Why Warren Buffett is wrong about tax rates

Note: non-sports post. Lots of numbers, though!

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As you've probably heard by now, Warren Buffett thinks the rich should pay more taxes. Much of his argument is based on the fact that wealthy people pay a lower percentage of their income to the government. Buffett writes,

"Last year my federal tax bill — the income tax I paid, as well as payroll taxes paid by me and on my behalf — was $6,938,744. That sounds like a lot of money. But what I paid was only 17.4 percent of my taxable income — and that’s actually a lower percentage than was paid by any of the other 20 people in our office. Their tax burdens ranged from 33 percent to 41 percent and averaged 36 percent."

But, like a lot of numbers that get thrown around, this "percent of taxable income" is misleading. Yes, the number 17.4 is lower than the number 36. But if you look more closely, Buffett is actually paying at a comparable rate to that of his employees.

The issue that confuses things is that Buffett earns most of his income through corporate dividends (some of it also comes from capital gains, but I'll ignore those for now). Dividends are paid out of after-tax profits of corporations. That means, effectively, that the corporation has already paid most of Buffett's tax.

Suppose Buffett's employee earns $50,000, and pays $18,000 in taxes, which is 36 percent. As for Buffett himself, suppose he owns shares of McDonald's. Let's say he owns 7,609 of those shares, which correspond to the same $50,000 in McDonald's pre-tax profits. (My figures are approximate, all rounded from this Value Line summary.)

So, what happens? Well, McDonald's gets taxed at about a 30% rate. So that leaves only $35,000 in after-tax profits. Then, the company pays Buffett a dividend. It doesn't pay the entire $35,000, because it keeps some to reinvest. It pays Buffett only about half of that, maybe $17,000. Then, Buffett pays an additional 15% tax on that $17,000.

So: on his $50,000 in profits, Buffett pays $15,000 through the corporation, and then an extra $2,550 in dividend tax. That's a total of $17,550 out of $50,000, which is ... about 35%, approximately the same as his employee.

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Actually, that's not quite right. It actually understates Buffett's tax rate.

As we saw, McDonald's makes $50,000, pays $15,000 in taxes, sends $17,000 to Warren Buffett, and reinvests the remaining $18,000. But our calculation assumed that the $18,000 part is still Buffett's, but is fully tax paid. It's not. Eventually, Buffett will claim that $18,000 personally, either through another dividend, or through a capital gain when he sells his stock. At that point, he'll pay another 15%.

So, really, the bottom line is: Of every dollar Buffett earns through McDonald's, he gets to keep 85% of 70% of it. That's 59.5%. So his effective tax rate is 40.5%.

You can argue that 40.5% is too high, or you can argue that 40.5% is too low. But you CANNOT argue that Buffett's tax rate is only 17%. That simply isn't true in any real sense. It's true only in a misleading technical sense, in that McDonald's pays some of Buffett's tax for him. The fact that the corporation makes the payment doesn't mean that it doesn't actually come out of Buffett's pocket.

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This is actually a standard explanation of why taxes on dividends are lower than taxes on "work" income. In fact, it's actually the stated rationale. Canada has a complicated method of calculating taxes on dividends, a method that actually takes into account how much corporate tax was already paid. The explicit idea is that the overall tax rate should be the same, no matter if you earned the income through a direct investment, through an investment in a corporation, or through employment. It doesn't always work out perfectly, according to my accountant (who tells me it's a little higher through a corporation), but it's close.

It's well-enough known to economists and accountants and people who work in corporate finance that, like other bloggers who have written about this, I'm surprised Warren Buffett didn't know it.

Now, it could be that he knows it, but doesn't believe that the corporate taxes should "count". A lot of people somehow believe that corporations should count as separate "people," and so it's fair for both McDonald's and Buffett to pay taxes separately, where the total adds up to more than if Buffett made the money directly.

But that really doesn't make sense. The fact is that if Buffett owns McDonald's, and McDonald's earns $50,000 from his investment, that $50,000 *belongs to Buffett*, even if, right now, it's classified as corporate earnings. Corporations, and their earnings, are the property of their owner, and Buffett is that owner. The fact that the first $15,000 of taxes appears on the corporate tax return instead of Buffett's absoutely does not change the fact that Buffett is paying that tax.

