Returns to Information and Returns to Capital
One of the benefits of maintaining this blog is that it gives me the opportunity to think aloud, expressing half-formed ideas in the hope that the feedback will help me sort through some interesting questions. My last post on double taxation attracted a number of thoughtful (and in some cases skeptical) comments for which I am grateful.
What I was trying to do in that post was to evaluate two incompatible statements: Warren Buffet's declaration that he pays a substantially lower tax rate at 18% than any of his office staff, and Mitt Romney's conflicting claim that his effective tax rate is close to 50%, the sum of the corporate tax rate and the rate on long-term capital gains. I argued that since the corporate tax is capitalized into prices at both the time of purchase and the time of sale, it ought not to be simply added to the capital gains tax to determine an effective rate.
The point may be expressed as follows. Over the past couple of years Romney seems to have paid about 3 million dollars in taxes on income of about 20 million annually, a rate of about 15%. If his effective tax rate is 50% then his "effective" gross income is about twice his current after-tax income, or approximately 34 million. What he is claiming, in effect, is that in the absence of the corporate tax, and with no change in the nature of his economic activities, he would have been able to secure a capital gain of 34 million annually. This does not seem plausible to me. Elimination of the corporate tax would certainly result in a one-time gain to any currently held long positions, but I don't see how it could allow him to generate an extra 14 million, which is 70% greater than his current gross income, on an ongoing basis every year.
Whatever the merits of this argument, I think that most commenters on my earlier post agree with me on two things:
The adding-up approach to effective tax rates does not work for short sales and related derivative positions, since it would lead to the absurd conclusion that short sellers were paying a negative effective tax rate on capital gains.
Elimination of the corporate tax would result in a sharp rise in equity prices and a windfall gain to current long investors, but would have more modest and uncertain effects on the returns to future investors who enter positions after the lower rate has been capitalized into prices.
In particular, the following comment from Richard Serlin got me thinking about the nature of capital gains:
With regard to short selling, when the corporate tax first hits (or becomes known to hit), they'll get a windfall, but then their expected returns (of the short sales people actually choose to take) will adjust to the new norm for their risk. It's not like short selling opportunities that pay a fair market risk adjusted return always exist, anyway. When they do, it's largely not a reward for the capital, but for the information that the stock is an overpriced bad deal.
It is certainly true, as Richard points out, that profits to short positions are rewards for information, broadly interpreted to include the processing and analysis of information. They are not returns to capital in any meaningful sense, although one requires capital to enter a short position. But the same is true for at least some portion of the profits to long positions. In fact, the essence of Buffet's investment strategy is to identify underpriced companies in which to take long (and long-term) positions on which capital gains are then realized.
If capital gains are viewed largely as a return to capital, then the double taxation argument makes some sense. But viewed as a return to information and analysis, it is not clear why capital gains should be given preferential tax treatment relative to the income generated, for instance, by doctors or teachers.
I suspect that Warren Buffet views his income as being generated largely by information and judgment, and does not believe that his opportunities for ongoing capital gain would be substantially increased if the corporate tax were eliminated. He does not therefore see the tax as a significant burden, and does not consider his effective gross income to be substantially greater than that which he declares on his tax returns. Whether Romney himself feels the same way is impossible to know, since political expediency currently compels him to take a very different position.