Cut a Check, Mr. Buffett

FORECASTS & TRENDS E-LETTER
by Gary D. Halbert
August 23, 2011

IN THIS ISSUE:

1. Warren Buffett Says the Super Rich are “Coddled”

2. Breaking Down Buffett’s Numbers

3. What Buffett Didn’t Say

4. What is the “Fair Share” for the Rich?

“Coddling” the Super Rich

On August 14, Warren Buffett, arguably the world’s best known investor, wrote an op-ed piece for the New York Times suggesting that millionaires and billionaires should no longer be “coddled” by the tax code. He said that he and his “super-rich” friends continue to get “exorbitant tax breaks” while others pay a much larger percentage of their income in taxes each year.

I’m sure that Mr. Buffett’s message hit the right button with a lot of people, especially the way it was heralded in the mainstream press. However, what you need to know is that his comments were no more than another salvo in a class warfare battle that will rage from now until at least the election next year.

You might recall that Buffett supported candidate Obama back in 2008, so it’s not much of a surprise to see this kind of class warfare statement come from him. After all, he’s pretty much universally respected and has one of the best investment track records on the planet. And now he wants to volunteer himself and his peers to pay more taxes.

Not convinced about the political aspect? How about Buffett’s comment about how the “…poor and middle class fight for us in Afghanistan...?” What this has to do with income taxation I’ll never know, but I do know that this is a politically charged statement meant to show that the current tax code (read: Bush tax cuts) is inherently unfair when the “mega rich” appear to benefit more than the average taxpayer.

This week, I’m going to discuss what Mr. Buffett said – and what he didn’t say – in relation to taxation. We’ll cover who pays taxes and what the “fair share” for the rich should be. Finally, I’ll tell you about a way to voluntarily contribute money to the government, should you be so inclined. How about you, Mr. Buffett? I’ll come back to that question later.

Breaking Down the Numbers

It’s not the first time that Buffett has wished the blessings of higher taxes for himself and his peers, but this time he provided numbers. Buffett’s $6,938,744 tax bill in 2010 amounted to an overall tax rate of 17.4%, including payroll taxes. Doing a little math results in a total income for Mr. Buffett of $39,877,839 for last year ($6,938,744 divided by 0.174). However, as I’ll discuss in more detail below, he falls short of saying exactly how much of this was in the form of wages versus capital gains and dividends.

He then compared his 17.4% tax rate to those of his office staff, which ranged from 33% to 41%, with an average of 36%. At first glance, these rates seem very high for total tax rates. They appear to be more in line with marginal tax rates that apply to the various tax brackets, but Mr. Buffett’s article appears to be comparing apples to apples, so we’ll assume he’s talking total tax rates for his employees.

One answer to why the staff tax rates look so high might be the greater effect of payroll taxes on his employees. Since he mentioned in his article that his tax rate included Social Security and Medicare taxes, we’ll assume that his employees’ tax rates do as well. Payroll taxes amounted to 7.65% of the first $106,800 of pay in 2009 (known as the “taxable wage base”) and 1.45% of salary income above that amount.

While it’s impossible to tell exactly what the average earnings are for Mr. Buffett’s staff, it’s pretty safe to say that most earn less than the $1 million income level he suggests should pay more taxes. Buffett sets his sights clearly on the “millionaires and billionaires” in terms of income, not accumulated wealth. This is a big distinction since income taxes are paid on income, not your total net worth.

Buffett specifically mentions the 236,883 households with incomes of $1 million or more as those who should be paying higher taxes. However, Obama wants to raise taxes on married couples making $250,000 or more and individuals making $200,000 or more, far below Buffett’s target range which, ironically, would likely include some of Mr. Buffett’s staff. Thus, Buffett’s call for higher taxes just might land on his own staff if Obama gets his way. Gee thanks, boss!

What Buffett Didn’t Say

Many of the articles and interviews I saw related to Mr. Buffett’s latest statements noted a couple of things. First, his tax rate is low as compared to his peers at similar income levels. According to IRS income tax statistics for 2008, the top 0.1% of taxpayers was taxed at a rate of 22.70%, so Mr. Buffett must have a good CPA.

