By James Kwak
It’s really hard to defend the carried interest exemption (the one that allows private equity and venture capital partners to pay tax on their share of fund profits at capital gains rather than ordinary income rates). You have to give Greg Mankiw a hand: he sure gave it a good shot in the Times this weekend.
Mankiw’s general point makes a lot of sense. He argues that it’s sometimes hard to distinguish returns from labor and returns from investment, using five examples of people who buy a house for $800,000 and later sell it for $1,000,000. For example:
“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.”
In this case, although some of Carl’s profit is due to his labor, all of it gets treated as capital gains by the tax code. In a perfect theoretical tax world, you would divide Carl into two people, the investor and the carpenter, and the investor would pay the carpenter some amount for his labor; the carpenter would pay ordinary income tax on that amount (and the investor would deduct it from his taxable profits). But that’s not how we do things.
The key example, for Mankiw, is the next one:
“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.”
In this case, Dan pays capital gains tax on his $100,000 in profits because he’s part of an investment partnership—even though the thing he contributed to the partnership is labor, not capital. Private equity partners, Mankiw argues, are just like Dan: they enter into a partnership with investors, in which the private equity guys contribute expertise and effort and the investors contribute cash. Hence they should pay capital gains on their share of the profits (usually 20 percent).
But there are two big problems with this argument, one of which Mankiw essentially points out. Mankiw recognizes that Carl is contributing labor, even though the tax code pretends he is just contributing capital. If the basic principle is that the capital gains rate should be reserved for profits from investment activity, not labor activity, it’s clear that Carl should pay ordinary income tax on some of his profits; it’s just as clear that Dan should pay ordinary income tax on all of his profits.* (That’s also the logical result if you think, as many supply-siders do, that the point of lower capital gains rates is to encourage savings; Dan in particular didn’t save any money.)
In other words, Mankiw’s own examples make it look like Dan is benefiting from a dubious loophole. Then he argues that since private equity partners are doing the same thing Dan is, they should benefit from the same dubious loophole. That’s not much of a defense.
The other problem is that private equity partners are not actually like Dan the carpenter. If Dan and Ms. Moneybags are in a true 50-50 partnership, then Dan is on the hook for half of their losses, as well. The great thing about 2 and 20, for private equity partners, is that they get a cut of the profits but they don’t absorb a share of the losses. This means that the 20 is more like a performance bonus than like a partnership share. So if the 20 is in a gray area, as Mankiw argues, it is even closer to ordinary income than Dan’s partnership share—which, as Mankiw shows (although he doesn’t quite come out and say it, for obvious reasons), should be treated as ordinary income.
Still, I don’t think you can do a better job than Mankiw does trying to defend the carried interest loophole. Which just shows how indefensible it is.
* The same argument can be made about most stock-based compensation, including stock owned by company founders. If Mark Zuckerberg ever sells any of his bajillion dollars’ worth of Facebook stock, he will pay capital gains tax—even though he earned that stock by contributing expertise and labor to the company, not investing his savings in it. As a onetime company founder, I used to think that I was entitled to capital gains tax rates because I bought my shares on day one (for a pittance). But from a substantive perspective, it’s clear that mainly what I contributed to the company was labor, not investment. In the end, this is all an argument (though not necessarily a conclusive one) against a distinction between ordinary income and capital gains in the first place.
The Baseline Scenario 
Mankiw’s examples just make the inherent paradoxes more clear.
The solution is obvious: Abolish both the income tax and the capital gains tax, and replace them with a direct tax on wealth. After all, what do income or capital gains have to do with how much constitutes your fair share? The definition of “rich” is “having a lot of stuff”, not “having a lot of income”.
It would be completely trivial: The more you own, the more you owe. Even the estate tax could be abolished, because whether you own an estate or your kids do, the same tax would get extracted from it every year.
I have yet to hear any coherent argument against this idea.
“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.
In this case, although some of Carl’s profit is due to his labor, all of it gets treated as capital gains by the tax code.”
I don’t think this is correct. In this case, Carl has a business. It doesn’t matter whether it’s an incorporated business, it’s still a business. The profit is not a capital gain, but is income. Carl is subject to both income tax at regular income tax rates and to self-employment taxes.
The utterly bizarre thing is that nobody is questioning why, should Dan the carpenter have to pay income tax, and Ms Moneybags capital gains tax, Ms Moneybags will be the one paying at a lower rate.
