Liberals often praise Warren Buffett for his statement about paying tax at a lower rate than his secretary, to show that not all billionaires are ridden with greed and won’t resist efforts to tax them more vigorously.
If only. Truth is, Buffett takes advantage of the provisions in our tax code that favor wealth over work just as much as anyone else does. We heard this loudly and clearly in 2021, when a ProPublica expose revealed that Buffett’s “true tax rate” was obscenely low, even compared to other billionaires. In a statement to ProPublica, Buffett expressed a desire to see changes to federal tax law to address wealth inequality generally, but justified his own tax avoidance, stating: “I believe the money will be of more use to society if disbursed philanthropically than if it is used to slightly reduce an ever-increasing US debt.” Imagine if we all could make that decision.
A subsequent ProPublica report revealed that Buffett had stuffed a Roth IRA with $20.2 million as of 2018. His Roth IRA balance undoubtedly is far larger today. One of his deputies at Berkshire Hathaway, Ted Weschler, had stuffed $264 million into his Roth. Buffett didn’t answer ProPublica’s email questions about his Roth IRA. A possible explanation for Buffett’s failure to respond: it would be hard to justify his Roth IRA maneuver with his philanthropy, since his philanthropic objectives could be achieved just as easily through the traditional IRA he converted to a Roth.
You have to go back a few decades to get the full flavor of Buffett’s sophistry in justifying his own light tax treatment. Buffett often speaks of his secretary paying income tax at a higher rate than he does, suggesting that his own rate should be increased. But Buffett knows well that the nominal rate applied to capital gains is far less significant to their ultra-light income tax treatment than the policy of not taxing investment gains until investments are sold. In a letter to Berkshire Hathaway shareholders in March 1990, Buffett described the minimal taxation of the company’s 23.8 percent year-on-year return as being hugely valuable to him as well as Berkshire’s other shareholders:
Because of the way the tax law works, the Rip Van Winkle style of investing that we favor – if successful – has an important mathematical edge over a more frenzied approach. Let’s look at an extreme comparison.
Imagine that Berkshire had only $1, which we put in a security that doubled by year end and was then sold. Imagine further that we used the after-tax proceeds to repeat this process in each of the next 19 years, scoring a double each time. At the end of the 20 years, the 34% capital gains tax that we would have paid on the profits from each sale would have delivered about $13,000 to the government and we would be left with about $25,250. Not bad. If, however, we made a single fantastic investment that itself doubled 20 times during the 20 years, our dollar would grow to $1,048,576. Were we then to cash out, we would pay a 34% tax of roughly $356,500 and be left with about $692,000.
The sole reason for this staggering difference in results would be the timing of tax payments. Interestingly, the government would gain from Scenario 2 in exactly the same 27:1 ratio as we – taking in taxes of $356,500 vs. $13,000 – though, admittedly, it would have to wait for its money.
We have not, we should stress, adopted our strategy favoring long-term investment commitments because of these mathematics. Indeed, it is possible we could earn greater after- tax returns by moving rather frequently from one investment to another. Many years ago, that’s exactly what Charlie and I did.
Now we would rather stay put, even if that means slightly lower returns. Our reason is simple: We have found splendid business relationships to be so rare and so enjoyable that we want to retain all we develop. This decision is particularly easy for us because we feel that these relationships will produce good – though perhaps not optimal – financial results.
In those five paragraphs, if you read just a little between the lines, Buffett conveys the following messages:
- The tax law confers special tax treatment on investors that hold highly profitable investments over the long-term, as compared to investors who change investments frequently.
- The special treatment of those long-term, highly profitable, investments benefits the US Treasury, although there is some disadvantage in having to wait to receive tax payments until investments are sold.
- Although the tax law favors the approach he and Charlie Munger have taken at Berkshire, they didn’t operate that way for tax purposes. Rather, their approach is also better for non-tax reasons and for reasons apart from maximizing their pre-tax gain as well.
