Warren Buffet Op-Ed and Weekend Reading 8/18/2011

Warren Buffett recently published an opinion editorial in the New York Times called Stop Coddling the Super Rich. Buffett has been clear about his political views before, but due to the bluntness and timeliness of this article, it has received extremely widespread commentary and reaction, both positive and negative.

To summarize the article, Buffett argues that in this time of US deficits, debts, cuts, and unemployment, in addition to making spending cuts, the wealthy should pay higher taxes like they used to, and he defines wealthy as those making over $1 million, and especially those making over $10 million. To substantiate his point, he provides the information on how much he paid in taxes, and points out that he pays a lower percentage than anyone in his office, despite being the wealthiest by far. He claims he pays about 17% in taxes, while everyone else in his office pays between 33% and 41%.

I suppose I’ll get it out of the way and say I agree with him, but my main interest in this article is to analyze his claim, the claims of those who disagree with him, and to mostly stick to the facts about how this taxation works. This situation is relevant to dividend investing, because it is primarily about taxes on dividends.

Why Buffett’s Reported Tax Rate is So Low

The tax system in the US is complicated, just like most other countries. In theory, the more you make, the higher percentage you pay in taxes. In US history of the 1900s, the top tax rates were significantly higher than they were now, but a few presidents and Congresses, especially Reagan and Bush II, were responsible for reducing the top tax brackets significantly, for better or worse. In certain periods, dividends were taxed at the same rate as ordinary income, so people in the top tax brackets paid the top tax rate on their dividends. Under Bush II, the income tax brackets were mildly cut, and the dividend tax was substantially cut down from ordinary income tax to only 15% (or 0% for those in low tax brackets).

So, the most US citizens pay on qualified US dividends in taxes is 15% now. This was extended in 2010 until at least 2012, because President Obama and the Democrats made a deal with the Republicans in exchange for things they each wanted. I wrote an article before this occurred, about how tax changes may affect or not affect dividend investing, and a few months after that article, the tax cuts were extended, but the same article may be relevant as 2012 approaches.

So how does Buffett pay low taxes? It’s because most of his income that he fills out in taxes comes from dividend stocks, and dividends are taxed at only 15%. Most of Buffett’s wealth is in the form of tens of billions of dollars worth Berkshire Hathaway stock, which he doesn’t sell (but sometimes gives away). Since Berkshire pays no dividends, he receives no personal income from his Berkshire stock, so he pays no taxes on it. If he were to sell Berkshire stock, he would have to pay capital gains taxes, which are fairly low, but would amount to billions of dollars on his position. He gets a relatively small (at least for him) six figure salary for his job as Chairman and CEO, which gets taxed as ordinary income. In addition to his Berkshire stock and his CEO salary, Buffett owns a personal portfolio of dividend stocks that is worth somewhere around $2 billion. Many of these companies are the typical dividend blue chips, including ones you’ll find in my portfolio like JNJ and PG, and from this portfolio, he makes somewhere around $60 million in dividends.

So his total taxable “income” is these tens of millions in dividends, his small six figure salary, and possibly a few other sources here and there, but mainly those two things. He gives a portion of this income away and gets to deduct it from taxes, so a smaller majority of the income is left, and is taxable. So, for most of his income, he is taxed at 15%, and for a small portion, he is taxed at a higher rate (ordinary income taxes plus payroll taxes), and for some of the money he gives away, he is not taxed. The result is that on his tens of millions of dollars of taxable income, he pays around 17.4% in taxes, which according to him is lower than anyone in his office.

The Counter Arguments

Although I agree with him, Buffett’s article is misleading. He’s not paying 17%.

I’m sure he’s completely aware of why it’s misleading, and he tends to write very simply to get his point across. (He once wrote a very good article to educate the population on the US trade deficit, and to present his solution to the US trade deficit, and told the story in the form of inhabitants of two islands: Thriftville and Squanderville.) But that doesn’t change the fact that it’s inaccurate, and here’s why.

Buffett’s real income is not that $60 million in dividends. His real income is his portion of the operating profit of every company he partially owns, including Berkshire Hathaway and his personal stock portfolio, (plus that small six figure salary which I’m going to ignore from now on since it’s smaller than a rounding error for him). Owning shares in a company represents owning that portion of profits, and the operating income is the pre-tax profit (in general; there is also interest expense). The profit is then taxed, and is represented as net income, of which a portion is paid out in dividends, and those dividends are taxed again at 15%.

