By John L. Chapman, Ph.D.
Warren Buffett, the world’s second richest man and a wildly successful investor for half a century, wrote a provocative essay last week in the New York Times in which he called for higher taxes on the rich. Mr. Buffett, a lifetime Democrat and strong supporter of President Obama’s philosophy of wealth redistribution, asserts that neither he nor the “mega-rich” he personally knows are influenced by tax rates in their behavior as investors. Indeed, he considers it “unfair” that capital gains are currently taxed at 15%, a rate also applying to carried interest in investment partnerships for alternative vehicles such as private equity and hedge funds, while ordinary income from wages typically hits the middle class at 25% rates (and goes to 28% at $82,250, and on up to 35% for mid-six figures). As he says, last year he paid taxes equal to 17.4% of his $42 million income, whereas most of the middle-income employees at Berkshire Hathaway paid at rates nearly double that, thanks to ordinary rates at 35% and much higher payroll tax liability versus Buffett’s.
Mr. Buffett’s remedy? Leave tax rates where they are “for 99.7% of all Americans”. But he says, “for those making more than $1 million — there were 236,883 such households in 2009 — I would raise rates immediately on taxable income in excess of $1 million, including, of course, dividends and capital gains. And for those who make $10 million or more — there were 8,274 in 2009 — I would suggest an additional increase in rate.”
The question for our purposes is a simple one: will higher tax rates imposed on the “mega-rich”, or on those who make above Mr. Obama’s much lower bar of $250,000, induce economic growth and job creation? And concomitantly, will these higher taxes create capital wealth via a more buoyant stock market for investors, which can only result from higher corporate profits? After all, we remind our readers that there will be no long term recovery, and no meaningful new job creation, without a sustained rise in profits.
To answer this question, we revert to both economic theory and empirical history and reality for perspective. First, in terms of pure theory, all taxation is distortive of production and exchange patterns that are most preferred, and would prevail in a world with no taxes. In a series of papers and books on the welfare effects of taxation beginning in 1962, Arnold Harberger, then at Chicago and later at UCLA, showed that there is an unambiguous “dead-weight loss” of welfare via reduced output and consumption thanks to taxation. In looking at corporate taxation, for example, Harberger depicted this graphically via his famous “Harberger triangles”, which showed a wedge between supply and demand at the competitive optimum point of maximal output at a market price that was equal to marginal cost: in simple terms, this tax wedge show how taxes cause market prices to be higher, which reduces quantity demanded, but also lowers revenues to suppliers thanks to bearing part of the cost of the tax. Less output, lower revenues and profits, and higher consumer prices are the result of corporate taxation, and similar effects are in play with income taxes: lower demand for output, less consumption, lower sales and profits, lower investment that funds future output.
Of course taxation is a “necessary evil” in civilized society where government has a legitimate role, and the benefits derived from more civility and less anarchy well offset the costs of lost consumer and producer welfare. So the real question to be answered is, what is the optimal amount of taxation to fund government? This is the canonical question of public finance, because too much taxation can lead to costs that exceed the benefits of an efficient civil society, not least by crowding out consumption and productive investment that fuels the jobs and wealth creation of tomorrow. And relatedly, tax rates that are excessive, by destroying incentives to work and produce, can be counterproductive in raising revenues for the government to fund its operations.
This latter point is seminal with respect to the current challenges to our economy. Economist Arthur Laffer, a key architect of the Reagan Revolution, depicted the relationship between tax revenues received by the government and the effective tax rate in his famous 1974 drawing of the Laffer Curve.
The Laffer Curve shows tax revenues received by the government as a function of the effective tax rate. At a 100% tax rate, no one would work or produce, and the government would receive the same revenue as if it did not collect taxes at all. There is, therefore, an optimal tax rate that maximizes the government’s tax revenues, above which work disincentives swamp higher rates.
The Laffer Curve, as drawn on a restaurant napkin by Laffer in 1974.
For our purposes, the question is, as a practical matter, at what point is the optimal tax rate reached? In his New York Times piece Mr. Buffett says that this graphic is not operative in his world: “I have worked with investors for 60 years and I have yet to see anyone — not even when capital gains rates were 39.9 percent in 1976-77 — shy away from a sensible investment because of the tax rate on the potential gain. People invest to make money, and potential taxes have never scared them off.” While unspoken as such, President Obama believes this as well, as evinced by his oft-repeated and tonally-inflected derision of “millionaires and billionaires” and “corporate jet owners“. Likewise Bill Clinton before him, as well: indeed, this is the core crux of the political debate in this country with respect to taxation. Will higher taxes harm the economy further, or help close the budget deficit?
