The terrible economic news from both Europe and the United States has led to much soul-searching on both sides of the Atlantic. How did we get here, and how can we get out of this jam? In my past columns for Hoover’s Defining Ideas, I have insisted that both economies will be able to extricate themselves from their deep slumps only by promptly reversing those policies that have brought them to the brink. A successful and sustainable political order requires stable legal and economic policies that reward innovation, spur growth, and maximize the ability of rich and poor alike to enter into voluntary arrangements. Limited government, low rates of taxation, and strong property rights are the guiding principles.
Unfortunately, many spiritual and economic leaders are working overtime to push social policy in the exact opposite direction. At the top of the list are two prominent figures: Pope Benedict XVI and financier Warren Buffett.
Illustration by Barbara Kelley
The Pope was on his way to recession-torn Spain—to lead the Roman Catholic Church’s weeklong celebration of World Youth Day—when he denounced those nameless persons who put "profits before people." He told journalists, "The economy cannot be measured by the maximum profit but by the common good. The economy cannot function only with mercantile self-regulation but needs an ethical reason in order to work for man." Standing alone, these words mirror the refrains of countless Spanish socialists, whose relations with the Pope have soured in recent years. Their shared premises help explain why Spain finds itself in such a sorry state.
Denouncing those who put ‘profits before people’ may stir the masses, but it is a wickedly deformed foundation for social policy. Profits, like losses, do not exist in the abstract. Corporations, as such, do not experience gains or losses. Those gains and losses are passed on to real people, like shareholders, consumers, workers, and suppliers. It is possible to imagine a world without profits. Yet the disappearance of profits means that investors will be unable to realize a return on either their capital or labor. Structure a system that puts people before profits, and both capital and labor will dry up. The scarcity of private investment capital will force the public sector to first raise and allocate capital and labor, though it has no idea how these resources should be deployed to help the people, writ large. A set of ill-conceived public investments will not provide useful goods and services for consumers (who are, after all, people), nor will it provide sustainable wages for workers (who are also people). Poor investment decisions will lead to a massive constriction in social output that harms all people equally.
Denouncing those who put ‘profits before people’ may stir the masses, but it is a wickedly deformed foundation for social policy.
The proper response to these difficulties is to treat profits as an accurate measure of the cost of capital, rewarded to those individuals and firms who supply some desirable mix of goods, services, and jobs that people, acting individually and not collectively, want for themselves. The genius of Adam Smith, whose musings on the invisible hand are too often derided, was to realize that private markets (supported, to be sure, by suitable public infrastructure) will do better than a command and control system in satisfying the individual’s wants and needs.
The Pope offers no serious answer to Smith’s point when he talks about "the ethical need to work for man" and the "common good." In both of these cases, he treats a collection of diverse individuals as though they form part of some harmonious whole. "Man" in the Pope’s formulation is a grammatical singular but a social collective. The "common good" speaks of some aggregate benefit to a community that is not securely tethered to the successes and failures of the particular individuals within the collectivity.
As a technical matter, it becomes critical to have some reductionist argument that transforms statements about these groups into statements about the individuals who compose them. Ordinary business people understand this intuitively when they speak of win/win transactions. These are transactions that generate gains to all parties involved in the bargain.That common expression, "win/win," is the distillation of sound economic theory, for the more win/win transactions a society can generate for its people, the greater its economic prosperity.
False claims for social justice come at a very high price.
The great advantage of competition in markets is that it exhausts all gains from trade, which thus allows individuals to attain higher levels of welfare. These win/win propositions may not reach the perfect endpoint, but they will avoid the woes that are now consuming once prosperous economies. Understanding the win/win concept would have taken the Pope away from his false condemnation of markets. It might have led him to examine more closely Spain’s profligate policies, where high guaranteed public benefits and extensive workplace regulation have led to an unholy mix of soaring public debt and an unemployment rate of 20 percent. It is a tragic irony that papal economics mimic those of the Church’s socialist opponents. The Pope’s powerful but misdirected words will only complicate the task of meaningful fiscal and regulatory reform in Spain and the rest of Europe. False claims for social justice come at a very high price.
A similarly harsh verdict must be rendered on Warren Buffett, whose much discussed editorial in the New York Times foolishly condemns the very economic system that allowed him to flourish as an extraordinary investor. Rhetorically, Buffett’s editorial reads like the confession of a man who got away with putting his hand in the cookie jar. He starts by insisting that in difficult times the principle of "equal sacrifice" should guide collective deliberations. In good autobiographical fashion, he then admits that the current tax system has allowed him to get away with paying just under $7 million in taxes this past year, which works out to be 17.4 percent of his $40 million personal income.