I think I posted this same opinion a while ago, so forgive me for repeating myself.
IMO, the real reason the carried interest special treatment should be eliminated is not because of a labor vs capital distinction, but rather because these folks have zero at risk capital.
The main requirement for a capital gains treatment should be that the capital was placed at risk during the investment period. The investment has to be subject to uncertainty and market forces for capital gains treatment to apply.
The carried interest case obviously fails this test and that’s why it should be eliminated. Getting all wound up in capital vs labor distinctions just adds confusion, IMO. The real issue is whether the capital was at risk. In the case of carried interest, it was not.
These examples are what provide the excitement and vexing qualities of income taxation, in my opinion.
Prof Makiw’s illustrations appear generally correct, but people like the “investor” and “carpenter” and their CPA’s, are always going to structure the transactions on the tax return so the lowest tax rate in set against the gain.
The job of the examiner is to question the characterization, and then try to overcome it, if “facts and circumstances” that are tangential to the discrete transaction of selling property after fixing up, suggest business income, as an earlier poster noted.
The “investor” designation, therefore, would come under particular scrutiny. These issues are one reason an agent’s interview can take several hours, and why a tour of the “business” is always sought.
Greg Mankiw the economist agrees with you, and disagrees with Greg Mankiw the political adviser: http://gregmankiw.blogspot.com/2007/07/taxation-of-carried-interest.html
You’re all missing the big picture. Mankiw is out of touch. Where the hell do dilapidated houses cost $800,000? Weimar Germany?
“In a perfect theoretical tax world”
What does that mean? Is that “world” already one populated by our present tax code and is that our standard for perfection? Are there alternatives or are we perpetually stuck with what we’ve got?
Or is there an alternative tax universe that would upend that “perfect theoretical tax world” and offer a more perfect world?
At least until a couple of years ago, the tax code treated artists the way you want carried interest to be treated, much to the chagrin of artists. An artist spends $100 on supplies to make a painting. Her work sells for $1000, but instead she donates it to a charity. Deduction? $100 (cost of materials.) Ten years later she is famous and her paintings command $100K. You bought one for $1000 ten years ago and donate it to a museum. Tax deduction for you? $100K. Capital gains for you? $0. The artist also donates a painting she made 10 years ago and held in reserve. Tax deduction? $100, same as 10 years ago. Go explain that one.
Or is there an alternative tax universe that would upend that “perfect theoretical tax world” and offer a more perfect world?
No, there is not some other perfect theoretical tax world. There is the chance to rerun your life and make the same mistakes over again, it already been proved that the elders are very accomplished at this. And no one knows why God gave power to the children, especially the confused adults.
A major key being missed in this discourse is risk. The carpenter invested his time and perhaps the cost of materials, as did the artist. The resulting value, be it artwork or a house does not matter, has been increased in value by both investmetns: labor and capital. Both were at risk. Both provided opportunity for loss as well as gain. The carpenter could have lost the value of his time and skills applied to the house. The artist surely lost the value of his or her time too, as well as materials purchased. They all invested and hence risked what they had, labor or capital or both. Taxation needs to refect that risk. Working for a salary one might have to sue to collect is far less risky than buying property to renovate or spending time and materials to create art. Let’s not be blind to this.
The risk associated with the venture will be compensated for by a corresponding higher return, according to asset pricing theories. Therefore, an entrepreneur investing his labor expects a higher return than an employee drawing a salary. The discussion here is about the asymmetric tax treatment of capital gain versus other forms of income, including interest income. Following the risk argument, the question then becomes, should the tax system be designed to encourage risk taking?
Manikow’s paper states a premise for capitol gains that sees capitol gains as a ordinary business result. In fact for most of us CG is a one time result, i.e. selling a house we have lived in for some time. For the real estate investor or Bain Capitol Cg is ordinary business income. Both are in the business of buying things and reselling them, maybe after some fix up. Why is this activity different from a grocer buying lettuce and reselling it after repackaging it? Activities that are routine should be treated as ordinary, but a business owner that buys a building fixes it up, uses it as his business location for years and then sells it should, maybe, get CG treatment on on a one time basis.
Even without the special tax rate, capital gains already get preferential treatment: payment of tax is deferred until the asset is sold. With income from labor, the tax must be paid in the year the income is received.
Also, the idea that reduced capital gains tax “encourages investment” is suspect: what would rich people do with their excess money without favorable tax treatment? Spend it all?
