A Charity Premium and Premature Taxation, pt 2.

Previously we discussed whether or not there was a charity premium–whether money given to charity better invested for societal good than money given to the government. Before I (nervously) get into Part II, I wanted to briefly address some of the comments. I agree with Tom’s suggestion that money taken away from the government wouldn’t result in cuts in the most wasteful government programs but rather some of the least well-funded and socially useful. It’s a sad truth that the worst spending programs–farm subsidies, defense, expensive pensions–are the best represented by lobbyists. It’s unfortunate that the farm bill protects itself by holding school lunches hostage, and odd that it implies we can never get rid of pork barrel projects. The solution is not to starve the government into giving up its pork, but to first get rid of the pork, and put the government on the diet after (of course, it’s hard to starve someone with a triple-A rated credit card). We’re also not suggesting that charity replaces government services, or that government services could ever replace charity. Given the status quo balance between charitable donation and tax revenue, should we tip it a bit to encourage more charitable donation or tip it the other way to increase tax revenue (or keep the status quo)?

I bring all this up because of the recent reports on how Bill Gates and Warren Buffett are lobbying America’s billionaires to donate at least half of their wealth to charity. They would raise $600 billion if America’s portion of Forbes’ 400 richest list sign up. Buffett, of course, has pledged over 99% of his considerable wealth, much of it to a foundation that doesn’t even have his name on it. I think most reasonable people would agree that this type of generosity is pretty noble from all involved.

Bill and Melinda Gates.

Buffett made his currently-valued $47 billion fortune as a shrewd investor. He built up his investment machine, Berkshire Hathaway, from the ground up. Yet despite his wealth, he has always lived a relatively frugal life. He famously still lives in the Omaha house he purchased in 1957 for $31,500 ($242,000 in 2010). His biographer implies in The Snowball that Warren’s frugality was due to his drive to always make more money–instead of buying a new suit, Warren thought about how much money he could make if he invested the money instead, in his own company.

Money, of course, doesn’t compound in value solely for great money managers. Entrepreneurs who reinvest in their own business can afford to take less venture capital, increase their personal stake in the company, and amass greater fortunes later on. Taxing individuals at high rates early in their careers reduces their future net worths because it deprives those individuals of needed capital for their businesses. Of course, that’s also money the government uses in funding its programs.

Now if those future billionaires are intending to donate a large amount of their fortunes to charitable causes late in life or upon death, I wonder if it would be more efficient for the government to let the individual donate/”invest” the money for later instead of the government spending it now, as we theorize, inefficiently.

Perhaps there could be a plan where individuals who [contractually?] pledge to donate some very high percentage of their fortunes to pre-vetted charities should be taxed at lower rates until they get there. So for example, instead of taxing Warren Buffett at the highest rate all throughout his millionaire years when he was still building up Berkshire Hathaway, it could have been better to tax him at a lower rate then, wait for him to use that added capital to amass an even larger fortune than he has today, and then have him donate 99% of that even larger fortune.

One problem with this is that the government loses out on individuals who end up losing their wealth, so it’s a gamble that certain people will pay out handsomely in the future. Another criticism is that with the extra capital, people will either be more risky with their investments, or more profligate in their consumption, resulting in a smaller fortune in the end. These could be balanced out by the society/government achieving a much higher sum return (95% to charity might outweigh the yearly 4% additional taxes, particularly after accounting for the charity premium), and the fact that the wealthy will still be motivated by competition to do better, and by inheritance to still maximize the lesser portion of money their descendants get. There’s probably an upper-limit on consumption for most people. A lower and more palatable tax rate might also see less tax evasion and trickery from the wealthy. Finally, there’s an altruism/reputation bonus from charitable donation that the hated estate tax could never replicate.

This idea of course captures the existing anti-tax sentiment that high taxes can lower the productivity of the wealthy (as Alex mentioned, the dead-weight loss of taxation). The difference is that instead of saying the government makes up for the loss in tax revenue only through some overall higher GDP for the country, it also adds a likelihood for society to capture the increased productivity of those particular individuals through promised large charitable contributions later in life.

7 thoughts on “A Charity Premium and Premature Taxation, pt 2.

  1. Where exactly would the cutoff be for qualifying for the “Warren Buffet of the Future” exemption? If simply anyone was allowed to forgo paying taxes until their wealth reached some impossible level and/or until they died, I think almost everyone would opt into this system, or at the very least a large enough number to create nightmarish financial situation. Even if you assume increased charity and whatever charity premium exists will counterbalance the decrease in tax revenue at some juncture in the future, in the short term there would be a huge decrease in the total amount of money being spent on socially valuable programs. If you allow only those who have sizable amounts of capital already make such a contractual arrangement (say, millionaires) you could probably reduce to somewhat manageable levels the impact of the time-lag of the eventual increase in charitable giving, but you’d still need to be really careful about properly limiting the ability of such individuals to spend their money freely. Realistically, you would have to find a way to ensure that individuals committed a certain amount of their income to investing in building their fortune, since even given that there is an upper-limit on consumption said upper limit is, for most people, *really* high. On the same note, you’d probably have to toss some sort of limitation upon how much money they could spend on any sort of personal consumption, since otherwise the tax-free lifestyle is just begging to be abused.

