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Obama’s Great Buffett Confusion

Wednesday, September 28, 2011

Warren Buffett says he is willing to pay more taxes. Here’s why that’s not relevant.

I really like bananas. Great way to start the day. Tasty and nutritious.

Wegman’s sells them for 49¢ a pound, but I would pay more than that. At 99¢ a pound, I’d still get them. I’m happier paying less, but I could afford the higher price.

So why doesn’t my grocery store take advantage of this? It could double the price of bananas and still keep my business. One reason might be that the nearby Safeway would start flaunting its lower prices and lure me away. But another argument is that I am not typical in my passion for the fruit. There are certainly other customers who are much nearer to indifference. At 49¢, they’ll pick up a few bananas; at 59¢, they’ll go with the melon. In economic parlance, the folks most likely to switch away when the price goes up are the marginal buyers. I, with my ardour, am an inframarginal buyer. For price setting, it’s the marginal buyers that grocery stores think about. At 99¢ a pound, I’d still be buying, but the store’s overall banana sales would fall sharply.

The taxpayers we ought to worry about are those who feel conflicted about whether to undertake an additional project, expand their business, or put in a few more hours.

I bring all this up because of billionaire Warren Buffett and his friend President Obama. Buffett likes the investing work he does and he has been very successful at it. He has argued that he would keep doing that work even if he were taxed more heavily. I believe him. He already chooses to pay himself far less than he might—reportedly $100,000 per year, a large part of the reason he is not in a higher tax bracket. But it is unlikely that Buffett is typical—others might work less if taxed more.

The recent widespread discussion of Buffett has created confusion between wealth (which we do not tax) and income (which we do). Buffet is a rare case of a very wealthy man with relatively small income, and his case illustrates that our income tax is not really a wealth tax. Buffett is also unusual because he is one of those inframarginal taxpayers—or banana fanatics, in my example above—who would keep working or starting businesses even at a higher tax rate.

When it comes to setting policy, however, those taxpayers are not the ones to be concerned about. The ones we ought to worry about are the ones at the margin, those who feel conflicted about whether to undertake an additional project, expand their business, or put in a few more hours.

But why should we worry about them? Imagine for a moment that Buffett’s sentiments are fairly common and that even 19 out of 20 employers would just pay the higher taxes and only one would throw in the towel. What does it matter if there were only one tax-sensitive outlier in the bunch? That would be a mere 5 percent; should it really drive the whole conversation?

As income taxes go up, the willingness to hire workers goes down.

To put this in perspective, a small percentage can make a big difference. Civilian employment in the United States peaked in November 2007 at 146.6 million jobs. In August 2011, there were 139.6 million jobs, a drop of 4.75 percent—seemingly small percentage changes can cause significant pain.

We do not have good evidence on how the willingness to invest and employ varies from entrepreneur to entrepreneur. There is evidence, however, that as income taxes go up, willingness to hire workers goes down. Whether this is because all employers are cutting back a little, or because a few are cutting back a lot, the net effect is an unhappy one.

For those who are relentlessly committed to making a point—e.g. about the need to raise taxes—there can be a certain appeal to tossing about slippery examples of inframarginal cases, like that of Buffett. But to base policy on such arguments is so misguided as to make one go, well… bananas.

Philip I. Levy is a resident scholar at the American Enterprise Institute.

FURTHER READING: Levy also writes “China's Investing Woes,” “The Multilateral Vacuum,” “Trade Fireworks,” and “Will Exports Save the U.S. Economy?

Image by Rob Green | Bergman Group

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