By Daniel Shuchman
Having a net worth over $40 billion may command some authority and attention for one’s views on economics and taxation. But it should not buy one an exemption from basic logic, intellectual integrity, or consistency.
Such seems to be case with Warren Buffett, who yet again took to the op/ed pages of the New York Times this week to call for higher taxes on citizens earning more than $500,000. The idea that higher income people should pay more in taxes, whether born of a desire for greater progressivity and/or a desire to raise more revenue, is certainly a legitimate viewpoint. However, any serious person espousing such an argument should be expected to address several basic questions: What will the standard of fairness be? How is it to be determined that any particular income group is paying its “fair share?” And if taxes are to increase, whether to address the deficit or for “fairness,” what degree of negative impact on economic growth and investment is one willing to tolerate? Regrettably, the recent presidential campaign featured much demagoguery but few answers. Mr. Buffett is no more illuminating.
The so-called Oracle of Omaha begins by making the manifestly absurd assertion that tax rates do not influence investment behavior. Astonishingly, Mr. Buffett claims that when he was a fund manager, “never did anyone mention taxes as a reason to forgo an investment opportunity….” “Only in Grover Norquist’s imagination,” he derisively contends, do investors adjust their plans based on the prospects for taxation. Such statements defy economic logic. The amount and nature of taxation, whether of the income stream generated by a particular investment, or that levied on interim dividends or capital gains realized upon the disposition of an asset, must be among the many complex factors considered by any rational investor in assessing the relative merits of an investment opportunity. If this proposition is not self-evident to you, you can go straight to the authority himself.
Mr. Buffett has left extensive and contemporaneous documentation of his investment thinking going back five decades. And it is clear not only that Mr. Buffett has always understood this fundamental economic axiom, but that tax considerations have been a critical animating factor throughout his business career. (Indeed, during the period when he was initially accumulating great wealth, Mr. Buffett was quite passionate about the desirability of low tax rates.) As early as 1963, he wrote a letter to the investors in his hedge fund, The Buffett Partnership, Ltd., in which he laid out some of the fundamental tenets of his investment philosophy as it relates to taxation. One was the following:
“I am an outspoken advocate of paying large amounts of income taxes – at low rates.”
He goes on to note that in the real world not all investors share his approach: “A tremendous number of fuzzy, confused investment decisions are rationalized through so-called ‘tax considerations.’” One would think this behavior has meaningful economic consequences in the aggregate. Mr. Buffett assures his partners that he is utterly disciplined and rational, though no less aware of the importance of taxation to investment results:
“My net worth is the market value of holdings less the tax payable upon sale. The liability is just as real as the asset unless the value of the asset declines (ouch), the asset is given away (no comment), or I die with it….Investment decisions should be made on the basis of the most probable compounding of after-tax net worth with minimum risk.” [emphasis added]
That oblique reference to giving assets away is highly revealing, and we’ll return to it in a minute. Scarcely a year later, the emerging star fund manager reported to his investors that the Buffett Partnership had sold some investments and thus would incur taxable realized gains (the quaint sum of $2,826,248.76 in total, as it turned out). But he assured them that virtually all of his gains qualified for long term tax treatment. “We make investment decisions based on our evaluation of the most profitable combination of probabilities. If this means paying taxes – fine – I’m glad the rates on long-term capital gains are as low as they are.” [emphasis added]
Sensitivity to tax rates and structures, if not extensive efforts at tax minimization, has been a consistent focus for Mr. Buffett. In 1990, he shared with his stockholders the sample of a letter he had sent to a business owner whose company was a prospective acquisition target for Berkshire Hathaway. In it, Mr. Buffett explained to the potential seller why it was essential that the seller’s family retain a 20% interest in their business:
“We need 80% to consolidate earnings for tax purposes, which is a step important to us.”
One can only wonder, whether the deal would have happened, and at what price, if the seller had insisted on retaining 21% or more.
Notwithstanding the nasty asides at Grover Norquist, Mr. Buffett has been quite expansive on the complex tradeoffs inherent in investment decisions, and how taxes can be a pivotal swing factor. In 1984, Mr. Buffett discussed a new investment that he had made in the bonds of the Washington Public Power Supply System (WPPSS):
In the case of WPPSS, the “business” contractually earns $22.7 million after tax (via the interest paid on the bonds),and those earnings are available to us currently in cash. We are unable to buy operating businesses with economics close to these. Only a relatively few businesses earn the 16.3% after tax on unleveraged capital that our WPPSS investment does and those businesses, when available for purchase, sell at large premiums to that capital.