    Mind you, such restrictions aren’t unheard of — restrictive covenants in loan agreements are quite common (and in a sense, the type of contract you talk about could possibly even be seen as a loan agreement of sorts). It’s just that if you include these types of covenants, and effectively guide the investing and spending activities of all these potential Warren Buffets, I’m not sure you’ve really created a system all too much different than taxation. It’s not as though those individuals would actually have full control of their ‘income,’ after all, and signing over their financial autonomy and freedom in their consumption habits for the rest of your life seems to be a fairly oppressive contract to expect anyone to willingly enter into.

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  3. Uhm, this may be a dumb question, but I thought that this idea (not exactly “starving the government” but more “rewarding giving to charity”) was why charitable donations were tax deductible? Pledges to give a certain amount of your estate don’t count for this (except in terms of estate taxes later on), but transferring your assets over to a foundation (even if that foundation is in your own name) does count, to my knowledge, so Gates and Buffett are actually already taking great advantage of this system.

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  5. I knew as I was writing this that it’d get a lot of heat. Thanks for reading, guys.

    Trevor, I think the process would be more akin to an application than a simple opt-in. One prerequisite should certainly be being a multimillionaire/established investor already. Instead of restriction consumption/action guidelines, which I’d also like to avoid, I think you could simply have some minimum donation promise taken out of the estate. I don’t think people will end up overconsuming for the same reason that they don’t overconsume with the expectation of the estate tax kicking in–it just reduces the inheritance for their descendants. Alternatively, maybe these individuals could put the money into investment funds that they could never withdraw from (but importantly still control the voting rights of those shares), but nonprofits would at some set point in the future. Anyway, I’m not trying to come up with a great idea (this probably isn’t one) so much as advocating for some plan for the Buffetts of the world to have more time to invest their money for a bigger donation.

    Emily, I think this doesn’t replace tax deductibility; it would supplement it… sort of like advance deductibility. The idea is that if forty years ago Buffett had been able to pay less taxes and put that money into Berkshire Hathaway, he’d be even richer today and his donation would be even larger. Instead, that capital he could have used to reinvest in his company was sent to the federal government. And the money he is donating today is what he’s accumulated *after* taxation.

  6. I realize you’re trying to advocate a specific plan here — obviously any advantage there would be in the hands of someone trying to nitpick away at your proposal, since assuming any such plan could work it would need be far more complex than you could reasonably come up with yourself. However, even on the more conceptual level it seems difficult ex ante to have any clue whether simply being a wealthy investor has any sort of reasonable implications for reliable future results. If we had the capability to make such nuanced determinations about the future returns on our hypothetical tax-free money managers, Social Security privatization would be the Best Idea Ever as opposed to a highly contentious notion.

    I also think that perverse incentives towards consumption would be more pronounced than you think. There’s enough of a market for clever lawyers to deal with the consequences of estate tax that we already know people are trying to game the system to maximize the assets they and/or their heirs have available. Even if you don’t think that anyone would abuse a tax-free lifestyle for their own benefit, the implications of this program for most of the heirs of those who entered into it would probably be negative — if you assume the percentage required for eventual charitable donation is at least equal to the tax rate initially avoided, the heirs would end up with less than they would under the status quo.

    Additionally, I think the idea of giving away dazzling percentages of your wealth to charity is something which is an obvious idea for someone who had $5b (I think Gates and Buffett are dead on with their efforts), but would probably seem like a ridiculous idea to anyone with $5m. Someone who is capable of providing for all of their foreseeable descendants to live whatever sort of lives they could reasonable want while *still* having billions of dollars to dispose of is in MUCH different shoes than someone whose wealth is just beginning to reach into the area where the estate tax applies. Today, Buffett can give away 99% of his wealth and still be very, very well off, but if you had told a 30 year old Buffett he could avoid taxes for the rest of his life in exchange for giving away 99% of his wealth to charities upon his death, I doubt he would have been as willing to gamble so thoroughly with his ability to provide for his heirs.

    Allowing people to place aside money in some sort of separate trust they couldn’t withdraw funds from themselves which would eventually yield a payoff to charities sounds more promising, though honestly I’m not sure how much that differs from a slight reworking of charitable remainder trusts — I’m too much of a dilettante in the trusts and estates field to be positive.

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