Topic: Tax and Budget Policy

Finally Legal!

I can finally report that I am driving a legal automobile.

As readers will recall, this was my third trip (see here and here for previous installments in the saga). Actually, it was my third and fourth trip. When I got to the DMV this morning, happily clutching the Fairfax County tax receipt to my chest, I was told that I also needed an emissions test. It would have been nice of the bureaucrats to tell me that on my first trip, but why expect miracles.

So I had to exit the line, go back out to my car, and drive (illegally, once again) to a nearby service station. This interaction with the private sector was predicatably brief, so I was back at the DMV in less than 30 minutes. Unfortunately, Dan Griswold must have been hard at work in the interim since there was now a long line of people, none of whom appeared to be native-born Americans.

But after a 90-minute wait, I got up to the counter, and was able to get registered - but only after dealing with a libertarian quandary. While twiddling my thumbs, I noticed that I could request a vanity plate. Wouldn’t it be nice, I thought, to have a license plate reading “anti gov.” But getting a special plate also involved paying more money - funds that presumably would help finance the sloth-like bureaucracy that I despise. After wrestling with my conscience (which usually comes out on the short end), I decided that the cause of freedom would be best served by having the vanity plate.

I feel guilty about giving government more money, but I somewhat compensated by paying for my registration and vanity plate with a credit card, which means at least some small slice of the $103 gets diverted to the financial services industry. It ain’t easy being libertarian, but I somehow muddled through.

Great Moments in Local Government, Part II

I am moving ever closer to being a compliant citizen of Fairfax County and the State of Virginia. As I noted in an earlier post, I am seeking to renew the registration on my car, but I failed miserably in my first trip to the Department of Motor Vehicles.

The trip to the Fairfax County tax office was rather successful, albeit a bit puzzling. The ostensible purpose of the trip was to pay a mysterious overdue tax and then a $20 fee to remove a “hold” on my registration. But the County bureaucrat said there was no overdue tax. This made sense because I hadn’t received any notices in the mail, but I can only imagine why the automated system was trying to get me to cough up $174 (I’m now thankful my efforts to comply were unsuccessful).

Yet even though there was no unpaid tax, the County still insisted on getting $20 to remove the hold. In an ideal world, I would have loudly protested this ridiculous demand. In the spirit of the Founding Fathers, I would have pointed out the absurdity of being forced to pay the remove a hold for a tax liability that did not exist. In reality, the County got its money and I’m just happy that I have (at least in theory) just one final visit to the DMV.

I never did ask, by the way, why the County thinks I have four cars. While I am a tad bit curious, discretion is the better part of valor when dealing with bureaucracy. Stay tuned.

Taxing Private Equity

Promising fiscal responsibility, the Democrats in Congress passed a pay-go budget rule requiring offsets for proposed spending increases. But because the Dems have so many new spending demands — more health care for kids, more farm subsidies — there is a desperate search for added revenue and a rush to impose new taxes without adequate thought regarding the possible damaging consequences.

Enter the private equity industry. As Congress has increased regulations on public markets, private equity has boomed as an efficient tool to restructure businesses while channeling the savings of pension funds, foundations, and university endowments into productive, high-return investments.

But where some people might see financial innovation and growth, Congress sees a pot of money to raid with higher taxes. I’m not a private equity (PE) expert, but here is a big picture perspective on the economics of PE taxation:

Private equity firms are partnerships. Earnings of partnerships are not taxed at the entity level but flow through to individual owners of the firm.

General partners of PE funds channel some of their own savings, but mainly savings of outside limited partners, into investments in businesses. As a return, general partners receive a management fee (taxed at ordinary income tax rates) and a share of future profits of the assets owned by the fund. The latter return, called carried interest, is typically 20 percent of fund profits.

The carried interest comes mainly from capital gains realized on the sale of businesses owned by the fund. So let’s say a fund called the Edwards Group bought a poorly managed company called Reynolds Motors for $100 million, then turned the company around with better management, and sold it a few years later for $200 million.

The $100 million of capital gain on the sale would flow through to both the limited partners and the general partner, who receives a 20 percent share. The return to both types of partners is taxed at the 15 percent federal capital gains rate, because indeed the underlying transaction generated a capital gain.

The carried interest return is contingent upon the success of the fund. An advantage of providing a capital gain return to fund mangers is to align their interests with the interests of the outside investors. If managers do a good job in growing the value of businesses owned, then both limited and general partners win (and so does the economy).

However, some members of Congress are arguing that the return to general partners should be treated as labor income or “compensation for services,” not capital income, and subject to ordinary tax rates, which top out at 35 percent.