- The tax law’s light treatment of long-term investments makes sense from both a revenue generating and incentive-based tax policy standpoint.
Buffett’s math is correct, which makes that first point—that the tax law confers special tax treatment on long-term, high-yielding investments—absolutely true. The remainder of his message is self-serving nonsense.
In Buffett’s concocted example of an investor doubling her investment every year for 20 years, the government benefits from the investment growing tax free. But in the case of more pedestrian investment results, that’s not true, when you take into account the cost of what Buffett acknowledges—that when investment gains are not taxed until investments are sold, the government has to wait for its money. That means the government must borrow more to offset the foregone tax revenue.
While Buffett’s acknowledgment regarding the time value of tax payments appears almost as an afterthought in his investor letter, the reality is that for investments with more typical rates of growth, it’s a huge factor. And a first approximation, if the product of the rate of growth of the investment and the tax rate is below the government’s borrowing rate, the cost to the government of having to wait for its money will exceed the additional tax revenue it receives from the taxpayer from waiting until the investment is sold.
Consider, for example, an investor whose holding grew at 10 percent per year for 20 years. If the investor’s gains are not taxed until the investment is sold after 20 years, the increased tax revenue at the end of the 20 years would not be sufficient to cover the government’s borrowing costs. For example, at today’s 10-year Treasury yield of about 4.2 percent and maximum long-term capital gains rate of 23.8 percent, the total of the foregone tax revenue from not collecting tax each year on the investor’s annual 10 percent investment gain on a $1 million investment, together with the interest on the amount borrowed to replace that revenue would, after 20 years, equal $1.44 million. At the end of those 20 years, the $1 million would have grown to $6.73 million, and the tax on the $5,73 million of gain would be $1.363 million, leaving the government about $75,000 worse off by forgoing tax on the investor’s annual gains. It sounds modest, but there are tens of thousands of investors making that sort of investment, with possibly zero making investments that double in value each year, as in Buffett’s hypothetical, for 20 years.
There are other fallacies in Buffett’s logic. For many investments, the growth trajectory slows over time. In those situations, what starts out looking like the comparison Buffett presented in the long run looks like the scenario for the investor with a more modest overall growth rate.
What Buffett failed to take into account, and what causes delaying taxation until sale to always be a losing proposition for the government is the investor who purchases the asset an investor sells to pay tax currently on an investment. If, to pay taxes, an investor sells an investment that continues to add value after the sale, the growth in value will still generate tax revenue, only from a different taxpayer. Buffett’s comparison fails to take this into account. Consider those imaginary home run investments of Berkshire that Buffett used in his example. If Berkshire had been required to sell those investments each year to pay income tax currently, the investor who purchased from Berkshire would benefit from the future growth, and pay tax on its investment gains. Buffett never takes those taxes into account in his example.
Buffett stated to his shareholders that the tax advantages of holding an investment over selling it and redeploying the proceeds didn’t impact his and Charlie Munger’s investment decisions. But the reality is they had a fiduciary duty to Berkshire’s shareholders. That means they were duty bound to take all circumstances that could impact overall results into account. Yes, they may decide to sell an investment, for valid reasons, despite the potential tax advantages of not doing so, but they can’t ignore tax consequences in making their determination.
Where Buffett’s logic goes completely off the rails, however, is his implication that not taxing investment gains until investments are sold is sound policy from the perspective of how it impacts investor behavior. A few more steps in Buffett’s analysis of the hypothetical Berkshire investment that doubled in value each year for 20 years shows why. The end result of that investment, as Buffett notes, is 27 times as good as it would be if the tax applicable to investment gains were collected every year and paid from the investment. Now compare that to an investment that increased at 10 percent per year for 20 years. That investment is more valuable at the end of 20 years as well. Applying the same 34 percent tax rate that Buffett referenced, one dollar returning 10 percent per year for 20 years would be worth $6.73 if the 34 percent tax is applied at the time of sale, as opposed to $3.59 if the tax is applied annually to each one-year gain.
