Warren Buffett and High Taxes

Warren Buffett has asked for higher taxes for himself and other wealthy investors.  His policy aims are not clear, nor is it clear what policies he would endorse.  In response to Buffett, Steve Schwarzman has noted that he pays a hefty 53% of his income in taxes.

Many Americans are not interested in this debate between the super-wealthy.  But these issues have far-reaching implications for the economy.  I have tried to simplify a few numbers to show that Buffett’s proposal – if properly understood – would destroy the accumulation and creation of wealth, and the ability of private investors to keep investing in the private markets. 

Let’s assume that Warren Buffett is serious when he says that he wants an annual tax on wealth accretion, not just on his income.  That is, Buffett wants to be taxed on the amount by which his holdings in Berkshire-Hathaway (BRK) rise every year, not just the amount of actual “income” he realizes.  Such a policy would have dramatically affected his net worth over the last 20 years. 

Warren started out in 1991 owning approximately 475,000 Series A common shares of BRK.  He owns 350,000 shares of Berkshire-A (BRK-A) today, having converted the remainder to Berkshire-B (BRK-B) for distribution for charitable purposes – to the Bill & Melinda Gates Foundation and to his family charities.  But for all intents and purposes, he owns the same amount today that he owned in 1991, except for those shares that he has disposed of to charity (which presumably lowered his tax bills on other investments).

However, that would not be the case if he were required to “true up” his ownership each year with the tax man.  Berkshire has seen an amazing run-up in its value over 20 years – from $6,700 on the first trading day of 1991 to $113,400 on the first trading day of 2011, adding a whopping $50 billion in value to Uncle Warren’s net worth.  By taking a few liberties with the numbers, however, one can easily determine that Buffett would own less than half of his wealth today if he had been required to pay tax on wealth accretion each year for the last 20 years. 

For example, in 1992, Berkshire’s “value” had increased 30.6% -- trading at $8,750 on the first trading day of that year.  If Buffett had been required to pay tax on that gain at 31% -- the last year before the Clinton tax increase to 39% -- he would have owed slightly over $300 million on his imputed “gain” that year of nearly $1 billion.  To pay those taxes, he would have sold nearly 35,000 shares.  Ouch. 

It gets worse the following year.  By the first trading day of 1993, BRK-A shares were trading at 11,735 –a 34% gain from the prior year.  But the tax rate had climbed to 39% (remember the Clinton tax increases were retroactive).  In order to pay his taxes that year, he would have sold nearly 48,000 shares – that number would decline to 44,000 shares if he had already disposed of 35,000 shares to pay taxes the prior year.  But his ownership would clearly decline year after year to pay those taxes – by an additional $28,000 shares in 1994, 46,000 shares in 1995, 6,000 shares in 1996, and so on. 

It gets complicated in 2000, when the shares of BRK-A fell on a year-over-year basis.  Would Warren’s proposal allow him to use that loss to carryback against the prior year’s taxes?  Could it be carried forward?  These kinds of questions are not easily answered in the abstract, which is why governments that try to tax wealth have a hard time identifying how the wealth increases – should it be taxed on an annual basis?  Maybe every three years?  Maybe every three months?  (That seems to be the position of the IRS with respect to withholding for partnership gains – would it make sense if the “value” of the partnership was fluctuating from quarter to quarter?). 

Assuming that Warren gets some credits for his loss years – even the terrible year of 2000 – his share ownership would have fallen to 169,000 shares after the 2008 calendar year.  Even assuming he scurried out to the market and repurchased BRK shares from his tax refunds (one has to assume he would have to borrow, since tax refunds are usually not paid for months or years after the end of the relevant tax year), Buffett would still own only 186,000 shares by the end of 20 years – less than 40% of the shares he started with!  That effect would be compounded if this were carried back another 22 years to 1969 -- when Buffett first acquired all his shares in BRK. 

And, since he claims that 99% of his net worth is invested in BRK, he would presumably not be the richest man in the world today – a citizen of some other country would have to take that title. 

