Warren Buffett and after-tax returns

November 28, 2012

In an op-ed this week in The New York Times, Warren Buffett writes that investors ought to assess investment ideas without regard to their personal tax rates.  He opens by suggesting no reasonable person declines a good investment opportunity based on the after tax return.  Quoting a hypothetical investor response, Mr. Buffett writes:

“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 percent.” Only in Grover Norquist’s imagination does such a response exist.

He later closes the op-ed in similar fashion, with a tongue-in-cheek challenge:

In the meantime, maybe you’ll run into someone with a terrific investment idea, who won’t go forward with it because of the tax he would owe when it succeeds. Send him my way. Let me unburden him.

To be clear, we are big fans of Mr. Buffett’s investment style and more than impressed with his long term returns.  He is one of the greatest investors of modern times.  But many  of us who invest in early-stage, high-growth companies – the companies responsible for all net job growth in the economy – disagree with the idea that individual tax rates don’t matter when it comes to investment decisions.  Investors will always seek the best risk-adjusted return on their money, whatever the external constraints.  If taxes and other risks go up, they will expect higher returns to compensate for the greater risk; when those returns aren’t available or attractive they will sit on their money.

Reasonable people will disagree on what tax rates should be.  But can we at least agree that there are some forms of investment activity which promote economic growth, and that those forms ought to be encouraged, perhaps with favorable tax treatment?  Our investors’ capital is tied up for years, resulting in reward only if our portfolio companies grow (and hire).  That is not the same activity as trading securities or Treasury bonds, which Mr. Buffett has done with amazing success, and for which he practices his own tax-avoidance strategies.  Mr. Buffett’s minimum tax on “millionaires” is essentially a tax on capital gains, which is a tax on economic growth and job creation.

We’d like to take issue with something else Mr. Buffet seems to suggest.  In his op-ed he seems to treat investments as being either “worth doing” or “not worth doing.” However one of his well-known nostrums is that obviously “terrific” investment opportunities are rare, and that value is more likely to be found or created via attention to the more mundane operating or competitive considerations at the margins.  And at the margins, changing the tax rate clearly affects the viability of additional projects.  As a friend of ours recently said, this is true for established companies as well as start-ups:  for Costco (one example) to build a new store, a 40% tax rate on the income will require much higher sales expectations for the store than if taxes were 30%, or 20%, or 0%.  It’s the same analysis regardless of who is making the investment decision: rich angel investor, venture capitalist, Fortune 500 CFO.  When taxes are higher, fewer stores get built and fewer companies get started.

There’s a heroic assumption embedded in the op-ed’s analysis:  that there will always be a nicely growing economy, with plenty of opportunity, and no shortage of entrepreneurs.  We believe it is not safe to assume that entrepreneurs will continue to risk their wealth and careers, expend the energy, and make the enormous sacrifices required to build a business no matter how big a bite the taxman takes out of their eventual reward.  It’s fine to say investors will look for the best opportunity regardless, but if there are fewer entrepreneurs there will be fewer opportunities, and the economic pie will start to shrink.

Mr. Buffett is no doubt correct that “terrific” ideas will still find willing investors, but what about all the not-obviously-terrific-but-still-really-good ideas?  For every Facebook there are hundreds of other early-stage companies who receive financial backing and grow nicely and thousands of new stores opened by established companies; those investments are approved only if the after-tax returns are sufficient.  The economy is not built on a series of towering home runs that clear the fence no matter how strong the wind is blowing into the park.  Winning takes singles, doubles, walks, anything that advances runners and scores runs.  Raising taxes on investment is like building a pitcher-friendly park and keeping the infield grass long:  you better plan on low-scoring games.

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