The Forgotten Man of the Tax Debate

By Blake Hurst 

Obama, Romney, and Buffett, listen up. In all the bickering over incentives and tax fairness, there has been little mention of the thing that matters most of all: cash.

The election, at least recently, seems to be all about taxes. Romney’s tax rates, Warren Buffett’s secretary’s tax rates, President Obama’s myriad plans to raise tax rates. Democrats argue that fairness demands a tax increase. Republicans worry that tax increases will harm incentives to work, invest, and take risks. And besides, Republicans point out, Romney’s tax rates aren’t that low once the corporate tax rate is taken into account.


Makes me wonder what I should think. Intuitively, it seems obvious that increasing tax rates will lessen incentives to take risks or work hard. Increase taxes on investment, and you ought to get less investment. That seems simple enough on its face, and investors surely pay attention to after-tax returns on investment when they decide what to do with their capital.
Not so fast, says Warren Buffet. According to the oracle of Omaha, people invest regardless of tax rates. According to Buffett: “I have worked with investors for 60 years and I have yet to see anyone—not even when capital gains rates were 39.9 percent in 1976-77—shy away from a sensible investment because of the tax rate on the potential gain. People invest to make money, and potential taxes have never scared them off.”

Cash left in the hands of successful investors increases the chances that capital will be allocated in efficient ways.

There does seem to be some evidence to bear out Buffett’s opinion about investment taxes. According to a study by the Urban Institute, there is no correlation between taxes on investment income and the amount of investment (although there is other scholarship that disagrees). Many people think that the relationship between marginal tax rates on wage income and work effort is just as tenuous.
It’s obvious that the Obama administration does not believe that tax rates on investment are a factor in investment decisions, or that marginal rates on real income affect how hard and how much people work. In fact, President Obama’s faith in Americans’ willingness to put in long hours, no matter the marginal rate of taxation, is touching. Incidentally, it occurs to me that nobody has thought to ask Warren Buffett’s secretary about her investing philosophy. Is she as impervious to incentives as her boss?
In all the arguments over incentives and tax fairness, there has been little mention of, well, cash. I’ve read long, learned dissertations on work effort, impassioned pleas for incentives to encourage a rekindling of animal spirits, and exotic calculus in service of whatever agenda an economist possessed before the study was undertaken. But cash is rarely mentioned.
As a small businessman, I can’t argue that I worked harder or longer the year after the Bush tax cuts were passed. I would imagine that my effort was pretty much the same as the year before. The same goes for my investment plan. I invest everything left after living expenses and taxes, no matter what the capital gains tax rate is. I have no plan to sell my farmland or my business. Like Warren Buffett, I’m not selling, so the tax rate on any expected gain doesn’t matter to me.
The only question that matters to the growth of my business is this: how much cash does the tax man leave me?

With higher tax rates, it would have taken me many years longer to build the capital necessary to expand my business.

Now, finance theory, at least the one called the Modigliani-Miller theorem, argues that the market is basically indifferent to how a business is financed. Debt or equity, it matters not. If taxes are so high that I can’t save cash to reinvest in my business, it doesn’t matter, because if the expected return of investment in my business is greater than the cost of capital, the market will provide.
However, neither Modigliani nor Miller has been in contact with my banker, who seems unaware of financial theory. When we expanded our farm recently by purchasing a neighboring place, the lender required at least 35 per cent of the purchase price as a down payment. That would be cash. It mattered not the capital gains tax rate, the cost of capital, the expected return, or what Obama considers fair. Business is hard and cash is king.
My wife and I had built the cash reserves necessary to make that down payment on our new farm over a period of years–years, interestingly enough, when the government taxed business and investment income at rates far lower than those envisioned by the present administration. With higher tax rates, it would have taken me many years longer to build the capital necessary to expand my business. Someone else would now own our neighbor’s farm, and our family business would have been much less likely to survive and grow. That is the cost of tax rates being too high, and that is why tax rates matter.
The economy thrives when businessmen can save the cash necessary to provide employment and expand their businesses. When tax rates are punitive, the ability to generate capital in the form of cash is drastically curtailed.

It occurs to me that nobody has thought to ask Warren Buffett’s secretary about her investing philosophy. Is she as impervious to incentives as her boss?

The more skillful the investor, the more cash is generated from profitable investments. Cash left in the hands of successful investors increases the chances that capital will be allocated in efficient and productive ways. The more profits invested in growing businesses by the founders and managers of those businesses, the more quickly the economy grows.
The skills that make successful businessmen and investors are not spread equally among the population, and they certainly don’t coincide with the ability to win elections. Better to encourage investment by leaving cash in the hands of those who know how to use it. Even if tax rates have no incentive effects (although I’m sure they do), cash in the form of retained earnings is important, and too often overlooked.
My family businesses don’t add much to the overall economic prosperity of our nation. They’re small, not terribly profitable, and are hardly giant engines for job creation or on the cutting edge of innovation. They do, however, employ nine family members throughout the year, with another dozen or so employees during the busy season. Without sensible tax rates on both labor and capital, we can’t build the equity we need to expand in good times and survive the bad times. That’s why tax rates matter.
Since our situation is multiplied tens of thousands of times across our economy, from family restaurants to small trucking firms to the corner bodega, discussions of fairness, questions of incentives, and the proper rate of taxation should never neglect cash left in the hands of businesspeople. You can be sure that cash money is foremost in the minds of the people who are actually making the economic decisions that drive our economy.
Blake Hurst is a Missouri farmer and a frequent contributor to THE AMERICAN.