More on Greg Mankiw’s weak arguments for the Bain capital gains preference
by Linda Beale
More on Greg Mankiw’s weak arguments for the Bain capital gains preference
A few days ago, I commented on the weak arguments Greg Mankiw had put forth in his op-ed to support the preferential treatment of compensation for private equity and real estate partnership “profits” partners. He points out the categorization problem–that it is not always easy to be sure what is a “capital gain” and what is “ordinary income”. I concluded along the lines of arguments I have repeatedly made on this blog: the main thing the categorization problem teaches us is that we should eliminate categorization problems that create inevitable inequitable differentiations by eliminating the category difference.
Get rid of the preferential rate for capital gains (and with it the need to distinguish capital gains from ordinary income), and you will in one stroke simplify corporate and partnership and individual taxation tremendously. Much of the Code is invested in trying to prevent smart tax lawyers from using tax alchemy to convert one type of income into another. See, e.g., section 1059 (extraordinary dividends to corporate shareholders), section 304 (sales between affliated corporations treated as redemptions), section 302 (providing tests that, if not satisfied, treat redemptions as dividends if there is e&p), etc.
Uwe Reinhardt makes a similar argument in the Economix blog carried by the New York Times. See Capital Gains vs. Ordinary Income, New York Times Economix Blog (Mar. 16, 2012). Reinhardt uses Mankiw’s own introductory textbook in microeconomics to make the tax equity argument that many have been making about carried interest–it is unfair to tax a money manager at a preferential rate compared to firemen, postal inspectors, college professors, school teachers and neurosurgeons.
In his popular textbook “Principles of Microeconomics,” Professor Mankiw teaches students that “horizontal equity states that taxpayers with similar ability to pay should contribute the same amount.” Well put.
Consider now a person who bought a vacation home for $500,000 and two years later, during one of our recurrent real-estate bubbles, sells it for $1.5 million. That $1 million profit is now taxed at a rate of only 15 percent. If the home had been the principal residence of this person and his or her spouse, half of the $1 million profit would not be taxed at all.
Suppose next that this tax-favored person’s neighbor were a busy neurosurgeon whose many hours of hard, physical and intellectual work earned him or her a net practice income of $1 million during those same two years. That neurosurgeon would pay the ordinary income-tax rate on that income (on average a bit less than 35 percent, because only income over $388,350 a year is taxed at 35 percent).
By what definition of the term would can one call the glaringly differential tax treatment of the real estate investor and of the neurosurgeon horizontally equitable?
Reinhardt goes on to make another of the arguments that I have been pressing for months in this blog–that the assertion that preferential rates are necessary for stock market transactions because they are rewarding investment in the corporations is baloney–most reported gains on securities are from secondary market trades, not from direct investments in corporations.
[T]he proponents of lower capital-gains taxation conjure up an image of, say, Jones purchasing shares of stock directly from the issuing corporation, which then invests the proceeds in new structures and equipment.
More typically, however, sales and purchases of corporate common stock take place among parties quite outside of the issuing corporation. For example, Jones may buy the stock from Chen, who may have reaped a capital gain from once buying and now selling the stock. Chen may have bought the stock from another person not related to the issuing company.
When Jones pays Chen, it is anybody’s guess what Chen does with the money. For all we know, Chen will spend it on a luxury car. Why, then, should any gain Chen enjoys on his or her investment in that stock be granted a tax preference? No new capital formation was supported by this trade in a stock sold by the company years ago.
The ugly truth about the insistence on the capital gains preference is that it rewards people at the top of the income and wealth distribution and serves to maintain the status quo of the allocation of resources. This is what is really meant by “fiscal conservatism” these days–ensuring that resources remain inequitably distributed to the very wealthy who are the “shakers and movers” of society through the influence their money can buy. The right-leaning Supreme Court has made that even more inevitable than it was before, through the Citizens United decision upholding the right of corporations to contribute any amount to influence political campaigns, based on the laughable assertion that such “super-PAC” rights undergird free speech.
crossposted with ataxingmatter
Your Jones and Chen case is an example of the “used car” issue. How much of the price of a new car is based on the fact that the old car has a trade in value. How much of the cash netted in the IPO is BECAUSE of anticipated capital gains? So even the gains of later owners contribute to some degree to the capital in an IPO. Of course trying to figure THAT out would be even more difficult than drawing a line between capital gains and income.
