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.

Long Live The Euro!

As the European debt crisis continues to worsen, a growing consensus seems to be emerging that Europe must either form a fiscal union to rescue countries mired in debt or suffer a devastating dissolution of the currency union. The first choice is unappealing to citizens of wealthy Northern European countries because they do not favor paying for the excesses of foreign governments. And few Europeans seem keen on the idea of surrendering economic sovereignty to foreigners.

The second choice - in which some or perhaps even all Eurozone members would ditch the currency - would cause all sorts of economic hardship. Changing currencies from the Euro to some new national currency would be a chaotic process. A country would most likely need to freeze bank withdrawals and convert the currency denomination of contracts. So, if someone had 30,000 Euros saved in the bank and still owed 9,000 Euros on a car loan, both balances would be legally converted from Euros to the new monetary unit. This new currency would be worth less than the Euro. Families that had been saving money in banks could see the value of their savings slashed. Investors would flee in the short term and quite possibly stay away for years, leading to a dearth of capital to fund investment in new businesses. Because many contracts denominated in Euros involve parties from more than one country, some very thorny legal issues would arise about what currency the contracts should be denominated in going forward.

Throughout the financial crisis, policy makers have employed scare tactics to justify aggressive interventions and bailouts: If the banks are allowed to fail, economic catastrophe would result. If Greece defaulted, the entire financial system would collapse (a contention that seems inconsistent with Europe's latest rescue plan, which calls for banks to "voluntarily" concede a 50% haircut on their Greek positions). I suspect that European leaders portrayal of only two options - fiscal union or Eurozone breakup - is yet another scare tactic. A Eurozone breakup would indeed be chaotic. But it is hardly the only viable alternative to fiscal union.

A country can default within the Eurozone. In reality, Greece already has. Banks have agreed to accept less than they are owed on Greek government bonds. The Euro is still around.

The argument that a country cannot default within the Euro system remains one of the least thoroughly explained notions in current policy debates. Perhaps the best explanation I've seen of such logic appears in The Economist:

If a messy default is forced upon a euro-zone country, it might be tempted to reinvent it own currency. indeed it may have little option. That way, at least, it could write down the value of its private and public debts, as well as cutting its wages and prices relative to those abroad, improving its competitiveness. The switch would be hugely costly for debtors and creditors alike. But the alternative is scarcely more appealing. Austerity, high unemployment, social un-rest, high borrowing costs and baking chaos seem likely either way.

In other words, a country might prefer to simply convert all contracts into a new currency and print that currency to service debts. Unfortunately, this would most likely lead to massive inflation and capital flight, causing families to suffer a severe loss in the value of their savings, among many other unwanted consequences of high inflation. There is little reason to think that citizens would actually be better off.

The fact of the matter is that Greece cannot honor its debts and should haircut them even more than it already has. Owners of that debt will suffer losses. The Greek banking system may need to be recapitalized. All of this can be done within the Eurozone without imposing severe hardship on the Greek people, though they will have to stop spending above their means. By writing down the debt, the amount of austerity required will be greatly reduced.

Banks and politicians are arguing that if the people of Europe do not use their money to avoid defaults and rescue the financial system, calamity will ensue (in the form of a chaotic Eurozone breakup). However, this argument is unconvincing. It is easy to imagine a country applying a haircut to its debt while continuing to use the Euro. Such a result will lead to some bankruptcies and a significant loss to investors. But it need not lead to economic chaos. It has the added benefit of bringing back some level of fairness to the financial system. Investors who chased profits without properly accounting for risks should not be made whole at everyone else's expense.

None of this is to say that a default within the Eurozone will be a simple and painless affair. But for countries that are unable to honor their debts (Greece certainly and maybe Portugal and *Ireland), it is the best path forward.

*Ireland actually entered the financial crisis in decent fiscal shape. Only after assuming the liabilities of financial institutions did the government find itself mired in debt. The people of Ireland would be far better off today had their government not acquired massive debts in order to bailout bank investors.

Occupy Wall Street

When I take the subway to the office, I get off at the Fulton Street stop in downtown Manhattan and then walk about half a block south to Zuccotti Park, home of Occupy Wall Street. I usually take a quick look at the protesters to see if anything notable is going on. But on most days it is too early for real action. So I cross the street, ascend to the 48th floor of a skyscraper and trade bonds all day. After work, I usually head to a gym on John St., meaning I walk by the Federal Reserve Bank of New York. Located at 33 Liberty Street, the FRBNY is an imposing stone structure built in the 1920's. Its vaults contain $415 billion of gold bullion, making it the word's biggest repository of the precious metal. The most awesome power of the Federal Reserve, however, is its ability to create money. This has enabled the Fed to save banks, prop up the prices of assets held by banks, and lower interest rates across the country. Although Zuccotti Park is only a few blocks away, the area around the FBRNY remains devoid of protesters. And I have not heard much dialogue from Occupy Wall Street about specific changes that the Fed should implement. This daily cycle of walking past the protesters, trading bonds, and then walking past the fortress-like Fed leaves me thinking that the Occupy Wall Street Movement is not on the right track.

