Turning the Tax Debate, Part II

WebCPA carried a story yesterday entitled "Private Equity Fights Back", quoting objections of industry representatives to Congress who, for example, "disputed the notion that partners in private equity firms were exploiting a tax loophole to avoid higher taxes on their compensation."

Another investment firm executive told the Senate that the proposed tax hikes would hurt investors. "We believe passing the [publicly traded partnership] legislation will discourage the salutary trend of alternative investment firms going public, will increase the relative attractiveness of non-U.S. capital markets and will target unfairly a single industry," said John B. Frank, managing principal of Oaktree Capital Management in Los Angeles.

Keep in mind that this issue picked up momentum in large part because of the Blackstone IPO, which raised a long simmering dilemma about proper tax treatment of a particular form of income–carried interest–which was traditionally earned by private partnerships, but was now going to be earned by a public company. At least in a relative sense, the treatment of carried interest has been a sweetheart deal for the general or managing partner of an enterprise, especially with the lower capital gains rates of the moment. Blackstone simply tried to preserve that advantage going into its next stage of existence, hence the term ‘publicly traded partnership legislation’. But Congress has made it clear that it will not allow such a deal to persist in a large, publicly traded corporation, which is understandable (in a way) because corporate earnings in the U.S. are subject to some of the highest marginal tax rates in the world.

We would simply like to point out, again, that this debate could be immensely valuable to the country if it were turned on its head. Most of what Mr. Frank said in the quote above is true at the margin. Imagine if, instead of raising the tax rate on one industry, Congress was planning to raise taxes on all industries except for one. His quote might then go something like this:

‘We believe that passing this legislation will discourage companies in all of the affected industries from going public, which will increase the relative attractiveness of non-U.S. capital markets, as well as non-U.S. domiciles, and unfairly target 99% of this country’s industries.’

Two things are clear from this hypothetical exercise. First, there is a fairness issue at work, and there’s no clear reason why these two robust and burgeoning industries should receive more favorable tax treatment than others. Representatives from the industries being targeted should be more forthcoming about that fact, rather than trotting out flimsy excuses. We agree with Sen. Baucus on that point:

…Baucus, D-Mont., who chaired the hearing and is co-sponsoring the proposed legislation, expressed his skepticism about the industry. "I hope that we can have an honest discussion," he said. "And I hope that the many lobbyists employed by hedge funds and private equity will not make the glass even darker than it already is."

But second, and most important, is that courage and candor from Sen. Baucus and his colleagues is just as important. The real problem at work here is not that all U.S. industries are taxed fairly, and two isolated ones are being undertaxed. It’s that most U.S. industries and companies are taxed unfairly (or suboptimally if you prefer), which causes a host of problems, some apparent, many others unseen, and this situation is increasingly damaging to our competitive position relative to the rest of the world. The people best positioned to point this out, and turn the debate in a more productive direction, are (1) politicians and (2) the people whose firms and industries are under scrutiny. It may not be outside the realm of possibility that, for example, Representative Rangel and Senator Levin will grasp this as an opportunity for tax simplification, but they would probably bear plenty of political risk–perceived risk, anyways–by saying so forthrightly. Better for the people providing testimony to Congress to take the lead on this. Rather than point out how this kind of measure will harm a particular corporate form in a particular industry, they should instead point out the wide range of private and public benefits that would flow from a more equitable and globally competitive U.S. tax code applied to all domestic enterprises! In other words, admit that you’ve got it good, and then explain why that should be the rule, and not the exception.

Easterly: What Bono Doesn’t Say About Africa

We just came across this compelling op-ed from early July by William Easterly, author of The White Man’s Burden*:

JUST WHEN IT SEEMED that Western images of Africa could not get any weirder, the July 2007 special Africa issue of Vanity Fair was published, complete with a feature article on "Madonna’s Malawi." At the same time, the memoirs of an African child soldier are on sale at your local Starbucks, and celebrity activist Bob Geldof is touring Africa yet again, followed by TV cameras, to document that "War, Famine, Plague & Death are the Four Horsemen of the Apocalypse and these days they’re riding hard through the back roads of Africa."

