Carried Interest

Mitt Romney earned a hefty 21.6 million dollars in 2010. But he paid a measly 13.9% of that in income taxes to the Federal Government. Under current law, any "ordinary income" over $380,000 is taxed at 35%. Various loopholes, deductions, and legislative oddities make it possible for Romney to pay a smaller share of his income in taxes than your doctor probably paid.

Mitt did not do anything illegal. But the tax code that makes this possible is deeply flawed. Romney benefited from a concept called "carried interest." Before explaining any further, I am compelled to offer the following warning: learning about carried interest might upset you and/or make you less willing to pay your income taxes. It is a bogus concept. Supporters of carried interest often resort to contortions of logical reasoning to justify its existence. Indeed, recent columns in prominent publications like the NY Times and Bloomberg have done exactly that. My aim below is to offer readers a clear explanation of carried interest and an easy to understand critique of some of the recent articles that have attempted to defend its continued existence.

The first thing to understand is that the American government currently taxes income that individuals make by working at different rates than it taxes income people earn by investing. Income earned by working is taxed according to a bracket that ranges from 10% for lower earners to 35% for the highest earners. Certain types of investment income, on the other hand, receive special treatment and are not subject to the taxes as specified in the bracket. Income earned from dividends and long-term capital gains (a long-term capital gain is the money made from price appreciation on an investment that is held for at least one year) is currently taxed at only 15%.

Ok, so money earned by working is taxed differently than money from dividends and long-term capital gains. Put that knowledge aside for a moment while we go over the basic structure of investment partnerships like hedge funds, private equity funds, and venture capital funds. The details of how these firms make money is not very important. Just know that all of them are hired by institutions like pension funds, university endowments, and wealthy individuals to invest their money strategically. The investment partnerships charge a fee for this service. A typical fee structure is known as "two and twenty" in Wall Street lingo. If a private equity fund charges "two and twenty" it means that it keeps 2% per year of any money the client invests and 20% of any gains. So, let's say a pension fund gives a hedge fund $10,000,000 to invest on its behalf for 2 years. At the end of the 2 years, the $10 million has grown to $13 million. But the pension fund will not be getting $13 million back. The private equity partnership will keep $400,000 because 2% x $10,000,000 x 2 years = $400,000. It will also keep a 20% performance fee for the $3,000,000 gain it achieved, which equals $600,000. So, the partnership will keep a total of $1 million and the pension fund will receive $12 million.

Now let's talk about taxes. The private equity fund did not risk any of its own money. The partners of the private equity fund received $1,000,000 in fees. You might think that the $1,000,000 in fees should be treated as ordinary income subject to the ordinary tax bracket. After all, the private equity partners did not invest their own money to create this $1,000,000 in profit; all of the income takes the form of a fee paid for a service (the service being strategic investment). Somehow, Congress and the IRS have agreed to allow the partners to treat the $600,000 performance fee as a capital gain. Therefore, the private equity partners only have to pay a 15% tax rate on the $600,000 of income. The thinking is that because the private equity firm has a share in the profits of an investment, the resulting income should be treated as investment income. This logic fails to account for the fact that the private equity firm is not investing its own money. Rather, it is performing work on investors' behalf. Whether the investor wants to pay the private equity firm with a fixed fee, a share of the profits, or a lifetime supply of M&M's, the compensation should be treated as ordinary income.

Gregory Mankiw is a frequent NY Times columnist, Harvard economics professor, and advisor to the Romney campaign. His column on March 3 attempted to explain carried interest by positing some theoretical examples, three of which I reproduce below:

• Carl is a real estate investor and a carpenter. He buys a dilapidated house for $800,000. After spending his weekends fixing it up, he sells it a couple of years later for $1 million. Once again, the profit is $200,000.

• Dan is a real estate investor and a carpenter, but he is short of capital. He approaches his friend, Ms. Moneybags, and they become partners. Together, they buy a dilapidated house for $800,000 and sell it later for $1 million. She puts up the money, and he spends his weekends fixing up the house. They divide the $200,000 profit equally.

• Earl is a carpenter. Ms. Moneybags buys a dilapidated house for $800,000 and hires Earl to fix it up. After paying Earl $100,000 for his services, Ms. Moneybags sells the home for $1 million, for a profit of $100,000.

Carl would be able to treat his $200,000 profit as a capital gain because he invested his own money. Under current partnership law, Dan would be able to claim his $100,000 income as capital gain because he has been given a carried interest in Mrs. Moneybag's investment. On the other hand, Earl would have to pay ordinary income tax because he was paid a fixed fee for his work. Mankiw writes:

In some ways, this treatment makes sense. After all, Dan is doing half of what Carl did, so why should he have to pay a higher tax rate than Carl did on that half of his income? On the other hand, it seems that Dan is getting off easy. Dan does not seem very different from Earl, because both are getting $100,000 for fixing up the house.

