Taxes Matter

In Corporate Taxes, Income Tax Rates on December 18, 2012 at 1:17 am

Taxes matter. When Warren Buffett says otherwise, we have to assume he’s lying to advance his partisan agenda. Famous investor Clifford Asness of AQR says of Buffett’s bizarre claim taxes are irrelevant, “In the field of economics and finance you’d be hard pressed to find something more patently wrong.” [1]

Municipal bonds are tax-free .  They’re at a lower yield than taxable bonds.  This is Finance 101.  The very reason they’re tax-free is to give municipalities a break when they borrow. Investors accept a lower rate on an AA-rated municipality’s bond than from an AA-rated corporation’s bond purely based on the tax benefit. If taxes didn’t matter, they’d be priced the same.

You can find the mathematical equation how tax benefits cause the municipal bond to be lower at Wikipedia. [3]

Asness mentions the fact companies are speeding up sales, share repurchases, regular and special dividend payments
(e.g. see Costco). Buffett helped someone with an unusual Berkshire Hathaway $1.2 billion share buyback in December 2012. [5]. If taxes didn’t matter, why would hundreds of companies bother to speed up January 2013 payments into December 2012? Marketwatch reports, “Companies are largely motivated by a likely upcoming change in the tax rates on dividends.” [2]

Warren Buffett’s claim, “Never did anyone mention taxes as a reason to forgo an investment opportunity that I offered,” may or may not be true to his personal experience but it is dead wrong for the economy in general. Asness points out, too, that Buffett himself has carefully orchestrated his own income and estate to minimize taxes. It is very much Buffett’s freedom to pay as little tax as he legally can yet the fact he bothers shows taxes do matter. Smart, rich people do structure their economic lives to minimize tax. The higher the tax on investments, the lower the net return. As tax rates go up, some investments become unfeasible. Asness says:

Consider how every business-school student, investment banker and investment analyst on Earth has been taught to choose whether to invest in a specific project or company. You make a spreadsheet (a napkin will do sometimes). You put in your best guess of the future cash flows, and you discount those cash flows back to the present at some required rate of return you believe reflects the risk entailed. Of course, opinions about the future cash flows and the proper discount rate can vary widely, but the essential methodology is ubiquitous.

Now here’s the kicker: Nobody who pays taxes and has ever done this exercise has failed (while sober) to use after-tax cash flows in this calculation. Somewhere in the spreadsheet there is a number, say 20%, or 28%, or a Gallic 75%, representing the taxes you’ll pay on the assumed cash flow—and you only count the amount you’ll get after paying this tax. If you turn the tax rate up high enough, projects or companies that looked like good investments become much less attractive and vice versa. Mr. Buffett is undoubtedly right that rich people will continue to invest some amount in something regardless of the tax rate (except for a 100% rate!). He’s also undoubtedly right that an investment that easily clears all hurdles will likely still be attractive after a small tax increase. But life, and the investment decision, occurs at the margin. Fewer and smaller investments will be made if the after-tax prospects are worse. It’s just math and logic, unassailable and commonly accepted regardless of one’s political persuasion.

I’m a Manager of Financial Planing & Analysis.  Taxes absolutely are part of the investment equation. If taxes are higher, the marginal projects – the ones where you’re on the fence about whether or not to invest – become less attractive and eventually, don’t make sense. Perhaps you invest in Brazil or Turkey, instead.

My insight is rich people have a choice what to do with their money.  If you earned a half million and received a special $50,000 year-end bonus, what do you do?  Do you spend it on a luxury imported car?  Do you take a long, expensive trip to Asia?  Or do you invest in new but somewhat risky business venture of an acquaintance?

Savings means forgoing current enjoyment. People, naturally, like to spend money on themselves and their loved ones right now. In order to ask them to defer that spending pleasure, they want an economic return, especially if their investment is a risky one where they might end up with a total loss. Every percent increase in taxes on investments tunrs that save versus spend decision a little more heavily toward spend now. This is especially true of those who are well-to-do, earning several hundred thousand dollars but not Buffett rich (Warren being one of the world’s richest men).


[3], retrieved 12/17/2012.

Picture from Wikipedia Commons.

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