Relevant and even prescient commentary on news, politics and the economy.

The Effect of Capital Gains Tax on Investment

Matt Yglesias, servitor to our corporate overlords, suggests that the reduced capital gains tax rate paid by rentiers like Willard Romney is really a very, very good thing.  To wit:

The main reason Romney’s effective rate is so low is that the American tax code contains a lot of preferences for investment income over labor income.
. . .
But this is definitely an issue where the conservative position is in line with what most experts think is the right course, and Democrats are outside the mainstream.
.  .  .
That’s the theory, at any rate. It’s a pretty solid theory, it’s in most of the textbooks I’ve seen, and it shapes public policy in basically every country I’m familiar with. Even researchers like Thomas Piketty and Emmanuel Saez (see “A Theory of Optimal Capital Taxation”) who dissent from the standard no taxation of investment income position think capital income should be taxed more lightly than labor income. Empirically, it’s a bit difficult to verify that variations in capital gains tax rates and the like really are making a material difference to investment levels. But then again the data is noisy.

Scott Lemieux at LGM demurs.

Sure, if you 1)accept the premise that reducing or eliminating capital gains taxes will result in productive infrastructure investments rather than worthless accounting tricks, 2)ignore the economic benefits created by consumption, 3)assume that significant numbers of people will forgo money for doing nothing just because the profits will be taxed , and 4)ignore the fact that in most jurisdictions consumption is also “double taxed,” then reducing capital gains taxes looks good.   But since all of these assumptions are (to put it mildly) highly contestable, it’s just question-begging.

My response to Matt is that in my jaundiced opinion, you might as well consult The Necronomicon of Abdul Alhazred as an economics textbook for an issue like this; and that in a world that has on the one hand Krugman, Thoma and Delong, and on the other Fama, Cochran and Cowan, a consensus among experts is about as likely as lions lying down with lambs for some purpose other than a quick snack.

To Scott I say, why assume or ignore anything when that oh-so-noisy data is readily available?

Graph 1 shows the capital gains tax rate and year-over-year growth in gross domestic private investment (GPDI,) each presented as a percent.  If Matt and what he calls “the mainstream” are right, then there should be a negative correlation between the tax rate and investment growth, since higher taxes would be a disincentive to investment.

Graph 1  C G Tax Rate and GPDI, 1954 – 2011

Instead, what we find is that over time, as the capital gains top rate has gone down, so has GPDI.  This is indicated by the downward slope of the best fit straight lines through each data set.  The best fit lines are based on the data through 2008, so the huge 2009 negative in GPDI is not represented.

One way to handle noisy data is to superimpose a moving average.  The dark heavy line that snakes up to a top in 1978 is an 8-Yr moving average.  This top corresponds exactly with the last year of the 40% Cap Gains Tax rate.  The purple horizontal line is the period average of GPDI YoY growth from 1954 through 2011.   Note that until 1986, the 8 Yr line is mostly above the long average line, and since 1986 it is mostly below.

This is not because the bottoms in the GPDI data set are lower since 1986.  A quick look shows that, except for the 2009 plunge, they are not.  It is because the peaks are lower.  The table gives a count of extreme data points for GPDI growth, before and after 1982, the year the Cap Gains rate was reduced to 20%.

Even at a detail level, it appears that a higher tax rate corresponds with a higher rate of investment growth, as both curves peak in 1978.

Graph 2 provides a close-up view of 1985 through 2005.

Graph 2  C G Tax Rate and GPDI, 1985 – 2005

When the Cap Gains tax rate was increased from 20 to 28% in 1987, the rate of investment growth increased from 1.4 to 5.2%, and stayed at about that level until it was derailed by the 1990-91 recession.  Then from 1992 through 2000, 8 of 9 years had GPDI growth above the long average (purple line,) an unprecedented occurrence.  Granted, the last three of these years were at the lower C G Tax rate of 21.19%, instituted in 1998.  But also note that this decrease did absolutely nothing to spur increased investment.

Cutting across the data in a different way, Graph 3 presents a scatter plot of the C G Tax Rate and YoY GPDI growth, each presented as an 8 Yr average.