If these examples leave your head spinning, you are not alone. Economists and tax lawyers who study these issues are unsure about the best way to handle these situations in practice.

Here is where carried interest enters the picture. Carried interest from a private equity partnership is like the income that Dan earns from his real estate partnership. In this case, however, Dan is not a carpenter but a specialist in business turnarounds. The partnership does not buy dilapidated houses to fix up and sell; it buys troubled businesses to fix up and sell. And just as Dan the carpenter can treat his share of the partnership income as a capital gain, Dan the business specialist can do the same.

Mankiw says that "Dan is doing half of what Carl did" and therefore it is reasonable that they should both pay the advantageous capital gains rate. This is not true. Unlike Dan, Carl invested his own money. Carl's savings were at risk if the project went South, whereas Dan's savings were never part of his arrangement. It makes sense that Carl's gains are treated as a return on investment. It does not, however, make sense that Dan's compensation should be treated as investment income; Dan has not invested any capital. He has simply performed a service for Ms. Moneybags and they have agreed that his payment will be a share of any profits.

Bloomberg News recently ran an opinion piece entitled "If Carried Interest Irks You, You Don't Get It", written by a tax attorney named William Dantzler. Dantzler makes the valid point that there is sometimes a grey area between working and investing. He cites the example of an entrepreneur who works to build a company and then enjoys the benefit of the lower capital gains rate when he sells that company for millions of dollars, despite the fact that he never really invested significant financial capital:

Bill Gates has a capital gain when he sells Microsoft Corp. (MSFT) stock even though, by most accounts, Microsoft would not exist without his considerable effort. Similarly, the distinction between capital gains and ordinary income has never been based on the amount of money invested or, indeed, whether there was any investment at all. An entrepreneur who starts a business with no investment (or more likely an investment by someone else with money) still generates capital gains on the sale of her business, and it is sometimes said that this fact accounts for the vibrancy of the tech economy in the United States.

What then would be the basis for saying that a private- equity executive with a carried interest should have his percentage of the capital gain from the sale of an underlying investment recharacterized as ordinary income? Is it because he sweats and the other investors don’t?

Dantzler is higlighting the fact that investors who both invest their own capital and perform some work that increases the value of that investment receive a special tax advantage; despite the fact that they have performed work and invested, all of their profits can be treated as capital gains for tax purposes. There is something a little unfair about a system in which an entrepreneur can convert the profits he earns by working - as opposed to investing - into a capital gain. If Bill Gates or Carl the Carpenter performs work that increases the value of an investment, the value of that work should theoretically be taxed as ordinary income. But Dantzler incorrectly suggests that because some entrepreneurs receive an unfair benefit, we must also extend this largesse to private equity managers. The problem of entrepreneurs receiving a special advantage is not remedied by creating a special tax law that arbitrarily includes investment partnerships in the lucrative arrangement. Why not also include doctors, waitresses, and teachers? Dantzler then proceeds to suggest that from a legal perspective, "It would be very hard to draw a fair line between the type of private-equity investment that is deserving of capital gain treatment and that which is not." In reality, it would be pretty straightforward: Anytime wealth is transferred from one party to another as a form of compensation (ie., a performance fee for investing), it should be considered ordinary income.

Now, if this discussion leaves you wondering if capital gains taxes should even be lower than ordinary income taxes in the first place, you are not alone. Many people argue that this system should be abolished. Indeed, the Tax Reform Act of 1986 equalized the rates for a few years. However, there are also many valid arguments in favor of a two-tiered approach. That debate is for another day. The point of this discussion is that given that we have such a system, there should not be a special exception for partnerships that allows private equity managers to avoid paying billions of dollars in taxes.

Our National Debt Matters, Part 2

After reading my post about why our national debt matters, two astute readers pointed out that Americans do not actually own the vast majority of U.S. debt. There are different ways to count how much debt the United States owes. Depending on the method used, foreigners hold between 33% and 50% of the total. Anyway you cut it, it's a big number. The United States will have to send that money abroad. This inconvenient fact casts further doubt on Krugman's thesis.

To his credit, Krugman does acknowledge that foreigners have sizable holdings of U.S. Treasuries. But he suggests that because private Americans have been investing in higher yielding stocks and bonds overseas, this does not matter much. Taxpayers may have to send money overseas, but overseas corporations have to send money back to private citizens in the United States, the thinking goes. The truth is that foreigners own at least 2.3 trillion more American assets than Americans own overseas. And the number continues to grow. More importantly, the American government uses the money it borrows to fund wars and pay for entitlements. Foreign companies use American capital to improve their productivity and future competitiveness.

