Tag Archives: Interest Deductibility

Carried Interest and Your Private Sweat Equity

30 Saturday Dec 2017

Posted by in Central Planning, Taxes

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Suppose your rich uncle buys an old house to do some fix-ups and hopes to resell it at a gain. He has the cash and is willing to split the profit 50-50 if you’re willing to handle a few restorations over the next year. Even better, under the partnership he’ll form with you, your profit will be taxed as a pass-through capital gain. You’ll be taxed at only 15% (or 20% if your income is already very high). You’ll provide the labor, but your cut won’t be taxed at ordinary income tax rates.

That’s Just Like Carried Interest

A similar example is provided by Greg Mankiw, along with several others, to illustrate the ambiguity of “capital gains” under our tax law. What might surprise you is that the tax treatment of the deal with your uncle is exactly the same as the tax benefit received by the general partner (GP) in a private equity fund. The GP is the “worker”, as it were, who manages the capital paid-in by the fund’s investors (or limited partners). The GP attempts to build the fund’s value in various ways. The investors, on the other hand, take the same role as your uncle. The GP earns fees as a cut of the investment gains; those fees are essentially treated as capital gains for tax purposes. In the case of the private equity GP, however, the income is called “carried interest”, but there is no real difference.

The tax treatment of carried interest has been a target of progressives and populist critics for many years. This article in The Hill derides the GOP’s failure to close the carried interest “loophole” in the Tax Cut and Jobs Act (TCJA) recently signed into law by President Trump. Of course, wealthy private-equity players have sought to protect the rule with generous campaign contributions to key politicians. However, as illustrated by the partnership with your uncle, pass-through business taxation combined with the treatment of capital gains provides the same benefits to any business-person who invests “sweat equity” into the improvement of an asset for ultimate resale, including the business itself.

Should “sweat equity” earned by a worker be taxed more lightly than the direct receipt of “sweat wages”? The worker does not “own” the asset in question prior to the work effort, a fundamental distinction from what we normally consider to be a capital gain. On the other hand, the worker shoulders risk that the asset’s value will fail to meet expectations. My view is that it is not appropriate for the tradeoff between private risk and return to be managed via the income tax code or by government generally. Nevertheless, the sweat-equity conversion of labor value into asset appreciation is treated by tax law as a capital gain and is taxed at a lower rate than wages (except at low levels of taxable income).

Equal Protection Under the Tax Law

The carried interest rule and relatively “light” taxation of returns on capital are not at the root of the problem here. Rather, it is the disparate treatment of different kinds of income for tax purposes and the high taxation of ordinary income, even in the wake of the the TCJA’s passage. Diane Furchtgott-Roth argues that the low carried-interest tax rate is necessary to encourage productive investment. Peter Wayrich agrees, but again, that is not a good rationale for disparate (and high) taxation of labor income. This note in the Economic Policy Journal contains a quote on Senator Ron Johnson’s proposal to tax all productive entities at the 20% carried-interest tax rate. The potential loss of revenue might require a higher rate, but the proposition that rates should be equal across all forms of business organizations is more sensible than the complex changes promulgated for pass-throughs under the TCJA. Moreover, the progressive premise that tax rates on capital income should be high is a prescription for low rates of saving, a diminished pool of investment capital, and ultimately low growth in labor productivity and wages.

Demonizing Private Equity

The private equity business is criticized for reasons other than carried interest, but mainly due to superstition that these firms routinely engage in plundering healthy enterprises to extract value and victimize helpless employees by reducing wages or leaving them without work. Simple economics reveals the shallow thinking underlying such claims. As a first approximation, private equity can be profitable only when target firms are under-performing or undervalued. A healthy market for business ownership is necessary to ensure that firms with untapped value survive. Weak performance might stem from any number of circumstances but must be addressable under new management. That includes a management shakeup itself, and it could include a capital infusion to upgrade facilities, elimination of unprofitable product lines, a spin-off from a neglectful parent company, or wage renegotiation to improve competitiveness (but never ask a leftist if wages are too high, even as the employer fails).

Interest Deductibility

The tax benefits of carried interest enhance private equity deals relative to traditional merger and acquisition activity. Again, that illustrates the oddity of having different tax rules for different firms. In the past, the gains from carried interest have been magnified by another unfortunate aspect of the tax code: the interest-deductibility of business debt. The TCJA doesn’t completely eliminate this economic peculiarity, but it places a severe restriction on its use (see #6 on the list at the link).

In general, interest deductibility has favored the use of debt in the capital structures of all businesses. That leverage increases financial risk and bids up the level of interest rates faced by all borrowers. Private equity firms have made liberal use of debt in structuring buyouts. Their borrowing capacity combined with carried interest and the debt subsidy has undoubtedly made deals more attractive at the margin.