So, under our system of not taxing investment gains until investments are sold, Buffett’s home-run investment, after tax, is worth more than 100,000 times as much as the investment with an ordinary return of ten percent per year. If the gains on each investment were taxed annually, that home-run investment would be worth a little over 7,000 times as much as the ordinary-returning investment.
That tax policy Buffett seemed to think was a good idea back in 1990, then, has the effect of widening—dramatically—the after-tax difference between investments with supersized returns and those with more ordinary returns. How does that happen? Simply put, the policy of delaying taxation of investment gains until investments are sold is shockingly regressive. As the yield on an investment grows, and the period over which it produces that yield lengthens, the effective annual tax rate on the investment decreases. That obviously exacerbates wealth inequality.
Consider the effective annual tax rates in the scenarios we’ve been discussing. When you do the math, the effective annual tax rate on Berkshire’s hypothetical supercharged investment—that is, the tax rate which, if applied to the annual gain each year on the investment and paid for by reducing the amount invested, would provide the same end result for Berkshire as the 34 percent tax paid at the time of sale after 20 years—is 4.11 percent. The payment of a 34 percent tax on 20 years of compounded gains reduces that annual pre-tax growth rate of 100 percent by a trifling 4.11 percent, to 95.89 percent.
The effective annual tax rate on the 10 percent annual return investment? 18.6 percent. That’s still a healthy reduction from the 34 percent nominal rate. But it’s about 4.5 times the effective annual tax rate paid on the supersized return investment.
And if it’s individuals holding those two investments under today’s maximum tax rate of 23.8 percent on long-term capital gains, the differences in their respective effective annual tax rates worsens slightly: 12.4 percent for the ordinary yield investment, about 4.6 times the 2.7 percent for the supersized return investment.
This glaring flaw in our tax policy shows up in the size of the fortunes of America’s top billionaires. Take Jeff Bezos, for example. He’s sold a good bit of his Amazon shares but still has about $200 billion worth left, comprising most of his net worth. His original investment in those shares, about $200,000 in 1994, has grown roughly one million-fold, about the same as Buffett’s hypothetical investment that doubled each year for 20 years, but achieved over a somewhat longer period. Bezos’ Amazon shares have had an average annual growth rate over those 31 years of about 56.2 percent. If he sold those shares and paid the 23.8 percent tax on his gains, he’d be left with $154.2 billion. If we assume that growth has been at an even pace over the 31 years, his effective annual tax rate over the 31 years would be 2.43 percent. [If we take into account the uneven rate of Amazon’s growth in value, the effective annual tax rate would be slightly higher.]
But if Bezos had been taxed at a 23.8 percent rate on his Amazon gain each year and paid the tax by selling just as many shares as needed, his Amazon fortune from that $200,000 investment would be about $12.5 billion. That still would be a stunning after-tax annual growth rate of 42.8 percent. And Bezos still would be phenomenally wealthy. But the wealth difference between him and the rest of us would be over 90 percent smaller. We wouldn’t have anywhere near the oligarchic distribution of wealth we do today.
Buffett’s repeated reference to the rate of tax applied to his gains, and how that rate is less than the rate his secretary pays, largely ignores this problem. Eliminating the preferential tax rate for long-term capital gains would be a step in the right direction, and one we advocate for income over $1 million in any year. But it would be a baby step. If Bezos sold his Amazon shares and were taxed on his Amazon gains at the maximum income tax rate for individuals, 40.8 percent, he’d still be left with about $118.4 billion after paying his tax bill. His effective annual tax rate in that scenario: 4.66 percent. Not as obscenely low and 2.43 percent, but still obscenely low.
So much for good billionaires advising us on tax policy. The very tax policy Buffett championed 35 years ago—and presumably still does today—is the source of today’s oligarchy. Thanks, Warren.