Our National Debt Matters

Paul Krugman recently advanced an interesting theory in a piece for the Houston Chronicle. The Nobel economist argued that “Debt matters, but not that much”. The crux of his argument is that in the case of the United States national debt, it is mostly money that America owes to America. Because Americans own the vast majority of outstanding treasury bonds, we will simply be giving money to ourselves when we do eventually get around to repaying. This, Krugman argues, is very different than the debt a family owes on its mortgage. In the case of a family, the money owed is money the family will lose in the future. Whereas the mortgage debt is only a liability for a family, our national debt is both a national liability and a national asset for a the country. The implications of this reasoning for government policy – if correct – would be significant. Rather than obsessing about what programs to cut and whom to tax, we could deploy more money to cure joblessness, improve education, provide healthcare, and maybe even colonize the moon (if you haven't been following the Newt Gingrich campaign, you might be interested to know that the former Congressman says he plans to establish a permanent base on the lunar surface if elected president). Indeed, Krugman says that Washington is excessively focused on “the allegedly urgent issue of reducing the budget deficit.”

I wish Mr. Krugman were correct. Unfortunately, he is mistaken. Our national debt does indeed matter very much and repaying it will involve national hardship, much like that endured by a family repaying an imprudently large mortgage. When the U.S. Government spends more money than it receives in revenues, it sells bonds to raise cash to cover the shortfall. Historically, Americans have purchased the majority of these bonds. Krugman suggests that when the owners of the bonds are also Americans, it follows that America is not really losing anything. Tax revenues will have to be higher in the future to repay this debt, but future Americans will be receiving most of this cash. So America is not losing substantial sums of wealth. True. But this analysis misses the crucial point.

Deficit spending diverts capital from private markets. That can be good or bad. When government deficits are used to increase future productivity, they can actually increase a nation's wealth. Borrowing money to build a strategically placed bridge or a successful research facility, for example, is often profitable for a country because the economy will be more productive in the future. But when the spending does not result in investment that increases economic productivity, the debt created will cause a decrease in future living standards. Borrowing money to fund wars in Iraq and Afghanistan, for example, has done little to improve our economic productivity and has diverted resources from activities that would make us wealthier in the future.

A useful way to illustrate the downside of indebtedness is a stylized comparison. First, consider a country – call it Austerity – with a fiscally conservative government that balances its budget. The people of Austerity collectively save 1 billion per year. Since there are no government bonds to buy in Austerity, families invest savings in stocks and bonds issued by corporations. The 1 billion in capital that the corporations receive each year is used for new factories, research, and training programs to improve employee skills.

Contrast Austerity with its neighbor Stimulus. Stimulus is economically similar to Austerity, except that the government has decided to lower taxes by 500 million and sell 500 million in government bonds to cover the shortfall. Because the people of Stimulus have an extra 500 million in disposable after tax income, they both spend and save more money than their neighbors. Stimulusarians save a total of 1.25 billion per year and spend an extra 250 million. Of the 1.25 billion in savings, 500 million is invested in government bonds. That leaves only 750 billion to invest in corporations. As time goes by, the corporations of Stimulus – which have have less money to spend on improving productivity - become increasingly less productive than corporations in Austerity.

On average, retirees in Austerity are able to build up retirement savings of 500,000. All of theses savings are in corporate bonds and stocks. Because of lower taxes, Stimulusarians are able to save 625,000 for retirement. 375,000 is invested in private markets and 250,000 is in the form of government bonds. But Austerity is really a much wealthier country than Stimulus. In Austerity, retirees leave future generations a nation that can produce more output per person than the economy of Stimulus. That is why the value of corporate investments in Austerians' retirement accounts is 33% higher than the value of private investments in Stimulusarians' accounts. In both countries, retirees will stop working; they will rely on the productive capacity of younger generations to feed, clothe, and take care of them. But because Austerity is able to produce more per worker, younger generations will pay lower taxes and enjoy a higher standard of living.

Amidst the recent roller coaster of booms, bubbles, busts, bailouts and Bernanke press conferences, it is easy to forget that investing is supposed to be about lending capital to help foster innovation and growth. When governments run deficits, they divert capital – and therefore real resources - from private markets. Depending on how the government uses that capital, both superior and inferior economic outcomes can be achieved. Oftentimes, governments use deficits to fund entitlements, military spending, and other activities that do not increase future economic productivity. When this happens, future generations must bear a burden that causes their real living standards to decline.

None of that is to say that deficit spending is inherently bad or that providing a social safety net is not an excellent policy. Rather, when we do run deficits, we must keep in mind that we are diverting capital from private markets and creating a burden on future taxpayers. Only when those costs are outweighed by the benefits of deficit spending should we spend more than we receive in tax revenues. Unfortunately, the United States is currently using deficit spending to pay for wars and underfunded social programs that do little to increase productivity. Contrary to Krugman's assertion, this will indeed matter very much to the future American way of life.