Warren Buffett, taxing capital income is a bad idea

In 2011, superstar investor Warren Buffett made headlines not for his investment recommendations but for his opinion that tax rates on high earners should substantially increase. 

Buffett proposed the Buffett Rule, which would impose a minimum 30 percent effective tax on those with incomes exceeding $1,000,000. This was supported by then-President Barack Obama and 2016 Democratic Presidential nominee Hillary Clinton.  

Buffett repeated his opinion earlier this year, arguing “The wealthy are definitely undertaxed relative to the general population.”

Buffett might be viewed as the New Age Robin Hood. But it is not as if Buffett has been putting his money where his mouth is. For years, Buffett has exploited all tax benefits to minimize his tax payments, including unrealized income offsets.

Buffett does this by transferring the income growth in his assets into price appreciation of Berkshire Hathaway stock, which is the corporation that he runs. The tax is not due until the stock is sold.

And speaking of Berkshire Hathaway, Buffet’s corporation paid one of the lowest corporate tax rates last year among all major U.S. corporations. Buffett’s Berkshire Hathaway paid a -8 percent tax rate, which was third lowest tax among the Fortune 100 companies.

Federal tax rates on high earners are relatively low not only because of the tax considerations used by Buffett, but also because capital income is often taxed at a lower rate than labor income.

Contrary to Buffett’s opinion, and those of Democratic presidential candidates Sen. Bernie Sanders (I-Vt.) and Sen. Elizabeth Warren (D-Mass.), low capital income tax rates are a good thing.

If Buffett’s recommendation were implemented, the U.S. economy would decline, capital would move abroad and the costs would be borne by workers.

Standard economic logic robustly indicates that capital income be taxed at a very low rate, if at all. This finding is not based on political considerations. Rather, capital income is about the most inefficient source of tax revenue in the economy. Economists don’t like taxing capital income because it generates relatively little revenue in the long run while it distorts economic decisions, particularly the decisions to invest and innovate.

The main reason is that investing is how individuals support future consumption. Taxing capital, year after year, means an ever-spiraling tax on future consumption. Consider an investor who has a 10-year planning horizon. Taxing capital income at just a 20 percent rate for 10 years generates roughly a 200 percent tax rate on this future consumption. High tax rates on capital income leads investors to shift out of highly taxed assets and leads to capital flight.

European countries, which tend to have much higher tax burdens and much larger government sectors, tax capital income at relatively low rates. Dividend taxation is about 23.5 percent in Europe, the median capital gains tax rate in Europe is 15 percent and the average corporate income tax rate in Europe is 22.5 percent.  

And for those who believe that the wealthy will end up paying higher capital income taxes, think again. The incidence of capital income taxation is ultimately borne by workers, even though the tax is levied on capital.

Empirically, investors have required a fairly constant after-tax return. As tax rates rise, they reduce investment until the required after-tax return is restored. Lower investment means lower capital per worker, which reduces worker productivity and pay. Taxing capital income is not in the best interest of workers.

Countries that have heavily taxed capital income, and/or taxed wealth, have suffered and reversed course. In the 1940s and 1950s, Great Britain taxed capital income at nearly 100 percent rates. Investment dropped to nearly zero, and economic growth declined enormously until capital income tax rates were aligned with those in other major countries.

In 1992, 12 major European countries taxed wealth. By 2017, only four of those countries (France, Norway, Spain and Switzerland) still taxed wealth. The experiences of other countries were plagued by implementation problems, including valuing assets that are traded infrequently, such as art and jewelry, and lower revenue collection than was predicted. 

There is a much more efficient method of taxation that treads lightly on low earners. Implement a national sales tax and expand the earned income tax credit. This reduces the tax burden on low-income households. It is also a tax that is much harder to escape than many other taxes, even for the Warren Buffetts of the world. 

Lee E. Ohanian is a professor of economics and director of the Ettinger Family Program in Macroeconomic Research at UCLA. He’s also a senior fellow at the Hoover Institution at Stanford University.