Greg Mankiw's Contorted Defense of Mitt Romney

James Kwak Baseline Scenario March 7, 2012

By James Kwak

It’s really hard to defend the carried interest exemption (the one that allows private equity and venture capital partners to pay tax on their share of fund profits at capital gains rather than ordinary income rates). You have to give Greg Mankiw a hand: he sure gave it a good shot in the Times this weekend.

Mankiw’s general point makes a lot of sense. He argues that it’s sometimes hard to distinguish returns from labor and returns from investment, using five examples of people who buy a house for $800,000 and later sell it for $1,000,000. For example:

“Carl is a real estate investor and a carpenter. He buys a dilapidated house for $800,000. After spending his weekends fixing it up, he sells it a couple of years later for $1 million. Once again, the profit is $200,000.”

In this case, although some of Carl’s profit is due to his labor, all of it gets treated as capital gains by the tax code. In a perfect theoretical tax world, you would divide Carl into two people, the investor and the carpenter, and the investor would pay the carpenter some amount for his labor; the carpenter would pay ordinary income tax on that amount (and the investor would deduct it from his taxable profits). But that’s not how we do things.

The key example, for Mankiw, is the next one:

“Dan is a real estate investor and a carpenter, but he is short of capital. He approaches his friend, Ms. Moneybags, and they become partners. Together, they buy a dilapidated house for $800,000 and sell it later for $1 million. She puts up the money, and he spends his weekends fixing up the house. They divide the $200,000 profit equally.”

In this case, Dan pays capital gains tax on his $100,000 in profits because he’s part of an investment partnership"”even though the thing he contributed to the partnership is labor, not capital. Private equity partners, Mankiw argues, are just like Dan: they enter into a partnership with investors, in which the private equity guys contribute expertise and effort and the investors contribute cash. Hence they should pay capital gains on their share of the profits (usually 20 percent).

But there are two big problems with this argument, one of which Mankiw essentially points out. Mankiw recognizes that Carl is contributing labor, even though the tax code pretends he is just contributing capital. If the basic principle is that the capital gains rate should be reserved for profits from investment activity, not labor activity, it’s clear that Carl should pay ordinary income tax on some of his profits; it’s just as clear that Dan should pay ordinary income tax on all of his profits.* (That’s also the logical result if you think, as many supply-siders do, that the point of lower capital gains rates is to encourage savings; Dan in particular didn’t save any money.)

In other words, Mankiw’s own examples make it look like Dan is benefiting from a dubious loophole. Then he argues that since private equity partners are doing the same thing Dan is, they should benefit from the same dubious loophole. That’s not much of a defense.

The other problem is that private equity partners are not actually like Dan the carpenter. If Dan and Ms. Moneybags are in a true 50-50 partnership, then Dan is on the hook for half of their losses, as well. The great thing about 2 and 20, for private equity partners, is that they get a cut of the profits but they don’t absorb a share of the losses. This means that the 20 is more like a performance bonus than like a partnership share. So if the 20 is in a gray area, as Mankiw argues, it is even closer to ordinary income than Dan’s partnership share"”which, as Mankiw shows (although he doesn’t quite come out and say it, for obvious reasons), should be treated as ordinary income.

Still, I don’t think you can do a better job than Mankiw does trying to defend the carried interest loophole. Which just shows how indefensible it is.

* The same argument can be made about most stock-based compensation, including stock owned by company founders. If Mark Zuckerberg ever sells any of his bajillion dollars’ worth of Facebook stock, he will pay capital gains tax"”even though he earned that stock by contributing expertise and labor to the company, not investing his savings in it. As a onetime company founder, I used to think that I was entitled to capital gains tax rates because I bought my shares on day one (for a pittance). But from a substantive perspective, it’s clear that mainly what I contributed to the company was labor, not investment. In the end, this is all an argument (though not necessarily a conclusive one) against a distinction between ordinary income and capital gains in the first place.

Mankiw’s examples just make the inherent paradoxes more clear.

The solution is obvious: Abolish both the income tax and the capital gains tax, and replace them with a direct tax on wealth. After all, what do income or capital gains have to do with how much constitutes your fair share? The definition of “rich” is “having a lot of stuff”, not “having a lot of income”.

It would be completely trivial: The more you own, the more you owe. Even the estate tax could be abolished, because whether you own an estate or your kids do, the same tax would get extracted from it every year.

I have yet to hear any coherent argument against this idea.

"Carl is a real estate investor and a carpenter. He buys a dilapidated house for $800,000. After spending his weekends fixing it up, he sells it a couple of years later for $1 million. Once again, the profit is $200,000.

In this case, although some of Carl's profit is due to his labor, all of it gets treated as capital gains by the tax code."

I don’t think this is correct. In this case, Carl has a business. It doesn’t matter whether it’s an incorporated business, it’s still a business. The profit is not a capital gain, but is income. Carl is subject to both income tax at regular income tax rates and to self-employment taxes.

The utterly bizarre thing is that nobody is questioning why, should Dan the carpenter have to pay income tax, and Ms Moneybags capital gains tax, Ms Moneybags will be the one paying at a lower rate.

I think I posted this same opinion a while ago, so forgive me for repeating myself.

IMO, the real reason the carried interest special treatment should be eliminated is not because of a labor vs capital distinction, but rather because these folks have zero at risk capital.

The main requirement for a capital gains treatment should be that the capital was placed at risk during the investment period. The investment has to be subject to uncertainty and market forces for capital gains treatment to apply.