A second issue is that Mr. Buffett doesn’t say how much of his income came from wages, dividend income, short-term and long-term capital gains and “carried interest,” a type of compensation applicable to investment managers under certain conditions. While Buffett provides no breakdown of the sources of his income, his overall 17.4% would indicate that most is taxed at a rate of 15%, which applies to dividends, long-term capital gains and carried interest. This is supported by Buffett’s comment in the article that the mega-rich, “…pay income taxes at a rate of 15% on most of their earnings...”

The question now becomes why the tax code allows these types of income to be taxed at such low rates. Unfortunately, a full discussion of the justification for taxation of various types of income is beyond the scope of this short E-Letter. However, I will attempt to provide a brief summary below:

Dividends – Dividends are payments of company earnings to shareholders, essentially representing a return on the money invested in the company’s stock. The problem with dividends is that they come from money that has already been taxed once at the corporate level, and are then taxed again at the personal level.

The individual tax rate on dividends is up to 15%, while corporate profits are taxed at a maximum rate of 35% - one of the highest corporate tax rates among the developed nations. As a result, the combined personal and corporate income tax rate can be up to 50% (15 + 35). It’s hard to argue that wealthy individuals who receive dividend income are somehow being “coddled” when the money they receive in dividends has already been taxed once.

This double taxation is why you see some companies buy back shares or otherwise invest their retained earnings rather than pay dividends, since doing so is a very tax inefficient way of rewarding shareholders.

Long-Term Capital Gains – This type of income is generated when an investor sells a security (stock or bond) that has been held for one year or more. The investment of money into the economy is a keystone of capitalism and is therefore encouraged. However, there’s no guarantee that any particular investment will produce a gain, and many do not.

Thus, capital gains tax rates reward investors who make long-term commitments in stocks and bonds which help the economy grow. Because provision of capital is necessary for the economy, the tax rate for these gains is also currently set at 15%. This relatively low tax rate helps to compensate for taking the risk of losing the entire amount of the investment.

Carried Interest – This type of income is among the most difficult to explain because it applies only to a very small percentage of individuals who manage investment partnerships. Most of these investment vehicles are known as “hedge funds.” I’m sure you’ve seen news articles noting how billionaire hedge fund managers pay taxes at a rate of only 15%. Again, class warfare sells.

The justification for a 15% tax rate on carried interests is a bit harder to explain not because it’s unjustified, but rather because it involves the complexities of investment partnerships. Suffice it to say that the partnership simply passes on the tax treatment of its holdings to the partners. As a result, if carried interest is mostly dividends and long-term capital gains, then the 15% rate would apply.

However, many investment partnerships trade frequently, meaning that dividends would be minimal and gains would be short-term in nature and taxed at ordinary income rates. Beyond that, thousands of hedge funds lose money and cease to exist, offering no income to its partners or managers. These are the people the mainstream press will never tell you about.

The bottom line is that Mr. Buffett pays a lower percentage of his total income in taxes than his staff because most of his income receives preferential treatment under the tax code. The discussion above shows clearly that there are some categories of income that have been deemed important enough to merit lower rates in order to provide an incentive for investors to take risks. You and I can argue all day about whether such treatment is justified, but our argument would have to be based on more than just the idea that the rich are somehow “coddled” by the tax code.

Other Observations

There’s also the issue known as the “elasticity of income.” All this means is that some people have the ability to determine when they recognize income and when they don’t. In Mr. Buffett’s article, he notes that the mega-rich pay taxes at a rate of 15%, meaning that they have income that is mostly made up of dividends and long-term capital gains.

In the case of long-term capital gains, they are only recognized when an investor sells an asset. Thus, no sale, no tax. That being the case, those mega-rich buddies of Mr. Buffett could decide not to sell their assets so as to recognize no income. Likewise, they could invest in stocks that don’t pay dividends and also escape taxation, or put their money in municipal bonds which have even more favorable tax treatment.

History has shown that collections of capital gains taxes rise when tax rates are lower. Why? Because investors usually don’t have to sell and recognize income. As a result, they can wait until favorable tax rates come along to recognize the income. The bottom line is that you could increase the capital gains tax rate and actually collect less tax revenue from that source. Ditto for dividends. Mr. Buffett has to know this, which makes it even clearer that his article was nothing more than political rhetoric.

A final issue in the Buffett article I’d like to take issue with is his assertion that no one in his over 60 years of investing has based a decision on whether or not to invest on the prevailing tax rates. That may be true for Mr. Buffett’s crowd, but it certainly doesn’t ring true with my firm’s experience. Tax efficiency is a question often put to my staff in regard to the actively traded investments we recommend. It’s hard to believe that billionaires don’t ask the same question.

