OPINION: Tax rates do matter

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If an investment is profitable at 15% tax, it will still be profitable at a 35% tax rate, say some commentators. Clifford Asness argues to the contrary.

There are important questions we need to answer about taxes. How progressive or regressive? How should rates vary on different forms of income? How much of fixing our fiscal problems should come from raising revenue versus cutting spending? I have my opinions and you are entitled to yours. But some basic truths, old fashioned as it may sound, really aren't subject to opinion.

Nevertheless, in an effort to support raising taxes, particularly capital-gains taxes, and to head off the argument that such hikes would be a drag on the economy, billionaire investor Warren Buffett argued in a New York Times op-ed last month that tax rates don't matter to investment decisions. He wrote that if someone comes to you with a good investment idea, no one says, "If the taxes are too high, I would rather leave the money in my savings account, earning a quarter of 1 percent."  In the field of economics and finance you would be hard-pressed to find something more patently wrong.

Consider how every business-school student, investment banker and investment analyst on Earth has been taught to choose whether to invest in a specific project or company. You make a spreadsheet (a napkin will do sometimes). You put in your best guess of the future cash flows, and you discount those cash flows back to the present at some required rate of return you believe reflects the risk entailed. Of course, opinions about the future cash flows and the proper discount rate can vary widely, but the essential methodology is ubiquitous.

Now here's the kicker: Nobody who pays taxes and has ever done this exercise has failed (while sober) to use after-tax cash flows in this calculation. Somewhere in the spreadsheet there is a number, say 20%, or 28%, or a Gallic 75%, representing the taxes you'll pay  on the assumed cash flow—and you only count the amount you'll get after paying this tax. If you turn the tax rate up high enough, projects or companies that looked like good investments become much less attractive and vice versa.  Buffett is undoubtedly right that rich people will continue to invest some amount in something regardless of the tax rate (except for a 100% rate!). He's also undoubtedly right that an investment that easily clears all hurdles will likely still be attractive after a small tax increase. But life, and the investment decision, occurs at the margin. Fewer and smaller investments will be made if the after-tax prospects are worse. It's just math and logic, unassailable and commonly accepted regardless of one's political persuasion.

Some recent commentators have actually tried to prove the illogic that Buffett merely asserts. They argue that if an investment was  profitable at a 15% tax rate, it will still be profitable at, say, a 35% tax rate—just less so. Therefore investors will still go ahead with it.  But here, as in so many things, the government doesn't play fair. It taxes gains, but losses are deductible only under certain conditions and circumstances. In finance-speak, the government grants itself a call option on your profits. This fact alone will make investments that were profitable at one tax rate decidedly not so at a higher one.

The bond market offers particularly compelling evidence that people focus on after-tax cash flows when making investments and that they will, contrary to Buffett's assertion, alter their investment behaviour based on tax rates. The yield on tax-free municipal bonds is almost always considerably lower than the before-tax yield on taxable corporate bonds of similar risk. Despite his claim that taxes don't matter, we can be sure that Buffett would not hold corporate bonds in his taxable portfolio if, before taxes, they yielded only the rate on otherwise similar tax-free munis. This sort of investment decision is just one example of how taxes affect our actions. Consider that George Lucas sold Lucasfilm Ltd., including the Star Wars franchise, to Disney this year at least partially to avoid a likely coming hike in the capital-gains tax. While Buffett is telling us taxes don't matter, here's proof that taxes are stronger than The Force.

I have great admiration for Warren Buffett as an investor. He has also been smart about minimizing his tax bill. From making sure his  profit is in the form of long-term capital gains and not, for instance, dividends, to how he structures his bequests and charitable  contributions, Buffett is perhaps our premiere national example that tax rates and tax structure affect people's investment decisions in a very real way.  Taxes matter. They matter to business and life decisions alike. They matter to the rich and to the poor. They are, or at least they should be, incorporated into nearly every financial decision made. Discussing tax policy without acknowledging this fundamental reality is bizarre. Actually asserting the opposite is wilful ignorance.

Mr. Asness is the managing and founding principal of AQR Capital Management.

 

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