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.
If a merchant sells something a store there was an intial investment and return on investment but that is called prfit and taxed as ordinary income. The money managers move other peoples money from one pile to another and take a handful for their pockets. Thats called capital gains . Personally I call it stealing.
“Making money from managing other people’s money, in other words, is not per se productive for the economy”
Eh?
Just try living in an economy that doesn’t have professional money managers then. You’ll see how “productive” it is without them.
Tim that is historical nonsense.
You can make an argument for the crucial role of credit, which existed before the establishment of the forerunners of commercial banks, which in Western terms we could put in Northern Italy in the Early-High Middle Ages, but the suggestion that Western Civilization was crucially dependent on those bankers managing the float and in recent decades managing the aptly named ‘derivatives’ that have trillions of dollars of ‘assets’ in multiples of actual real word production/equity flying around (and among other things creating ‘carried interest’) is something to be demonstrated and not just asserted.
Because there was in fact civilized life prior to the repeal of Glass-Steagal and attendant merger of insurance and investment banking and commercial banking. Because very little of modern finance seems in alignment with old days of ‘borrow short and lend long’ and providing liquidity via the simple float.
Call me a troglodyte but at this point I am willing to revise the old lawyer joke to read:
“What do you call 40 quants at the bottom of the ocean (and the brokers who press the buttons on subsequent trades)?”
“A good start”
We are a long way from the days that the role of bankers in supplying liquidity/grease to the gears of commerce justified the service charge. Instead it is just seas of grease flowing back and forth and pigs getting fat on the slop. While telling the rest of us we would really be sorry if they went on a diet.
Well some empirical evidence that any of this actually has resulted in utilitarian greatest good results would be welcome. As opposed to “Ricardo! Pareto! Hey it’s Halley’s Comet!”
Of course a lot depends on the precise delimination of “professional money managers”. Because God help us we live in a world where the Blackstone Group (formerly PG Peterson’s shop) tells us they are not in fact a hedge fund but rather a fund of hedge funds. Somehow the float between borrowing at 2% to lend a 3% turned into fourth derivatives with differential equations of log functions thrown in for good measure.
We are a long way from the image of a guy with an oil can simply lubricating the gears of commerce here. And I will take my bets on returning to the days of Glass-Steagal. Because Phil, Wendy, Dick, and Alan (plus Bob Rubin) have a lot to answer for in my book.
The carpenter is a very poor analogy. The person who bought and sold the house receives capital gains, whether he does the work himself or hires a carpenter to do it. The people managing funds are like a hired carpenter. Even if the carpenter was paid on a contengincy basis based on the sale price, he would be taxed on that as income. No capital = no capital gains.
At a very real level, the carried interest loophole IS a reaction to the excessively sweet deal given to capital gains in the tax code, and the fact that fund managers were jealous of the low rate paid by the people whose money they were managing. At some level the existance of a capital gains rate distinct from normal income is the fact that otherwise, different investors would pay different rates. Of course the very low CG tax rates are one reason that we have seen the Tech and RE bubbles: We’ve been funneling more money to Wall Street than it can come up with productive uses for. So instead it’s been blowing speculative bubbles.
The carpenter is a very poor analogy. The person who bought and sold the house receives capital gains, whether he does the work himself or hires a carpenter to do it. The people managing funds are like a hired carpenter. Even if the carpenter was paid on a contengincy basis based on the sale price, he would be taxed on that as income. No capital = no capital gains.
At a very real level, the carried interest loophole IS a reaction to the excessively sweet deal given to capital gains in the tax code, and the fact that fund managers were jealous of the low rate paid by the people whose money they were managing. At some level the existance of a capital gains rate distinct from normal income is the fact that otherwise, different investors would pay different rates. Of course the very low CG tax rates are one reason that we have seen the Tech and RE bubbles: We’ve been funneling more money to Wall Street than it can come up with productive uses for. So instead it’s been blowing speculative bubbles.
The carpenter is a very poor analogy. The person who bought and sold the house receives capital gains, whether he does the work himself or hires a carpenter to do it. The people managing funds are like a hired carpenter. Even if the carpenter was paid on a contengincy basis based on the sale price, he would be taxed on that as income. No capital = no capital gains.