Why is there a difference in tax rates for earned income and capital gains? If I make $100K at my job or business my income is taxed at one rate whereas if I make $100k from investments I pay a lower rate. Yet the $100k I receive is the same in both cases?
The world is awash in capital which is why an ungodly amount has gone into speculation and vulture funds as opposed to creating goods and services.
Of course I agree, but mainly because the US Tax Code if rife with examples of just such obvious obfuscations. My argument, of course, is that to have fairer taxation, we must fully revise the tax code by cleaning out such crap and replacing it with rational taxation policy. I recently heard and argument regarding higher rates on the wealthy where the person on the side decrying such changes stated that the 1% are already paying 40% of the taxes. Sure they are, and probably have mostly paid a similar proportion. There are lots of arguments to be made here:
1) They are deriving the greatest benefits from the economy, and, the tax code actually is written to their benefit now, so why shouldn’t they?
2) Their use of their money to advocate legislation to their benefit has broadly resulted in the supression of economic activity benefiting the average citizen and has pushed a large percentage of the 99% into earnings levels which make paying taxes unnecessary or impossible.
There are lots of arguments to be made, but until the tax code is cleaned up. such arguments are essentially meaningless. The area of the code relating to the taxation of profits of all kinds is a prime area of focus for tax reform. As an example, a big deal was made of the fact that GE paid no corporate tax last year, but, in the wake of that discussion, I discover that about 75% of US corporations did not pay any tax (a fact substantially owing to the Sub-S classification taxation structure, as well as the various “LL” type setups).
Let’s say that the law is changed regarding carried interest. So Dan and Ms. Moneybags structure their next venture like this: Ms Moneybags makes a $798,000 mortgage to the new venture. Dan and Ms. Moneybags then each invest 50% of the required equity – $1,000 each. 50/50. And then split the $200,000 profit 50/50. Now Dan isn’t being compensated for labor. He’s got a capital gain too.
If we want to end the lower tax rate for capital gains, then go for it. Until then, leave carried interest alone. Because if capital gains are taxed favorably for the wealthy, then they should be taxed favorably for all. And let’s not make the accountants rich. This is all so easy to structure around and it’s so obvious that it’s easy to structure around.
President Ronald Reagan signed the Tax Reform Act of 1986 into law and said: “Fair and simpler for most Americans, this is a tax code designed to take us into a future of technological invention and economic achievement, one that will keep America competitive and growing into the 21st century.”
I suspect that most Americans don’t understand what Reagan meant by “economic acheivment”, so with the benefit of hind site, it might be helpful to explain that… as about 4% of the global population, Americans now own more than 50% of global market share. That is to say that lower capital gains (in relation to income taxes), was never about fairness among the US citizenry, it was, and is, about putting capital in the hands of American investors who are pitted in an economic war. And… ‘carried interest’ as policy was intended to insure that a maximum amount of capital would be invested as opposed to being spent on deductable expenditures.
Like it or not, Capitalism leads to a point in time when machines will do most of the tedious chores, and the small percentage of those who own those machines will rule the world (probably from behind walls that encircle all of the best real estate).
But the 1986 tax reform ended the distinction between capital gains and regular income, didn’t it? Reagan and Bradley ended the distinction. That’s a good thing. But if we are going to tax capital gains differently, then carried interest deserves the same benefit. Carried interest has all the risks of investing capital AND is earned by time and effort too.
bill,
I’m sorry, but I do not understand your comment. If there is no longer a “distinction”, then how do we get “differently”?
And yes, capital gains via interest earned would have the same risks as “investing capital”, but what does that have to do with fairness, or the purpose, of having a tax break for investors as opposed to other types of income. Taxing the interest earned annually would at least make capital gains policy moreso fair, Warren Buffet’s secretary would then at least have less of a chance of paying more taxes than what her boss does. And losses would serve as deductions against other income. So you seem to be saying that ‘two wrongs make a right’ in this case. But of course, as I explained above, none of this has anything to do with fairness in the first place.
One must see all of this in the context of ‘trickle-down-wishful-thinking-
unknowable-assumption-based-dupe the masses-type of theory that is in fact, as I mentioned above, actually based on a jingoistic type of
economic theory.
