Thinking About Taxes

This morning's New York Times contains an op-ed by Warren Buffett that has naturally gotten quite a lot of attention: "Stop Coddling the Super-Rich".  Progressive cheer.  Others point out that capital income is taxed twice (corporate income tax and then capital gains/dividend tax), meaning that the effective rate is much higher than the statutory15% capital rates.  And that in advocating for higher taxes, Warren Buffett is not necessarily always an entirely disinterested party.

All of this will be convincing to people who already agree with it, and unconvincing to those who don't.  Almost no one changes their minds on these things.

Well, except me, maybe.  I'm in the process of possibly changing my mind about the carried interest rules, which allow hedge fund managers to pay taxes on their management fees at the 15% capital gains rate.  It's a rule that naturally attracts the ire of many progressives, and is in fact cited by Warren Buffett in the abovementioned op-ed.  So naturally I've been mulling this as I followed the reactions to Buffett's op-ed.  And I think it's worth writing about, because I think that both the debate about the carried interest rule, and the more general outrage when various rich people have low effective tax rates,  tend to be very shallow.  As, frankly, was my original opinion on the carried interest rule.

Until last week, my opinion was basically that the carried interest rule was a loophole big enough to drive huge trucks of money through.  Then I spent a while debating the question with some friends, including a securities lawyer who kindly exposed my gross ignorance of the relevant law (and even more kindly, refrained from pointing and laughing as he did so.)  I had committed the Fallacy of Chesterton's Fence:

In the matter of reforming things, as distinct from deforming them, there is one plain and simple principle; a principle which will probably be called a paradox. There exists in such a case a certain institution or law; let us say, for the sake of simplicity, a fence or gate erected across a road. The more modern type of reformer goes gaily up to it and says, "I don't see the use of this; let us clear it away." To which the more intelligent type of reformer will do well to answer: "If you don't see the use of it, I certainly won't let you clear it away. Go away and think. Then, when you can come back and tell me that you do see the use of it, I may allow you to destroy it."

This paradox rests on the most elementary common sense. The gate or fence did not grow there. It was not set up by somnambulists who built it in their sleep. It is highly improbable that it was put there by escaped lunatics who were for some reason loose in the street. Some person had some reason for thinking it would be a good thing for somebody. And until we know what the reason was, we really cannot judge whether the reason was reasonable. It is extremely probable that we have overlooked some whole aspect of the question, if something set up by human beings like ourselves seems to be entirely meaningless and mysterious. There are reformers who get over this difficulty by assuming that all their fathers were fools; but if that be so, we can only say that folly appears to be a hereditary disease. But the truth is that nobody has any business to destroy a social institution until he has really seen it as an historical institution. If he knows how it arose, and what purposes it was supposed to serve, he may really be able to say that they were bad purposes, that they have since become bad purposes, or that they are purposes which are no longer served. But if he simply stares at the thing as a senseless monstrosity that has somehow sprung up in his path, it is he and not the traditionalist who is suffering from an illusion.
. . . which is particularly stupid in the case of tax law. Its emergence is not shrouded in the mists of history; it was written by people for some particular purpose.  Yet I did not ask myself a very simple question: why does the carried interest rule exist?

Of course, it was possible that it was just a loophole written in at the behest of greedy hedge fund managers.  But I should not have assumed that it was so, particularly since this does not turn out to be the case.  At least as I know understand it, carried interest taxation is a longstanding feature of partnership taxation.  And it exists not so that hedge fund managers can afford to buy genuine gold tile to line the floors of their extravagant mansions, but so that partners who come in with less capital can build "sweat equity".  

I submit that increasing the taxes paid by hedge fund managers should not be an aim of public policy.

Before my progressive readers start fulminating, I ask that you read this carefully.  I am not saying that we shouldn't make hedge fund managers pay higher taxes.  Indeed, on balance, I still think that we should.  But the important question is not "Do hedge fund managers pay too little in taxes?"  The important question is "Should the tax code treat 'sweat equity' the way it treats regular equity?"

In other words, either we get rid of the carried interest for partnerships, or we don't.  Perhaps the hedge fund managers have brought the problem to our attention, but we should not change the law simply to discommode them.  Either treating sweat equity as a capital asset is a good idea, or it is not.

There are arguments for an against. The arguments for the carried interest are fairly compelling: without it, the partners who contributed ideas and talent end up being taxed much more heavily on their earnings than partners who contributed financial assets.  This is not only sort of unfair, and impedes the ability of talented people with few financial resources to move into the moneyed class, but also might have implications for economic growth: if your gains are going to be taxed at ordinary income rates, why quit that safe job and risk all on an untried venture?  