It’s a dark and scary picture of a helpless, backward continent that’s being offered up to TV watchers and coffee drinkers. But in fact, the real Africa is quite a bit different. And the problem with all this Western stereotyping is that it manages to snatch defeat from the jaws of some current victories, fueling support for patronizing Western policies designed to rescue the allegedly helpless African people while often discouraging those policies that might actually help…

In truth, Africans are and will be escaping poverty the same way everybody else did: through the efforts of resourceful entrepreneurs, democratic reformers and ordinary citizens at home, not through PR extravaganzas of ill-informed outsiders.

http://www.latimes.com/news/opinion/la-oe-easterly6jul06,0,6188154.story?coll=la-opinion-rightrail

On a related note, Foreign Policy offers a more apprehensive view of African development in "Fool’s Gold", which discusses the ‘resource curse’, a prominent idea in development economics.

*For those unfamiliar with Easterly, the following review of his book, excerpted from Amazon.com, is a good primer on his background:

From Publishers Weekly
No one who attacks the humanitarian aid establishment is going to win any popularity contests, but, neither, it seems, is that establishment winning any contests with the people it is supposed to be helping. Easterly, an NYU economics professor and a former research economist at the World Bank, brazenly contends that the West has failed, and continues to fail, to enact its ill-formed, utopian aid plans because, like the colonialists of old, it assumes it knows what is best for everyone. Existing aid strategies, Easterly argues, provide neither accountability nor feedback. Without accountability for failures, he says, broken economic systems are never fixed. And without feedback from the poor who need the aid, no one in charge really understands exactly what trouble spots need fixing. True victories against poverty, he demonstrates, are most often achieved through indigenous, ground-level planning. Except in its early chapters, where Easterly builds his strategic platform atop a tower of statistical analyses, the book’s wry, cynical prose is highly accessible. Readers will come away with a clear sense of how orthodox methods of poverty reduction do not help, and can sometimes worsen, poor economies. (Mar. 20) Copyright © Reed Business Information, a division of Reed Elsevier Inc. All rights reserved.

Posner: Is Financial Management a Drain on Social Resources?

Meek: Senator Obama Gets Tough on Terror

James Gordon Meek offers a laudatory review of the anti-terrorism strategy recently outlined by Sen. Barack Obama:

Today we write in the New York Daily News about Sen. Barack Obama’s effort to stake his claim to the issue of countering Al Qaeda, including my analysis of the wisdom of threatening major military operations to nail Osama Bin Laden and company in Pakistan. Suggesting a unilateral approach to striking Bin Laden has the Pakistani government in an uproar. They already had their blood up from the Bush administration’s attack last month on their inability to stop Al Qaeda from regenerating itself in the northwest tribal areas bordering Afghanistan.

The speech by the Illinois Democrat was surprisingly sophisticated for this early in the campaign season – even as a response to Sen. Hillary Clinton (D-N.Y.) calling his foreign policy views "naive" – and demonstrated an unusual depth of understanding about the secret CIA-run war along the Afghan-Pakistan border. One line in particular by Obama jumped out at me: "The Taliban pursues a hit and run strategy, striking in Afghanistan, then skulking across the border to safety."

That is not only true – and true also of Al Qaeda-led fighters conducting cross-border ops – but surprising to hear in any public setting these days, much less a high-profile political speech by a leading presidential candidate. Obama had help from a group of former Clinton and Bush National Security Council veterans, including some who haven’t even endorsed him: Richard Clarke, Susan Rice, Rand Beers and Mary McCarthy.

Looking at the Obama contracts traded at Intrade Prediction Markets, it doesn’t appear that the speech had an immediate impact on his expected chances for success, so we’ll have to wait and see whether the Democratic or general electorate will lean towards Meeks’s position. What the contracts do show, quite clearly, is that so far Obama has been the horse in the Democratic race in 2007, with his expected odds increasing steadily from 20% to 35-40%, while Sen. Clinton’s have meandered sideways–albeit around a still commanding 40-50%.

On a side note, based on some back of the envelope calculations we did on Clinton, Obama, Giuliani, and Thompson (as top two candidates/prospective candidates from each party), the expected probability that Sen. Clinton becomes president (probability of winning x probability of nomination) is about twice that of the other three. The odds on Democrats retaining control of Congress were over 70% for each house at the time, so markets are placing very short odds on a complete Democratic takeover in 2008 with Clinton at the helm (and conversely, very long odds on the Republican party getting its act together anytime soon). Time will tell.

