Topic: Tax and Budget Policy

The Laffer Curve: Separating Fact from Fiction

Critics of pro-growth tax policy are perpetually vigilant for opportunities to condemn the Laffer Curve as a free-lunch scheme pushed by political hacks who want to claim that all tax cuts pay for themselves. And while it is true that some tax-cut advocates are too aggressive in their assertions, the critics often are guilty of knocking down straw men (while dodging the real issue, which is whether the right kind of tax rate reductions lead to growth and the degree to which that higher growth leads to revenue feedback).

The latest skirmish in this long-running battle revolves around a Wall Street Journal editorial on corporate tax rates. The WSJ’s editorial included a graph showing corporate tax rates and corporate tax revenue and included a line purporting to show that the revenue-maximizing corporate tax rate is somewhere between 25 percent and 30 percent, a bit of artwork that has been criticized by Brad DeLong and Mark Thoma.

But if the Laffer Curve is an absurd notion, why did the World Bank (hardly a bastion of supply-side thinking) report that “high tax rates do not always lead to high tax revenues. Between 1982 and 1999 the average corporate income tax rate worldwide fell from 46% to 33%, while corporate income tax collection rose from 2.1% to 2.4% of national income. … A better way to meet revenue targets is to encourage tax compliance by keeping rates moderate.” And if the Laffer Curve is discredited, someone needs to tell the European Commission (a bureaucracy infamous for trying to harmonize corporate rates at high levels), which recently admitted that “it is quite striking that the decline in the corporate income tax rates has not resulted, so far, in marked reductions in tax revenue, both the euro area and the EU-25 average actually increasing slightly from the 1995 level.”

Or, shifting from corporate taxes to broader measures, how about new research from two German economists (neither of whom are known as supply-siders), which reported that, “We find that for the US model of a labor tax cut and of a capital tax cut are self-financing in the steady state. In the EU-15 economy of a labor tax cut and 85% of a capital tax cut are self-financing.”

Or what about the experience of Ireland? Would critics deny that that there has been a Laffer Curve effect in Ireland, where corporate tax revenues have jumped from less than 2 percent of GDP to more than 3 percent of GDP (a result that is all the more impressive considering the rapid growth of GDP in the Emerald Isle)? And are they really willing to categorically deny any supply-side response following the Reagan tax rate reductions? The 1997 capital gains tax cut? The 2003 tax rate reductions?

Tax-cut advocates should be careful not to over-state the revenue feedback caused by tax cuts – especially for tax cuts that are poorly designed (such as the Keynesian rebates and credits adopted in 2001). But opponents of lower tax rates are equally misguided (or disingenuous) if they blindly assert that changes in tax policy never impact economic performance, and thus never cause revenues to rise or fall compared to static estimates.

Unfortunately, revenue estimating today is based on the absurd notion that tax policy does not affect macroeconomic performance. During 12 years of GOP rule in Congress, Republicans failed to modernize the revenue-estimating process at the Joint Committee on Taxation. No wonder they deserved to lose.

The Media’s Snapshot View

An AP story on the minimum wage begins, all too typically:

The nation’s lowest-paid workers will soon find extra money in their pockets as the minimum wage rises 70 cents to $5.85 an hour today, the first increase in a decade.

Some versions of the AP story, though not the ones that ran in the Washington Post and the New York Times, did acknowledge the possibility that some low-paid jobs might disappear. But most of the news stories this week focus more on criticism of the increase for being too low than on the consensus of economists that minimum wage laws reduce employment for low-skilled workers. It’s enough to make you think Bryan Caplan’s right about the irrationality of the political process. But it’s really just an example of the tendency to look at market processes with a “snapshot view” rather than a dynamic understanding of costs and consequences.

On an unrelated note, unions are outsourcing the arduous job of picket lines to non-union workers. Apparently the carpenters and construction workers are too busy working in our booming economy to have time to picket non-union contractors. The picketers aren’t paid union wages, but they are paid above the minimum wage.

Politicians Seeking Pro-Growth Tax Cuts to Lure Successful People Back to France

The International Herald Tribune reports on the tax-cut battle in France. The President and his Finance Minister are seeking to cut taxes and change the French attitude about wealth creation. In another sign that tax competition is a valuable tool for better policy, the articles explains that a key selling point is the need to make the country attractive once again to the numerous French tax exiles living and working in nations with lower tax rates:

In proposing a tax-cut law last week, Finance Minister Christine Lagarde bluntly advised the French people to abandon their “old national habit.” …Citing Alexis de Tocqueville’s “Democracy in America,” she said the French should work harder, earn more and be rewarded with lower taxes if they get rich. …The government’s call to work is key to its ambitious campaign to revitalize the French economy by increasing both employment and consumer buying power. Somehow it hopes to persuade the French that it is in their interest to abandon what some commentators call a nationwide “laziness” and to work longer and harder, and maybe even get rich.
France’s legally mandated 35-hour workweek gives workers a lot of leisure time but not necessarily the means to enjoy it. Taxes on high-wage earners are so burdensome that hordes have fled abroad. (Sarkozy cites the case of one of his stepdaughters, who works in an investment banking firm in
London.) In her National Assembly speech, Lagarde said that there should be no shame in personal wealth and that the country needed tax breaks to lure back the rich. “All these French bankers” working in London and “all these fiscal exiles” taking refuge from French taxes in Belgium “want one thing: to come back to France,” she said. “To them, as well as to all our compatriots who are looking for the keys to fiscal paradise, we open our doors.”

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….