Buffett has noted in his prior shareholder letters that Berkshire-Hathaway already pays a hefty tax bill.  In his 1998 letter to shareholders, for example, he noted that Berkshire paid $2.7 billion to the Federal Treasury and that was enough to keep the government running for half a day.  He also complained about a $30 million payment to the Treasury that year that he would have preferred to have kept: 

“Berkshire truly went all out for the Treasury last year. In connection with the General Re merger, we wrote a $30 million check to the government to pay an SEC fee tied to the new shares created by the deal. We understand that this payment set an SEC record. Charlie [Munger] and I are enormous admirers of what the Commission has accomplished for American investors. We would rather, however, have found another way to show our admiration.” 

That complaint about fees does not seem consistent with the goals of a man who wants to pay more to the Treasury.  Maybe he just wants to fund the government solely with individual tax payments.  But corporations do not really pay the taxes – their stockholders or customers do.  And the taxes are a drag on those corporations – and, in the case of Buffett, would be a drag on his ability to keep investing in Berkshire-Hathaway.

Buffett has used other ways of trying to minimize his taxes – all legal, but not consistent with the goals of a man who says he wants to pay more to the Treasury.  For example, in 2006, he converted about 125,000 of his shares to start donating them to the Gates Foundation and to charitable foundations set up for each of his children to run.  The letters setting forth those intentions were filed publicly, and demonstrate that Buffett was planning to reduce his taxes.  For example, rather than giving all the funds in one year, he agreed to give the Gates Foundation 10 million shares of BRK-B shares, but only in a tax efficient manner that gave him the benefit of tax deduction.  Here is how he wrote it in his letter for the Gates Foundation: 

“Ten million B shares will be earmarked by me for [Foundation] contributions….  In July of every year, or such later date as you elect, 5% of the balance of the earmarked shares will be contributed….To illustrate, in 2006, 500,000 shares will be contributed.  In 2007, 475,000 shares (5% of the 9,500,000 remaining after the 2006 contribution) will be contributed and thereafter 5% fewer shares will be contributed each year.”

His “gift” was further conditioned “satisfy[ing] legal requirements qualifying my gifts as charitable and not subject to gift or other taxes.”  Pretty complicated for a man who doesn’t care about paying more in taxes. 

It is also worth noting that he could not make such a large charitable deduction if his investment had been eaten away by taxes in the 40 years prior to his charitable decision. 

This discussion does not take into account other mechanisms in the tax code that have benefitted Buffett – all legitimate: taking a lower salary than his job would otherwise warrant, not paying dividends (BRK has not paid a dividend to stockholders since 1969), preventing double taxation of corporate profits from BRK’s portfolio companies, dividend exclusions (which he argues are not that helpful in reducing taxes), or the means by which BRK’s offshore reinsurance investments are not taxed by the Federal government.  And Buffett uses highly-paid accountants to keep the tax rates low.  Then he complains that his tax rate is lower than his secretary’s.  If all the corporate taxes are taken into account, that is not likely to be true. 

All this also does not address the serious Constitutional questions about Buffett’s proposal.  The Constitution – in order to limit the power of the Federal government – precluded any direct tax on the people by the Federal government.  Taxes were assessed directly on the States, and a census would be conducted every 10 years to determine the proportion of payment each State would owe.  That arrangement was neatly upset by the adoption of the 16^th Amendment, which gives Congress the right to tax “incomes, from whatever source derived, without apportionment among the several States, and without regard to any census or enumeration.”  It is not clear that Congress has the power to tax wealth accretion, unless it forced the sale of every stock at some point in each tax year, which would have interesting market repercussions. 

There is a mechanism already in place to permit taxpayers to pay more to the Treasury if they want to do so.  They can simply write out a check.  But Buffett’s call to restructure the tax code to prevent capital accumulation by investors is antithetical to his investment style over the last six decades, the investment philosophy of his mentor, Benjamin Graham, common sense, and a free market. 

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