October 7, 2024

Today’s Economist: Bruce Bartlett: Mitt Romney, Carried Interest and Capital Gains

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Bruce Bartlett held senior policy roles in the Reagan and George H.W. Bush administrations and served on the staffs of Representatives Jack Kemp and Ron Paul. He is the author of “The Benefit and the Burden: Tax Reform – Why We Need It and What It Will Take.”

The issue of Mitt Romney’s taxes continues to be a political liability for him. A NBC News/Wall Street Journal poll last month found that 36 percent of registered voters have a more negative opinion of him because of the issue, up from 27 percent in January, compared with 6 percent who have a more positive view.

Today’s Economist

Perspectives from expert contributors.

As I have discussed previously, the two years of returns Mr. Romney has been willing to release, for 2010 and 2011, show that he paid much lower effective federal income tax rates in both years than his running mate, Representative Paul D. Ryan, whose income was 85 percent to 90 percent lower than Mr. Romney’s in those years.

A key reason for Mr. Romney’s low tax rate is that a very substantial amount of his income comes from capital gains – 51 percent in 2011 and 58 percent in 2010. Capital gains, no matter how large, are taxed at a maximum rate of 15 percent, whereas wage income can be taxed as much as 35 percent by the income tax plus taxes for Medicare and Social Security. The latter two are not assessed on capital gains.

Significantly, much of Mr. Romney’s capital gains income achieved this treatment through a special tax loophole called carried interest. According to recently released documents, executives at Bain Capital, where Mr. Romney made the bulk of his estimated $250 million fortune, saved $200 million in federal income taxes and another $20 million in Medicare taxes because of the carried interest loophole.

The way the loophole works relates to the peculiar method in which money managers are compensated. Typically, they receive a fee of 2 percent of the gross assets under management, much of which comes from employee pension funds, plus 20 percent of any increase in value.

Thus, on $1 billion of assets the managers would automatically get $20 million that would be taxed as ordinary income. If the assets increased 10 percent to $1.1 billion, they would get another $20 million. For tax purposes, this additional $20 million would be treated as a capital gain and taxed at 15 percent.

The theory is that the money managers effectively become part owners of the assets they manage as a result of the fee structure. Critics contend that the distinction between the 2 percent and 20 percent fees is purely artificial — that in reality all their compensation should be treated as ordinary income and taxed as such.

Among the sharpest critics of carried interest is Victor Fleischer, a law professor at the University of Colorado. In a Sept. 4 post on DealBook, he explains that the New York attorney general’s office is looking into the issue, seeking to determine whether money managers have been illegally converting their 2 percent management fees into lower-taxed capital gains.

The New York Times recently commented in an editorial that while the carried interest loophole is unjustified, the core problem is lower tax rates on capital gains generally. Said The Times, “As long as income from investments is taxed at a lower rate than income from work, there will be no stopping the search for ways, legal or otherwise, to pay the lower rate.”

The view that capital gains should be treated as ordinary income for tax purposes is one that is widely shared by liberal tax reformers. They got their wish, briefly, from 1987 to 1990 because Ronald Reagan agreed to raise the tax rate on capital gains to 28 percent from 20 percent in return for a reduction in the top rate on ordinary income to 28 percent from 50 percent, as part of the Tax Reform Act of 1986.

There are three big problems, however, with taxing capital gains at the same rate as ordinary income. First, even if that were the case, capital gains would still be treated more beneficially, because the taxes only apply to realized gains. Those that are unrealized would remain untaxed. Investors needing cash could simply borrow against their assets to minimize their taxes, rather than selling and realizing a capital gain.

To equalize the taxation of capital gains and ordinary income, it would be necessary to tax unrealized gains. In theory, all increases in net wealth should be taxed annually, according to the economists Robert M. Haig and Henry C. Simons. But a 1920 Supreme Court case, Eisner v. Macomber, held that only realized gains could be taxed.

As long as a taxpayer decides when or if to realize gains for tax purposes, that is a very valuable loophole even if gains are taxed at the same rate as ordinary income. For one thing, a taxpayer can easily match gains with losses to avoid having net taxable gains. And, of course, capital gains would still avoid the 15.3 percent payroll tax, which applies only to wage income.

Second, there is a problem with inflation insofar as capital gains are concerned. Many academic studies have shown that a considerable portion of realized capital gains simply represent inflation, rather than real increases in purchasing power.

While theoretically capital gains could be indexed for inflation, it would be very complicated. For one thing, it is not clear what the appropriate price index should be. For another, there is the problem of also indexing losses. Historically, Congress has felt that simply excluding a certain percentage of capital gains from taxation was a better way to compensate for inflation.

Third, it is a fact of life that those with great wealth are the principal beneficiaries of the capital gains tax preference, and they exercise influence in our political system far out of proportion to their numbers. They will pressure both parties relentlessly to restore a lower tax rate on capital gains and eventually they will be successful. Keep in mind that two Democratic presidents, Jimmy Carter and Bill Clinton, signed cuts in the capital gains rate into law.

In short, it is a pipe dream to believe that eliminating the capital gains preference is the key to fixing the carried interest loophole. It can and should be addressed by treating carried interest as ordinary income, without requiring that all capital gains be taxed as ordinary income.

Article source: http://economix.blogs.nytimes.com/2012/09/11/mitt-romney-carried-interest-and-capital-gains/?partner=rss&emc=rss

Today’s Economist: Bruce Bartlett: Why Hayek Isn’t Paul Ryan’s Guru

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Bruce Bartlett held senior policy roles in the Reagan and George H.W. Bush administrations and served on the staffs of Representatives Jack Kemp and Ron Paul. He is the author of “The Benefit and the Burden: Tax Reform – Why We Need It and What It Will Take.”