The carried interest case obviously fails this test and that’s why it should be eliminated. Getting all wound up in capital vs labor distinctions just adds confusion, IMO. The real issue is whether the capital was at risk. In the case of carried interest, it was not.

These examples are what provide the excitement and vexing qualities of income taxation, in my opinion.

Prof Makiw’s illustrations appear generally correct, but people like the “investor” and “carpenter” and their CPA’s, are always going to structure the transactions on the tax return so the lowest tax rate in set against the gain.

The job of the examiner is to question the characterization, and then try to overcome it, if “facts and circumstances” that are tangential to the discrete transaction of selling property after fixing up, suggest business income, as an earlier poster noted.

The “investor” designation, therefore, would come under particular scrutiny. These issues are one reason an agent’s interview can take several hours, and why a tour of the “business” is always sought.

Greg Mankiw the economist agrees with you, and disagrees with Greg Mankiw the political adviser: http://gregmankiw.blogspot.com/2007/07/taxation-of-carried-interest.html

You’re all missing the big picture. Mankiw is out of touch. Where the hell do dilapidated houses cost $800,000? Weimar Germany?

“In a perfect theoretical tax world”

What does that mean? Is that “world” already one populated by our present tax code and is that our standard for perfection? Are there alternatives or are we perpetually stuck with what we’ve got?

Or is there an alternative tax universe that would upend that “perfect theoretical tax world” and offer a more perfect world?

At least until a couple of years ago, the tax code treated artists the way you want carried interest to be treated, much to the chagrin of artists. An artist spends $100 on supplies to make a painting. Her work sells for $1000, but instead she donates it to a charity. Deduction? $100 (cost of materials.) Ten years later she is famous and her paintings command $100K. You bought one for $1000 ten years ago and donate it to a museum. Tax deduction for you? $100K. Capital gains for you? $0. The artist also donates a painting she made 10 years ago and held in reserve. Tax deduction? $100, same as 10 years ago. Go explain that one.

Or is there an alternative tax universe that would upend that "perfect theoretical tax world" and offer a more perfect world?

No, there is not some other perfect theoretical tax world. There is the chance to rerun your life and make the same mistakes over again, it already been proved that the elders are very accomplished at this. And no one knows why God gave power to the children, especially the confused adults.

A major key being missed in this discourse is risk. The carpenter invested his time and perhaps the cost of materials, as did the artist. The resulting value, be it artwork or a house does not matter, has been increased in value by both investmetns: labor and capital. Both were at risk. Both provided opportunity for loss as well as gain. The carpenter could have lost the value of his time and skills applied to the house. The artist surely lost the value of his or her time too, as well as materials purchased. They all invested and hence risked what they had, labor or capital or both. Taxation needs to refect that risk. Working for a salary one might have to sue to collect is far less risky than buying property to renovate or spending time and materials to create art. Let’s not be blind to this.

The risk associated with the venture will be compensated for by a corresponding higher return, according to asset pricing theories. Therefore, an entrepreneur investing his labor expects a higher return than an employee drawing a salary. The discussion here is about the asymmetric tax treatment of capital gain versus other forms of income, including interest income. Following the risk argument, the question then becomes, should the tax system be designed to encourage risk taking?

Manikow’s paper states a premise for capitol gains that sees capitol gains as a ordinary business result. In fact for most of us CG is a one time result, i.e. selling a house we have lived in for some time. For the real estate investor or Bain Capitol Cg is ordinary business income. Both are in the business of buying things and reselling them, maybe after some fix up. Why is this activity different from a grocer buying lettuce and reselling it after repackaging it? Activities that are routine should be treated as ordinary, but a business owner that buys a building fixes it up, uses it as his business location for years and then sells it should, maybe, get CG treatment on on a one time basis.

Even without the special tax rate, capital gains already get preferential treatment: payment of tax is deferred until the asset is sold. With income from labor, the tax must be paid in the year the income is received. Also, the idea that reduced capital gains tax “encourages investment” is suspect: what would rich people do with their excess money without favorable tax treatment? Spend it all?

Why is there a difference in tax rates for earned income and capital gains? If I make $100K at my job or business my income is taxed at one rate whereas if I make $100k from investments I pay a lower rate. Yet the $100k I receive is the same in both cases? The world is awash in capital which is why an ungodly amount has gone into speculation and vulture funds as opposed to creating goods and services.

Of course I agree, but mainly because the US Tax Code if rife with examples of just such obvious obfuscations. My argument, of course, is that to have fairer taxation, we must fully revise the tax code by cleaning out such crap and replacing it with rational taxation policy. I recently heard and argument regarding higher rates on the wealthy where the person on the side decrying such changes stated that the 1% are already paying 40% of the taxes. Sure they are, and probably have mostly paid a similar proportion. There are lots of arguments to be made here:

1) They are deriving the greatest benefits from the economy, and, the tax code actually is written to their benefit now, so why shouldn’t they? 2) Their use of their money to advocate legislation to their benefit has broadly resulted in the supression of economic activity benefiting the average citizen and has pushed a large percentage of the 99% into earnings levels which make paying taxes unnecessary or impossible.

There are lots of arguments to be made, but until the tax code is cleaned up. such arguments are essentially meaningless. The area of the code relating to the taxation of profits of all kinds is a prime area of focus for tax reform. As an example, a big deal was made of the fact that GE paid no corporate tax last year, but, in the wake of that discussion, I discover that about 75% of US corporations did not pay any tax (a fact substantially owing to the Sub-S classification taxation structure, as well as the various “LL” type setups).

Greg Mankiw's Contorted Defense of Mitt Romney

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