money in the bank or a safe or just purchased things with it.  The allocation is no longer doing its best for the investor and he is not being compensated for his risks.  What would you do if you were this investor?

If you were this investor, you would logically and reasonably reallocate the types of investments you hold based on these numbers.  Certainly your financial adviser would encourage you to do so.  What might that look like?

Investment tax Analysis Example 3

In Example 3 you can see that by reallocating the amounts invested in each category the savvy investor can still stay diversified but maximize his return relaltive to the risks involved.  Now the investor keeps (after taxes and inflation) almost $75 thousand and pays about $29 thousand in taxes.  By doubling the tax rate, we have incentivized the investor to react—to make changes.  Those changes have resulted in more than a 30% reduction in the amount of tax collected and given him a greatly lower return.  Everyone loses.  The investor is not being mean or vindictive.  He just cannot afford to invest in more risky assets like stocks to the same extent.  There is not enough return to keep his head above water if/when a stock goes South.

Let me put this in another, perhaps humorous way.  The more cynical among us sometimes refer to the financial markets as a casino.  So let’s extend that analogy.  In a casino you can play Roulette or you can play Blackjack.  In Roulette, there are 38 spaces on the wheel.  If you play only one number, the payout for a win is 36 to 1.  If you play Blackjack well, the odds are just a little less than 50/50, so the payout is double.  On all of these the odds are shaded a bit in the favor of the casino (which is why the longer you play in Vegas the more certain the casino operator is of taking your money).  My point is that no one would ever place a bet on Roulette–risk their money–if the payout was the same as Blackjack.  The amount of payout has to be “commensurate” with the level of risk.

If we increase the taxes and thus reduce the potential real payout on certain investments we must assume that some people will just not like the new odds and refuse to play the game.  Or at least play it less.

There Are Lots of Other Factors

Now, I get it.  Really.  This is a micro-economic example.  The additional demand for municipal bonds would impact the rates paid.  But also, the less money invested in corporate stocks would retard the overall economy more, resulting in the general stock returns being less too, and additional levels of taxation are added incentive to move money offshore, etc.  And there are other kinds of investments to consider, such as real estate, corporate bonds, etc.  But none of that extra complexity alters the power of our examples to prove the point at hand.  Namely, that individuals will alter their investments and other behaviors in meaningful ways when we tinker with the incentives.

What Do We Want?

Even in the deepest darkest Gulag of the former Soviet Union, individuals generally acted in a manner that they perceived was in their own best interests first.  Then they think about other things.  This is not bad or to be shamed.  Certainly people can become completely self-centered, but that is not what we are talking about.  We are talking about what individual people do with their time and resources—often without even being fully aware of it.  This undeniable fact of human nature is part of the reason Warren Buffet has been so successful and why he is talking about tax policy now.  But I do not want to get into an armchair psychological analysis of the man himself at this time.

Do we, as a nation, want people taking risks and investing in businesses and paying more actual tax dollars?  Or do we want to feel good about them paying a higher rate, but less real money?

I am not suggesting that we have discovered the Nirvana of tax rates in their current condition.  I am also certainly willing to consider that we might adjust the tax rate to find a better balance between reasonable revenue collection, the needs of the economy, and the primary “good” of individual freedom.  Even further, I am eager to engage the greater taxation debate from a practical and moral perspective and from what, to me, is the obvious core issue–that we do not have a taxation problem … we have a spending problem.

But I am saying that the Buffet Rule that would blindly double the rates on certain types of investment income is poorly-considered public and political pandering at best.  Warren Buffet has earned the sobriquet “Oracle of Omaha” due to his ability to see into the investment future, but he is demonstrating a distinct lack of foresight regarding economics … why people do the things that they do with their own money and resources.

Thanks for reading.