If you still don't agree with that, if you think that Buffett really isn't paying that 30%, then you might like these two options I'm about to show you. Those could reduce personal taxes substantially, while still providing the same amount of money to the government!

Here's number 1. As of tomorrow, ever person in the country has to start up a corporation, of which he/she is the sole shareholder and CEO. Also, all employers now have to pay any salary to the corporation.

So, what happens is this: your corporation now pays 30% of its income -- your salary -- in corporate tax. It then pays you the rest as a dividend. Like Warren Buffett, you now pay only 15% in taxes. Indeed, you might pay zero in taxes -- according to this Wikipedia page, low-income Americans pay 0% tax on dividends!

That means that Warren Buffett's employees will now definitely have a lower tax rate than he does -- or at worst, the same rate -- because they are taxed exactly the same way!

Would you support that new law? You probably wouldn't. You'd see that that was just a sneaky way of taxing people the same rate as always, but making it look like they're not paying much tax. That's exactly what I'm arguing in the case of McDonald's.

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Here's number 2. Right now, people take home a lot less than their salary, because of payroll deductions for income tax. Someone making $50,000 might actually take home only $35,000.

So here's what we do. We eliminate payroll deductions and personal income tax completely. Instead, we implement a corporate payroll tax, which works out to exactly the same as the income tax used to. So, now, your employer still gives you $35,000 to take home, but pays an extra corporate tax of $15,000. You pay zero percent tax on the $35,000.

Perfect, right? Now the income tax on "work" is zero percent. Warren Buffett is still paying 17.4% on his investments. Situation resolved!

I bet you think that's ridiculous. You probably should. Whether you pay the tax, or your employer pays the tax, it's the same thing: you do $50,000 of work, and the government gets 30% of it.

Well, it's the same thing for McDonald's profits. Whether McDonald's pays the tax, or Warren Buffett does, or they both do, the fact remains: McDonald's makes $50,000 of profit, and the government gets 40.5% of it. How much of that 40.5% comes from a cheque from Buffett, and how much comes from a cheque from McDonald's, doesn't matter.

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OK, here's one more suggestion that's less ridiculous.

Change the law a bit, so that when McDonald's pays a dividend to an American taxpayer, they don't pay tax on that part of their profit. That sounds kind of fair, right? If McDonald's doesn't get to keep it, they don't pay tax on it. Just like they can deduct interest that they pay to a bondholder, they can deduct interest that they pay to a shareholder.

Then, when the shareholder receives the dividends, tax them at the normal rate, as if they were "work" income.

Sounds reasonable, right? Well, it works out to almost same amount of tax collected. Actually, if Buffett's personal tax rate is around 33%, you can leave out the "almost" -- it's exactly identical.

McDonald's makes $50K. They send Warren Buffett $21,428.57. Buffett pays about 33% of that in taxes, or $6,978, leaving him $14,450. After paying Buffett, McDonald's has $28,571.43 left. They pay the government 30% of that, or $8,571.43. That leaves them $20,000 to reinvest.

That's EXACTLY what's already happening, in today's system where Buffett *appears* to be only paying 15%:

-- McDonald's makes $50,000
-- Buffett keeps $14,450 after taxes
-- McDonald's keeps $20,000 after taxes
-- The government gets $15,550.

One way you look at it, it looks like Warren Buffett pays only 15% in taxes. Another way, it looks like he pays 40.5% in taxes. A third way, it looks like he pays 33% in taxes. But the results, all three ways, are exactly the same!

No matter how you figure it, the bottom line is the same. Buffett gets 28.9% of the profit, McDonald's keeps 40% of the profit, and the government gets 31.1% of the profit. The difference is how you do the accounting. If you're a government that wants to make it look like the rich have it too good, you levy the entire 31.1% on the corporation, so that it looks like Buffett pays zero. If you're a government that wants to make it look like corporations aren't taxed enough, you levy the entire 31.1% on Buffett, so that it looks like McDonald's pays zero.

In a vacuum, Warren Buffett's supposed 17% tax rate doesn't mean anything. It's an artifact of how you do the accounting. To really see what's happening, you have to look at the end result. And that end result, in this example, is that the government winds up with 31.1% of the money that would otherwise have been Buffett's.

You may think that's too low. You might think that's too high. That's fine. But either way, the "17%" figure is not relevant, even if Warren Buffett thinks it is.