Where all of this gets really interesting, (at least for me), is where this effort to shift the US from a manufacturing nation, or what might be more broadly described as a producing nation, to a nation that is increasingly reliant on its financial services sector, failed to consider that the demand for cross-border capital began to diminish the moment that fiat currencies became standard. That is to say that any nation with a sovereign banking system can create capital ex nihilo so long as that capital is used in some productive way. That is in fact the beauty of capitalism, it allows for intelligent speculation. For support of this, China now having the world’s 3 largest banks, and a 25+ year run of growth averaging 6.5%, and an unparalleled record on poverty elimination, all suggests that capital controls and strict limits on foreign investment, combined with meticulous management of currency values, is policy that limits the volume of cross-border capital profits to the betterment of mankind. The days of the carry trade for example seem numbered, as do the days of toxic assets being traded across borders.
So, foreign investment is increasingly being seen as a type of tax on poor countries by wealthy countries as the reluctance to allow a percentage of profits to leak out of national economies steadily increases, and so… there is a time factor when it comes to the garnering of global market share. It thereby seems very unlikely that US investors will have any wind removed from their sails by an increase in capital gains, or in any type of tax for that matter, any time soon. I don’t expect any loopholes to be filled with mortar either, whether applicable to investors or to corporations. To think that fairness might trump ‘national security’ is naive, plain and simple.
The really, really, interesting thing though, is that we Americans discuss our tax system as if the US economy is still self-reliant. As if foreign inflows from T-bills and the resulting recycled dollars, and the profits from foreign investments via equities and all things neo-imperialistic, are not even worthy of mention. We of course assume that our contribution to global progress is covered by a combination of know-how, charity, and FDI, but at the point that we are falling behind in regards to education and have less and less to offer in regards to innovation, and considering that we are ranked at about 20th in per capita humanitarian aid, and that the dollars being recycled take away from developmental investment in poor countries and channel a portion of the ROW’s surplus capital to a population that consumes too much already, well… we do need to discuss our tax system but in A MUCH BROADER CONTEXT!
Raymond L. Love
@Doubting Thomas:
Sorry, the problem is Manikew is an academic who made a bad choice in explaining his example. The correct treatment, in accordance with the Code via the guildlines set forth in case law, depend on the nature and fequency of the taxpayer’s activities.
The way I read Manikew’s example is this is an amature who flips a house every few years. Flipping one house improved over a two year period, especially if you live in it as residence and don’t put a lot of money into improvements, remodeling, etc., is (at most) going to be captial gains.
OTOH, if he was a contractor and he was flipping four-to-eight houses a year, it’d likely be a self-employment business. If he was buying dumps, putting in tens of thousands of dollars and selling them in very short order at huge mark-ups, we’d be looking at self-employement even if it was just one or two properties a year.
As a CPA I’ve worked both sides of the fence. A few years for the IRS where I won the case in the routine flipper. (And there was a lot more to it, that was only part of his cheating.) As a CPA on the outside, I’ve had clients in both situations. My rule of thumb was if you were flipping more than the odd house, especially without renting the property first, we went straight to self-employment. And if you didn’t like it, you could find another CPA….
This is a recent, but classic case in this situation: TC Memo 2010-261. There are ten factors to be considered. You do not have to meet them all to be considered self-employed in this area.
Mankiw’s examples are purely made up, and do not correspond to reality.
Actually, the tax code does partly execute this division. If I borrow money from my IRA to invest in a rental property, fix it up MYSELF, sell it, and pocket the gains, then that’s considered an overcontribution and I can be fined.
If I don’t fix it up, but the market increases in value, I can keep the gains in my IRA and not suffer a penalty.
As to how to actually enforce this, I have no clue…
enforce this, a wearhouse, pun intended, that is not proved to be full,[fort knox], is empty.
@”You’re all missing the big picture. Mankiw is out of touch. Where the hell do dilapidated houses cost $800,000? Weimar Germany?”
In Perth, Western Australia.
James and moseszd have an essential problem: pass through.
The partnership takes the gains that come in and allocates them by agreement. It can’t change the nature of the gains. As long as all the capital gains that come in are allocated out and all the ordinary income that comes in is allocated out, all is good. Mankiew is, perhaps unfortunately, exactly right.
If you want to change this, equalize tax rates and increase personal deductions so that they reflect a personal “cost of doing business”, then fleshly people would be taxed on something like “net income”.
But without rewriting hundreds of years of partnership practice, not possible. And the bigger loophole is tax deferral due to not selling and creating tax events.