At a very real level, the carried interest loophole IS a reaction to the excessively sweet deal given to capital gains in the tax code, and the fact that fund managers were jealous of the low rate paid by the people whose money they were managing. At some level the existance of a capital gains rate distinct from normal income is the fact that otherwise, different investors would pay different rates. Of course the very low CG tax rates are one reason that we have seen the Tech and RE bubbles: We’ve been funneling more money to Wall Street than it can come up with productive uses for. So instead it’s been blowing speculative bubbles.
The carpenter is a very poor analogy. The person who bought and sold the house receives capital gains, whether he does the work himself or hires a carpenter to do it. The people managing funds are like a hired carpenter. Even if the carpenter was paid on a contengincy basis based on the sale price, he would be taxed on that as income. No capital = no capital gains.
At a very real level, the carried interest loophole IS a reaction to the excessively sweet deal given to capital gains in the tax code, and the fact that fund managers were jealous of the low rate paid by the people whose money they were managing. At some level the existance of a capital gains rate distinct from normal income is the fact that otherwise, different investors would pay different rates. Of course the very low CG tax rates are one reason that we have seen the Tech and RE bubbles: We’ve been funneling more money to Wall Street than it can come up with productive uses for. So instead it’s been blowing speculative bubbles.
The carpenter is a very poor analogy. The person who bought and sold the house receives capital gains, whether he does the work himself or hires a carpenter to do it. The people managing funds are like a hired carpenter. Even if the carpenter was paid on a contengincy basis based on the sale price, he would be taxed on that as income. No capital = no capital gains.
At a very real level, the carried interest loophole IS a reaction to the excessively sweet deal given to capital gains in the tax code, and the fact that fund managers were jealous of the low rate paid by the people whose money they were managing. At some level the existance of a capital gains rate distinct from normal income is the fact that otherwise, different investors would pay different rates. Of course the very low CG tax rates are one reason that we have seen the Tech and RE bubbles: We’ve been funneling more money to Wall Street than it can come up with productive uses for. So instead it’s been blowing speculative bubbles.
The carpenter is a very poor analogy. The person who bought and sold the house receives capital gains, whether he does the work himself or hires a carpenter to do it. The people managing funds are like a hired carpenter. Even if the carpenter was paid on a contengincy basis based on the sale price, he would be taxed on that as income. No capital = no capital gains.
At a very real level, the carried interest loophole IS a reaction to the excessively sweet deal given to capital gains in the tax code, and the fact that fund managers were jealous of the low rate paid by the people whose money they were managing. At some level the existance of a capital gains rate distinct from normal income is the fact that otherwise, different investors would pay different rates. Of course the very low CG tax rates are one reason that we have seen the Tech and RE bubbles: We’ve been funneling more money to Wall Street than it can come up with productive uses for. So instead it’s been blowing speculative bubbles.
“Well some empirical evidence that any of this actually has resulted in utilitarian greatest good results would be welcome.”
OK, empirical evidence.
Tehre’s a metal called scandium. The world would rather like to use more of it. It’s just the thing to make windmill blades and fuel cells from.
I happen to be an expert in scandium. Odd thing to be I know but someone needs to be and I am.
So, how do I finance running around looking for new places to get scandium from? What pays for me to be, at this very moment, in a German airport on my way to hte mines that produced the very first scandium metal ever produced? Where does the cash come from to buy tickets, feed and clothe me, come from while I’m doing this research?
As it happens it came from the City of London. Couple of guys running a boutique investment bank were able to rustle up $100,000 for me to go prospecting in old slag piles. This is allocation of capital, managing other peoples’ money, quite possibly leading top an increased supply of a desired resource.
We like having intermediaries like this. We like people haulking in hte deposits and parcelling out the loans, just as we prefer having millers so we don’t all have to buy grain and make our own flour.
Now, that the current system ain’t perfect: even I agree with you there. But Linda’s statement is so extreme as to be nonsense. That money being managed is not productive? At the very best we might says that she got carried away on the rip tides of her own rhetoric. At worst that she’s crazed….