Here the weight of the evidence — indeed, a mountain of it — is decidedly against Mr. Buffett, but space permits us only a few examples:
- At a “micro level”, there can be no better example that falsifies Mr. Buffett’s thesis than the famous (or infamous) luxury goods tax of 1990 as it applied to yachts. In late 1990 President George H.W. Bush negotiated a budget deal with Congress that called for higher taxes in several areas, including a luxury tax on yachts, private aircraft, high-end automobiles, jewelry, and furs. It was clearly targeted at “the rich”, who were thought to be as impervious to tax rate changes as Messrs. Buffett and Obama assert today. Yet by the summer of 1991 yacht sales had dropped off so sharply, that even Senator George Mitchell, the Senate Majority Leader from the ship-building state of Maine, was moved to call for repeal of this tax on the rich — though Senator Mitchell took pains to state that it was out of concern for the yachting industry’s employees who had suffered job losses in the thousands, “and not the welfare of yacht-owners”.
- At a “macro level”, there is solid evidence as well that invalidates Buffett’s thesis that tax rates do not matter to the rich, which for purposes of this discussion are investors with passive (capital gains) income. On at least five occasions in the United States in the last century (the Mellon tax cuts of the 1920s, John F. Kennedy’s tax cuts in the 1960s, the Steiger cut in capital gains from 40% to 28% in 1978 under Jimmy Carter, the Reagan tax cutting program in the 1980s, and the Bush 43 tax cuts of 2003), capital gains revenues increased after the rate was cut, and income tax cuts were associated with rising government revenues and economic growth in every instance as well. Congressman Bill Steiger’s 1978 legislation is particularly illustrative, as it passed over President Carter’s strong initial objection, but capital gains revenues jumped 30% year-over-year in 1979 alone.
- Economist W. Kurt Hauser wrote a series of articles in the 1990s describing the relationship between taxation, government revenues, and GDP, discerning what later came to be known as “Hauser’s Law”: to wit, that since 1945, government revenues as a percentage of GDP averaged close to 19.5%, with little variability, regardless of tax rates. In the Obama era, tax revenues as a percentage of GDP have plunged to the 14-15% range thanks to anemic growth in recent years, but prior to this were in a tight range around 18-20% of GDP. A series of graphs courtesy of Anthony Davies of Duquesne University and the Mercatus Center highlights this important economic lemma, which has such heavy bearing on correct policy moving forward, along with falsifying Buffett’s hypothesis that tax rates do not alter the behavior of economic agents or matter with respect to economic growth:
First, we see that as average marginal tax rates — that is, the arithmetic average of all marginal rates in a given schedule — have generally trended upward since 1954 (in red), the federal tax “take” as a percentage of GDP (shown in blue) has remained mostly flat, and certainly resistant to the 20% threshold. If Messrs. Buffett and Obama were correct, the blue line should rise pari passu with the red:
Secondly, we see that the capital gains rate (red) has jumped between 15% and 40% in the last sixty years, but has had no impact on the federal tax take as a percentage of GDP (blue):
Thirdly, corporate profits tax rates (red) have not impacted tax revenues as a percentage of GDP (blue):
And finally, marginal income tax rates changes (red) have likewise not impacted the federal tax take as a percentage of GDP (blue):
The foregoing graphs represent a devastating critique of the thesis that tax rates do not alter the behavior of economic agents. Mr. Buffett may believe this to be true about himself, and know, anecdotally, of a few instances of other “mega-rich” where this is true. But a core tenet of economic theory is that incentives matter, and a corollary prediction is that policy changes can induce new behaviors based on those incentive changes. In the aggregate, American tax-payers have rejected tax increases such that they will shift behaviors to prevent the federal tax take from ever rising much above 20%: for example, when excise taxes are implemented for luxury yachts, buying patterns shift away from American producers and toward foreign makers, or into non-taxed luxury leisure items. Not only do federal government coffers not see any increase thanks to the luxury goods excise tax, but indeed, unemployment is generated among luxury goods-makers who’ve been forced to suffer the tax, at the same time federal tax revenues may even decrease, in some cases.
