Wednesday, November 30, 2011

T's for Taxes; T's for Tennessee -- Part III (Carried Interest)

We’ve tackled some pretty big tax reform ideas lately – we pined for the higher marginal tax rates and greater number of brackets under Reagan here, and talked about the tax break for the well-off known as capital gains here. So let’s address a smaller, less controversial idea today. 


In fact, today’s problem is so small … we’ve already solved it through our reforms on capital gains. But it will serve as a good lesson on how the privileged tax position of capital gains is exploited by the most well-off.

This loophole is known as carried interestwhich is the
right to receive a specified share (often 20 percent) of the profits ultimately earned by an investment fund without contributing a corresponding share of the fund’s financial capital.  It is part of the standard compensation package for managers of private equity funds [and hedge funds, and a bunch of commercial real estate concerns as well]. 
Current law allows these managers to pay tax on all or most of their carried interest income at the 15 percent capital gains rate, instead of at the individual income tax rate that would otherwise apply, typically 35 percent for these high-income individuals. Rather than being taxed as managers receiving compensation for services rendered, recipients of a carried interest are taxed as though they were investors who had supplied 20 percent of the financial capital of the fund. 
If you’re a hedge fund manager, a typical compensation package might be a two-and-twenty – meaning that you would receive an amount equal to 2% of all the assets under management, as well as a 20% share of any profits – a performance fee. (Other factors – things like high water marks and expenses– will affect compensation, so this is a simplified version).

So let’s say you’re managing a small hedge fund with $100 million in assets. Because you are a very good manager, the fund makes $10 million this year. You will receive $2 million as your compensation, which will be taxed as ordinary income. But you will also receive 20% of $10 million, or another $2 million, as carried interest/performance fee. And this is the part which gets taxed as capital gains.

Why does this get taxed as capital gains? There's really no good reason. Proponents will argue that the 20% represents the gains that the manager would have received had he invested 20% of the capital of the fund. True ... but that's not what he did. The manager contributed ... nothing. Literally. 

The manager has provided a service, and he should be compensated (and taxed) for that. But in terms of capital ... the manager didn't add a single penny.

So how does this play out? Referring to our marginal tax rates chart:

2011 Taxes on $2,000,000




Marginal
Tax Brackets


Tax Rate
Over
But Not Over


10.0%
$0
$17,000
$17,000
$1,700.0
15.0%
$17,000
$50,000
$33,000
$4,950.0
25.0%
$69,000
$139,350
$70,350
$17,587.5
28.0%
$139,350
$212,300
$72,950
$20,426.0
33.0%
$212,300
$379,150
$166,850
$55,060.5
35.0%
$379,150
$2,000,000
$1,620,850
$567,297.5









$667,021.5


2011 Capital Gains Taxes on $212,300




Tax Rate
Over
But Not Over


15.0%
$17,000
$2,000,000
$2,000,000
$300,000


-






$300,000

So the manager would have a total tax liability of $967,000. But if we recognized all of the $4 million as ordinary income, then his tax bill would be much higher.

2011 Taxes on $4,000,000




Marginal
Tax Brackets


Tax Rate
Over
But Not Over


10.0%
$0
$17,000
$17,000
$1,700.0
15.0%
$17,000
$50,000
$33,000
$4,950.0
25.0%
$69,000
$139,350
$70,350
$17,587.5
28.0%
$139,350
$212,300
$72,950
$20,426.0
33.0%
$212,300
$379,150
$166,850
$55,060.5
35.0%
$379,150
$4,000,000
$3,620,850
$1,267,297.5









$1,367,021.5

Yes, we're currently giving tax breaks to hedge fund managers. We're that screwed up.

(For the sake of comparison, Topeka is now so broke that they're simply not prosecuting misdemeanors any more (including those for domestic violence).)

But as we noted earlier, this problem has already been solved. By taxing capital gains as ordinary income, this tax break simply disappears. It won't matter what the manager's compensation is called, or whether he made a capital contribution, because it will all be taxed the same.

Because income ... is income ... is income ... is income.