Graph 3 Scatter Plot of GPDI Growth vs C G Tax Rate, Smoothed

Even with smoothing, there’s a lot of scatter.  No surprise, since many other factors can affect investment: business cycle, commodity price shocks, wars, etc.  I’m tempted to say the obvious relationship is that a higher C G Tax rate leads to higher investment, but I don’t want to get into a correlation-is-not-causation brouhaha.  So I’ll simply say that the idea that lowering C G taxes leads to increased investment – and therefore increased economic growth – is not only unsupported by the data, it is refuted by the data, and therefore contrary to fact.

So, once again, we find a mainstream economic idea that is only valid in some imagined alternate reality.

Capital Gains Rate data can be found here (Returns With Positive Net Capital Gains Table, 1954-2008) and here.  There are a few slight discrepancies between these sources, mostly in transition years.  I have used the maximum tax rate, column farthest to the right in either table.
Gross Domestic Private Investment is FRED series GPDI.

Cross posted at Retirement Blues

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Bartlett: Mitt Romney, Carried Interest and Capital Gains

Via  Taxprog blog:

Bartlett: Mitt Romney, Carried Interest and Capital Gains
New York Times:  Mitt Romney, Carried Interest and Capital Gains, by Bruce Bartlett:

A key reason for Mr. Romney’s low tax rate is that a very substantial amount of his income comes from capital gains – 51% in 2011 and 58% in 2010. Capital gains, no matter how large, are taxed at a maximum rate of 15%, whereas wage income can be taxed as much as 35% by the income tax plus taxes for Medicare and Social Security. The latter two are not assessed on capital gains.
The New York Times recently commented in an editorial that while the carried interest loophole is unjustified, the core problem is lower tax rates on capital gains generally. Said The Times, “As long as income from investments is taxed at a lower rate than income from work, there will be no stopping the search for ways, legal or otherwise, to pay the lower rate.”
The view that capital gains should be treated as ordinary income for tax purposes is one that is widely shared by liberal tax reformers. They got their wish, briefly, from 1987 to 1990 because Ronald Reagan agreed to raise the tax rate on capital gains to 28% from 20% in return for a reduction in the top rate on ordinary income to 28% from 50%, as part of the Tax Reform Act of 1986.
There are three big problems, however, with taxing capital gains at the same rate as ordinary income.


First, even if that were the case, capital gains would still be treated more beneficially, because the taxes only apply to realized gains. …
Second, there is a problem with inflation insofar as capital gains are concerned. Many academic studies have shown that a considerable portion of realized capital gains simply represent inflation, rather than real increases in purchasing power. …
Third, it is a fact of life that those with great wealth are the principal beneficiaries of the capital gains tax preference, and they exercise influence in our political system far out of proportion to their numbers. …
[I]t is a pipe dream to believe that eliminating the capital gains preference is the key to fixing the carried interest loophole. It can and should be addressed by treating carried interest as ordinary income, without requiring that all capital gains be taxed as ordinary income.

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Romney and Private Equity’s Questionable Schemes for Paying Very Little Tax

by Linda Beale

Romney and Private Equity’s Questionable Schemes for Paying Very Little Tax

Presumably any American who wants to be informed is aware that GOP presidential candidate Mitt Romney‘s claim to business acumen resides in his experience at a private equity firm that made much of its money by ramping up debt at purchased firms and using that debt to repay whatever (usually relatively small) investment the equity firm partners made in what has come to be known as “LBO” deals (for “leveraged buyout”).  In LBOs, the equity firm investors almost always do well to exceedingly well, using mostly other people’s money.

Not so generally for the workers in the bought-out company.  The “rent” profits of the equity firm are often on the back of the workers, who may get fired in favor of outsourcing their jobs or get stuck in a rut, as productivity gains go to the new managers and owners and not to the workers.  At the least, the high debt load makes it very difficult for the company to succeed and certainly difficult for it to give its workers a fair shake.   Remember that one of Romney’s gaffs was to admit that he enjoys firing workers.
Why anybody thinks this kind of winner-take-all, leverage-’em-up mentality of private equity firms suggests the kind of leader desirable for a democracy that purports to provide genuine opportunity for all classes of citizens to live a decent life is beyond me.

But even if the very nature of the business and the common tools of over-leverage and “rent” profits for a very few already at the top don’t give voters cause for pause, then there are the many ways that private equity firm partners manage to avoid paying their fair share of taxes, which ensures that more of the tax burden falls on the less-well-off, that are worthy of consideration, even if candidate Romney has not (as his campaign claims) benefited from them personally.  That is because if Romney is elected president, his views on the acceptability of aggressive tax strategies of questionable legality will matter.  We should know what kinds of tax schemes are routine in the business that he touts as good evidence of his ability to serve as president of this nation–especially if some of them are obviously poor policy (the carried interest treatment) or highly questionable tax avoidance schemes (the management fee conversion waiver scheme).

