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Buffet Knows Tax Incentives

Once again Warren Buffet has managed to draw a large number of comments that he’s past his prime. This time it’s not for staying away from the latest hot investment though – it’s for his tax policy ideas. He’s not known for policy skills and we should be cautious about taking him as an expert on everything, but his view of tax incentives is probably a lot closer to the mark than most of his current critics such as Peter Foster and Jack Mintz in the National Post.

Mintz’s article mentions that higher taxes will reduce the incentives for businesses and entrepreneurs to invest. As a business owner, I find this logic to be backwards. Many small business owners will spend more because they know they get a tax deduction. Like with capital gains taxes, you can keep the full amount invested in increasing your future income or you can take some as profit and pay taxes every year. If their marginal tax rate goes down, that means they’re giving up more personal income by investing and spending. It’s different for large capital investments which must be financed from taxable profits (or a tax-deductible loan) and then amortized over time, but those eventually lead to tax deductions which will be worth more if the taxes are higher.

The other side of incentives is that people take on risk to earn a certain amount for themselves, which will be reduced by taxes. This does seem right on the surface. You don’t quit your  job and start a business just to fund national defense. But we’re talking about different things here. As Mintz points out, in the US the taxes are low in the average income range (in Canada I believe they’re a bit higher). An entrepreneur can earn an average or above average income without paying a lot of taxes. While this may not make them super-wealthy, the process comes with many personal benefits so even an above-average income can be enough incentive to take some risks.

The place where taxes might discourage a few entrepreneurs is when they want to go from 0 to deca-millionaire in under 10 years. Having that goal is fine, but it’s the type of thing that can also attract the wrong type of activity. You never want to do business with someone who’s only in it for the money because that just don’t cover everything involved. And from a government perspective they likely won’t contribute to society as much. Many countries that have encouraged investment have taken a big hit when another country adopts a slightly more favorable policy and the hot money goes there instead.

With taxes as low as they are now, a small increase would lead to a reaction closer to “oh well” than “oh shit”. As I write this I’m listening to Exile on Main Street, which was apparently named for the Rolling Stones’ decision to leave England and its (at the time) 90% marginal tax rate. Apart from being close to the highest tax rate that’s possible, that gives us a benchmark for when taxes are a disincentive – and we are nowhere near that in North America.

That’s not all though. The traditional economic theory of tax incentives is based on precise calculations – if someone can only make $400,000 instead of $500,000 they won’t take the risk. Some people may be close enough to say that, but business involves risks that can be much larger than the actual outcome so that kind of precision can be hard to find. You might end up getting $500,000 but you could have had anything from a loss of $1m to a profit of $3m. If the tax effect is smaller than the fundamental risk, it won’t have the incentive effect that economic logic seems to dictate.

Based on logic alone there are many reasons why a reasonable increase in taxes wouldn’t choke off business activity. If you go into behavioral economics (investments with a return for the business owner’s ego or risks taken on instinct rather than calculation) there are countless other examples of decisions that would not be impacted by a small increase in taxes.

I’m all for incentives to invest and I don’t see Canada being in quite the same hole that the US is, but we need to recognize that everyone has to play a productive role in keeping a functioning economy whether it means cutting loopholes or increasing tax rates. I’m currently in the middle of reading The Next Convergence, which rightly points out that in recent times developing countries increasingly seem to be coming up with more productive economic policies than the most advanced ones.

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  1. September 13, 2011 at 9:04 pm

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