In Buffett’s utopian world, higher taxes, including higher capital gains taxes, magically generate the revenues needed to eliminate the current massive deficit. For this bold proposition, we have Buffett’s personal assurance that he has never seen capital gains rates that approach 40 percent "scare off" large or small investors. This is a simple case of sampling error, for those people who are scared off by high capital gains taxes don’t beat a path to his doorway in the first place. It would have been better if Buffett had addressed the "lock-in effect" with respect to capital gains. People only pay capital gains when they sell their stock. Accordingly, investors are highly sensitive to the capital gains rate, because why sell if the net proceeds from the sale are so small that they more than negate a higher rate of return from a shrunken capital base?
On this logic, lower capital gains rates generate more tax revenue for the federal government. Yet Buffett doesn’t grasp the point when he writes:
In 1992, the top 400 had aggregate taxable income of $16.9 billion and paid federal taxes of 29.2 percent on that sum. In 2008, the aggregate income of the highest 400 had soared to $90.9 billion — a staggering $227.4 million on average — but the rate paid had fallen to 21.5 percent.
I’d take 2008 any day. In 1992, the country’s top 400 earners paid a total of $4.9 billion in taxes, which is a nifty sum to come from so few. But 16 years later, that amount rose to about $19.55 billion, leaving those most successful investors with an extra $71 billion in cash to invest in new ventures that could promise greater returns. This is win/win with a vengeance.
Limited government, low rates of taxation, and strong property rights should be our guiding principles.
Buffett acts like the dual increases in tax revenues and private gains had nothing to do with the reduction in the capital gains rates. It is a sign of his upside-down moral standards to regard a win/win change in the tax laws as a blunder just because the government had a smaller slice of the pie than it had before.
Buffett should reflect more deeply on the systemic dangers of taxing all those millionaires and billionaires to make up for the government’s huge tax shortfall. No fixed group of individuals is permanently wealthy. In fact the number of people in each of the supposedly elite categories of wealth—those earning $200,000 or more, $1 million or more, and $10 million or more—has fallen in recent years. With fewer individuals in these groups, lower incomes for those that remain in each group, and depressed stock prices, no wonder tax revenues have dropped to about 15 percent of gross domestic product. That outcome happened, moreover, without any reduction in tax rates in the upper brackets. When people at the top earn less, tax revenues drop precipitously.
The wise pundits of the left insist, like Buffett, that higher tax brackets do not diminish earnings. That point is surely overstated, especially for capital gains. What’s driving the current decline is not that highly skilled people are unwilling to work. It is that employers are unwilling to hire. Fancy bankers, doctors, lawyers, and venture capitalists may be happy to work for less. But the people who hired them in good times won’t keep on hiring them in bad times when the economy slows. When the other side of the market falters, the incomes of the rich slide as well, and in ways that future tax increases will only accelerate. The government will not find a treasure trove of revenues by raising taxes on former millionaires and billionaires.
So rather than heed the advice of the Pope and Mr. Buffett, we should take our guidance from another public figure: the late Reverend Ike. Many years ago, he said, "the best thing you could do for the poor is not be one of them." Government should give everyone at least that opportunity.
You write: 'In Buffett’s utopian world . . . .' I submit that Buffet's outlook is not utopian but particularly self-serving.
Warren Buffet's corporation (Berkshire-Hathaway) owns stock in insurance companies. Life insurance, of course, is exempt from federal and state income tax and from most state inheritance taxes as well. Furthermore, properly structured in a trust, it can also avoid federal estate taxes. It is a tax favored investment used by those members of the upper economic classes to pass wealth from one generation to another in a tax-efficient manner. This is done through such wealth transfer techniques as capital transfer and charitable remaindered trusts, to name only two. Large life insurance policies play primary roles in such financial techniques.
The higher and more burdensome the tax rates, the more advisable and convenient large life insurance policies become to the wealthy. The more convenient life insurance is, the more it will be used; hence larger profits for the insurance companies whose stock Berkshire-Hathaway owns.
I am not anti-profit. Still, I do not see Buffet as having any utopian vision. This 'sage of Omaha' is, to me, more like the 'fraud of Omaha.' He argues for higher tax rates and is seemingly concerned for the common good. All the while, he's ready to line his pockets with the higher insurance company stock prices which he already owns. Furthermore, as he, himself, has announced, he plans to pass much of his considerable wealth to the Gates Foundation in a massive tax-free transaction.
If he is really so bothered by his low tax rate, let him write a check to the IRS rather than advocating for higher taxes on everyone else. I won't hold my breath.
You rightly excoriate Mr. Buffet for his call for higher taxes. But I think you misunderstand his motives. For instance, his calls for estate taxes, which he has no intention of paying, are a cynical self-interested ploy inasmuch as some of his largest holdings are life insurance companies. These guarantee him a nice return on a steady flow of business so long as their fees are less than the statutory estate tax rate. In a nutshell I think Mr. Buffet is a scoundrel rather than a fool.