1. Carried Interest   (More after the jump)

The best known way private equity firm partners reduce taxes is by earning their compensation in the form of “carried interest” and claiming that such profits should be treated the same way a real capital investment in a partnership is treated, even though it is awarded as compensation for their purported management expertise and work and not as a return on an actual investment made.   That is, they claim they are profits partners in the firm and that their compensation is a distribution of the partnership’s profits (usually from gains on sales, and hence eligible for preferential capital gains) to them rather than compensation income.  As such they benefit from the extraordinarily preferential rate for capital gains in the current law as enacted under the Bush administration (generally 15%).  Carried interest is the primary reason that candidate Romney has to pay such a very low rate of taxes on his income from his business.

The Internal Revenue Code (the codification of the federal statutes governing the federal income tax) does not include a specific provision governing profits interests and indicating that such “profits” partners should be treated as actual partners in a partnership (without that partnership interest itself being subject to tax as compensation) entitled to receive capital gains distributions.  Accordingly, as one partnership tax treatise puts it, the tax treatment of a transfer to a “service partner” of a “profits interest” for services “has been uncertain” because “[n]o provision of the Code specifically exempts from taxation the receipt of any partnership interest in exchange for services.”  Willis & Postlewaite, Partnership Taxation, 6th ed, at 4-124.    There is some case law about profits interests, but those cases made it even less clear how and when such interests should be taxed.

Finally, the Service resolved the issue with administrative authority (heavily lobbied for in the interests of equity partners and real estate profit partners, in particular) in Rev. Proc. 93-27 (and later proposed regs and other items) that does not treat the issuance of a compensatory “profits interest” as  a taxable event in most instances.  The main reason for the treatment may well be the so-called “Wall Street Rule”–once incredibly wealthy taxpayers hire sophisticated, high-priced lawyers to produce opinons supportive of a taxpayer-favorable interpretation and then operate as though the Code blesses a particular activity, it is hard for tax administrators to issue regulatory authority that treats that activity differently.

2, Management Fee Conversion Waivers
But there is another lesser-known aspect to the compensation that private equity fund partners earn for their services in their private equity firms–the management fee.  Most explanations describe this as  compensation paid for services that is subject to taxation at the ordinary rate (just like a secretary’s wages would be).  But that disregards a practice that exists among a significant number of equity firms (the Times article linked below says about 40% in 2009) that are willing to take aggressive positions to avoid paying taxes and can afford to pay the tax professionals to provide a way to do it–the management fee waiver conversion scheme.

The conversion of management fees from ordinary income to capital gains is purportedly accomplished by “waiving” the fees (not necessarily across-the-board throughout the life of the firm, but often selectively and on a quarter-by-quarter basis),  Instead of getting fees, the partner claims they are “converted” to a share of related profits –i.e., they become an additional carried interest–and hence eligible for treatment as (deferred) capital gains from the firm. 

Some tax professionals think this conversion waiver works.  Much of this is again the “Wall Street Rule”–the claim that lots do it, the IRS has known about it, and oh it should be justifiable because now the “fee” is (sort of, maybe, kinda) at risk.  It is not really at risk in the way we ordinarily think of investment risk, since these are pre-tax dollars — the managers are not putting after-tax dollars at risk like any other investor is doing.  And as Vic Fleischer commented to the Gothamist blog, “there is a tension between economic risk and tax risk …. The way Bain set it up there’s not much risk at all, so it’s hard to see how this income should receive capital gains treatment.”  Christopher Robbins, NY AG: Bain Capital and others may have skirted tax law, the Gothamist (Sept. 2, 2012). 

I’d guess  that most professionals do not think the conversion scheme works, at least not in most instances.  This would be especially true for those who consider that interpretations of the law should further coherent bodies of law that work as fairly as possible.  And even more tax professionals likely think that the partnership rules should be adjusted to ensure that it doesn’t work, since otherwise we are perpetuating inequities in the tax system that favor the already incredibly rich.