Fairness in Taxation, and Economic Growth
The subject of tax equity has engendered a vast literature nearly equal to that of tax efficiency, and is far too deep a topic for the confines of this essay. But since Mr. Buffett has raised it, we offer a few brief comments, starting with the practical obervation that Washington policy-makers would do well to heed Hauser’s Law as a good proxy for long run reality, and strive to have policy conform to its dictates. That is to say, federal spending at 24-26% of GDP, per Mr. Obama’s policy preferences, is not only unsustainable, it is spending at a level guaranteeing national bankruptcy and economic collapse. So the only way in which a bigger government presence in the U.S. economy can be sustained, if that is the goal, is via strong GDP growth that permits federal spending to rise in turn.
How then is this best effected from the vantage point of tax policy, and how does “fairness” relate to this? Start with the realization that the tax code in the U.S. has become steeply progressive over time in terms of payment outcomes. When President Reagan was elected in 1980, the top 1% of all wage-earners paid 17% of all federal income taxes. Today the top 1% pay nearly 40% of the total. To further make the point, in 2009 the top one-fifth of one percent of all wage-earners — or the 250,000 individuals who earned more than $1 million, paid 20% of all income taxes, while the top 3% of wage-earners, those earning at least $200,000, paid fully fifty percent of all federal income taxes. Approximately half of all wage-earners pay no federal income tax at all (though they do pay payroll taxes).
The question arises, then, how does Mr. Buffett know what is “equitable”, if these staggering examples of progressivity are not enough? Of course the short answer is, this is a normative question and not subject to positive economic analysis, and hence Mr. Buffett is doing no more than stating his opinion. But on the question of taxation of the rich and its impact on economic growth, the record is far clearer.
If, again, we assume for the sake of illustration that consumption patterns are fairly stable beyond a certain level, and that excess marginal wage income and any capital gains income are “passively” invested, we can apprehend the cost to economic growth embedded in taxation schemes that are geared toward high earners. The United States has the highest material standard of living in the world thanks to one economic datum: the capital invested per worker is higher here than anywhere else. But this capital, in the form of machines, tools, factories, and intangible-but-very-real human skills and knowledge, depreciates on a daily basis. It must per force be replenished via invested savings and corporate profits recycling, and indeed it must achieve higher growth rates than the growth in the worker population, or else capital invested per capita will decline, and with it per capita real incomes as well.
To make this point concretely, according to the Federal Reserve, the U.S. economy is in round numbers comprised of $200 trillion in assets at the moment, and roughly $50 trillion of this is in tangible assets, of which half is housing and half is non-residential. If we take the latter $25 trillion and regard it as the capital stock of American business, we can say this $25 trillion “backs” the U.S. work force of 131 million workers. This amounts to more than $190,000 invested per worker in the United States, a staggering sum that more than anything else explains incomes in the U.S. versus those of, say, India, at one-tenth that of the U.S.
What Messrs. Buffett and Obama fail to apprehend is that every tax increase that yields an incremental $190,000 from the private sector destroys a job here. And if, in rough terms, 10% of the capital stock of business depreciates each year ($2.5 trillion), this, coupled with labor force growth of 2% per year (2.6 million X $190,000=$494 billion), implies that business fixed investment must at least equal $3 trillion per year. With total corporate profits in the U.S. running at $6 trillion currently there is certainly funding to cover this basic need, but dividend payouts used as consumption, along with payments or investments overseas, quickly dissipate the total — as will, eventually, higher tax levels.
Seen in this way, increased taxation of any kind is negative for job growth and capital formation. And this is especially true of high income earners, whose tax payments come right out of pure (post-consumption) investment funds. The minimum $40 billion in tax hikes next year sought by the President would cost at least 200,000 jobs per year directly, and a multiplier of that total indirectly.
Mr. Buffett and the President also fail to see the wealth effects from an ever-weakened U.S. dollar, thanks in part to progressive taxation which hits the to-be-deployed capital of both every day Americans as well as the “mega-rich”. But a dollar constantly depreciating in value further discourages the entrepreneurial risk-taking that will be so necessary to return to growth and prosperity.
America, Europe, and Japan are, in the words of Nobel Laureate and Columbia University economist Robert Mundell, in a “mini-depression“. Both theory and the weight of substantial evidence point to the U.S. being unable to “tax its way” to a budget balance, let alone to real growth on a sustainable basis. Indeed, Mr. Buffett’s plea for higher taxes on the wealthy may have made him feel good about himself, but in terms of economic policy, Buffett’s idea is, like Keynes’ before him, tantamount to eating the seed corn of the U.S. economy.
Mr. Chapman is chief economist at Alhambra Partners, and a director of research at Hill & Cutler Co. in Washington, D.C. He and Alhambra founder Joe Calhoun are writing a book about investing in the current turbulent era.