Disclaimer: The brackets above cannot be used to calculate actual tax liabilities without including other factors, most notably -- deductions. But they are indicative of tax liabilities over time, and between the well-off and the just-getting-by.

Tuesday, November 29, 2011

T's for Taxes; T's for Tennessee -- Part II (Capital Gains)

Recently, we discussed what to do with marginal tax rates and tax brackets. Today, we're onto capital gains.*

So why do capital gains matters? Because it's what the 1% use as income, but without (most) of the pesky taxes.

As we saw yesterday, a married couple making $600,000 saves about $100,000 a year in taxes under Obama as compared to what they would have owed under tax warrior Ronald Reagan. But the median American household ($50,000 in income) only saves about $1,000.

Presumably, the average household spends much of that $1,000 because, you know, $40,000 (approximately) in post-tax income isn't a lot to raise a family on. But our well-off couple will likely invest that $100,000, because, you know, they already have (approximately) $400,000 in post-tax income to spend. And when they sell off their investments, they'll do so at a screamingly low tax rate. 

Let's throw up the marginal tax rates for 2011 again.

2011 Married Filing Jointly
Marginal
Tax Brackets
Tax Rate
Over
But Not Over
10.0%
$0
$17,000
15.0%
$17,000
$69,000
25.0%
$69,000
$139,350
28.0%
$139,350
$212,300
33.0%
$212,300
$379,150
35.0%
$379,150
-

So let's say you are a married couple who made $212,300, and you paid $$44,664 in taxes.

2011 Taxes on $212,300




Marginal
Tax Brackets


Tax Rate
Over
But Not Over


10.0%
$0
$17,000
$17,000
$1,700.0
15.0%
$17,000
$50,000
$33,000
$4,950.0
25.0%
$69,000
$139,350
$70,350
$17,587.5
28.0%
$139,350
$212,300
$72,950
$20,426.0
33.0%
$212,300
$379,150


35.0%
$379,150
-






$44,663.5

You're doing pretty good -- maybe not great -- but you're at more than four times the median household income.

Now let's say that you're a married couple who've done quite nicely -- you've amassed a sizable chunk of savings -- and you're living off the investments, with capital gains of $212,300. Nice!

And you'll owe taxes of only $31,845, a bit more than two-thirds of what our first couple owed. That's because capital gains are not taxed in accordance with the chart above, but are instead subject to a flat tax of 15%.


2011 Capital Gains Taxes on $212,300




Tax Rate
Over
But Not Over


15.0%
$17,000
$212.300
$212,300
$31,845


-






$31,845


The first couple made their money by working for it -- through the sweat of their brow or by dint of their intelligence/charisma/leadership or some other combination of skills. They created something of utility, something which others in society used or enjoyed. Somebody wanted the stuff that they were making, and that's why they got paid in the first place. 

The second couple did none of that. They did invest wisely -- and kudos to them -- but they did no work.  What they did -- basically -- is make good bets. And our current tax code rewards their gambling by cutting their tax rate by a third (or more).

But gambling doesn't sound like investing. In most cases, though, it is. Unless you're involved in a public offering, all of the securities** you've purchased have been in the secondary market. This means that not one dollar of the purchase price you paid went to the issuer. Instead, all of the purchase price went to someone who purchased those securities before you. You've made a bet that the security will rise in price and, if you're right, you'll win! But you won't owe taxes on gambling winnings -- which are taxed as regular income. Instead, these winnings are classified as capital gains, and taxed at a much lower rate.


Here is another example of how the tax code works to the betterment of the 1%. Capital gains (and their preferential tax treatment) are very much skewed towards the wealthy. In fact, in 2001, 2002, 2003 and 2007 (the last year for which data is available), more than 10% of all of the capital gains in the country went to just 400 tax payers

And those 400 returns represents those filed by the the top 0.00026%. Not the top 1%, but the top 0.026% of the top 1%. The remaining 90% of capital gains is filtered down to the 99.99974% of us.

Except that it doesn't. The top 0.1% ends up with nearly half of all capital gains, so that leaves 50% for the 99.9% of us. 