The conversion waiver issue has come to the attention of the public now because the New York State attorney general is investigating private equity firms who may have engaged in this conversion waiver practice.  See Nichnolas Confessore et al, Inquiry on Tax Strategy Adds to Scrutiny of Finance Firms, New York Times (Sept. 1, 2012) (noting that the AG’s subpoenas, issued by the AG’s Taxpayer Protection Bureau, cover firms like Kohlberg Kravis, TPG Capital, Apollo Global, Silver Lake and Bain, and that Bain partners may have saved more than $200 million in federal income taxes, $20 million in Medicare taxes).
It’s not clear on what grounds the New York AG is investigating this issue, which appears on the surface to be primarily a federal income tax issue.  It could be some sort of state-law fraud claim but it could also be a claim that underpayment of state taxes routinely results from the filing posture taken,  Equity partners in firms using the conversion waiver would presumably be able to save on state income taxes through either rate preferences and/or deferral, depending on the state and how much the state’s laws build on the federal filing.  Though New York State does not have a preferential rate for capital gains, if the timing of reporting the income is set by the conversion waiver, the deferral would amount to a significant state tax savings that deprives New York of needed revenues.

[Aside:  By the way, some of the information about the management fee conversion waiver first came to broad public attention in connection with Bain and the trove of documents released at Gawker.com.  See John Cook, The Bain Files: Inside Mitt Romney's Tax-Dodging Cayman Schemes, Gawker.com (Aug. 23, 2012) (noting that the huge cache of Bain financial documents "shed a great deal of light on those finances, and on the tax-dodging tricks available to the hyper-rich that [Romney] has used to keep his effective tax rate at roughly 13% over the last decade”).   These documents, and the further analysis articles available at the Gawker.com site, are worth considering for their own revelation of what Romney’s real business is like and how that does (or doesn’t) suggest he can help our economy as president–it is a business where “opaque complexity” allows the “preposterously wealthy” to engage in “exotic tax-avoidance schemes”, according to the Gawker.com article.  (I have not yet personally perused much of the 950 page trove on Gawker.)  That said, Romney’s campaign issued a statement indicating that the candidate has not benefited from the conversion waiver practice.  We have not, of course, seen enough of Romney’s tax returns and supporting information to be able to judge this matter independently.  The focus on the conversion waiver thus provides yet another reason why candidate Romney should release 10 years of tax returns as other candidates have done.]

There are two additional readable pieces on this conversion waiver issue, plus a scholarly article that anyone wanting to better understand the details can peruse.  Vic Fleischer, a tax prof at Colorado who made his original contribution to academe by writing about carried interest, has an article that sets out the issues well, with an example contrasting the significant difference in after-tax results for a real investor compared to a profits-interest purported investor.  See Victor Fleischer,What’s at issue in the private equity tax inquiry, DealBook, New York Times (Sept. 4, 2012). See also Brian Beutler, Did Bain Capital Execs Break the Law Using a Common Tax Avoidance Strategy? Talkingpointsmemo.com (Sept. 3, 2012). The academic piece is Gregg Polsky, Private Equity Management Fee Conversions (Nov. 4, 2008).  The following two paragraphs are from the conclusion to that piece.

In fact, there are strong arguments that it is not. While managers argue that the safe harbor in Rev. Proc. 93-27 applies to the additional carried interest, there are both technical and conceptual claims to the contrary. Without the protection afforded by Rev. Proc. 93-27, the additional carried interest would be taxable upon receipt if it has a market value capable of determination. Both the context in which the additional carried interest is issued and the specific design features of the typical additional carried interest support the view that additional carried interests are significantly easier to value than prototypical profits interests.Under existing case law, this would mean that the additional carried interest is taxable upon receipt as ordinary income to the extent of its fair market value.

The IRS also has strong arguments under section 707(a)(2)(A), which recasts transactions that are artificially designed as partnership transactions in order to obtain tax benefits, such as character conversion. In the context of fee conversions, the most critical fact that favors section 707(a)(2)(A) re-characterization is the manager’s very limited exposure to risk. As a result, section 707(a)(2)(A) likely applies to fee conversions. If so, the manager’s attempt to convert the character of their management fee income would be thwarted.

cross posted with ataxingmatter

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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

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Is Capital Gains Tax Law Biased Against Low Income Investors?

Paul Caron at Taxprof blog points us to capital gains

Is Capital Gains Tax Law Biased Against Low Income Investors?

