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. 

Double Taxation

The release of Mitt Romney's tax returns has drawn attention yet again to the disparity between the rates paid on ordinary income and those paid on capital gains. It is being argued in some quarters that the 15% rate on capital gains vastly underestimates the effective tax rate paid by those whose income comes largely from financial investments, on the grounds that corporations pay a rate of 35% on profits. Were it not for this tax, it is argued, dividends and capital gains would be higher, and so would the after-tax receipts of those who derive the bulk of their income from such sources.

Romney himself has made this argument recently, claiming that his effective tax rate is closer to 50%:

One of the reasons why we have a lower tax rate on capital gains is because capital gains are also being taxed at the corporate level. So as businesses earn profits, that's taxed at 35 percent. Then as they distribute those profits in dividends, that's taxed at 15 percent more. So all total, the tax rate is really closer to 45 or 50 percent.

The absurdity of this claim is clearly revealed if one considers capital gains that accrue to short sellers, who pay rather than receive dividends while their positions are open. Following the logic of the argument, one would be forced to conclude that short sellers are taxed at an effective rate of negative 20%, thereby receiving a significant subsidy due to the existence of the corporate tax. The flaw in this reasoning is apparent when one recognizes that asset prices are lower (relative to the zero corporate tax benchmark) not only when a short position is covered, but also when it is entered.

There is no doubt that the presence of the corporate tax depresses the price of equities, but it does so both at the time of purchase and at the time of sale. If there were no corporate tax, dividends and capital gains per share would certainly be higher, but an investor would have paid substantially more per share to acquire his assets in the first place. As a result he would be holding fewer shares for any given initial outlay, and his after-tax income (holding constant the rate paid on capital gains) would not be substantially different.

To see why, it is useful to think about what determines the price of equities. Three factors are especially important: the current earnings of a firm (after payment of interest and taxes), the rate at which these earnings are expected to grow, and the riskiness of the security, which itself is linked to the degree to which the firm's earnings are correlated with broader market movements. Securities that are riskier in this latter sense tend to appreciate faster on average because investors would otherwise avoid them, depressing their prices and raising their expected returns until such returns are viewed as adequate compensation for the greater risk of holding them. This risk is routinely expressed as a market capitalization rate, interpreted as the expected return that investors require in order to hold the security. Airline and automobile stocks, for instance, have higher market capitalization rates than do shares in utilities.

The manner in which these factors interact to influence prices may be illustrated by considering the simplest possible case of a firm with constant expected earnings growth and a fixed dividend payout ratio. In this case, for reasons discussed in any introductory finance textbook, the fundamental value of the security is given by the simple formula D/(k-g), where D is the current dividend forecast (a constant share of the earnings forecast), g is its expected rate of growth, and k is the market capitalization rate. Shares in a debt-free firm that pays 20% of its earnings as dividends, is currently earning $10 per share annually, is expected to grow at 10%, and has a market capitalization rate of 12% would then have a share price of $100. After a year (assuming no change in these parameters) the share price would be $110 and the dividend payout $2. An investor would have made $12 on a $100 investment, a percentage return precisely equal to the market capitalization rate. All this is with no corporate tax.

Now suppose that a 35% corporate tax is in place, so after-tax earnings per share are $6.50 instead, with no change in other specifications. Dividends are then $1.30 per share and the initial share price is $65. After a year this rises to $71.50. Adding dividends and capital gains, an investor makes $7.80 for each share purchased at $65, again earning precisely 12%. Each share results in lower revenues to the investor, but since more shares can be purchased at the outset, aggregate income is no different.

None of this should be in the least bit surprising. Note, however, that if the corporate tax were to be eliminated today, there would be a sharp rise in the price of equities and current asset holders would enjoy a windfall gain. Similar issues arise with respect to the mortgage interest deduction: eliminating this would result in an immediate decline in home values, severely punishing those who purchased recently at prices that reflected the anticipated tax savings over the duration of the mortgage.

This does not necessarily mean that eliminating the corporate tax while simultaneously raising the rate on capital gains is necessarily a bad idea, or that elimination of the mortgage interest deduction is necessarily bad policy. A case could be made for both initiatives. The corporate tax is not uniformly applied due to the broad range of loopholes and exemptions, and the mortgage deduction is regressive and inhibits both neighborhood integration and labor mobility. But any such changes will have major distributional effects that must be taken into account in any comprehensive evaluation of the policy. Doing so properly requires a clear distinction between stocks and flows, and an analysis that goes a little deeper than simple arithmetic.