The OWS protesters have a diverse array of views, many of which I agree with. But the central thrust of the movement has somehow become about the divisions between what they call the 99% and the 1%. The following is from the main page of OccupyWallSt.org: Occupy Wall Street is [a] leaderless resistance movement with people of many colors, genders and political persuasions. The one thing we all have in common is that We Are The 99% that will no longer tolerate the greed and corruption of the 1%. I believe this is an unfortunate unifying theme. Most of the 1% are not corrupt. And I doubt they are particularly more greedy than the 99%. One datapoint to consider is from exit polls in the 2008 presidential election showing that of voters earning over $250,000 per year, 52% supported Obama. I reject the notion that the 1% is the problem.

OWS is correct that the government's stance toward Wall Street has been too generous. One can make a strong case that Congress and the Federal Reserve have been alarmingly obsequious in their dealings with the financial sector. I have tried to make that case in other posts in this space. But the movement ought to focus on some of the specific policy mistakes that have been made and continue to be made. Ending tax breaks for hedge fund managers, oil companies, and corporate jets would be a great place to start. In order to accomplish policy change within our democratic system, we need to figure out where Americans from across the political spectrum can come together and agree. Polls indicate that abolishing special tax breaks, ending Wall Street bailouts, and raising the top marginal tax rates are all issues where that could happen. But a vaguely defined condemnation of the 1% is not going to attract the support of the many conservative Americans who would also like to make the system fairer.

Occupy Wall Street has the world's attention. It should quickly establish a simple platform of policies that will make the United States a better place. Then it should use its publicity to promote those policies and educate people about why they make sense.

Sheila Bair

Today's NY Times Magazine has a noteworthy profile of Sheila Bair, the head of the F.D.I.C. during the financial crisis. Bair recently stepped down from her post and now appears more willing to speak openly about her opinions. Bair favored a tougher handling of the big banks than did her colleagues at the Federal Reserve and Treasury. She thought that bank bondholders should suffer haircuts if banks needed government aid. Indeed, that is how the F.D.I.C. handles troubled smaller banks on a regular basis. Depositors are covered by F.D.I.C. insurance and the creditors take a hit. Executive compensation can also be slashed because many of the bank's contracts are rendered null and void due to the insolvency. This occurs just about every week somewhere in America, but financial chaos does not result.

Proponents of the generous bailout terms offered to the biggest banks back in 2008-09 often said that such a process would not have been possible because the appropriate legislation did not exist. However, the government was engaged in various other bailout actions of questionable legality. And Congress was enacting major legislation - such as TARP - on a very tight schedule. Had the administration wanted to be tougher on banks, avoid financial chaos, and maintain market discipline by forcing losses on investors whose firms were insolvent, it could have done so. Unfortunately, Bair never really came out in public during the crisis and spoke as forcefully as she does in this NY Times interview. In the middle of the crisis, she argued that she favored an F.D.I.C style approach to the big banks in the future, but she failed to publicize the view that the government's current policy was deeply flawed, unfair, and unnecessary.

Icesave Referendum

Iceland does it again. The small country's leaders continue to buck the trend by refusing to force citizens to pay for banks' losses. The latest news relates to the Icesave dispute. When Iceland's Landsbanki went bankrupt in 2008, Iceland declined to reimburse overseas depositors. The United Kingdom and the Netherlands subsequently stepped in and used their own money to reimburse Landisbanki depositors in their countries. They have been pressuring Iceland to repay their costs ever since. In the latest chapter of the Icesave saga, President Ólafur Ragnar Grímsson is putting the decision of whether to reimburse the United Kingdom and the Netherlands to a public referendum in Iceland, thereby giving citizens control over the outcome.

You can read more about the Icesave dispute at Wikipedia and Bloomberg

During the last few years of financial turmoil, Iceland has tended to protect taxpayers while forcing bank creditors to suffer losses. The economy has suffered, but has not been the victim of the sort of crippling collapse that leaders in Europe and the United States continue to insist would occur if we did not bailout banks. Unemployment in Iceland is still lower than it is in Ireland, where politicians have imposed severe hardship on taxpayers to keep banks afloat.