Like most people, we have always admired Warren Buffett as an astute investor. He is thorough and rigorous in analysis, he uses a common sense approach to investing and he is patient and disciplined in his investment process. He also employs a common sense approach to compensation structures used at the companies owned in the Berkshire portfolio. Yet, Mr. Buffett’s current position on income taxes is a bit curious as it seems to be in direct conflict with the compensation philosophy and approach he supports at his portfolio of companies. In his comments regarding tax policy, Mr. Buffett highlights the fact that he pays taxes at a lower rate than his secretary and that this is not fair; middle class Americans should not pay taxes at a higher rate than the wealthy. While we agree with that statement in principal, there is a mixing of apples and oranges in the example Mr. Buffett has chosen. Mr. Buffett’s total compensation from his role as CEO and Chairman of the Board at Berkshire Hathaway was $524,946 in 2010. This includes $100,000 in salary and $424,946 in other compensation (such as security services provided to him and his director fees). More importantly, Mr. Buffett owns approximately 23% of Berkshire Hathaway which represents the vast majority (98%) of his net worth. Therefore, most of his income is provided by dividends from his Berkshire Hathaway holdings, which are taxed at a significantly lower (15%) rate. Averaging the amount of income taxed at the income tax rate versus the capital gains tax rate brings his average tax rate down to the mid-teen levels cited to illustrate the inequity of the current tax policy. This runs contrary to the tax rate experienced by the majority of “wealthy” individuals that derive most of their income from earned income, not dividend income. This is particularly true of small business owners.
A review of the proxies of Berkshire Hathaway (and the public companies in which Berkshire has a majority stake) does not yield any evidence of corporate compensation structures that are aligned with Warren Buffett’s recent stance regarding taxation. That is to say, one is unable to find commentary that suggests the highest paid employees are required to reapportion a percentage of their earnings to those in the company’s lower income brackets. In fact, in the booklet entitled “An Owner’s Manual” written by Mr. Buffett for Berkshire’s shareholders, Mr. Buffett prides himself on his hands off approach on the management of his portfolio companies and makes it clear that ultimately his fortunes (and that of his shareholders) are tied to the performance of those companies over the long-term. An unspoken corollary to his statement is that it requires good management teams and compensation structures that are appropriate to provide the proper incentives for the desired outcomes. Otherwise, people will take their talents elsewhere. If people do not believe compensation is commensurate with their effort, they will be less inclined to make the trade-off of long work hours for sacrificing time with family, friends and other activities and hobbies. After people make such sacrifices to then turn around and demand that person now give up an additional 20% (or so) of their income would likely prove to be a deterrent to motivation (to say the least). Also, this is not likely a company that Mr. Buffett would find of interest from an investment standpoint. So, why would he advocate that income tax policy be designed this way? It makes no sense.
Currently, about 25% of the American taxpayers pay 80% of income taxes while somewhere between 45 to 49% of Americans pay no federal income taxes at all. While social inequities must be addressed, we are not sure that the best way to do that is by raising the tax rates of those who are putting in the time and taking the risks that ultimately result in job creation. That seems to be more of a dis-incentive. Mr. Buffett’s suggested approach to taxes appears to be in direct conflict with his own approach to investments.
All comments and thoughts are welcome.
Denise M. Farkas, CFA