Min Dai (National University of Singapore, Department of Mathematics), Hong Liu (Washington University, Olin Business School) & Yifei Zhong (University of Oxford, Mathematical Institute), Is Capital Gains Tax Law Biased Against Low Income Investors?:

The current capital gains tax law stipulates that the tax rate for short-term investment (gains and losses) and long-term losses is equal to an investor’s marginal ordinary income tax rate, which implies that this rate for low income investors can be significantly lower than that for high income investors. In an optimal consumption and investment model with asymmetric long-term/short-term tax rates, we show that even though capital gains tax rates for low income investors are always lower than those for high income investors, the current capital gains tax law is significantly biased against low income investors in the sense that these investors are willing to pay a substantial fraction of their initial wealth to gain the same capital gains tax treatment as high income investors have. The main reason is that investors have the option of realizing capital losses at the (higher) marginal ordinary income tax rate and realizing capital gains at the (lower) long-term tax rate and the value of this option is significantly lower for low income investors than that for high income investors. This result is robust to various changes in model parameter values. Raising capital gains tax rates for low income investors to the levels for high income investors would reduce the bias and substantially increase stock market participation by low income households. With regard to the optimal tax realization strategy, in sharp contrast to most of the existing literature, we show that it can be optimal to defer short-term capital losses beyond one year and to realize short-term gains.

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Keynes and Picasso: Stimulative Conspicuous Consumption?

by Bruce Webb

Digby points us to the following NYT piece: At $106.5 Million, a Picasso Sets an Auction Record with what is in one sense an understandable bitter comment “Hey, dead artists need work too.” And as a comment on the odd priorities of our plutocracy a reasonable moral judgement, but as an economic evaluation? Maybe not. And perhaps some of the real economists can fill me in here.

Per the story the last time this work changed hands it was for $19,800. Which should mean that someone is exposed to capital gains on pretty much the full amount of the sales price. Even at 15% that is a reasonable chunk of change. Plus the seller has to put the net dollars SOMEWHERE, even if that is just buying more fine art. Now nothing guarantees that the proceeds will get spent/invested in the U.S., but unless the seller spends it all on tons of Bolivian blow it all gets injected somewhere in the world economy. Meanwhile the buyer had to free up capital from somewhere in order to pay for the painting, and while it is possible this was done by selling assets for a loss, or in the course of a tax-free exchange, chances are good that this ended up with another taxable event and/or unlocked previously unproductive capital. Plus the buyer had to come up with a substantial commission, another taxable event (to the dealer) and one likely to inject some spending of its own. Plus someone is going to receive a good sized insurance premium payment, and who knows the proximate result might be some blue collar jobs going to armed guards.

Now not every instance of conspicuous consumption has benign effects, huge money spent on diamonds, or ivory, or furs from endangered species means dollars ending up in the hands of organized crime or to the extent that there is a difference in the hands of kleptocratic dictators, but the transfer of existing pieces of fine art is on balance pretty benign (as opposed to true antiquities).

Obviously circumstances alter cases, there are a bazillion possible variables that might make this deal actually economically pernicious, but on balance aren’t the odds much better than even that this injection of $120 million (including commission and costs) into the economy has a net Keynesian effect? I am not saying that the path to economic nirvana runs along the road of the worlds top 400 billionaires deciding to spend $150,000,000 each on fine art, or collectible stamps or coin, particularly if they are just selling things back and forth within the same pool, but at a minimum some dollars are shaken free in the form of tax, commissions or wages at each transaction. And it is not like they are crowding most of us out of that particular market, I will never be bidding on a Picasso anything.

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Carried Interest: Senate Getting Swayed by Lobbyists

by Linda Beale

Crossposted with Ataxingmatter

Carried Interest: Senate Getting Swayed by Lobbyists

The Senate started discussion of the “extenders” legislation on Tuesday. IN the House version, HR 4213, there is finally a carried interest provision, though it is a weak one. (Recall that carried interest is the amount that managers of hedge, equity and other partnerships charge for managing assets of the partnerships, so it is compensation income but these “profits” partners claim that their allocations of capital gains from sales of partnership assets should retain capital gain treatment as such allocations do to partners who have contributed capital to a partnership, even though it is a payment for the managers’ services. See earlier postings on A Taxing Matter, here and here (JCT reports) and here (Weisbach study). ) After several years of attempts to tax wealthy fund managers on their compensation the same way that others are taxed–i.e., at ordinary income rates–the House included a revenue offset provision in the extenders bill that will eventually tax 75% of the carried interest at ordinary income rates.