The new restriction on interest deductibility is likely to reinforce an existing trend in private equity: gradually, GPs have been putting more “skin in the game“. That is, they are risking a bit more of their own capital. That is generally a good thing for investors. The article at the last link was written in March 2017, so the data shown for 2017 is almost meaningless. In 2016, however, the average GP commitment as a percentage of fund size was still less than 8% and the median was just 4%. These percentages should continue to increase with competition for deals and more restricted deductibility of interest expense.

Taxes and Value

If you want to encourage value-maximizing behavior, then don’t tax its makers (or its markers) heavily. Carried interest extends the tax treatment of “sweat equity” to those who “police” the private sector for unexploited value: private equity firms. By eliminating waste, resuscitating formerly productive enterprises, and exploiting new profit opportunities, their efforts are socially accretive. The popular narrative of an “evil” and “vulturous” private equity industry is both misleading and destructive. Beyond that, there is no reason to tax different forms of productive activity at different rates, but we do. The TCJA has lessened the tax disparities to some extent, but more equalization should be a priority. At least the business interest deduction has been restricted, which should lessen the artificial reliance on borrowed capital.

A Trump Tax Reform Tally

03 Wednesday May 2017

Posted by in Big Government, Taxes, Trump Administration

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The Trump tax plan has some very good elements and several that I dislike strongly. For reference, this link includes the contents of an “interpretation” of the proposal from Goldman Sachs, based on the one-page summary presented by the Administration last week as well as insights that the investment bank might have gleaned from its connections within the administration. At the link, click on the chart for an excellent summary of the plan relative to current law and other proposals.

At the outset, I should state that most members of the media do not understand economics, tax burdens, or the dynamic effects of taxes on economic activity. First, they seem to forget that in the first instance, taxpayers do not serve at the pleasure of the government. It is their money! Second, Don Boudreaux’s recent note on the media’s “taxing” ignorance is instructive:

“In recent days I have … heard and read several media reports on Trump’s tax plan…. Nearly all of these reports are juvenile: changes in tax rates are evaluated by the media according to changes in the legal tax liabilities of various groups of people. For example, Trump’s proposal to cut the top federal personal income-tax rate from 39.6% to 35% is assessed only by its effect on high-income earners. Specifically, of course, it’s portrayed as a ‘gift’ to high-income earners.

… taxation is not simply a slicing up of an economic pie the size of which is independent of the details of the system of taxation. The core economic case for tax cuts is that they reduce the obstacles to creative and productive activities.“

Boudreaux ridicules those who reject this “supply-side” rationale, despite its fundamental and well-established nature. Thomas Sowell makes the distinction between tax rates and tax revenues, and provides some history on tax rate reductions and particularly “tax cuts for the rich“:

“… higher-income taxpayers paid more — repeat, MORE tax revenues into the federal treasury under the lower tax rates than they had under the previous higher tax rates. … That happened not only during the Reagan administration, but also during the Coolidge administration and the Kennedy administration before Reagan, and under the G.W. Bush administration after Reagan. All these administrations cut tax rates and received higher tax revenues than before.

More than that, ‘the rich’ not only paid higher total tax revenues after the so-called ‘tax cuts for the rich,’ they also paid a higher percentage of all tax revenues afterwards. Data on this can be found in a number of places …“

In some cases, a proportion of the increased revenue may have been due to short-term incentives for asset sales in the wake of tax rate reductions. In general, however, Sowell’s point stands.

Kevin Williamson offers thoughts that could be construed as exactly the sort of thing about which Boudreaux is critical:

“It is nearly impossible to cut federal income taxes in a way that primarily benefits low-income Americans, because high-income Americans pay most of the federal income taxes. … The 2.4 percent of households with incomes in excess of $250,000 a year pay about half of all federal income taxes; the bottom half pays about 3 percent.”

The first sentence of that quote highlights the obvious storyline pounced upon by simple-minded journalists, and it also emphasizes the failing political appeal of tax cuts when a decreasing share of the population actually pays taxes. After all, there is some participatory value in spreading the tax burden in a democracy. I believe Williamson is well aware of the second-order, dynamic consequences of tax cuts that spread benefits more broadly, but he is also troubled by the fact that significant spending cuts are not on the immediate agenda: the real resource cost of government will continue unabated. We cannot count on that from Trump, and that should not be a big surprise. Greater accumulation of debt is a certainty without meaningful future reductions in the growth rate of spending.

