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Warren Buffett: What Business Can Soak All Benefits of Tax Reduction, or Have to Pass It to Consumers

December 21, 2011 | About:
The old maxim goes: “There are only two things in life that we can't avoid, death and taxes.” So tax is the obligation that no businesses can avoid and it affects the profitability greatly. The increase/decrease of tax rate can significantly decrease/increase a firm's profitability. However, there were several businesses which could pass all the taxes through to the end consumers. The increase in a business’ tax level can be offset by the higher prices charged to consumers. And vice versa, the tax decrease for the corporations would not help profits but would instead flow through, leading to lower prices for consumers.

Warren Buffett, in the letters to shareholders of 1986, commented on this issue: “our conclusion is that in some cases the benefits of lower corporate taxes fall exclusively, or almost exclusively, upon the corporation and its shareholders, and that in other cases the benefits are entirely, or almost entirely, passed through to the customer. What determines the outcome is the strength of the corporation’s business franchise and whether the profitability of that franchise is regulated.”

The example of a strong franchise with regulated profits is the electric utility field. In this field, the changes in corporate tax rates are mainly reflected in prices, not in profits. When the tax is cut, prices would be reduced right away. When the tax is increased, the price would increase. Similarly, in a price-competitive industry, such as commodities, businesses which Buffett considered weak as franchises, the profits are “regulated” not by the government but by the free market in a delayed, irregular but effective manner. In these industries, tax changes would affect prices more than corporations’ profits.

People would experience a different story with strong franchises in the unregulated profit businesses. The tax cut would benefit the corporations and their shareholders the most. Buffett said that many of Berkshire’s businesses, except those he owned in whole and in part, possessed such franchises. “Consequently, reductions in their taxes largely end up in our pockets rather than the pockets of our customers," he said. "While this may be impolitic to state, it is impossible to deny.”

He made readers think of the most able brain surgeon or lawyer in the local area. Those were considered to have the franchise in their specialties themselves. Would people expect the fees of these experts to be reduced when the top personal tax rate was being cut from 50% to 28%?

At that time, the corporate capital gain tax had been increased from 28% to 34%, effectively the following year of 1987. Buffett said the change would have the negative impact on Berkshire Hathaway (BRK.A)(BRK.B) as the rise in the business value had been and would be contributed a lot by capital gains.

At that time, three major investment holdings including Cap Cities, GEICO and Washington Post had a market value of more than $1.7 billion, nearly 75% of the total net worth of Berkshire. However, as three corporations retained much of their earnings, they delivered only $9 million to the bottom line of Berkshire Hathaway. At year-end 1986, Berkshire had $1.2 billion of unrealized gains in equity investments, and the tax increases which would be charged further on those gains if realized was recorded under deferred tax liability, reducing Berkshire's GAAP net worth.

About the author:

Anh Hoang
Money manager into global equities, especially with US and Vietnam markets. CFA level 3 candidate. Lecturer for Stalla - CFA course in Vietnam

Visit Anh Hoang's Website


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