Club for Growth: Back to the Future

In response to protectionist measures threatened against China, the Club for Growth has unveiled a petition reminiscent of the 1930 anti-tariff petition presented to President Hoover before passage of the Smoot-Hawley Tariff Act. Both were signed by 1,028 contemporary economists. It’s tempting (for some anyways) to believe that 1,028 economists can’t be wrong, and on this issue, I think they are indeed on very solid ground–although it’s important to bear in mind economist Gerald Meier’s observation in 1973 that "economic problems cannot be solved in a political vacuum" (in his book Problems of a World Monetary Order).The important question is whether policymakers will heed them this time around.

However it may turn out, it’s a valuable history lesson, and they’ve even posted the 1930 NY Times report on the original petition: http://www.clubforgrowth.org/media/uploads/smooth%20hawley%20ny%20times%2005%2005%2030.pdf

Turning the Tax Debate on its Head

We’re closely following the debate over the tax rate on ‘carried interest’ for private equity and hedge fund managers, and are somewhat dismayed that no one is seizing this as an opportunity to improve our nation’s tax code and economic future, rather than a mere technical debate over loopholes and fairness. We think it presents a golden opportunity, and here’s why:   

Excerpt: "Why should a surgeon, a schoolteacher or a CEO pay tax at more than twice the rate of a fund manager?" asked Joseph Bankman, a tax law professor at Stanford University.

Why indeed? The problem is, no one seems to be asking why those who trade their labor in other industries shouldn’t enjoy the same higher incentive tax rate that fund managers do! This political blindness is also reflected in our deteriorating position in the unfolding global tax competition. Forward thinking governments, having witnessed the strong economic performance that countries realize when they rationalize their tax systems, have quite rightly asked, "Why should we continue to exact public tribute at a rate that penalizes producers and prevents our economy from realizing its full potential?"

Excerpt: "There will be deals that don’t get done. There will be entrepreneurs that won’t get funded and turnarounds that won’t get undertaken," said Bruce Rosenblum, managing director of the Carlyle Group, in testimony before the Senate Finance Committee.

All true at the margin, but this leads to one of our favorite metaphysical quibbles–capital is capital, and far more things in this world are capital than standard economic models and tax codes allow. For example, anyone who trades their labor for income incurs ongoing carry costs to maintain their physical and mental capital. Bodies are subject to deterioration and require ongoing investments of food, water, shelter, clothing, exercise, education, etc (parallel arguments can be made regarding corporations and corporate tax rates). The bifurcation of labor and capital in tax codes is an artifical one, entirely suspended from the reality of producing income and wealth. The same can be said about the disparate tax rates applied to corporate income based on underlying organizational forms. The simple fact is that higher tax rates on any productive asset will tend to mean less of that asset is brought to market, whether it is financial capital or human talent and effort. Marginal investment, output, and wealth creation suffer as a result.

On a more practical level, we have to assume that a 15% tax rate on carried interest makes working for a private investment fund more attractive economically than working in positions where the effective tax burden is higher. In other words, a lower tax rate creates incentives that are likely to attract marginally more talent and effort to an industry, or a country. Why not lower the burden economy-wide and thus attract more productive assets into the American economy?

A far better approach for politicians in this debate would be to explicitly recognize the facts outlined above, and set about equalizing the tax burden on labor, financial, and corporate capital, at a level that is globally competitive. That last part is important–a flat tax rate across all productive factors might lower administrative and compliance costs, but if it’s set too high it would only chase productive resources abroad, and thus tend to cancel out any economic benefits.

On a side note, another favorite philosophical quibble of ours comes into play on this issue, and that is the wisdom of crowds. Very briefly: as we’ve similarly argued in regards to monetary policy, there is no way that politicians or tax authorities can know from year to year what the optimal level of taxation is. Only a complex adaptive system, like an electoral body, can come close to producing the ‘right’ answer. Food for thought, though it may be unpalatable fare to many politicians and tax administrators.

8/3/2007 - On a related note, according to an article posted on WebCPA’s site, the IRS has outlined plans to invest in compliance enforcement and technologies–an inferior alternative to improving the tax code itself, in our view. An economic perspective demands an assessment of the cost of these plans and the likely return on investment, which is probably markedly less than the return on tax simplification, and thus leads to a suboptimal outcome. It reminds us of the old adage about bees and honey–if you want more people to comply, make the code more palatable.