The carpenter is a very poor analogy. The person who bought and sold the house receives capital gains, whether he does the work himself or hires a carpenter to do it. The people managing funds are like a hired carpenter. Even if the carpenter was paid on a contengincy basis based on the sale price, he would be taxed on that as income. No capital = no capital gains.
At a very real level, the carried interest loophole IS a reaction to the excessively sweet deal given to capital gains in the tax code, and the fact that fund managers were jealous of the low rate paid by the people whose money they were managing. At some level the existance of a capital gains rate distinct from normal income is the fact that otherwise, different investors would pay different rates. Of course the very low CG tax rates are one reason that we have seen the Tech and RE bubbles: We’ve been funneling more money to Wall Street than it can come up with productive uses for. So instead it’s been blowing speculative bubbles.
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I agree with Bruce. In truth we can survive without banks. A business can be built. Granted maybe not as quickly or easly, but it can be done. The biggest service a bank provides is protection of one’s funds. I don’t have to hire my own security.
I agree, the carpenter is a real stretch, but then that is what people do who try to defend what they know is wrong. It’s like our AG saying the Constitution does not garauntee “judicial” review, just “review”. Really?
Earnings are earnings. This carried interest is just another way of elevating money over people in the priority concern.
Still I recommend the movie Other People’s Money. Of course everyone loved that Edward saw the light and became a ship builder and saving Cinderella Vivian. The Prince in Cinderella never got that far.
Tim…is there any way to put numbers on this sort of thing…ie. investments other than the more notable derivatives etc. Is this ‘entrpreneurial’ sort of money versus leveaged stuff.
Rather it is a good analogy that doesn’t support the carried interest deduction.
Rather it is a good analogy that doesn’t support the carried interest deduction.
I wonder if you appreciate the irony of your thesis (line drawing is hard and so we should obliterate the distinction between capital and ordinary income) appearing in the same screen as assertions like the below (which are nothing but line drawing):
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).
Money managers often do add value to the wealth of the persons whose money they manage. That is just the specialization of labor. That wealth goes to fund, smong other things that enhance the economy, insurance payments and retirement spending which increase aggregate demand, yes?
Hedge funds’ gains are “primarily speculative” – And line drawing should be avoided, right? LOL.
Private equity “often is destructive” of private business? Actually the studies show that it is largely neutral. It helps some and hurts others. Net net there is no meaningful difference vs other buckets of ownership.
An even bigger loophole is the one that allowed Romney to acquire a $100 million IRA. How does that work when the annual contribution limit is $5000 for us mere mortals? Well, Romney is allowed to value his partnership interest in Bain as zero dollars because it has no present value, since it only provides future revenue streams. This is a big loophole available only to hedge fund managers. It means that he can put his entire partnership interest in the IRA since the value is below the $5000 contribution limit. Once the partnership is in the IRA, it generates millions of dollars each year which are entirely tax free income. Romney’s 14% effective tax rate only applies to his taxable income. If you included his tax free income in his IRA, his effective rate would be even lower.
An even bigger loophole is the one that allowed Romney to acquire a $100 million IRA. How does that work when the annual contribution limit is $5000 for us mere mortals? Well, Romney is allowed to value his partnership interest in Bain as zero dollars because it has no present value, since it only provides future revenue streams. This is a big loophole available only to hedge fund managers. It means that he can put his entire partnership interest in the IRA since the value is below the $5000 contribution limit. Once the partnership is in the IRA, it generates millions of dollars each year which are entirely tax free income. Romney’s 14% effective tax rate only applies to his taxable income. If you included his tax free income in his IRA, his effective rate would be even lower.
An even bigger loophole is the one that allowed Romney to acquire a $100 million IRA. How does that work when the annual contribution limit is $5000 for us mere mortals? Well, Romney is allowed to value his partnership interest in Bain as zero dollars because it has no present value, since it only provides future revenue streams. This is a big loophole available only to hedge fund managers. It means that he can put his entire partnership interest in the IRA since the value is below the $5000 contribution limit. Once the partnership is in the IRA, it generates millions of dollars each year which are entirely tax free income. Romney’s 14% effective tax rate only applies to his taxable income. If you included his tax free income in his IRA, his effective rate would be even lower.