An Existing Solution for Mr. Buffett

There are a number of financial journalists who had the same reaction I did when Buffett came out with his “tax me more, please” comments. If he feels that he is paying too little in income tax, he can voluntarily contribute whatever amount he wants to the Treasury Department to help reduce the federal debt.

Let’s see how that might affect Mr. Buffett’s bank account: We know that Mr. Buffett paid 17.4% of his income in taxes and we calculated that this means his total income was $39 million and change. If we assume that he wants to pay the same 36% average tax rate as his staff members, it’s easy to do the numbers. 36% less 17.4% leaves 18.6% as Mr. Buffett’s catch-up tax rate. 18.6% of $39,877,839 amounts to an additional $7.4 million that Mr. Buffett could voluntarily pay in if he so desires.

If it makes you feel any better, making a voluntary contribution goes directly toward reducing the federal debt held by the public. Had this amount been paid in taxes, the money would go into the general fund of the government and have the effect of reducing the deficit. As a practical matter, it doesn’t make much difference whether you pay voluntarily or as an increase in taxes, since reducing the deficit has the same net effect on national debt as making a direct voluntary contribution.

Assuming my calculations above are correct, Mr. Buffett could ease his filthy rich conscience by cutting a $7.4 million check to the government. Not only that, but he could write letters to the 236,882 other households making $1 million or more per year and suggest that they do the same. Perhaps that would be a better use of his time than writing op-ed pieces for the New York Times, arguably the official publication of the Democratic Party.

Just in case you are among those who feel the need to pay additional taxes, you can learn more about making a voluntary payment to pay off a portion of the national debt held by the public at the Treasury website.

The “Fair Share” Argument

It might do well to delve into the statistics of income taxation to see why Mr. Buffett and his liberal counterparts want so much to soak the rich. I have presented income tax statistics a number of times over the years and they never fail to get responses, both positive and negative. However, the numbers are what they are.

First, let me be clear that the statistical analysis will relate only to income taxes, not payroll taxes. I have already mentioned above that workers must pay 7.65% (5.65% in 2011 due to the temporary payroll tax reduction) in payroll taxes up to $106,800 and 1.45% on wages above that amount, which the employer matches. Self-employed individuals pay double these percentages since they must pay both employer and employee sides. For these payments, workers receive future Social Security and Medicare benefits.

It is obvious that this flat rate of taxation is more of a burden on lower-paid individuals than those with higher incomes. However, since the Social Security part of the tax is used to calculate an eventual benefit, if taxes were increased on “rich” taxpayers, higher benefits would also be given to these individuals. Unless the payroll tax is uncoupled from an eventual benefit, it’s not likely to apply to higher incomes.

Plus, payroll taxes are paid on wages, not on capital gains, dividends or carried interest. Thus, based on Mr. Buffett’s opinion that most of the income for the super-rich comes from these sources, it wouldn’t do much good to increase the payroll tax unless you also made it applicable to non-wage income. I don’t see that happening anytime soon since doing so would effectively amount to a redistribution of wealth. Oh, I forgot... Obama is in favor of that, right?

In regard to income taxes, it’s obvious that Mr. Buffett feels that he and his millionaire and billionaire peers are not paying their fair share of taxes. So let’s take a look at how much income tax is paid by those at various levels of adjusted gross income:

Summary of Federal Individual Income Tax Data, 2008 (Updated October 2010)

	Number of Returns with Positive AGI	AGI ($ millions)	Income Taxes Paid ($ millions)	Group's Share of Total AGI	Group's Share of Income Taxes	Income Split Point	Average Tax Rate
All Taxpayers	139,960,580	8,426,625	1,031,512	100%	100%	-	12.24%
Top 1%	1,399,606	1,685,472	392,149	20.00%	38.02%	$380,354	23.27%
1-5%	5,598,423	1,241,229	213,569	14.73%	20.70%		17.21%
Top 5%	6,998,029	2,926,701	605,718	34.73%	58.72%	$159,619	20.70%
5-10%	6,998,029	929,761	115,703	11.03%	11.22%		12.44%
Top 10%	13,996,058	3,856,462	721,421	45.77%	69.94%	$113,799	18.71%
10-25%	20,994,087	1,821,717	169,193	21.62%	16.40%		9.29%
Top 25%	34,990,145	5,678,179	890,614	67.38%	86.34%	$67,280	15.68%
25-50%	34,990,145	1,673,932	113,025	19.86%	10.96%		6.75%
Top 50%	69,980,290	7,352,111	1,003,639	87.25%	97.30%	>$33,048	13.65%
Bottom 50%	69,980,290	1,074,514	27,873	12.75%	2.70%	<$33,048	2.59%
Source: Internal Revenue Service and The Tax Foundation

