Sunday, February 5, 2012

Fairness in taxes, part II

While millions of Americans are struggling to get by under the Great Recession of 2008, largely brought on by the investment community, lobbyists for that community are still trying to preserve one of the worst loopholes that it managed to obtain for some members of that group: the so-called carried interest tax break. Here's how Carl Levin, Senator from Michigan, described it:

Hedge fund managers generally make their money by charging their clients two fees. First, the manager receives a management fee, typically equal to 2 percent of the assets invested. Second, the manager typically receives 20 percent of the income from those investments above a certain level. This 20-percent share of the investment returns from hedge funds is known as "carried interest.'' Under current law, most hedge fund managers claim that this carried interest qualifies as a long-term capital gain, currently subject to a maximum tax rate of 15 percent, rather than being taxed as ordinary income, currently subject to a maximum tax rate of 35 percent.

But a moment's analysis shows that this money is ordinary income by any fair definition and should be treated that way. The 20-percent fee is not capital gains, because it applies not to capital that the hedge fund manager has invested, but to the payment he receives for investing capital that other people provide. Pretending that the 20-percent fee is capital gains when, in fact, it is payment for a service is an `"Alice in Wonderland'' argument that elevates fiction over fact.

(for full text of Sen Levin's comments, click here.)

Once again we see an attempt to twist capitalist theory to support a class of wealthy people who neither need nor deserve this support -- they are getting a tax break simply for doing their jobs. For example, take a plumber or carpenter who takes some work on spec: he works on a project for a "retainer" or the price of materials, and if it is successful, he gets paid the rest of the commission. Should payment then be given the capital-gains "discount" simply because he risked the commission on the successful completion of the job -- something that would be expected in any case? In fact, doesn't any worker risk her salary by performing work which, should it be shoddy, would result in her being fired?

And, of course, there is also the question of why the payoff is such a high percentage? If the investor makes $1 billion dollars, the hedge fund manager stands to make $200 million! It is only because the possible reward is so absurdly high that the risk of not getting it seems so dire. How much is that per hour of actual work? Does anyone deserve that kind of money (not to mention a preferred tax treatment as well)? Michael Milken, the purveyor of junk bonds, made this kind of money for years -- until he was thrown into prison.

It is this kind of gross favoritism of big money managers that has made the message of the "Occupy" demonstrators so compelling to so many people.

This series of blogs on tax fairness in not an attack on all wealthy people. It is hard to blame an investor for taking advantage of the tax breaks that are available. However, actually paying lobbyists and influence peddlers to get congressmen to vote for them is, in my opinion, antisocial behavior, as is the soliciting and acceptance of favors from these people unethical behavior on the part of senators and representatives.

As one of the readers of  this blog (Anonymous) has pointed out, not all wealthy people enjoy the kind of tax breaks that Mitt Romney, for one, gets. He pays only about 15% of his huge income (almost all capital gains) in taxes, while, recently, the wealthy (top 1/10 %) have averaged close to 30%. You can read some of the breakdown in this article (forwarded to me by Anonymous). This is up from the average rate of less than a decade ago simply because, as happens in most recessions, capital gains income has been severely reduced for members of the investing (and coupon-clipping) class. Don't shed any tears for them: unless tax policy changes, the growing surge in the stock and bond markets will have many of them riding high again, taxwise, before long. Also, as this article mentions, the percentage of all taxes paid by the upper class is higher than for those in the bottom 50% or so. This doesn't make them virtuous, simply very highly paid in comparison with the lower brackets. Also, this percentage that they pay is down from pre-Recession times -- also because recessions hurt many rich people as well as the non-rich (though usually not as seriously).


  1. Milken wasn't a hedge fund manager so it's pretty irrelevant how successful he was to your topic of tax fairness

  2. True. He was put in as an example of the kind of money that can be made when a money manager get a percentage of someone else's huge investment.

  3. He wasn't a money manager. He was a banker who worked for Drexel Burnham and underwrote corporate bond issues for sub-investment grade (ie "junk") companies. He didn't receive a percentage of somebody else's investment. He wasn't managing Revlon's money, as an example. Drexel underwrote Revlon's bond issues.

  4. I was under the impression that he received a percentage of the money that Drexel made as a result of his work. I am obviously not an expert on this and maybe I got it wrong. How, then did he make the several billions that he is worth?