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Update: Follow-up post here.

Self-Fulfilling Prophecies and the Iowa Caucus

A few days ago Nate Silver made the following intriguing comments on the Iowa Caucus (emphasis added):

There are extremely strong incentives for supporters of Mrs. Bachmann, Mr. Santorum and Mr. Perry to behave tactically, throwing their weight behind whichever one appears to have the best chance of finishing in the top two. What that means is that if any of these candidates appear to have any momentum at all during the final week of the campaign, their support could grow quite quickly as other voters jump on the bandwagon.

This is also a case in which the polling may actually influence voter behavior. In particular, if one of these candidates does well in the highly influential Des Moines Register poll that should be published on New Year’s Eve or thereabouts, that candidate might be a pretty good bet to overperform polling as voters use that as a cue on caucus night to determine which one is most viable...

I’m not sure that this theory actually makes any sense... But it may not matter if the theory is true. If voters are looking for anything to break the logjam between these candidates, mere speculation that one of them has momentum could prove to be a self-fulfilling prophecy.

What's most interesting about this is the possibility that even a methodologically flawed or misleading poll, provided that it is given credence, could coordinate expectations on one of these three candidates and result in a surge of support.

In fact, this seems to be precisely what has happened. A CNN/Time poll covering the period December 21-27 revealed Santorum to be in third place with 16% of the vote. This was an outlier at the time, and was sharply criticized by Tom Jensen of PPP and by Nate himself for surveying only registered Republicans:

What’s wrong with using a list of Republican voters for a Republican caucus poll? The answer is that it’s extremely easy for independent and Democratic voters to register or re-register as Republicans at the caucus site. Historically, a fair number of independent voters do this.

According to entrance polls in Iowa in 2008, for instance, about 15 percent of participants in the Republican caucus identified themselves as independents or Democrats on the way into the caucus site... Most other pollsters are making some attempt to account for these voters. They are anticipating that the fraction of independents and Democrats will be at least as high as it was in 2008 if not a little higher, which would make sense since Republicans do not have a competitive Democratic caucus to compete with this year.

The recent Public Policy Polling survey, for instance, estimated that 24 percent of Iowa caucus participants are currently registered as independents or Democrats and will re-register as Republicans at the caucuses. This month’s Washington Post/ABC News poll put the fraction at 18 percent. There is room to debate what the right number is but it will certainly not be zero, as the CNN poll assumes.

Since few independents and Democrats are inclined to vote for Santorum, the CNN/Time poll very likely exaggerated the level of support he enjoyed at the time. But despite this, it contributed to expectations of a surge which seem to have become self-fulfilling. The Des Moines Register poll released last night confirms this, with Santorum rising sharply from 10% on the 27th all the way to 22% four days later. This survey, conducted by the highly regarded Ann Selzer, has historically been among the most reliable of Iowa polls.

Did a misleading poll based on an unsound sample shift expectations in such a manner as to fulfill it's own flawed forecast? Tom Jensen certainly appears to think so:

Selzer had Santorum at 9% Tu-W. We had him at 10% M-Tu. Surge quite possibly generated by CNN poll that was quite possibly wrong... If CNN had shown Perry at 15% and he got all the momentum stories, the buzz in Iowa might be all about him this weekend.

The CNN/Time poll may also have given Romney an expectational boost at the expense of Paul by excluding independents from the survey. As Tom Jensen noted in his response, Romney was ahead of Paul in the restricted sample of the PPP poll, but quite clearly behind overall on December 27. It's an interesting example of how a seemingly innocuous methodological decision on a single primary poll could end up having major ramifications for the direction of the country.

The mechanisms at work here have some broader implications. They reveal the potential value to candidates (or their supporters) of manipulating prices in prediction markets such as Intrade, which have come to be closely monitored indicators of candidate viability. And they appear in all sorts of other contexts, from sovereign debt crises to speculative currency attacks.

In fact, any borrower who has financed long-dated assets with short term liabilities needs to periodically roll over debt, and the willingness of investors to facilitate this depends on their beliefs about whether other investors will continue to facilitate it in the future. These expectations are subject to capricious change, often as a result of small and seemingly unimportant triggers. The Iowa caucus illustrates the phenomenon, and the Eurozone debt crisis demonstrates its broader relevance.