Of course, there are also arguments against.  I tend to think that we tax labor income more heavily than capital income not because capital income is more awesome or virtuous than labor income, but because the supply of capital is more sensitive to tax rates than the supply of labor.  Most people have the choice between working and starving, and the latter isn't really very attractive, so hours worked are only weakly responsive to tax rates, at least near current levels.  But with capital, people have the choice of saving it here, saving it somewhere else with lower tax rates, or spending it now.  Spending it now is pretty attractive, especially since it faces much lower tax rates than saving.  So you have to be more careful about how heavily you tax capital income.

Sweat equity seems to me to look a lot more like labor than like saving--the principal doesn't usually have the choice of buying a yacht with his sweat and sailing around the Caribbean.  So I tentatively think that we should do away with the carried interest rule.  I understand the objections: carried interest is risky in a way that salaries aren't (but so are performance bonuses, which are taxed as ordinary income); carried interest represents capital income which has already had corporate taxes paid on it (but so do the salaries of secretaries at Fidelity).  Ultimately I come back to one question: how many partners will quit if you change the rules for carried interest taxation?  I think the answer is "not many".  So I think we should do away with the rule.  But I'm open to persuasion.

But what does this have to do with Warren Buffett?  I hear you cry.  And we've gotten rather far away from him, haven't we?  But not as far as you might think.  I said above that we should not make taxing hedge fund managers an aim of our tax policy.  Now I want to say the same thing about Warren Buffett.  Warren Buffett's effective tax rate is not a public policy issue.  To the extent that it is a problem, it is easily rectified by having Warren Buffett write a larger check to the government--something that the op-ed's author has it perfectly within his power to do.

Public discussion of tax policy tends to focus on the outcome, rather than the principles that produce those outcomes.  But "Warren Buffett should pay more taxes" is not a good principle.  There are 300 million people in the United States.  We cannot write a tax rule for each of them.

So let's consider--as Warren Buffett doesn't, much--what principles are at play here.

  1. The tax code should not cost too much, in terms of economic growth
  2. People with more ability to pay should pay a higher percentage of their income than people with less ability
  3. Activities which are undertaken for the public good should be taxed lightly if at all
  4. The tax law should be neutral with respect to persons (we do not slap a special surtax on Charles Manson or Bernie Madoff because they're vile; that's what jail is for.)
Notice that these principles are broadly incompatible.  The three biggest reasons that very rich people have lower effective tax rates than the rest of us are the special treatment of capital income, the tax-free status of municipal bonds (which used to be a sop to federalism, but is now just a subsidy for municipal infrastructure spending), and various charitable dodges which allow rich people to lower their tax bills while providing substantial capital infusions to nonprofits.  Many of the people I know who are outraged by Buffett's low effective tax rate are also avid supporters of charitable tax deductions, and the tax subsidy for municipal debt.  This is a nonsensical position.

Since they're incompatible, we have to start throwing some things out.  We have to choose: do we want to subsidize municipal bonds, and charities, or do we want Theresa Heinz-Kerry to have a tax rate more like an upwardly mobile professional's, and less like a probationer at Merry Maids?

Me, I think we should get rid of the tax exclusion for municipal bond interest.  I'm on the fence about charitable deductions, but lean towards eliminating them.  And I think we should eliminate the corporate income tax, along with the special rates for capital gains and dividends, and tax income once, when it hits a person.

The result would be a tax code that gave Warren Buffett a higher effective rate (though of course, we'd also lose several hundred billion collected by the corporate income tax every year).  But that's not the point: the point is that it would be a simpler system with fewer indirect subsidies.  If we want to subsidize things, we should do it the old fashioned way: by cutting a check. 

And though I think this system would be both more efficient, and more progressive, I'm not under the illusion that I will like all of the results.  We want too much out of our tax code.  It's very good at providing revenue.  Not so much at dispensing justice.

Update:  two commenters step in to point out that this is much more of an issue with private equity funds than hedge funds

Jeremy Naylor says:

Minor clarifying point - the carried interest tax break benefits private equity fund and real estate fund managers. The "Carried interest" earned by most hedge fund managers are short term capital gains (due to the frequent trading) which are taxed at ordinary income rates. It was really Steven Schwarzmann's 60th birthday party that brought this issue out of tax professor papers to Congress's eye (Sander Levin introduced a bill to tax carry as ordinary income in March, 2007, one month after the infamous birthday party - featuring Rod Stewart
To which Carlo adds:

Exactly. "Carried Interest" is not the same as the "Performance/Incentive Fees" that a typical hedge fund manager receives. Carried Interest is truly a creature of partnership tax and is typically calculated pursuant to a Distribution Waterfall, which is found in most private equity, venture and real estate funds. Hedge fund Performance Fees are not. And as Jeremy points out, if the Performance Fee is calculated on a short-term gain, it will be taxed as ordinary income. - A Hedge Fund Lawyer
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Megan McArdle is a columnist at Bloomberg View and a former senior editor at The Atlantic. Her new book is The Up Side of Down.

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