Over the years, Warren Buffett has gotten a lot of miles out of his folksy charm and ability to distill elaborate financial concepts into plain English. And recently, proponents of higher tax rates for the wealthy have gotten a lot of miles out of those qualities too, as the world’s fourth richest man has advocated repeatedly for just that policy. This week, Buffett was at it again — this time in the New York Times Op-Ed section — calling for, among other things, a higher capital-gains tax rate.
For years, capital gains have generally been taxed at a lower rate than ordinary income, partly in order to spur investment. The idea is that if taxpayers spend their money by investing in wealth-creating enterprises, then we’ll all be better off than we’d be if they simply spent their money consuming luxury goods or expensive vacations.
But Buffett took aim at this logic, writing:
Suppose that an investor you admire and trust comes to you with an investment idea. “This is a good one,” he says enthusiastically. “I’m in it, and I think you should be, too.”
Would your reply possibly be this? “Well, it all depends on what my tax rate will be on the gain you’re saying we’re going to make. If the taxes are too high, I would rather leave the money in my savings account, earning a quarter of 1%.” Only in Grover Norquist’s imagination does such a response exist.
Basically, Buffett is arguing that investors will invest, regardless of what portion the government takes out of their profit after the fact, and that we shouldn’t worry about using the tax code to encourage investment. Instead, he suggests, we should worry that a lower capital-gains rate is unfair to those who make most of their income from labor, which is taxed at a higher rate under current law. It’s this wrinkle in the tax code, after all, that allowed Mitt Romney to pay such low effective tax rates in 2010 and 2011.
So who is right? Economists on the left, like Jared Bernstein, former chief economic adviser to Vice President Joe Biden, argue that the evidence shows that higher capital-gains tax rates do not lead to less investment. In a blog post last summer, Bernstein cited several studies that show that changes in the capital-gains rate had negligible effects on investment. He wrote:
There are a few economic principles that we consistently get wrong in ways that do lasting damage to our economy and diminish our future. At the top of this list are arguments about large behavioral responses to changes in tax rates. I don’t think it’s zero, but I’ve simply never seen compelling evidence that tax increases significantly hurt growth, labor supply, jobs, wages, or that rate decreases provide much of a boost the other way.
Conservatives tend to respond that the reason it’s difficult to demonstrate empirically the negative effects of higher capital-gains taxes is that economies are huge, complex beasts full of moving parts. The dramatic economic growth of the Internet boom, for instance, may have drowned out the disincentives of higher capital-gains taxes when President Clinton briefly raised them in the 1990s — but that doesn’t mean that negative effects didn’t exist.
Another conservative line of argument is that capital-gains taxes raise the cost of capital for companies. Firms get equity capital from the stock market by issuing shares. If dividends and capital gains on those shares are taxed at a higher rate, then the value of those shares to investors will decrease and as a result, corporations won’t be able to raise as much money and will have less money to build factories and hire employees.
Finally, conservatives say that capital-gains and dividend taxes are examples of “double taxation.” When a firm whose stock you own pays a dividend, that dividend came out of corporate earnings that have already been taxed. And when you sell a stock and realize a gain, it’s quite possible that you bought that stock with money that was already taxed as labor income. If you’re a moderately wealthy wage earner already paying a high income tax rate who faces the prospect of paying that same high rate on investment returns, you may not leave your money in a bank account (as Buffett’s scenario lampoons), but it’s not hard to imagine your deciding to spend that money on luxury goods instead. Why get taxed twice?
Of course, this example of moderately well-off wage earners doesn’t represent the majority of investors. Many investors are, like Mitt Romney, already wealthy and simply reinvesting investment income that was taxed at a lower rate. And many more are invested in the stock market through 401(k) plans, which are funded with pretax wages.
Nobody likes taxes. They’re are a necessary evil — the only way we can fund government. But given the state of the middle class in this country, it would seem that higher taxes on capital gains, which hit mostly the rich, are one of the more palatable ways we can raise the revenue we need to bring the budget deficit under control. So while Buffett does oversimplify the case for increasing capital-gains taxes, the essence of his argument stands up to scrutiny. If we raise capital-gains taxes just a bit or even change the code so that they match the rates of ordinary income, there will still be investors ready to take advantage of winning investment ideas.