Sunday, January 29, 2012

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:
  1. 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.
  2. 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. 


  1. Things are different if you think Romney makes money from improving businesses.

    I'm going to pretend the business is an annuity cause I'm not familiar with the formula you used, but I don't think it matters. Say a business earns $1 a share (pre tax) each period and the interest rate is 10%. Each share is worth $10 in the no tax world, but in a 50% tax world each is only worth $5.

    Romney buys the business and uses his managerial skills to improve the businesses profitability such that it can double its dividend payment every period. After Romney joins each share is worth $20 in the no tax world and $10 in the 50% tax world.

    Thus in a no tax world Romney earns $10 per share, but only $5 per share in the 50% tax world.

    A person who buys then sells capital is unaffected by a corporate tax rate because both buy and sell price are lowered by the same proportion. However if you create capital yourself by starting or improving a business, you are made worse off by the tax.

    I guess you could think of entrepreneurs as having "potential capital" stored inside them, and any tax on capital lowers the value of this potential capital making them worse off.

  2. The above comment seems about right to me.

    Part of the challenge is getting the right context for the analysis of counterfactuals.

    Consider the position of somebody starting up a business from scratch, and investing seed capital. Then consider two scenarios, corresponding to status quo taxation versus an increase in the tax rate payable on both capital gains and dividends.

    The fact is that the after-tax return on book equity is going to be lower for the second case, other things equal. And it’s going to be lower to the degree that the venture becomes non-viable at the outset, other things equal. So there won’t be any further consideration of how the market values such an investment going forward, or what the return is from one period to the next under either tax/valuation scenario, because there won’t be any such investment. The original book value economics are what determines the original viability of the investment and its return – not a running comparison under two different tax rates with corresponding start and end date valuations.

    Now consider the position of somebody who’s already started up a business from scratch, with original status quo tax treatment of capital income. Suppose the tax rate on capital gains and dividends is now increased. Then the value of the investment will decline as a result. The fact that somebody else can now buy the investment cheaper and realize comparable returns going forward is moot. The original investor has been screwed.

    Romney is in the position of an original investor. The projected after-tax return on original book equity is what determined the economics at the outset, and that depended on avoidance of full double taxation. The fact that somebody else might be able to buy the investment from him now and in doing so adjust to either tax/valuation scenario in setting his offered price, is moot. It was the status quo tax treatment that made the original book value investment viable as a return on book equity proposition. Without it – with full double taxation – it would not have been viable, other things equal, because the projected after-tax ROE would have been too low.

  3. Talo, in both the no tax and 50% tax world, the investor makes a 100% return on their investment. The amount required to buy a business in the no-tax world is enough to buy two such businesses in the 50% tax world. If the investor is constrained by time or other resources and can only deal with one business at a time, your argument applies and the tax is costly. If the investor is constrained by capital then there's no difference in the two worlds.

    JKH, yes, context matters a lot and returns to seed capital will be affected by the tax. Most capital gains are not on seed capital though. Perhaps I should have left Romney and Buffet out of the picture... I'm really interested in the more general issue of (alleged) double taxation. Will think about it some more.

  4. Rajiv, I was thinking of a situation where a person buys a business and then invests their own time and money into restructuring the business, creating business plans, etc. The same amount of time or entrepreneurial expertise would be applied to the business in the no tax or 50% tax world, but returns are lower in the 50% tax world.

    I see this as more accurately reflecting Romney's activities. After all, if Romney is only investing capital in a business, he would earn the same return (given the same risk) regardless of where he invested it. Takeovers only make sense in a world where people can invest things other than capital into improving a business.

    The other way you can think of it is, yes a tax on capital only causes a one off fall in the value of capital the moment it is put in place (or anticipated), and from then on capital earns the same risk free rate plus risk premium. But this includes human capital that people will apply to a business in the future and earn a return. Thus a tax on capital causes a one off drop in the net present value in human capital, making people worse off. The difference between human and regular capital is the former is only ever rented out (for a wage) and never sold outright.

    This way of thinking seems strange though. It means wage earners are hit by a capital tax as well, because they are simply suppliers of unsellable human capital. So Romney is right to say a capital tax increases his effective tax rate, but it does so to wage earners too so he does actually have a relatively low tax rate. Hmmm

  5. Great posts, Rajiv. This discussion has really helped clarify my thinking. It seems to me now that the corporate tax is really a tax on management and labor more generally, not on capital itself. It means that you can't keep as much of the work you put into a company, but it doesn't directly affect the return on the actual financial investment you make in it.

    I would think the corporate tax would only affect return on investment to the extent that it slows corporate growth. But even if corporate taxes do slow corporate growth to some extent, it's hard to believe it could be by 35%.