You can read what the Congressional Budget Office says about the issue here. CBO has a concise summary, but their discussion reveals an underlying Haig-Simons view of the world. In this view, which favors a very broad-based income tax, capital gains would be heavily taxed and the deferral of capital gains disallowed. One of the problems with determining the “proper” tax treatment in the PE case, and with capital gains in general, is that our tax system is a hybrid between a Haig-Simons income tax and consumption-based taxation.

Many economists want to move the current tax system toward more efficient consumption-based taxation, under which there would be no capital gains tax. Capital gains from share appreciation represents double-taxation. Business valuations represent the present value of expected future returns. Thus when an individual or investment fund sells shares in a corporation and realizes a gain, that gain represents profits that will be taxed in the future under the corporate income tax.

If we moved the tax system toward a consumption base, we would drop the capital gains rate to zero. That sounds radical, but even a number of countries with ostensibly income tax systems, including Netherlands, New Zealand, and Taiwan, have capital gains tax rates of zero.

Suppose a small business person invests $100,000 and opens a restaurant, and then uses her “sweat-equity” to grow the venture into a business worth $500,000. She sells the business, nets $400,000 in capital gain, and pays the 15 percent capital gains tax. She put up the risk capital, but it seems that it was mainly her “labor” (brains and hard work) that created the gain. Part of her “compensation for services” for years of work is a capital gain.

That is similar to the PE story. Managing partners put sweat-equity into building the value of the businesses that the fund owns. If that sweat-equity results in boosting the value of the assets, it would seem that that gain should be taxed at the capital gains rate.

The CBO notes on page 8: “In the paradigmatic private equity case, most profits arise from long-term capital gains, so the profit allocated to the general partner’s carried interest will be taxed as long-term capital gains.”

However, partnership taxation is hugely complicated, so perhaps I’m missing something. Proponents of higher taxes argue that many of the people getting carried interest are just managers who don’t put up their own capital. It is interesting that general partners put up perhaps 5 percent of the capital of funds, but they receive 20 percent of the returns.

Nonetheless, the underlying economic events generating the carried interest returns are capital gains on the sales of businesses, and under a reformed tax system would not be taxed at all. Note that capital gains are not included in gross domestic product or the subcomponent called “national income.”

However, it is also true that the value-added, or compensation, of people in the PE industry is included in measures of GDP and national income. That value-added should be taxed once, but only once. In other industries, worker wages are taxed and employers deduct wages paid against their business taxes to avoid double-taxation. If proposals to increase taxes on PE managers move ahead, it seems appropriate to provide offsetting deductions somewhere else in the system.

Note that the current battle over the tax treatment of private equity firms has broader implications because the partnership form is used in many other industries, such as real estate and venture capital. Will Congress change the tax treatment of partnerships for all industries or just carve out private equity for special punitive treatment?

The hullabaloo over the PE issue does suggest some underlying unease about the lower rate of the capital gains tax in general. But any of us wage slaves could quit our jobs and try making our living off of stock trading from our home computer. If one is successful, one could be earning 100 percent of our income in the form of capital gains and paying just 15 percent tax. Is that fair? I think so. For one thing, you need to consider every level of taxation, including corporate-level taxation, to determine what is fair and efficient. But clearly more general education on capital gains is in order.

A final note: The economy has grown strongly in recent years, the unemployment rate is remarkably low, and the venture capital and private equity industries are pumping billions of dollars into new and restructured businesses. Interestingly, the basic structure of the 2 percent management fee and 20 percent carried interest has been used in the VC industry since its modern birth in the late 1970s. The financial structure of the industry has worked spectacularly well, with a very long list of VC success stories—Genentech, Cisco, Intel, Apple, and thousands of others.

With global economic competition increasing, I don’t think we want Congress to be throwing a wrench into the works of the nation’s hugely successful innovation financing system. Rather than hiking taxes on PE, Congress ought to move to a more neutral, lower-rate tax system that treats all industries equally.

Sarkozy, France’s Busy CEO

It must be exhausting to be the chairman and CEO of a nation-state-firm that runs everything from retirement plans to universities to energy firms. Steven Pearlstein reports on France’s “hyperactive new president, Nicholas Sarkozy”:

There he is lunching with student leaders at a local bistro to win their support for reform of the nation’s under-funded and under-performing university system.

Here he is on the phone with Russia’s President Vladimir Putin, sealing the deal for the French oil company, Total, for a 25 percent stake in the management of the giant Shtokman gas field.

Now he is in Toulouse, with German Chancellor Angela Merkel, announcing a new governance structure for Airbus that puts a loyal French technocrat in charge.