Therefore, Buffett’s total “real” income is in the billions rather than the millions, and most of the taxes he’s really paying, are being paid by the corporations at the corporate level, rather than being paid by himself. Still, those corporate taxes are really his taxes, and it’s important to view business income like this. Businesses make money for individuals, so it’s indirectly but accurately a part of an individual’s tax. Now, to mitigate this, one could argue that these corporate taxes are not just on the owners, but also on the customers since it affects pricing, so to be fair, let’s say that these percentages are the upper limit.

So to calculate his approximate real tax rate, he would have to:
-find the weighted average of the federal tax rate on the operating income of the companies he holds stock in
-find the weighted average payout ratio of dividends to operating income
-Calculate that a rough estimate of his tax rate is:
Tax Rate = (1.00)(% Federal Tax Rate on Operating Income) + (Operating Income Dividend Payout Ratio)(15%)
-A translation of this equation is that 100% of the operating income is taxed at whatever the rate is, and then a portion of this equal to the payout ratio is double-taxed at another 15%.
-Plus, if he ever sold his stake, we’d have to add capital gains tax on top of this.

I’ve seen some articles argue that his tax rate is 50%, since the number given for corporate tax rates is 35%, and dividends are taxed again at 15%. One such article is this one that was published on Forbes. It claims Buffett’s numbers are misleading, but these numbers are farther off. Buffett’s tax rate would only be 50% if corporations actually paid 35% in federal taxes (usually untrue), and if they paid out 100% of their operating income as dividends resulting in 100% double taxation (usually untrue). To take an example, Procter and Gamble’s effective tax rate is reported to be 27% by Morningstar, and only a portion of that is federal tax. Let’s say the federal tax rate is 20% for simplicity. Then, Procter and Gamble paid out approximately 35% of its operating income as dividends, which were taxed again at 15%. So, this rough estimate of the tax rate for an owner of Procter and Gamble is 1.00*20% + 0.35*15% = about 25%. Now, if we were accountants, we’d have to get into deferred taxes and other items such as foreign income that remains overseas, and the true tax rate is a bit gray.

To continue, Buffett is not paying any double tax on his Berkshire Hathaway stock, since Berkshire Hathaway does not pay dividends.

I’d estimate that his total real tax rate is somewhere between 20% and 30%, but it could be higher or lower depending on the precise federal corporate tax rates, precise payout ratios, and the gray answer to the philosophical economic question of which portion of corporate taxes are truly taxes on the owners, and which portion is a tax on the customers.

In addition, we could examine the reported 33% to 41% tax rate of his employees. Without details, we obviously can’t fact-check them, but I’d wager they are lower than these reported percentages. To get these figures, he’s taking into account income taxes and payroll taxes. But he’s focusing only on taxable income. These people likely have a lot of income that is not taxable, or is being taxed at a reduced and deferred rate, such as with an IRA, a 401(k), various government tax deductions and credits, and so forth.

Bringing it Together

Based on the arguments, the real situation is that he’s probably paying more than 17.4%, and his employees in his office are probably paying less than 33-41%. Still, I wouldn’t be surprised if he truly does pay a lower rate than some of them. The numbers seem to indicate that this is the case. Plus, his statement about wealthy fund managers holds true; they pay a very low tax rate. And, if Buffett wanted to legally minimize his taxes further, he could, by buying units of master limited partnerships (mostly deferred and somewhat reduced taxation), or by purchasing shares in companies that get huge government subsidies in the form of large tax breaks.

Although I disagree with his numbers, the basic concept holds fairly true. The poor pay little or nothing in taxes. The middle class and upper class pay a rather high rate of taxes, which comes in the form of income taxes and payroll taxes, and to some extent is mitigated with legal tax shelters (retirement plans), and tax credits and deductions. The rich can pay a huge variety in taxes depending on the source of their wealth, but it is likely lower than the upper middle class. Those who make money from work, get taxed pretty harshly. Those who make money with money, have far more options to reduce taxation. That’s the system he’s arguing against.

Buffet Interview

Recently, Buffett gave an interview where he talks about his opinion editorial. And for those who couldn’t care less about the politics of dividend taxation despite being dividend investors, he also talks about a lot of other topics, including his optimism on the US economy (and specifically why he is optimistic, and the two things stated by him that could potentially render his optimism incorrect). I highly recommend it:
Buffett Interview

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