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How do we decide whether to invest in a project? Discounted cash flow.

For example, suppose you’re thinking of building a factory (or starting a business). Once built, your best guess is that the factory will produce $10 profit every year. Discounting at a 5% required return, typical of stock market investments, the value of that profit stream is 1/.05=20 times the yearly profit, or $200. If the factory costs $150 to build, it’s a good deal and will return more than its costs. You build it. If the factory costs $250 to build, you walk away.

Did you forget to put in after-tax cash flows? Whoops, that's a B- now at best. For example, if the tax rate is 50%, then your after-tax profits are only $5 each year. Now the value of the profit stream is only $100. The factory still costs $150 to build however, so now you’d be a fool to do it. It truly is better to leave your money in the bank earning a quarter of a percent.

Mr. Buffett made an elementary accounting mistake. How did he get it wrong? Implicitly, he is thinking that he pays $100, then gets back $100 for sure, and only the profit is taxed. He's thinking that a 5% rate of return gets cut to 2.5%, which is still better than 0.025%. But when you build a factory or start a business, you are not guaranteed return of principal. You only get the profits, if any. If the government taxes half the profits, that’s like taking half the initial investment away.

This is perhaps an understandable mistake for a financial investor such as Mr. Buffett. In my example, the market value of the factory was $200, and falls to $100 when the tax is imposed. Mr. Buffett doesn't build factories or start businesses, he buys them. Now, Mr. Buffett -- ever the "value" investor -- can swoop in, buy the factory for $100, and a $5 per year after-tax cashflow generates the same 5% rate of return. But nobody will build new factories, and that’s the economic damage.

Ok, now you get an A. Let's go for the A+.

Mr Buffett ignored risk. If somebody offers you a 5% rate of return, risk free, when Treasury bills offer you a quarter of 1 percent, his name is Madoff, not Buffett-Buddy.

Mr. Buffett wants you to think his investments are arbitrage opportunities, and a 2.5% arbitrage is as attractive as a 5% arbitrage. That's false. Investments involve bearing risk, and taxes make those investments directly worse.

Now, the effect of taxes here is subtle. Yes, a 50% tax rate cuts a 5% expected return down to 2.5%. But it also cuts volatility too. Isn't this just like deleveraging? Answer: no, because unless you're investing in green energy boodoggles only available to Administration cronies, the government takes your profits, but does not reimburse your losses.

If the investment makes 10%, you get 5%. If it makes 5%, you get 2.5%. But if it loses 10%, you lose 10%. It's a strictly worse investment when taxed. (Yes, you might be able to sell the losses if the IRS doesn't notice what you're up to... but now you know why Buffett is a "master of tax avoidance.")

And there is always another margin: If rates of return on investment look lousy, just stop investing at all and go on a consumption binge. The estate tax is a big subsidy to the round-the-world cruise and private jet industries.

I am really amazed by how this argument has evolved. Only a few months ago, supporters of the Administration's plans for higher tax rates admitted the plain fact that higher tax rates on investment are bad for growth. But, they argued that higher taxes would be good for other goals, like "fairness," redistribution, or winning elections important for other policies they like such as ACA. (These taxes are not going to put a dent in the deficit.) And we had a sensible argument about how bad the growth effects would be, and how long it would take for them to kick in.

Now they're trying to argue that taxes aren't bad for the economy at all. Some are suggesting higher investment tax rates are actually good for the economy. All in the face of the natural experiment playing out in front of us across the Atlantic. The contortions needed to make this argument are just embarrassing. As above.

It seems clear to me that the Administration wants to raise the tax rate on high income people for political reasons, whether or not they raise tax revenues from such people; witness the deafening silence about reforming the chaotic tax code. The Buffetts of the world who can exploit the loopholes in the tax code and lobby for more will do fine in the new world. But they shouldn't stoop to such obvious silliness to try to fool the rest of us that pain don't hurt.

(Thanks to Cliff Asness who brought this to my attention and suggested some of the arguments.)

Monday morning pop quiz!

