How much should Buffett pay?

Well… That was unexpected. I open a blog and I get a link and an approving comment from Greg Mankiw! (Thanks Greg!) This is what I would call a win. Give me a second to bask in that glory… OK, let’s get back to business.

A lot of very interesting points were brought up and I can’t respond to all of them, but I want to respond to what I felt was a theme in the comments. It goes something like this: “Greg Mankiw and you don’t get it. We want to know whether Warren Buffett should be paying higher taxes or not.”

The problem with that argument is that tax policy is hard. It’s very hard. There are plenty of complicated questions, some of which have no clear objective answers. In other words, it’s complicated enough as it is and getting tax incidence mixed up with tax collection will just confuse the issues further. So let’s get the basics right first. If the President is proposing policy based upon a flawed understanding of the current tax system, his policy is also going to be flawed. Garbage in, garbage out.

So how should we tax Warren Buffett? I’m going to argue that raising taxes on capital gains is a bad idea. There are many ways to reach that conclusion (and ways to reach the opposite conclusion too) and I’m only going to bring up one here and I will bring up more in future posts.

Taxing capital gains discourages capital formation. Let’s imagine a very simple economy. Every day, people have 8 hours of time during which they may work. During that 8 hours of work, they have two activities available to them. They can spend 1 hour making a loaf of bread or they can spend 4 hours creating a machine. That machine every day creates 2 loaves of bread forever.

So how do you split your day? Well, you could make 8 loaves of bread, 2 machines or 4 loaves of bread and a machine. Which you choose depends upon how impatient you are. (Your time discount rate in econ-speak) If you are a very impatient person, you might choose to make 8 loaves of bread every day because having the bread right now is important to you. If you are very forward-looking, you might make 2 machines every day because you are willing to wait. If you are somewhere in between, you might make 4 loaves of bread and a machine every day.

Now obviously, we want there to be as many loaves of bread to go around as possible. That’s what growth is all about right? In the very short run, that means making 8 loaves of bread per day. But over the long-run, we’re better off the more machines there are because then we have many loaves of bread produced automatically every day.

Now the government imposes a tax on the output of the machine. Every day, when the machine creates 2 loaves, one is sent to the government and never seen again. Of course, this will shift the incentives. If you were on the edge whether to make a machine or just an extra 4 loaves, you now will decide to make the 4 loaves. In the long run, we are poorer.

[Update]

I don’t want to curb anyone’s well-deserved enthusiasm for my post, but I want to clarify something. What I am referring to here is the taxation of capital, not necessarily the income-progressivity of the tax system. Now of course, accumulating more capital does tend to lead to one being “rich”. But that’s a second-order consideration here.

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8 Responses to How much should Buffett pay?

  1. Ghengis Khak says:

    I think its also important to point out that when you say “we are poorer”, this doesn’t just mean the owner of the capital (though of course they are included in “we” as well).

    Historically one of the primary drivers of wage increases is increased access to capital. To put this concept simply — no capital accumulation, no wage gains. That is to say, the optimal taxation strategy purely from the selfish interest of wage-earning workers is to have no capital gains tax.

    Good post. Looking forward to reading more like it.

  2. Scott H. says:

    Class warriors don’t care about “we are poorer” in isolation (they can’t refute that). They want to see “how much poorer” versus “increase in fairness”. They like capital gains taxes because that is where the money is — for the wealthy.

    Best of luck on the new blog.

  3. NVS says:

    Your analogy about bread loves and machine is interesting . If i understand it correctly , what u mean to say is that high tax rates for the “rich” ones will somehow decrease the motivation amongst ppl to earn more since the value they receive will be less compared to their efforts ?

    Don u think that will also bring an increase in Black money because eventually ppl will try to save as much as possible. Also, those on the border will also resort to some techniques of which might be illegal in nature.
    The ill informed lot can also end up investing in certain schemes without understanding it completely, just to avoid tax.

    • Juan says:

      You are totally right, I live in latin america and that is exactly what happens here. Taxes are hughe, and somehow government thinks that it owns the money that people earn. The black market is in the order of 50%, the problem with that is that black markets are of low productivity, because corporations and investors cant put much money on it, they need the law to protect their capital. That is why when you go to a highly taxed, highly black marketed country, you hardly find formal shops and it is full of trade fairs and mobile merchants.
      As for the issue of no objectivity regarding taxes, I don´t agree. People don´t want to be taxed, they want to keep the product of their work. When Obama says “the rich should pay more” he is mistakenly assuming that rich people owe their money to “society”. If you increase taxes too much the big corporations and the rich will take their money out of the country. Obama should be focused on wealth creation, not on wealth distribution, he is spending 25% of the GDP, how much does he want to spend??

  4. NVS says:

    Reblogged this on Niravisms and commented:
    The article here refers to the famous suggestion put forward by the Oracle of Omaha Warren Buffet – “The rich should be taxed more ” and describes what might happen in such a case. I am just adding my points to that .

    As per Economics 101 , taxing more the higher bracket will result in less incentives . This will reduce the motivation for ppl willing to earn more since they will end up paying more tax .
    The ones who will be most affected are the ones on the border. A slightly more income and they ll end with up less money than before , sadly !! .
    And this will not end here .
    Ppl will soon start looking for alternatives to tax saving and following are the options that come into my mind at first.
    1.) Ppl will not be motivated enough towards higher salary and incentives. As a result, their efficiency and commitment to work might affected . Since this will deal with ppl at higher posts ( I assume that rich does not mean simply anyone above the middle class ) , the effect might be more than just at the personal level.
    2.) Unwanted investments in tax saving schemes and ppl might end up disturbing their finanicals.
    3.)It may give rise to illegal ways of saving tax like hiding certain/full part of income so that they do not fall in the same bracket.
    4.) Market may come up with new investment schemes and structures to handle this income flow , which can give rise to some innovative tools for savings.
    5.) The affluent class, if i may say so safely , will start lobbying for certain laws , be it on corporate scale,trust laws, tax loopholes in order to safeguard their interests .

    But it still remains to see which factor might actually work.


    NVS

  5. Eduardo Weisz says:

    I think your thinking is not that clear. In your example of taxation on capital gains, the person that produces a machine that gives him a net loaf of bread a day as capital gain represents a net gain of one loaf of bread a day. Which means that even with a taxation of 50% of net capital gains, the agent is better off once for each machine he increases his wellbeing in one loaf of bread (a net return of 1/8 of his daily productivity – intead of the 2/8’s he would have otherwise. Did i not understand your example correctly?
    The second point is that in the model the price of consumption is defined as r – the interest rate. Te alpha is another variable – it is difined as the anxiety for consumption of an individual given the current interest level of the interest rate.

    • PrometheeFeu says:

      You are right. But the machine is not free. The agent still has to give up some bread today in order to have a functioning machine tomorrow. Some agents who are happy to do that when the machine produces 2 loaves may not be willing to do that when the machine only produces 1 loaf of bread a day.

  6. That is why when you go to a highly taxed, highly black marketed country, you hardly find formal shops and it is full of trade fairs and mobile merchants.

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