I would argue that we don’t need to encourage more investment for the simple reason that we have already given Wall Street more money than it can come up with productive use for. Investment bankers are people who scream drought while treading water.
Your Jones and Chen case is an example of the “used car” issue. How much of the price of a new car is based on the fact that the old car has a trade in value. How much of the cash netted in the IPO is BECAUSE of anticipated capital gains? So even the gains of later owners contribute to some degree to the capital in an IPO. Of course trying to figure THAT out would be even more difficult than drawing a line between capital gains and income.
I would argue that we don’t need to encourage more investment for the simple reason that we have already given Wall Street more money than it can come up with productive use for. Investment bankers are people who scream drought while treading water.
Inflation. One issue related to taxation of capital gains and capital income is that nominal not real gains are taxed. Consider Reinhardt’s example, except the house was purchased in 1935. The seller would, in fact have realized a huge loss (and it must be a really really huge house).
The solution would be to write a price index (say the CPI) into the tax code so the old price is updated. Then tax the resulting capital gain as income. I think the reason this is not done is that Congresscritters consider the math impossibly hard. It isn’t anymore. It can be programmed into turbotax. Certainly the math is nothing compared to trying to distinguish income and capital gains.
See also historical value depreciation and inadvertant taxation of inventory profits.
What’s the problem ?
Even in the old days it would not have been that hard, (Assuming a once a year adjustment) then you would have a table that says increase you basis by the percent in the table, which would consist of a year and a percent. Not much more complex than the tax tables
Robert, I don’t claim to understand a lot of these things so explain why I pay income tax on nominal gains if I put that $500,000 in a bank to earn interest. But if I buy property, I’ll instead pay capital gains tax on the gain when I sell it. In both cases, inflation eats away the financial gain but we want to somehow compensate for inflation only in the second case. There must be a good reason.
Guessing the logic has to do with double-taxation in that interest payments paid by banks or corporations for their corporate debt are deductible expenses from their taxable income. Thus for tax revenue equivalency, individuals pay taxes on interest income received, while corporations shield taxes on interest income paid.
For capital gains, their is no tax shield on the “issuer” side.
Say you and I partner to open a flower shop. You’ve got skills in running a flower shop and I’ve got capital. I provide 100% of the capital for 50% of the equity in the partnership, and you take a salary from the revenues generated by the store. You pay income tax on your wages, and when we sell the store in 5 years at 300% of the original capital, I pay capital gains on my share less my basis of 100%, so capital gains on 50% of original capital, and you pay cap gains on your share less your basis of 0%, so 150%. Note that cap gains are paid in total on the full appreciation, i.e., 200%.
If instead we don’t know each other, but contract with Robert such that he’ll take a 20% stake in the business for his matchmaking services, Robert would also pay capital gains and the total capital gains paid to the government by the 3 of us would still be 200%.
Okay m.jed but the question remains, why one would argue to protect one type of investment income from inflation but not the other type.
guessing again here, but aside from the double-taxation issue, there’s the issue of relative certainty. Interest payments are due contractually, whereas capital gains are speculative, in the sense that the issuer of the security has no contractual obligation to provide a return on investment.
Yes. Or at least maybe. But there seems to be no downside risk in hedge fund management fees treated as ‘carried interest’. No gain, no fees,or at most standard management expenses (somebody pays the utility and space rent bills). So a little potential downside on the margins but nothing like the gains on the upside. Seems like another case of socializing losses (by zeroing them out and perhaps giving an allowance against actual operation expenses) while privatizing gains. At a tax discount. In what way are hedge fund operators speculating? Heads we win, tails you let us write off all expenses as business deductions?