Lobbyists responded that they would work on the Senate to make the bill less distasteful to their clients. So they are lobbying for even lower rates in the Senate. And they are focusing on what they think will be a sympathetic case–family partnerships that run family real estate businesses. A substitute amendment is under consideration, which would change the percentages and grant even more favorable preferential treatment to fund managers for their compensation for services–65% generally, with an even more favorable 45-55 split if the assets are held by the partnership for at least seven years. Text of the substitute amendment, a summary and other information is available at the Senate Finance Committee website on HR 4213.

Just a few comments:

1) the purported economic justification for privileged treatment of fund managers–that there won’t be as much management of funds or funds that invest–is absurd. Fund managers were making money head over heels but still will make most of that money even if they pay taxes on their services income the same way ordinary folks do. They won’t stop acting as fund managers if they have to pay ordinary income rates on their income. There will not be any fewer funds if the managers don’t get the special privileged tax rates that they claim for carried interest. There won’t be any less investing activity. There won’t be any great harm to family partnerships or real estate partnerships or hedge funds or private equity funds. None of the managers of any of these funds merit the exceptionally lucrative tax break that they have been claiming in the carried interest mechanism, and none of them will receive so low a return that they will quit the business if they have to pay the same tax rates that ordinary Americans pay on their services income.

2) Any provision that splits the rate structure is arbitrary, makes the tax Code more complex, invites gamesmanship on holding periods, and will be passed only as a way to appease wealthy donors so that they will continue contributing lots of funds (that should have been paid to We the People as taxes) to individual House and Senate campaign chests of those that are holding out for a “softer” bill.

3) there is no justification whatsoever for a half-way measure in which fund managers are privileged to pay low rates on a substantial part of their income from services, while ordinary taxpayers continue to pay ordinary rates. That sort of “compromise” merely proves that the House and Senate are willing to sell out ordinary taxpayers and continue to favor the wealthy and that fairness loses when the House or Senate is thinking about campaign contributions. The split just proves the outsize influence that lobbyists for the shadow banking system still hold over Congress, even though the unregulated shadow banking system (including hedge and private equity funds and real estate partnerships) was a significant cause of the financial crisis.

4) Accordingly, the House compromise, and the Senate substitute, make a mockery of the basic fairness concept in taxation. The problem with carried interest is that it allows a few financial managers a preferential tax break on their compensation income. The entire Congress is now aware of the fairness problem. In spite of their awareness that there is no justification for the tax break that these wealthy fund managers have claimed for years, lobbyists for the privileged few who have enjoyed this tax break are pushing to retain the break. Since we know that the Senate and House understands that this is an unfair tax break that ordinary Americans do not enjoy and that cannot be justified in any way as a necessary tax expenditure to encourage an activity, then it must mean that the House and Senate are too corrupt to pass decent legislation that treats these wealthy fund managers like ordinary people.

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New Year’s Tax Resolutions

by Linda Beale

A quote from Amartya Sen, and my New Year’s Tax Resolutions (for Congress and the Obama Administration)

The time between December 30 and January 4 seems to be filled with lists. Along with the ever-present list of “to dos” that haven’t been done and still are hanging around waiting for our attention, there are everyone’s “10 best” lists (e.g., the ten best movies–regretably, I don’t think I saw ten new movies in 2009, so can only say I thought Slumdog was a decent showing) or their opposite (e.g., the ten worst celebrities of the year, every one of them with Tiger Woods and Gov. Sanford firmly placed near the top). And of course there are those New Year’s resolutions that we are supposed to deliberate over and then deliver on when the New Year rolls around–mine is to join my hubby in his morning walk and to give up doughnuts completely.

Not being one to gather quotes all year just for this final celebration, here’s one quote that I believe is worth thinking about as we head into the new year. Amartya Sen writes, in “The Idea of Justice” (Belknap Press 2009), at 32:

Being smarter may help the understanding not only of one’s self-interest, but also how the lives of others can be strongly affected by one’s own actions. Proponents of so-called ‘Rational Choice Theory’ (first proposed in economics and then enthusiastically adopted by a number of political and legal thinkers) have tried hard to make us accept the peculiar understanding that rational choice consists only in clever promotion of self-interest (which is how, oddly enough, ‘rational choice’ is defined by the proponents of brand-named ‘rational choice theory’). Nevertheless, our heads have not all been colonized by that remarkably alienating belief. There is considerable resistance to the idea that it must be patently irrational–and stupid–to try to do anything for others except to the extent that doing good to others would enhance one’s own well-being.”


