I Wish Warren Buffett Would Stop (Effectively) Lying About His Tax Rate
Back when I was a child, and long before he was a household name, my hero was a businessman from an hour and a half north of my hometown named Warren Buffett. His company was much smaller back then – he didn’t even own all of GEICO! – and the very first time I read about him, there was only a single class of stock, trading at right around $10,000 per share. I read everything I could about his company, which wasn’t much (I didn’t even know what he looked like for years as the Internet didn’t exist in its present form back then and I had not yet attended a stockholder meeting), and would get excited when I wrote his office building in Omaha, only to receive a message or signed annual report in return.
The thing that attracted me was his integrity. He didn’t seem to play games the way other people did. That was the kind of behavior I wanted to emulate, especially coming from a household where there was only one major rule: Don’t lie. We would be forgiven for nearly anything, except lying.
I think that is why it has bothered me so much over the past few years that Warren Buffett has repeated the claim his tax rate is lower than his secretary, Debbie. It appears to be true. Yet, he knows damn well it is a technicality caused by the election choices he’s made for his holding structure and the way the IRS form 1040 works. In a world of soundbites, it is effective, but I consider it highly dishonest. In fact, it is a bit disheartening because I cannot understand how a man of his caliber could be that intellectually deceitful.
And what interests me, particularly, is that the halo effect of my admiration makes me feel uncomfortable even criticizing him for this, which is in itself problematic.
An Illustration of Indirect and Direct Taxation of Income
To illustrate my point, let’s walk through a hypothetical scenario. Let’s imagine Warren Buffett owned all of Berkshire Hathaway. The entire thing. It’s all his.
Last year, Berkshire Hathaway generated $24,980,000,000 in operating income.
It paid $2,744,000,000 in interest expense, leading to pre-tax profits of $22,236,000,000.
On that $22,236,000,000 of pre-tax profit, it was required to pay the government $6,924,000,000 in taxes.
That is 31.14% of everything it made.
At this point, Buffett’s personal tax filing still shows no income and no taxes. Yet, if he were to convert Berkshire Hathaway into an S-Corporation or an LLC with a partnership taxation election, it would all show up on his personal tax filing. No matter how the paperwork is done, he still paid 31.14% of his income to the government.
That’s his effective tax rate. It’s 31.14%. That’s what he paid. It doesn’t matter how he reports it, that is the reality. To act like his tax rate is 0% because he’s indirectly paying his bill through an intermediary is dishonest especially when the Berkshire Hathaway owner’s manual – which Buffett himself wrote – states in the very first principle:
We do not view the company itself as the ultimate owner of our business assets but instead view the company as a conduit through which our shareholders own the assets.
And here’s where it gets worse. Imagine that Berkshire Hathaway declares a dividend. Buffett is sitting at home and wants to enjoy those earnings. After all, profit is only good if you can use it for something.
Since he is a long-term holder who meets the requirements for dividends to be “qualified”, he gets the special “low” dividend tax rate of 20% on the Federal level (most investors will pay 15% or less, but this amount triggers the top tier). The Federal Government then would take another bite at the apple, grabbing 20% of the $15,312,000,000, or another $3,062,400,000. Now, he’s left with $12,249,600,000.
That’s not all … the new 3.8% surcharge on dividend income for those making more than $200,000 is going to apply. That means there would be an extra $581,856,000 in Obamacare taxes on the income on top of the regular dividend tax. He’s now left with $11,667,744,000.
Are we done? Not even close! The State of Nebraska taxes dividends at 6.84%. Generally, you can go off your net-of-Federal-tax figure (this is complex, but if anything, this would understate the tax bill so we’ll go with it for the sake of conservatism; again we’re going to oversimplify here and not get overtly technical).
That means his home state is going to grab another $798,073,690.
Thus, by the time he actually gets the cash deposited into his checking account at the local bank in Omaha (he would actually hold Treasury bills but, for the last time, we’re keeping this simple), his $22,236,000,000 in pre-tax profit has been turned into $10,869,670,310. That means he got to keep only 48.89% of his money, as the government’s effective cut reached 51.11%.
Wait! There’s more! The effective state and local sales tax rate in Omaha is 7%. That means if he wanted to go spend that $10,869,670,310, he’s going to have to give up another $760,876,922 in sales tax. That leaves him $10,108,793,388.
And if any of the things he buys includes tangible property like automobiles, he’s going to be charged regular property taxes, licensing fees, and other expenses on top of it.
In other words, to convert $22,236,000,000 in pre-tax earnings to spendable cash that he could enjoy in our scenario, he’d only be left with $10,108,793,388. The government would have pocketed $12,127,206,612 at various stages along the way. That represents 54.54%.
This Will Never Get Fixed Until All Taxes Are Individual and All Tax Shelters Destroyed
This is why Americans are forced to play tax games. This is why you have to fund tax shelters, set up pension plans, use accelerated depreciation schedules, rollover real estate profits into similar projects, or hold investments for certain lengths of time. The entire thing is a mess; a patchwork of stupid policies that punish effort and labor, while approaching confiscatory levels unless you intervene and restructure your affairs to avoid paying the tax; e.g., billionaire Ross Perot at one time earning hundreds of millions of dollars and not paying a single penny because he took advantage of the tax incentives in place on municipal bonds, or Mitt Romney having a possible $100+ million in an IRA.
Could Buffett get around those dividend taxes? Yes. It’s another tax game. He could borrow against his ownership stake in Berkshire Hathaway, use the debt as spending cash, and avoid triggering them, lowering his effective rate somewhat. However, he would likely see much of this eventually repaid by his estate when his assets were used to settle debts. (Again, it’s more complicated – you have step-up taxation basis in some cases, charitable deductions in others, etc.)
Alternatively, he could convert his operation in this scenario into a pass-through entity, abolishing the corporate income tax entirely. It is somewhat ironic that this is the plan upon which nearly every respectable conservative and liberal economist agrees; that corporate tax rates need to be abolished and taxes need to be applied to the individual owners. Stop the games. Make it easy. Make it impossible to lower your taxes without cheating (and ending up in jail).
It won’t happen. I’ve said it before, but we saw this in Kansas when the Republican legislature attempted such a plan. The real estate and real estate broker lobby came in and tried to shut down the entire thing because they didn’t want to lose the home interest exemption.
Buffett’s soundbite is going to result in worse policies that will end up having the second and third order incentive effect of causing more people to pay even more, perhaps aggressive, tax games. It’s not an intelligent course of action. I understand why he’s doing it, I just think it’s immoral to try to persuade the public with wrong information on an issue like this. It’s manipulating people by using their ignorance of corporate structures and tax rules against them.
I still love Berkshire Hathaway. I still have a huge part of my family’s common stock holdings invested in its shares. Some of my extended family hold bonds, collecting interest income, from the business to help fund their retirement. But this tax rate lie … I don’t like it. I don’t like it at all. I think it’s because there is zero probability it is an honest error. Not for someone that brilliant; that coldly ruthless; that laser focused.
It’s painful. Every time I hear him repeat the lie, somewhere in my heart, I feel my admiration lessen just a bit.