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Tax decisions must be weighed carefully

Dec 9, 2012 @ 12:01 am

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Warren E. Buffett may be a great investor, but, judging by his Nov. 25 Op-Ed in The New York Times, he is a poor student of economic history and human behavior.

In his article, he called for a minimum 30% tax rate for taxable income of $1 million to $10 million a year, and 35% for income above that. Such minimum rates imply capital gains and dividend tax rates of 30% to 35%.

Mr. Buffett also supports eliminating the Bush tax cuts for those earning more than $500,000 a year, meaning the top income tax rate for these individuals would rise to 39.6% (plus the already-passed Medicare surtax of 3.8% on investment income).

He argues that such tax increases on the “rich and the ultrarich” would have no meaningful impact on the economy, as the rich would not go “on strike” and leave their money in low-interest-paying savings accounts but would continue to invest.

INSIGNIFICANT AMOUNT

Let's look at some of the flaws in Mr. Buffett's proposal. First, raising the minimum tax on the highest earners to 35% would raise an insignificant amount of money in relation to annual trillion-dollar federal deficits.

If the 400 highest earners, who earned an average of $202 million in 2009, according to the Op-Ed, were taxed at 35% rather than the 19.9% he says they paid, it would raise an additional $12.3 billion — hardly a solution to the deficit problem.

As for Mr. Buffett's claim that high income and capital gains tax rates didn't deter investing in the 1950s and 1960s, he has no idea how many investors were deterred by those tax rates. With after-tax returns insufficient to offset risks, many investors may have resisted.

Mr. Buffett also said that the 70% top tax rate didn't affect U.S. economic growth during the period, but he ignores the fact that the situation was vastly different.

Europe and Japan were recovering from the war and were great markets for U.S. companies, which had virtually no competition. Despite this warm tail wind, there were five recessions between 1953 and 1975.

Mr. Buffett appears to think that tax considerations don't change behavior, that people don't act to minimize their taxes. His own behavior belies that belief, however.

For example, Mr. Buffett is giving most of his wealth to the Bill & Melinda Gates Foundation in annual installments over 20 years. He could have simply left his money to the foundation in his will, but then his estate would have been hit with a huge estate tax bill.

By giving most of it while he is living, he reduces the estate tax bite and provides himself with a nice annual tax deduction.

In addition, his proposal that the Bush tax cuts be allowed to expire for people earning $500,000 or more would leave many owners of Subchapter S small businesses exposed to significantly higher taxes. That is because such corporations pass their income, losses, deductions and credits through to their shareholders, which are often families.

Many families thus would face significantly higher tax burdens if a company's income were greater than $500,000. The increased tax burdens would likely slow the growth of these businesses.

WEIGH THE EVIDENCE

The point isn't to make fun of Mr. Buffett's analysis but to show that the president and Congress must carefully weigh the evidence of the impact of tax decisions as they seek to raise revenue to help balance the budget. The objective must be to raise it in the most economically efficient manner — in a way that does the least damage to growth.

Legislators also must do their homework on spending cuts, which, if not thoroughly planned and implemented, could affect growth. Unfortunately, there is little evidence that either side is approaching these issues with the appropriate care.

Throughout this mess, financial advisers must observe the direction of the negotiations on avoiding the fiscal cliff: Their high-net-worth clients likely will be affected if a deal is reached, and all their clients will be affected if one isn't.

Advisers must be ready to quickly advise on the impact of any agreement and on ways to minimize that impact.

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