As the above table illustrates, the top 5% of taxpayers (those making $159,619 or more) paid well over half (58.72%) of all income taxes paid while accounting for 34.73% of total adjusted gross income (AGI). The top 10% (those making $113,799 or more) accounted for almost 70% of all income taxes.

I think you’d agree that neither of these income thresholds amount to being “rich,” but that’s where the bulk of income taxes are coming from. These numbers show the progressive nature of our tax system, in that the top 5% earns 34.73% of income but pays 58.72% of income taxes. I don’t know what it takes for some people to consider an amount to be the “fair share” for those with higher incomes, but this seems to fit the bill.

For some 50% of US taxpayers, the fair share comes out to 2.7% of all income taxes paid, which is in addition to any payroll taxes for Social Security and Medicare. Many critics of the liberals’ cries to increase taxes ask what’s unfair about 50% of taxpayers paying over 97% of all income taxes? They have a point, but considering the low income threshold of $33,048 dividing the top 50% from the bottom 50%, it’s hard to imagine the lower 50% taking on any additional taxes.

Beyond that, the Tax Policy Center estimates that 46% of American households will be exempt from paying income tax in 2011. Many conservatives focus on this number as proof of the tax code fostering a welfare state. However, it’s important to dig a little deeper to see exactly who these individuals are. According to an article summarizing the Tax Policy Center Study, this 46% is, in part, made up of the following:

Elderly on Social Security: Approximately 22% of people who pay no federal income tax are the elderly whose primary income is from Social Security;

Low incomes: A married couple with two children earning less than $26,400 will pay no income tax in 2011 due to the effect of standard deductions. This accounts for roughly half of the 46% who pay no income taxes; and

Other benefits to low-income families: Some families that earn more than the accumulated standard deductions may still escape paying income taxes due to programs such as the earned income tax credit. This and other provisions aimed at low-income families account for another 15% of those who do not pay income taxes.

The old saying goes that you “can’t draw blood out of a turnip” and it appears from the income thresholds that the bottom 50% of taxpayers pretty much fits that description. Since the wealthy have elasticity of income and can defer selling assets to avoid taxable gains, guess who’s left? That’s right – as I recently pointed out – the middle class. If you believe that Congress and President Obama can fill their desires for expanding government without raising taxes on the middle class, then you’re fooling yourself.

Of course there is another option – SHRINK THE GOVERNMENT!

When you get down to it, the problem isn’t that the rich, or the bottom 50% or the middle class aren’t paying their fair share of taxes, it’s that the government has grown so large that it consumes far more than its fair share of the wealth of our nation. Wealth that could otherwise be put to work funding expansion and creating jobs in the economy.

Conclusion

It’s no coincidence that Warrant Buffett penned his recent editorial and then President Obama echoed his proposal shortly thereafter. Make no mistake, this was a coordinated political move, pure and simple. The problem is that those identified by Obama as “rich” are making far less than the $1 million threshold discussed by Mr. Buffett.

Don’t get me wrong, I greatly respect Warren Buffett and his abilities to identify viable investments. I have no doubt that Mr. Buffett sincerely feels he is under-taxed. After all, he has joined the “Giving Pledge” which, according to its website, encourages wealthy families to leave most of their assets to philanthropy.

However, I fear that Mr. Buffett is out of his element in the political field and needs to refrain from making additional overly simplistic statements.

Very best regards,

Gary D. Halbert

SPECIAL ARTICLES:

Would Buffett Plan fix US woes?
http://moneywatch.bnet.com/economic-news/blog/financial-decoder/buffett-on-taxes-rich-should-pay-more/4830/

My Response to Buffett and Obama, by Harvey Golub
http://online.wsj.com/article/SB10001424053111903639404576516724218259688.html?mod=WSJ_Opinion_LEADTop

Voluntary contributions to the public debt (go for it Warren):
http://www.treasurydirect.gov/govt/reports/pd/gift/gift.htm