And there’s Sarko in Brussels, criticizing the European Central Bank for keeping the euro too high and demanding more leeway for France’s ballooning budget deficit.

Rupert Murdoch probably delegates more than this. But Sarko is determined to prove that he can singlehandedly reform the operations of a production-and-distribution entity far larger and more complex than the notorious business conglomerates that eventually displayed significant diseconomies of scale. He’s like a real-life version of the classic Saturday Night Live sketch of a hard-charging President Reagan driving his aides to exhaustion as he masterminds international financial transactions around the clock and around the world.

But as many of the conglomerates found, it might be easier to focus on the French state’s core business — protecting the life, liberty, and property of French citizens — if it sold off some of its peripheral lines, like universities, gas fields, health insurance, airlines, telephones, gambling….

A Scolding from the EC

The bureaucrats in Brussels may not be able to solve Europe’s demographic problems. They may not be able to promote economic liberalization in Europe’s welfare states. And they may not be able to provide any guidance to nations failing to assimilate large numbers of immigrants. But they can scold European men about not doing the housework.

The EU Observer reports on the latest farce from Brussels:

The European Commission is calling on Europe’s menfolk to help out more at home as a first step to improving women’s career prospects and ending the gender pay gap across the bloc. …EU employment commissioner Vladimír Spidla said, addressing a press conference in Brussels on Wednesday, “It is not possible to reduce the gender pay gap if we do not help out more at home.”

…In the communication, the Commission sets out ways in which the EU can bridge the gender pay gap. It wants the 27 member states to set objectives and deadlines to eradicate the gap, and will also push for equal pay to be made a condition for winning public contracts.

Treasury Secretary Highlights Importance of Competitive Corporate Tax System

Writing for the Wall Street Journal, Secretary of the Treasury Henry Paulson, Jr. warns that America now has an uncompetitive corporate tax system. Mr. Paulson explains that other nations have been slashing their tax rates — and reaping big rewards — while the United States has been sitting on the sidelines. This means less investment in America, which translates into lower wages for American workers:

[T]he U.S. is once again a high corporate tax country. We now have, on average, the second-highest statutory corporate tax rate (including state corporate taxes), 39%, compared with an average rate of 31% for our top competitors… Ireland, for example, has engineered its own economic miracle, in large part due to a reform program that cut corporate tax rates to a level one-third that of the U.S. And the trend continues. Germany will reduce its total rate from 38% to 30% in 2008. France, Japan and the United Kingdom have signaled they may also lower their corporate rates.

…Business tax policy levers, such as the corporate tax rate, depreciation rates and investor taxes, as well as the taxes levied on small businesses through the individual income tax, should strive towards a similar purpose: to encourage economic growth by reducing the tax burden on additional investments. Yet, the current tax code distorts capital flows, hurting productivity, job creation and our global competitiveness. Take just a few examples. Taxes on capital income raise the price of future consumption and discourage saving and capital formation. Reduced capital formation gives labor less capital to work with and lowers labor productivity, reducing real wages and income.

…Over the past two decades, while U.S. tax law has grown more complicated and our statutory corporate income tax rate has increased, other nations have been reducing their rates to replicate our miracle. A study by Treasury economists estimated that a country with a tax rate one percentage point lower than another country’s attracts 3% more capital. It’s not surprising then, that average OECD corporate tax rates have trended steadily downward.

Bush Waxes Philosophical on Health Care

People sick of the big-government conservatism practiced by the Bush administration might be excited at the headline in today’s Washington Post: “Bush: No Deal On Children’s Health Plan/President Says He Objects On Philosophical Grounds.” But President Bush’s philosophical objection to the proposed expansion of the State Children’s Health Insurance Program is in no way a reversal from his stance that big spending is okay as long as Republicans can take credit.

What philosophy does Bush subscribe to?  Apparently, it’s the philosophy that says the federal government should only expand the welfare state by billions of dollars, instead of tens of billions of dollars: “The president said he objects on philosophical grounds to a bipartisan Senate proposal to boost the State Children’s Health Insurance Program by $35 billion over five years. Bush has proposed $5 billion in increased funding and has threatened to veto the Senate compromise and a more costly expansion being contemplated in the House.” 

Later in the article Bush is quoted as saying, “I think it’s going to be very important for our allies on Capitol Hill to hear a strong, clear message from me that expansion of government in lieu of making the necessary changes to encourage a consumer-based system is not acceptable.”

He also said, “I’m worried that there will be a strong incentive for people to switch from the private sector to the government.” 

If only the president had adopted a similar attitude when he approved a $1.2 trillion expansion of Medicare in 2003 in lieu of consumer-based approaches.