Duke Biz Professor Misses Half the Story

To paraphrase the great Thomas Sowell, “there are no solutions in life, merely trade-offs.”

Duke University associate business professor David McAdams ignores that self-evident truth in this N&O guest column. In an attempt to shill for the Obama-endorsed “Buffet rule” on taxes (a rule, by the way, based on a lie anyway) McAdams tries to convince readers that in some certain circumstances jacking up capital gains taxes will incentivize entrepreneurs to expand and create jobs.

To make his case, McAdams conjures up a hypothetical business owner who receives most of his income from capital gains (which he likely earned from investments using income that was already taxed) and some income from a business venture. While McAdams readily admits this person’s total tax bill would rise, the changing mix of his tax bill under the Buffet rule would favor his business venture. As he explains:

Consider, for example, a millionaire whose income consists of $1 million in capital gains and $100,000 from a chain of hot dog stands. This millionaire pays taxes of 15 percent on capital gains and 35 percent on net income from the hot dog stands, for a total of $185,000 ($150,000 plus $35,000). This amounts to an average tax rate of 16.8 percent, less than the 25 percent marginal rate paid by many middle earners.

Under the Buffett rule, he would have to pay 25 percent of all income in taxes, for a total of $275,000. However, he would be keeping 75 cents of every additional dollar generated by the hot dog stands, compared with 65 cents of every dollar without the Buffett rule. So this millionaire would have more incentive to expand his hot dog business, hire more workers, and so on.

Great solution, right? But what about the trade-off?

McAdams conveniently (or intentionally) ignores the flip side to this change in tax liability. To follow McAdams math, to reach a new total tax bill of $275,000, that millionaire would have to pay $250,000 (or 25%) on his capital gains. That would be an extra $100,000 – or a massive 67% increase in  his capital gains tax bill. Does McAdams seriously think that this would have no impact on investment decisions? Would this millionaire just obediently pay this huge increased tax bill on his investments, or seek other alternatives with his assets? My bet is on the latter.

But what of the millionaire’s increased “incentive to expand his hot dog business, hire more workers, and so on”? Business owners may indeed have a greater incentive to do so, but where would they get the money to expand? That’s right – from the capital markets. The very same capital markets that the Buffet rule would serve to dramatically decrease. The very resources needed for business expansion would be dried up, forcing up interest rates and making it unaffordable for many business to expand – not to mention to discourage new business ventures from starting in the first place.

How much each of these effects would trade off against each other is anyone’s guess. But it is highly irresponsible for a university professor to ignore these trade-offs. To ignore such an important element to the narrative is either intellectual laziness or willful negligence.