Here are my thoughts on the specific elements contained in the proposal, as non-specific as they might be:

What I like about the proposal:

  • Lower tax rate on corporate income (less double-taxation): The U.S. has the highest corporate tax rates in the developed world, and the corporate income tax represents double-taxation of income: it is taxed at the corporate level and again at the individual level, perhaps not all at once, but when it is actually received by owners.
  • Adoption of a territorial tax system on corporate income: The U.S. has a punishing system of taxing corporate income wherever it is earned, unlike most of our trading parters. It’s high time we shifted to taxing only the corporate income that is earned in the U.S., which should discourage the practice of tax inversion, whereby firms transfer their legal domicile overseas.
  • No Border Adjustment Tax (BAT): What a relief! This was essentially the application of taxes on imports but tax-free exports. Whatever populist/nationalist appeal this might have had would have quickly evaporated with higher import prices and the crushing blow to import-dependent businesses. Let’s hope it doesn’t come back in congressional negotiations.
  • Lower individual tax rates: I like it.
  • Fewer tax brackets: Simplification, and somewhat lower compliance costs.
  • Fewer deductions from personal income, a broader tax base, and lower compliance costs. Scrapping deductions for state and local taxes in exchange for lower rates will end federal tax subsidies from low-tax to high-tax states.
  • Elimination of the Alternative Minimum Tax: This tax can be rather punitive and it is a nasty compliance cost-causer.

What I dislike about the proposal:

  • The corporate tax rate should be zero (with no double taxation).
  • Taxation of cash held abroad, an effort to encourage repatriation of the cash for reinvestment in the U.S. Taxes on capital of any kind are an act of repeated taxation, as the income used to accumulate capital is taxed to begin with. And such taxes are destructive of capital, which represents a fundamental engine for productivity and economic growth.
  • Retains the mortgage interest and charitable deductions: Both are based on special interest politics. The former leads to an overallocation of resources to owner-occupied housing. Certainly the latter has redeeming virtues, but it subsidizes activities conferring unique benefits to large donors.
  • Increase in the standard deduction: This means fewer “interested” taxpayers. See the  discussion of the Kevin Williamson article above.
  • We should have just one personal income tax bracket, not three: A flat tax would be simpler and would reduce distortions to productive incentives.
  • Tax relief for child-care costs: More special interest politics. Subsidizing market income relative to home activity, hired child care relative to parental care, and fertility is not an appropriate role for government. To the extent that public aid payments are made, they should not be contingent on how the money is spent.
  • Many details are missing: Almost anything could happen with this tax “plan” when the real negotiations begin, but that’s politics, I suppose.

Mixed Feelings:

  • Descriptions of the changes to treatment of pass-through” income seem confused. There is only one kind of tax applied to the income of pass-through entities like S-corporations, and it is the owner’s individual tax rate. Income from C-corporations, on the other hand, is taxed twice: once at a 15% corporate tax rate under the Trump plan, and a second time when it is paid to investors at an individual tax rate, which now range from 15% to almost 24% for “qualified dividends” (most dividend payments), but are likely to range up to 35% for “ordinary” dividends under the plan. So effectively, double-taxed C-corporate income would be taxed at total rates ranging from 30% to 50% after tallying both the C-corp tax and the individual tax. (This is a simplification: C-corp income paid as dividends would be taxed to the corporation and then immediately to the shareholder at their individual rate, while retained corporate income would be taxed later).

Presumably, the Trump tax plan is to reduce the rate on “pass-through” income to just 15% at the individual level, regardless of other income. (It is not clear how that would effect brackets or the rate of taxation on other components of individual income.) Is that good? Yes, to the extent that lower tax rates allow individuals to keep more of their hard-earned income, and to the extent that such a change would help small businesses. S-corps have always had an advantage in avoiding double taxation, however, and this would not end the differential taxation of S and C income, which is distortionary. It might incent business owners to shift income away from salary payments to profit, however, which would increase the negative impact on tax revenue.

  • Interest deductibility and expensing of capital expenditures are in question. Interest deductibility puts debt funding on an equal footing with equity funding only if the double tax on C-corp income is fully repealed. Immediate expensing of “capex” would certainly provide an investment incentive (as long as “excess” expenses can be carried forward), and for C-corporations, it would certainly bring us closer to elimination of the double-tax on income (the accounting matching principle be damned!).
  • There is no commitment to shrink government, but that’s partly (only partly) a function of having abandoned revenue neutrality. It’s also something that has been promised for the next budget year.
  • The tax reform proposal represents a departure from insistence on revenue neutrality: On the whole, I find this appealing, not because I like deficits better than taxes, but because there may be margins along which tax policy can be improved if unconstrained by neutrality, assuming that the incremental deficits are less damaging to the economy than the gains. The political landscape may dictate that desirable changes in tax policy can be made more easily in this way.

Shikha Dalmia wonders whether a real antidote for “Trumpism” might be embedded within the tax reform proposal. If the reforms are successful in stimulating non-inflationary economic growth, a “big if” on the first count, the popular preoccupations inspired by Trump with immigration policy, the “wall” and protectionism might just fade away. But don’t count on it. On the whole, I think the tax reform proposal has promise, though some of the good parts could vanish before a bill hits Trump’s desk, and some of the bad parts could get worse!