In light of Sen’s helpful clarity about the ridiculousness of ‘rational choice theory’, I also offer the following as the resolutions that I wish Congress and the Obama administration (and/or various administrative agencies thereof) would make (and follow through on) for this new year of 2010.

1) The Treasury should resolve that it will no longer provide special dispensation to the financial institution powers that be, such as its invalid notice indicating that it would not enforce the law on loss corporations for too-big-to-fail banks, thus allowing too-big-to-fail banks to become even bigger by buying loss banks, and then allowing them to use those losses in direct contravention of the law and avoid paying income tax for years (or perhaps decades). A similar “notice” went out recently–Notice 2010-12–stating that Treasury will continue to fail to enforce the rules under section 956 regarding what constitutes an obligation and hence relieving US shareholders of controlled foreign corporations ( many of them possibly the same too-big-to-fail banks) of further US taxpaying obligations. (This notice continued the nonenforcement decision Treasury had made in 2008, in Notice 2008-91. Too bad decisions do not make a good decision.)

2) The Supreme Court should resolve to deal with the problem of financial institutions claiming patent protection for all kinds of financial software and financial engineering “solutions” and for others claiming patent protection for tax planning strategies by releasing a decision in the Bilski case that clarifies the “abstract idea” exception. The Court should say that no patent can be granted for innovations that merely utilize the positive laws to assert that a transaction carried out in a particular way will have a particular legal result, or for other methods of conducting transactions or of organizing human activity that do not involve the technological arts, as understood under European patent law.

3) Congress should resolve to end the preferential treatment of those few Americans who own most of the financial assets of the country by ending the capital gains preference.

4) Congress should resolve to eliminate the preferential tax treatment of the earned income of hedge fund and equity fund managers (the so-called “carried interest”), and any other “partners” that manage partnerships and earn a share of the partnership’s gains as their compensation (such as real estate partnerships).

5) In order to restore some sort of balance between worker and employer, Congress should eliminate the business deduction for any compensation in excess of 20 times the average salary (about $1 million). The cap on compensation deduction to apply to compensation in any form (stock, assets, cash), whether or not “performance related”.

6) In order to treat the gifts of ordinary Americans to charities of their choice the same as the gifts of multi-millionaires to charities of their choice, Congress should repeal the special rule that permits a charitable contribution deduction for the value of stocks rather than the investment basis in the stocks. Will that limit contributions that are made? Perhaps, though it is clear that contributors do so for many reasons and not merely for the contribution deduction.

7) Congress should resolve to resolve the estate tax situation once and for all, before some do-nothing heir-to-be decides that 2010 is the right time for the wealthy person in his life to go. Congress should enact a modest exemption of $2 million but should make the estate tax rates progressive (beginning at2009s 45%, but moving up to at least 65% for the largest estates).

8) Congress should resolve to revisit the tax brackets. We have an economy in which the average income is around $50,000, but there are individuals who make more than $500 million a year. That spread is so large that it cannot be adequately addressed by brackets that focuse on the first $350,000 or so. Those who make $200 million a year have incredibly more freedom of choice, and the few dollars they pay in taxes are merely peanuts compared to the precious funds from an average family. We need to make the income tax more progressive by adding additional rate brackets–perhaps as many as 3 or 4 more. That would still be a far cry from the income tax system before Reagan took office, when we had top rates more than double today’s top rates. But it would address the dire fiscal need of the country in a way that is doable without creating undue suffering.

9) Congress and Treasury should resolve to clean up the partnership tax rules so that they do not offer such extraordinary flexibility to partners to arrange their affairs to avoid taxation–for example, by eliminating the electivity permitted to partners in many places in the rules (make the remedial method the only method allowed for taking into account book-tax disparities in contributed property) and by changing the way that partners take account of partnership debt (such as being able to get distributions of nonrecourse debt that monetize partnership property appreciation).