And all of that is taxed at 15%, the same tax rate which would kick in at $17,000 if you actually worked at a job. So if you made $8.50 an hour (and worked a forty hour week, fifty weeks a year), you'd be taxed at exactly the same rate which applies to the gambling winnings of the nation's wealthiest individuals. 

But it's actually worse than that, because we haven't figured in Social Security and Medicare taxes. As we noted in our discussion of Social Security,  capital gains are currently excluded from Social Security (usually 6.2%, but currently 4.2%) and Medicare (1.45%) taxation, So that's an additional 5.65%.

This means that the lowest combined tax rate applicable to working stiffs -- 15.65% - will always be higher than the combined tax rate -- 15% -- applicable to the gambling winnings of the well-off. Always.



Fortunately, there is a solution, and  this instance is actually quite simple.

Income ... is income ... is income ... is income.

There is no reason to treat capital gains differently than earned income, and there have been occasions where we've done exactly that. We did so from 1913 to 1921, and again from 1986 to 1990.

Eliminating the tax break for capital gains would also do wonderful things for the deficit. According to the Wall Street Journal's analysis of "Sen." Tom Coburn's report on tax breaks, taxing capital gains (and qualified dividends***) at a maximum rate of 15% costs this country about $80 billion in lost revenue. 

Best of all, the tax would be paid by those most able to pay it. As we noted above, fully half of all capital  gains go to the top 0.1% of Americans. 

For comparison, restoring marginal rates on the top 0.1% to those during the Reagan administration would bring in somewhere less than $100 billion a year. Treating capital gains as regular" income would likely double that figure. 

Remember the Super Committee? Good times, good times.



The Super Committee was supposed to find $1.5 trillion in deficit reductions over the next decade, and they failed miserably. But with the changes to the tax code we've discussed in the past couple days, we're on target to reduce the deficit by $140 billion a year -- and that's just from eliminating tax breaks for the top 0.1%!

That's $1.4 trillion over ten years -- pretty close to what the Super Committee was supposed to accomplish. If you add in the additional revenue by taxing the rest of us -- and not just the top 0.1% -- we get some wiggle room. We should be able to  do some things to make the tax code more progressive at the same time. We could take the Reagan era marginal rates:


1982 Married Filing Jointly (2011 Dollars)
Marginal
Tax Brackets
Tax Rate
Over
But Not Over
0.0%
$0
$7,906
12.0%
$7,906
$12,788
14.0%
$12,788
$17,671
16.0%
$17,671
$27,670
19.0%
$27,670
$37,203
22.0%
$37,203
$46,969
25.0%
$46,969
$57,199
29.0%
$57,199
$69,523
33.0%
$69,523
$81,846
39.0%
$81,846
$106,493
44.0%
$106,493
$139,511
49.0%
$139,511
$199,035
50.0%
$199,035
-


.. but spread out the brackets. Maybe the first $10,000 should be free from taxes, or maybe the 22% bracket should kick in at $40,000 or $45,000. We've got some room to play here, because we've vastly expanded the pool of income subject to taxation as regular income.

We can do this.

* For the purposes of this post, capital gains will mean long-term capital gains. Short-term capital gains are already taxed as regular income in an effort to support price stability. We think this is a pretty good idea, and would be open to assessing a tax penalty on short-term capital gains to support long-term ownership. But we've also got some other ideas on supporting price stability -- namely, the Tobin tax -- which we'll discuss in a later post.

** It's certainly possible to invest in other things, such as real estate. But unless you're actually building a house, you're not creating a social good. You're flipping which -- unless you're doing some major renovations -- is basically gambling. 

*** What are qualified dividends? Briefly, they're bastard offspring of the Bush tax cuts. Before that, dividends were taxed as regular income, but starting in 2003, qualified dividends were taxed as if they were capital gains.

Disclaimer: The brackets above cannot be used to calculate actual tax liabilities without including other factors, most notably -- deductions. But they are indicative of tax liabilities over time, and between the well-off and the just-getting-by.