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More Class Warfare: The Real Point of the 18th Amendment (Prohibition)

Consider the wording of the 18th Amendment passed out of Congress during WWI and ratified in 1919.

Section 1. After one year from the ratification of this article the manufacture, sale, or transportation of intoxicating liquors within, the importation thereof into, or the exportation thereof from the United States and all the territory subject to the jurisdiction thereof for beverage purposes is hereby prohibited.

Section 2. The Congress and the several States shall have concurrent power to enforce this article by appropriate legislation.

Section 3. This article shall be inoperative unless it shall have been ratified as an amendment to the Constitution by the legislatures of the several States, as provided in the Constitution, within seven years from the date of the submission hereof to the States by the Congress.

and then consider what is missing from it.

And the answer is “purchase, possession, or consumption”. All of which remained legal. Which meant that serving alcohol in a private residence whether at a dinner party or a cocktail party or a garden party was perfectly okay, at worst the host would have to claim some “pre-war” stock. Why even Senators and Congressmen and Presidents could (and did) openly consume intoxicating beverages in their offices and within limits at private clubs. Which would raise instant issues of hypocrisy and “goose and ganderism” except for one thing the history books gloss over. Prohibition was all about maintaining maximum productivity on the factory floor by effectively denying open access for workingmen. Because while in theory there would be no barrier to buying beer by the glass, or the beer bucket, or gin by the drink, or the bottle, it was clearly illegal to sell it in any open city or town setting. And it was not like the workingman could afford to have a bootlegger deliver booze by the case to be legally tucked away in some rich man’s cellar.

Which gets me to the point, and one that I barely have even anecdotal support for, though I believe it is out there. Prohibition largely worked for the actual purpose for which the wealthy and powerful ALLOWED it to be put in place. The 20s were the golden era for the new science of industrial engineering and production efficiency. Jobs that a generation or more before had largely been done by craftsmen were increasingly being done by factory workers operating on “the line” with every move under observation by those who would implement improvements based on Taylorism, after Frederick Winslow Taylor the father of time-motion studies. Which efficiency improvements you were not likely to get in the kind of alcohol infused workplace of the century before.

As an indication of the soundness of this theory consider that in reading about the business and social affairs of the American elite in the 1920s there is not a single hint that alcohol use was restrained or repressed, no instead this was the golden age of cocktails. Nor was there any evidence of an upsurge in piety among that group. But there was (and always will be) a class interest in boosting labor productivity and grabbing the spoils. I suggest that was what in part made the Roaring 20′s what they were. A program of prohibition that largely left the elites unaffected while clamping down on at least day time consumption by the working class.

Consider this an open thread on class warfare and labor share. Or whatever. Me, I am going to grab a stiff drink.

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David Simon via Bill Moyers

I can’t get past just how juvenile the thought is that if you just let the markets be the markets, they’ll solve everything.  And if profit is your only metric, man, what are you building?  David Simon

This is the first part of an interview with David Simon.   He is a “journalist and creator of the TV series The Wire and Treme…”   Mr. Simon talks about America as a “Horror Show”.   (video below the fold)

What caught my attention is that this is the first time I have heard someone in the public sphere use the word “selfish” instead of the more benign word “greed”.

You know when we started out space program, which was, you know, an unqualified success in the end, the rockets kept blowing up on the launching pad. Somehow we figured out a way to keep launching rockets and do it right. And that’s a very different America from the tonality of this one, which is selfish, which is I have my health care still and I don’t want to pay for anybody else to get back in the boat.

Some excerpts:

The Supreme Court has walked away from any sort of responsibility to maintain democracy at that level. That’s the aspect of government that’s broken.

And it doesn’t matter whether it’s Obama or Clinton or Bush or anybody at this point. If this is the way we’re going to do business, we’re not going to do business. You know, they’ve paid for it to be inert. And it is inert. And ultimately that aspect of capitalism hasn’t been dealt with in any way.

We’ve changed and we’ve become contemptuous of the idea that we are all in this together. This is about sharing and about, you know, when you say sharing there’s a percentage of the population (and it’s the moneyed percent of our population), that hears socialism or communism or any of the other -isms they want to put on it. But ultimately we are all part of the same society. And it’s either going to be a mediocre society that, you know, abuses people or it’s not.

If how much money you have is the defining characteristic of citizenship or of value or of relevance, of human relevance, and if that’s all that we’re going to measure (and apparently, since 1980 this all we’re going to measure), you’re going to get a society to live in that is structured on that metric. And it’s going to be a brutal one.

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Explaining Class Warfare

Last month one hundred and fourteen thousand unemployed moochers…suddenly yank the government teat out of their mouths, get off the couch for forty hours a week? Why?
I say follow the money; cause I found out, that right around the time those people got those jobs…they started getting paid!
And just where does that money come from? Right out of the pockets of the job creators. How’s that for your socialist redistribution of wealth? Folks, it’s called class warfare.
Mr Colbert has created a new party that will issue a certificate to sooth the hurt of the job creators. The Certificate of Richness issued by:
Protecting Industry Titans and Yachtsman party. The P.I.T.Y. party.
And right on cue:
If President Obama is re-elected and raises taxes, Westgate Resort’s David Siegel says he will have to lay off workers and downsize his company — or even shut it down.

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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  See John Cook, The Bain Files: Inside Mitt Romney's Tax-Dodging Cayman Schemes, (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 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 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? (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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