10) Congress should re-visit the rules on mergers and acquisitions, so that a tax-free merger becomes an unusual event. Part of the problem we are facing today is that multinational corporations have grown so big that they wield enormous power globally and can sometimes appear to be able to order laws to suit them. Witness the fact that we are well beyond the beginnings of the financial system crisis, and no single piece of legislation imposing new and better regulations on the banks have been enacted. The size of corporations ensures that they will become as focused on raising rents for their managers as they will on making profits for shareholders, and that they will care not one whit for the ordinary American who is their customer, or their low-wage employee, or the resident of a town that they leave derelict when they move to sunnier shores. We say that the rationale for tax-free reorganization provisions is to encourage efficient organization of corporations. But efficiency is not God, and in fact focus on efficiency may leave democracy and fairness far behind. We should give tax-free treatment only to shareholders who get no boot for any of their stock, and only in transactions where a high percentage of the consideration is stock (perhaps 80% or more).

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Wyden’s Proposal for taxing oil and gas speculators

Ron Wyden, Democratic Senator from Oregon who serves on the Senate Finance Committee and the Energy Committee, is generally considered a liberal, though with a mixed bag of positions that hardly qualify on all grounds. He is against the estate tax and favors lowering rates of capital gains taxes, neither of which makes sense, from my perspective, in an economy already tilted to favor capital (and hence those in the upper distributions) and in need of revenue. His positions on the environment have been fairly consistently progressive. Back in 2004, for example, he worked on legislation to “get tougher” on responses to oil spills and get kinder in expediting loans to people impacted by those spills. See this press release. He has supported the US addressing CO2 emissions even if the big economies of China and India don’t (S. Con. Res. 70, May 15, 2008).

So what happens when you put tax policy (where I’m not terribly impressed with many of his positions) together with environmental policy (where he seems to have a fairly decent record)?

Today, Wyden introduced a bill (S. 1588) that deals with both of these issues. It would end a tax break currently enjoyed by speculators who trade in oil and gas. They’d have to pay tax at the ordinary income rates, rather than getting the preferential capital gains rates (o% for the first two income brackets, then 15%). This would be achieved by treating the gains as short-term capital gains (or losses) even if they would be treated as long-term under other provisions. Gains in trading by tax-exempt investors–e.g., Harvard’s endowment and similar funds– would be taxed as unrelated business income.

What’s the rationale? “To amend the Internal Revenue Code of 1986 to provide the same tax treatment for both commercial and non-commercial investors in oil and natural gas and related commodities, and for other purposes.” The first section has a short title that perhaps reveals more–it is the “Stop Tax-breaks for Oil Profiteering Act” (STOP Act). The bill also calls for a study of commodities exchanges and the effect of tax policy on the demand and price of commodities, and particularly of oil and gas.

I’m no expert in this area, but this sounds at first impression like a good idea. Wyden’s point is that those who use such fuels in their businesses have to purchase those commodities and treat any profits on related trading as ordinary. But speculators pay lower capital gains rates on trading profits, which may well mean that their trading distorts the market and raises prices.

Of course, I’ve long argued for eliminating the capital gains preference altogether, either through repeal of the provision in the regular tax or adding it as an adjustment in the alternative minimum tax. While I’d rather there be a wholesale change–to remove all the characterization games that taxpayers play and to help move the tax system towards a fairer one that does not give such inordinate preference to owners of capital over workers, these commodities trades may be an appropriate target, especially given their likely impact on pricing in an era when we can expect increasing oil and gas scarcity.

Any thoughts?

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A Rare Economics Post from Me

Yes, I’m still distracted (and under deadlines), but this is too good to pass up.

Greg Mankiw sends us to “Wisdom from Michael Kinsley.” Which turns out to be this:

There is no need to encourage risk-taking entrepreneurship with special tax breaks. Risk takers will take risks, and if the risks work out they shouldn’t mind paying the same level of taxes as everyone else. If the risks don’t work out, they won’t have to.

I agree completely with Kinsley, but am surprised that Mankiw does as well, especially as Kinsley correctly presents the issue in the process of another of his pox-on-Obama’s-house conclusions:

Obama…proposes exempting the sale of small businesses from the capital gains tax, allowing small businesses to avoid the burdens his health care plan would place on big businesses, and so on.

Michael Kinsley has argued that small businesses should pay capital gains taxes, and that they “shouldn’t mind paying the same level of taxes as everyone else.” By extension, the preferential rate for capital gains should be eliminated.

It’s nice to see that Greg Mankiw calls this “Wisdom.”

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