Air Traffic Control

You often need a crisis, real or imagined, to get major policy changes enacted. There are two looming challenges in our backwards and bureaucratic air traffic control system that might nudge Congress toward reform. The first is that the government system is having a hard time keeping up with the continued growth in air travel.

The second, as Government Executive magazine reports today, is that a large group of controllers are nearing retirement and the government might have a hard time finding replacements.

These challenges add to the woes of the Federal Aviation Administration, which has mismanaged the air traffic control (ATC) system for decades. The FAA has struggled to modernize ATC technology in order to improve safety and expand capacity. Its upgrade projects are often behind schedule and far over budget, according to the Government Accountability Office. (Discussed in here). 

Privatization of U.S. air traffic control is long overdue. During the past 15 years, more than a dozen countries have partly or fully privatized their ATC, and provide some good models for U.S. reforms.

Canada privatized its ATC in 1996, setting up a fully private, non-profit corporation, Nav Canada, which is self-supporting from charges on aviation users. The Canadian system has received rave reviews for investing in new technologies and reducing air congestion, and it has one of the best safety records in the world.

The United States should be a leader in air traffic control, especially given the nation’s legacy of aviation innovation. A privatized system would allow for more flexible hiring policies, replacement of expensive human controllers with machines, and access to private capital for infrastructure upgrading. It is also likely that privatization would help improve safety and reduce air congestion by speeding the adoption of advanced technologies.

NR Editors on SCHIP

In an editorial released Friday, National Review’s editors highlight the many problems with the State Children’s Health Insurance Program, or SCHIP.  That program ostensibly was created for low-income children.  Congress is presently trying to expand the program to cover as many non-poor children – and even non-children – as they can get away with.

I agree with most of the editorial, though I worry about its conclusion:

If the Democrats agree to enact some free-market reforms, it might be worth supporting a modest expansion of S-CHIP. Otherwise, President Bush should make good on his veto threat.

I think one would have throw in some pretty hefty free-market reforms to offset the harm done by expanding SCHIP.  Letting people purchase health insurance out-of-state wouldn’t be enough.  The package would have to include weightier reforms, such as President Bush’s proposed standard deduction for health insurance or large health savings accounts.

I discuss the many problems with SCHIP in an upcoming Cato Institute Briefing Paper.

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.

Hash Brownies and Harlots in the Halls of Power

Eight British Cabinet ministers have admitted that they smoked marijuana in their youth, most of them “only once or twice” in college, which would be an atypical pattern. The revelations began with Jacqui Smith, the new Home Secretary, the equivalent of the attorney general. They also include the police minister and the Home Office minister in charge of drugs. The eight have been dubbed the “Hash Brownies,” in acknowledgment of Prime Minister Gordon Brown.

On Wednesday Brown announced that Smith would lead a government review of the laws on marijuana, specifically with reference to whether simple possession should be again grounds for arrest. (The law was eased in 2002.) Several leading Conservatives in the Shadow Cabinet have also acknowledged using drugs, and party leader David Cameron has emulated President Bush in saying that he’s not obligated to discuss every detail of his private life before he entered politics.

In the United States many leading politicians including Al Gore, Newt Gingrich, Bill Bradley, and Barack Obama have admitted using drugs, while Bush and Bill Clinton tried to avoid answering the question.

In both Britain and the United States, all these politicians support drug prohibition. They support the laws that allow for the arrest and incarceration of people who use drugs. Yet they laugh off their own use as “a youthful indiscretion.”

These people should be asked: Do you think people should be arrested for using drugs? Do you think people should go to jail for using drugs? And if so, do you think you should turn yourself in? Do you think people who by the luck of the draw avoided the legal penalty for using drugs should now be serving in high office and sending off to jail other people who did what you did?

And the same question applies to Sen. David Vitter, who has acknowledged employing the services provided by the “D.C. Madam.” Many people have compared Vitter to other politicians who engaged in adultery, or have mocked his commitment to “family values”–he has said that no issue is more important than protecting the institution of marriage from the threat of gay couples getting married. But the other politicians usually cited were not breaking the law when they had affairs, and Vitter’s hostility to gay marriage while cheating on his own is a matter of simple political hypocrisy. The more specific issue, as with the pot-smoking drug warriors, is that Vitter (presumably) supports the laws against prostitution. Yet he himself, while a member of the United States Congress, has broken those laws and solicited other people to break them.

Vitter should be asked: Do you think prostitution should be illegal? If so, will you turn yourself in? Or will you testify for the defense in the D.C. Madam case, asking the court not to punish Deborah Jeane Palfrey if it’s not punishing you?

I hope that Jacqui Smith, Barack Obama, and David Vitter will engage in some introspection and conclude that if they didn’t deserve to go to jail, then neither do other pot smokers, prostitutes, and their customers. They might decide that not every sin or mistake should be a crime. But they should not sit in the halls of power, imposing on others the penalties they don’t think should apply to them.

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….

Meet the New Farm Bill

Prepare to pay more for your food. The House Agriculture Committee on Thursday unanimously passed a 2007 farm bill that, in the words of a committee press release, “makes historic investments in conservation, nutrition and renewable energy while maintaining a strong safety net for America’s farmers and ranchers.”

For “investments,” read “spending increases,” and for “a strong safety net,” read “subsidies and trade barriers to keep commodity prices and production artificially high.”

Sadly, the new 2007 farm bill looks a lot like the old 2002 farm bill that is due to expire on September 30. No real changes were made in the Title 1 commodity programs that lavish production subsidies on farmers who grow corn, wheat, cotton, and other program crops. Trade barriers remain against imports of lower-priced sugar, rice, and dairy products.

As we have pointed out in a number of recent Cato studies on farm policy, tens of millions of American families will continue to pay for these programs through taxes and higher prices at the grocery store. Once again, members of the House Agriculture Committee, Democrats and Republicans alike, have demonstrated that they represent a small number of farmers rather than the general interests of the American people.