  5. He was one of the partners in a private firm, so of course he received a percentage of the profits in the firm. But that's no different than any other private company. How did the make the money? He was one of the main leaders in a firm that was incredibly successful earnings large amounts of fees for underwriting bond offerings. But he wasn't a "money manager" and neither was Drexel. So they didn't earn a cut of somebody's else investment. They charged a percentage of the proceeds that they raised for issuers. The same way that JPMorgan and BankofAmerica earn underwriting fees today on the securities they place. Same way that real estate brokers earn a commission that's based on a percentage of the selling price of the home. But he has zero to do with hedge funds or capital gains rates.

  6. OK, thanks. I guess I was relying too much on my recollection that he made a large amount of money as a percentage of some huge profits. I should have looked back to check the exact mechanism.

    I think I will omit Milken from this blog entry after a while, since, as you say, he is not relevant to the issue of taxes anyway.

  7. And you're blaming the Great Recession on hedge fund managers who pay at the capital gains rate?

  8. ?? I never said such a thing. I only said that taxing them at capital gains rate ("carried interest") is unfair. Of course they are not responsible for the Great Recession.

  9. You may not think the capital gains rate is "fair", but those people are paying much higher overall tax. Let's say you and I both work as college deans and earned $300,000 hypothetically one year and after tax kept$200,000 of it. You kept it under your mattress and I invested it in a stock which doubled. Because i now have capital gains, my effective rate is lower than yours. Is it unfair that my overall rate is lower?

  10. I don't understand: Is this a new point? You're only being taxed on the $200,000 you made on your investment. In other words, you are keeping about $170,000 of the $200,000 you made. If you were paying in the usual bracket for that income, you would keep about $130,000. You are getting a tax break of $40,000 over someone who made the same amount of money as salary -- not fair in my opinion.

    The fact that I put my money under my mattress is irrelevant -- it was (would have been) foolish of me to do that: I should have asked you for advice and doubled my money as you did! I would have been pleased to pay the usual rate if I had to, and keep an additional $130,000. (Which, incidentally, is more than I ever made in a year of doing full-time teaching and research.)

    If you didn't get that additional $40,000, would you have kept your money under your mattress? I doubt it. The capital gains tax, as I've maintained, is unneeded. If you believe the official reasons for it, then it is a misguided "incentive" -- a form of social or economic "engineering" which costs the country lots of money. However, I suspect the real reason we have it is that highly effective lobbying and highly susceptible politicians (of both parties) got it passed.

    BTW, lots of college presidents make $300,000 or more a year; some even deserve it. However, I don't think it would be easy to find a dean who pulls down that amount -- there might be a few but I doubt that they deserve it.

    One of the reasons colleges have become so expensive is the proliferation of administrators: name a service or division of academia and there is a dean, associate dean and assistant dean for it, along with an office for each and support staff with computers, faxes and printers etc. It's very much like the British Navy that Gilbert & Sullivan so effectively satirized in "Pinafore."

  11. New point? No. It's an example of how paying a lower effective rate isn't "unfair". There is nothing unfair about the person who decides to invest paying a lower effective rate than the person who doesn't invest.

    Making money on an investment is not apples-to-apples versus earning a salary. Sure you would be pleased to pay the "usual" rate if you knew for certain that the investment would pay off. But in reality the investment doing well has a lot more risk associated with it than earning a salary. If the tax rates were the same, and I told you that you could either work a second job and earn $x as salary or make an investment which MIGHT earn $x but there's a chance it would earn less, you'd always choose the second job because the expected value of that outcome would be higher.

    Like I've said in the past, if the capital gains rate were raised, you'd see money flow out of the markets affected (equities, housing, start-ups, etc). The more you tax something the less of it you get. And those in the top brackets have the flexibility to alter their investments towards those that get the best after-tax returns. If you jack up the capital gains rates, you'll see investments reallocated towards municipal bonds, MLP's, tax sheltered accounts and out of equities, real estate and start-up businesses. Stay under the mattress? No. But it would seek other opportunities that don't promote as much economic growth.

  12. You said - "You are getting a tax break of $40,000 over someone who made the same amount of money as salary -- not fair in my opinion."

    Actually, no. The two people pay the same amount of taxes on the salaries they earned. That's fairness.