Only an observation...if you invent brand-new taxes on the rich...then they will do what they’ve done for the past 100 years....go back to congress and ask for more tax credits. Believe me....it’ll be less than a month after new taxes are created, for new exemptions and credits to be created...if the rich pay campaign contributions to the right folks.

So even if you could find the votes to create new taxes....it doesn’t mean taxes really exist after twelve months. We could invent a 98-percent tax rate, but a guy might only pay $7 in the end because of various credits that he takes.

It’s America, and we know the game.

This is all about politics. Obama is all about wealth redistribution. Raising taxes on the rich is an obsession for him. His is on the record as acknowledging it doesn’t matter if raising a tax on the rich won’t raise much revenue, the symbolic value is more important to him.

Buffett is a shrewd businessman. He likely saw the threat Obama posed to his investment empire and decided the best way to protect himself was to jump on board the Obama train. By being on the inside he can influence policy to best protect his companies and accumulated wealth from harmful rules and regulations in return for his public statements supporting the taxes for the rich that will have little impact on him personally as he is well beyond the wealth accumulation phase of his career. Buffett knows increases in marginal tax rates at the top end serve primarily to limit the middle class individual trying to accumulate wealth. These marginal tax rate increase do little to hurt those individuals who have accumulated great wealth. The holders of great wealth, like Buffett, have much more to fear from taxes on net worth or assets. By being on the inside he steers the Marxists to raising marginal tax rates and ignoring the true “soak the rich” asset taxes.

What Buffett ignores is the appetite of the beast will never be satisfied. Once Boehner caves and Obama has his higher marginal income tax rates, as well as higher dividend and capital gains tax rates, the economy will go into a recession, tax collections will fall, and he will need more stimulus money to shovel at his voting base. at the time of the mid term elections. He will then have to look for more sources of revenue. The useful fool Buffett, assuming he is still living, may find his Marxist collaborator now turns on him and proposes a net worth or asset tax on billionaires.

Let me put this in a simple way that everyone can understand.

This is Obama’s attack on the perceived rich white man.

His people like it because they see the white man as rich and they see themselves as the recipients of the cash.
Obama like sit because even though he is the smartest hybrid that ever walks , he see’s it the same way as his people.

Make the evil white Honky pay.

The whole thing is racism plain and simple.Economics don’t mean squat to Obama because he doesn’t understand economics anyway.He doesn’t understand that when the rich Honky has no more to give, he will have t no more to redistribute. He will keep doing what he is doing now, Print more money until it has no value.

If income taxes are no problem for investors, why doesn’t Berkshire/Hathaway pay theirs?

Stupid me, I can’t tell if you are the author of the analysis. Thank you for posting it, as it helps explain what we are going to be in for as investment dries up.

I would actually like to return to the original Buffet q&a, however. I think it is LONG past the time that we can ignore how much we feed the beast of Government from our earnings. It is self-destuctive to take in income beyond our needs in an environment where it is taxed, and the taxes are used as they are - so pointedly to the detriment of those paying.

So, yes. Pass up the investment. Pay off equity. Lower your profile. Higher taxes need to result in lower revenue to the Government, or there will be no end to what they will take.

Weisenthal and Mankiw respond to the hypocrisy that is Warren Buffet:

To that end, economist and former Romney advisor Greg Mankiw has a short post talking about Buffett as a master of "tax avoidance," wherein he lists four things Buffett does to avoid paying taxes.
Berkshire never pays a dividend (so the jump in dividend tax hikes don't effect him).
Berkshire only trades long-term (so short-term cap gains, which are taxed at income tax rates don't effect him).
He's giving most of his money away to charity.
His children won't pay income taxes on any assets that are bequeathed to them, so an income tax hike doesn't affect them.
None of these are wrong or illegal or anything. And giving your money away to charity is admirable. So the point isn't that Buffett is doing anything wrong, but that he's advocating policies which will have very little effect on him. So if we're going to listen to him because of who he is, it's not preposterous to note how little of an effect rule changes would have on him.

Other folks, in the past, have charged that Buffett specifically benefits from the tax proposals he backs.

GREG MANKIW: Warren Buffett Doesn't Tell You About How He's A Master Of Tax Avoidance