Greg Mankiw attempting to justify carried interest

by Linda Beale

Greg Mankiw attempting to justify carried interest

Greg Mankiw wrote an op-ed in the Sunday Times Money section: Capital Gains, Ordinary Income and Shades of Gray, New York Times (Mar. 4, 2012).

Mankiw notes the historical trend in the US to differentiate between capital gains and ordinary income regarding tax rates (though we have had notable experiements, both in the regular tax and in the AMT, to the contrary). He asserts that there are “good reasons” for the preference for capital gains income–offering only the standard idea of lack of indexation for inflation/deflation as an example.

The purpose of the piece is to justify the carried interest treatment of money managers’ gains from dealing with other people’s money as equivalent to a carpenter who fixes up a dilapidated house and gets capital gains on the sale of the home, though the gains are really paying off the carpenter’s sweat equity. Since the carpenter gets capital gains under our system, he says, why shouldn’t the money manager who does an analogous activity (assuming–which may be a rather big jump– that hedge fund, private equity and other money managers are doing “sweat equity” that adds to the value of the assets under management, and should be viewed analogously to the carpenter).

The problem with making these analogies, especially in the area of capital gains, is that the idea of capital gains is problematic to start with. We’d be much better off with a code that made no such distinction, since there are certainly instances where the distinction is an arbitrary one. Since the line drawing isn’t easy (and it isn’t), then the distinction shouldn’t exist at all in the tax code. That would be the right solution overall.

Nonetheless, the fact that a category is hard to apply generally doesn’t mean that there isn’t a right answer–or at least a better one– in particular circumstances. It is particularly inapt to compare money management with rehabilitation of dilapidated property. Rehabilitation of real property adds “real” value, in that the property is upgraded and will physically last longer than it would have without rehabilitation. Money managers don’t necessarily add any value–they may make money for themselves and others, but there is no real productivity gain in the economy in many (if not most) instances and certainly in any case where the gain is primarily speculative (often the case with hedge funds) or destructive of domestic businesses (often the case with private equity funds).


Private equity fund managers, you will recall, invented the leveraged buyout (or maybe it would be more accurate to say that the idea of the leveraged buyout led to private equity funds). The idea behind leveraged buyouts was to take a stable, money-making company that wasn’t heavily debt-ridden, load it up with debt to cover the acquisition cost of the company, and use the cash flows from the company to pay off the acquisition debt. Private equity funds like Bain Capital could then leverage a minimal investment of their own with the purchased company’s debt to get huge profits, once the debt was paid off with good cash flows (already existing out of the company, with nothing due to the “management” of the money manager). The better the company taken over was, the more its cash flow could be counted on to pay off the debt, the more leverage would be added, the quicker the debt was paid off, and the better the ultimate profit. Sometimes this takeover was relatively harmless for the “good” company, but many times it was harmful–the takeover changes and debt resulted in focus solely on profits and not on long-term investment, and the company’s long-term stability was destroyed. The process was seldom positively beneficial for the company over the long term or for its community (though it may have been for particular shareholders and the managers themselves). The point here, of course, is that the LBO was targeted to (already)”good” companies with low leverage and high cash flow that could easily borrow in the market to cover the cost of the acquisition.

Later, of course, as the age of financial speculation got fully underway, private equity firms started taking over companies that could never expect to pay back the additional debt the LBO loaded them with. The private equity firms made their money in these cases by driving them into bankruptcy and laying off or firing the workers. Equity firms still got their profits out of the deal by selling off the components. But the companies (and especially their workers) were done for–if the companies survived at all, they were just parts of some conglomerate with very different functions.
Making money from managing other people’s money, in other words, is not per se productive for the economy as a whole and is not something we should reward with low taxation that acts as an incentive to the activity. We should recognize the money manager’s take as what it is–compensation for work done–and tax accordingly.

As an aside, I’ll note that it wouldn’t be unreasonable to have a handyman take ordinary income on his share of the profit that serves as reasonable compensation for his labor, but in most cases that’s a difficult facts and circumstances issue for the Service to sort out after the fact. One reason carried interest is such an obvious place to repair the problematic categorization of labor income as preferential capital gains is that there will be a partnership and there will be records of “management fees” and “carried interest allocations”. Given our sophistication about partnership allocations, identifying and classifying the carry as ordinary income is a relatively simple endeavor.

crossposted with ataxingmatter

James Kwak
has a take on it also.