Because the Republican presidential nominee, Mitt Romney, remains an enigma to almost everyone, those seeking insight into his core philosophy have focused on his choice of Representative Paul D. Ryan, who has been much more forthcoming about his intellectual influences, as his running mate.

Today’s Economist

Perspectives from expert contributors.

Mr. Ryan has credited a variety of people, from the Representative Jack Kemp to the libertarian novelist Ayn Rand, for his thinking. An article in this week’s New York Times Magazine credits another: the economist Friedrich von Hayek. Mr. Ryan mentions Hayek among his influences in the introduction to his Roadmap for America’s Future, which embodies his plan to slash the size of government.

Hayek has long been popular among conservatives mainly because of one book, “The Road to Serfdom,” published by the University of Chicago Press in 1944. Although written for a British audience – the Austrian-born Hayek was teaching at the London School of Economics when he wrote it – the book found its greatest success in the United States.

The New York Times had a great deal to do with the success of “The Road to Serfdom.” Its introduction was written by John Chamberlain, who had been The Times’s principal book reviewer in the 1930s. The Times’s book review was written by one of its editorial writers, Henry Hazlitt, who was effusive in his praise not only for the book’s substance but for its elegant style as well. It was featured on Page 1 of The Book Review on Sept. 24, 1944.

According to Hayek’s biographer, Alan Ebenstein, The Times’s review was the major reason that “The Road to Serfdom” became a best seller. Indeed, its influence continues, aided by recommendations from Representative Ron Paul, Republican of Texas, and the radio host Glenn Beck to members of the Tea Party movement.

Hayek’s basic thesis is that socialism inevitably transforms into totalitarianism. A key reason is that socialism cannot work economically, he believed. During the 1930s, Hayek was in the forefront of the socialist calculation debate, in which he, Ludwig von Mises and other economists proved that pure socialism had to fail because it lacked a true price system to guide efficient production and distribution.

The inevitable failure of socialism, Hayek thought, would eventually require authoritarian methods to try to make it work, as was the case in the Soviet Union and Nazi Germany. At the time he wrote his book, Britain, France and other European countries were adopting explicitly socialist policies, like state ownership of major businesses and industries.

Although there has never been much support for European-style socialism in America, World War II and the New Deal led to a great expansion of government. In 1944, it looked as if the United States were traveling rapidly in the same direction as Europe, and Hayek’s thesis was not implausible, given recent history.

The big problem for that those who continue to cite “The Road to Serfdom” as a guide is that they must essentially ignore everything that happened after 1944. Communism’s high-water mark occurred a few years later, and before long it became obvious that communism was not a path to prosperity. Nor has anything remotely like Nazism ever resurfaced.

By the 1970s, few reputable economists really thought that socialism was a good idea. Ironically, one of them was Gunnar Myrdal, with whom Hayek shared the 1974 Nobel in economic science.

In 1979, the conservative Margaret Thatcher, whom Hayek greatly admired, became prime minister of Britain and quickly began selling the state enterprises that had been acquired after the war. “Privatization” became a worldwide phenomenon, and the number of state-owned enterprises fell. Communism collapsed in 1989, and the Soviet Union dissolved in 1991.

Thus postwar history is exactly the opposite of what Hayek predicted. Liberalism did not beget socialism, which did not beget totalitarianism.

Another problem for conservatives like Mr. Ryan is that Hayek would have been likely to oppose many of their pet ideas, like abolishing Medicare. In “The Road to Serfdom,” Hayek explicitly endorsed social insurance:

Nor is there any reason why the state should not assist the individuals in providing for those common hazards of life against which, because of their uncertainty, few individuals can make adequate provision. Where, as in the case of sickness and accident, neither the desire to avoid such calamities nor the efforts to overcome their consequences are as a rule weakened by the provision of assistance – where, in short, we deal with genuinely insurable risks – the case for the state’s helping to organize a comprehensive system of social insurance is very strong.

In “The Road to Serfdom,” Hayek also endorsed state aid to victims of floods and earthquakes, government policies to regulate working hours and to control poisonous substances. In other writings and interviews, he endorsed antitrust laws, a minimum wage and even the Tennessee Valley Authority, long a right-wing bête noire. In a 1982 interview with The New York Times, Hayek was even skeptical of Ronald Reagan’s economic plan, calling it “a very risky thing to do.”

Moreover, Hayek was not doctrinaire about the importance of political freedom. In a 1979 interview with The Times, he defended the Chilean regime of Augusto Pinochet, which combined political repression with free-market economics, calling the results “absolutely fantastic.” Asked whether this view was inconsistent with his philosophy, Hayek replied, “You can have economic freedom without political freedom, but you cannot have political freedom without economic freedom.”

For such transgressions, some on the right have long viewed Hayek as a dubious ally. For example, the libertarian economist Walter Block wrote a detailed attack on Hayek in 1996 for being at best a lukewarm defender of the free market.

I suspect that in his heart, Representative Ryan is more attracted to the dogmatism of Rand than the complex, nuanced philosophy of Hayek, who told the Cornell political scientist Theodore Lowi that Rand angrily called him “a compromiser” on the only occasion they met.

Article source: http://economix.blogs.nytimes.com/2012/08/28/why-hayek-isnt-paul-ryans-guru/?partner=rss&emc=rss