One cannot fault Mr. Buffett for striving to maximize after-tax returns for himself and his shareholders within the confines of the law as it existed at any point in time. What is shameful is that, in an effort to advance a political agenda, he would now use his credibility to rewrite history and deny that tax rates and characteristics can have substantial economic effects by altering the financial calculations confronting businesses and individuals.
Mr. Buffett now proposes that the minimum individual tax rate for those making between $1 million and $10 million should be 30%, and for those making over $10 million it should be 35%. No rationale is given for these rates. Why not 25%? Why not 50%? The reader is given no insight as to whether these rates are based on some distributional principle, an attempt to maximize government revenue, or something else. We are left only with The Oracle’s arbitrary decree which we are apparently not to question. Mr. Buffett’s sanctimonious tone is inversely proportional to his willingness to propose any reform that would materially impact his own financial position. Virtually all Mr. Buffett’s wealth is attributable to the ownership of stock, not current wage income. He has commenced a plan to give away his shareholdings to various charitable foundations (a noble endeavor) which will also avoid triggering many billions of dollars in tax payments. He is conspicuously silent about whether he would support a tax reform that eliminates charitable deductions.
But perhaps the most disturbing aspect of Mr. Buffett’s revisionist history comes when he turns to his prescriptions for our nation’s deficit and debt. The federal government’s goal should be to raise revenues of 18.5% of GDP and to spend 21% of GDP, he recommends. Nowhere does he explain why these levels are optimal and whether they derive from a social, economic, moral, fiscal or national security perspective. Mr. Buffett acknowledges that these ratios guarantee future annual deficits but he takes comfort that “assuming even conservative projections about inflation and economic growth, this ratio of revenue to spending will keep America’s debt stable in relation to the country’s economic output.” He seems awfully complacent about the prospect of our country incurring hundreds of billions of dollars of additional debt, every year, potentially forever. Won’t this eventually have dangerous or even disastrous consequences?
Mr. Buffett used to think so. Here he is, in 1984, when the debt and deficit of the United States were a fraction of what they are today, explaining why he doesn’t like to buy long term bonds:
That’s because bonds are as sound as a dollar – and we view the long-term outlook for dollars as dismal. We believe substantial inflation lies ahead, although we have no idea what the average rate will turn out to be. Furthermore, we think there is a small, but not insignificant, chance of runaway inflation. Such a possibility may seem absurd, considering the rate to which inflation has dropped. But we believe that present fiscal policy – featuring a huge deficit – is both extremely dangerous and difficult to reverse. (So far, most politicians in both parties have followed Charlie Brown’s advice: “No problem is so big that it can’t be run away from.”) Without a reversal, high rates of inflation may be delayed (perhaps for a long time), but will not be avoided. If high rates materialize, they bring with them the potential for a runaway upward spiral.
Eerily, those words could have been written today. (We can only hope they will not turn out to have been prophetic after all.) In the intervening three decades, as our fiscal situation has dramatically worsened, it appears that Mr. Buffett has adopted former Vice President Cheney’s famous view that “deficits don’t matter.” If this seems odd for a temperamentally cautious investor, it is. Mr. Buffett’s aversion to personal and corporate debt has been stated often and vociferously in his communications. It is clear that he would never allow Berkshire Hathaway (let alone his personal finances) to operate with substantial debt and permanent operating losses. Yet mysteriously, he now decrees such a fiscal program to be a prudent and responsible course for our nation as a whole.
The breezy assumption that a continuing and substantial deficit can be financed indefinitely is all the more jarring when one considers that Buffett issued this ominous warning as long ago as 1987:
“The faith that foreigners are placing in us may be misfounded. When the claim checks outstanding grow sufficiently numerous and when the issuing party can unilaterally determine their purchasing power, the pressure on the issuer to dilute their value by inflating the currency becomes almost irresistible. For the debtor government, the weapon of inflation is the economic equivalent of the “H” bomb, and that is why very few countries have been allowed to swamp the world with debt denominated in their own currency. Our past, relatively good record for fiscal integrity has let us break this rule, but the generosity accorded us is likely to intensify, rather than relieve, the eventual pressure on us to inflate. If we do succumb to that pressure, it won’t be just the foreign holders of our claim checks who will suffer. It will be all of us as well.”
As far-sighted as he is, one senses that Mr. Buffett could scarcely have imagined the scale of “claim check issuance” that later ensued, especially in the last few years. Maybe he has been lulled into complacency since no reckoning has yet occurred.
One can only hope that he owns some tax-exempt inflation-indexed bonds, just in case.
Mr. Shuchman is a New York money manager. He has written for The Wall Street Journal, Reason, and other publications. His views are his own.