Thursday, July 26, 2007

One nice thing about returning to NYC

Our cats, although well cared for while we were away, appear to have missed us terribly. I infer this because, ever since our reunion with them, they have been expressing their burning love for us (to the extent consistent with the feline temperament). They also have made it clear that they keenly remember all the details of their daily feeding rituals.

Hedge funds / carried interests

During my month out of the country, I was sufficiently in touch via the Internet & e-mail to realize how dominant the hedge funds / carried interests issue has remained in Washington tax policy thinking. This bemused me a bit, on the view that, of all the important things in our society that tax policy can affect, this doesn't necessarily rise to the top as Issue # 1. As always happens when an issue takes off politically, symbolism is clearly an important part, here relating to the general trend of rising inequality in the U.S., in particular or at least at the very top, and the policymaking trend in recent years of doing less to address inequality rather than more. The hedge fund managers with their multi-million dollar paydays and deferred 15 percent tax rate are just one piece of the larger picture, but are naturally felt to stand for the whole thing.

Not to deny that there is significant money at stake here. And the transactionally related issue of the Blackstone IPO slicing a big hole in the previously prevailing rule that publicly traded entities are taxed as C corporations adds to the importance of what's going on with the hedge funds, as that could conceivably reshape the choice of entities landscape a bit. So the issues certainly merit attention, even if their comparative prominence is a bit peculiar.

While I feel strongly impelled to comment on publicly prominent tax issues like this one, I do have an "art for art's sake" side that prefers issues to be intellectually interesting rather than publicly prominent (albeit that actual social importance counts heavily in my metric as well). But I am starting to think that the issues here are indeed pretty interesting for their own sake, on the conceptual as well as the practical design level.

One seemingly under-appreciated issue in debate so far concerns the significance of the corporate tax to how we think about the hedge fund managers who pay little tax on huge compensation deals. Suppose the manager gets $100 million, is taxed only at the 15 percent capital gains rate, perhaps a couple of years down the road, and that the other partners are tax-exempt so that their not deducting the fee is irrelevant. There is still one more level to consider, if what the partnership does is invest in C corporations. What about the corporate-level tax on those corporations? Does it matter to the analysis?

Let's start outside the hedge fund realm with Bill Gates. He builds a hugely profitable company (and suppose for simplicity that he owns 100%), but suppose further that he pays himself no salary or dividends and profits purely from stock appreciation. We then have a rising billionaire who appears to be paying no tax.

Suppose, however, that Microsoft is being taxed on its annual economic income at the full statutory rate. This would seem to make the problem go away (leaving aside the question of whether the rate structure is progressive enough). After all, if we taxed Microsoft under a flow-through approach like that used for partnerships, we would think of Gates as reporting all its income and paying tax on it. Likewise if we had an integrated corporate tax with shareholder-level credits for corporate-level tax paid, assuming the corporate rate and his were the same. So the only reason Bill Gates appears to be getting away with murder, under actual law, is that he does not bear the nominal incidence of the corporate tax since Microsoft is treated as a separate taxpayer. (Questions of the economic incidence of the corporate tax would be unchanged by placing the nominal incidence of the tax on him as in the flow-through or corporate integration scenarios.)

Obviously, this view places heavy emphasis on Microsoft's being fully taxed. Corporate-level tax planning might defeat this result. Also, it assumes that we have no reason to like a two-level corporate tax.

How does it apply to hedge funds and carried interests? I am still learning (from Victor Fleischer and others) about what's really happening on the ground in this area, and I note Victor's comment, from his widely-circulated "Two and Twenty" draft, that a hedge fund is a "compensation scheme masquerading as an asset class." But let's consider for now four categories of business activity that fairly commonly use this structure. Two that have been less commented on are oil and gas activities and real estate activities, on which it is enough for now to note that these activities often receive highly preferential tax treatment - weakening the argument that corporate-level taxation does the trick, although arguably converting the nature of the problem from inequity to inefficiency.

The other two categories that have been widely mentioned are (1) the classic hedge funds that try, a la Long-Term Capital Management, to exploit market inefficiencies in stock pricing to generate profits for the investors, and (2) private equity funds that take ownership positions in under-performing companies, raise the stock value, and then flip the stock. In distinguishing these two, I don't mean to imply either that everyone is a clean case of one or the other, or that statutory rules could be drafted that conveniently and accurately sliced the world into these two categories - only that they are conceptually different.

In both cases, the carried interest rule may mean that the manager, who has the market power vis-a-vis his investors to extract most of the economic return, conceptually has labor income on his efforts that is taxed at only the 15 percent capital gains rate. But does the corporate-level tax on the companies that issued the underlying stocks make up for this?

I'm still just starting to think about this, and reader feedback is welcome. But the private equity fund case strikes me as pretty close to the Bill Gates example. The restructuring generates extra corporate-level income that is taxed if the corporate tax is well-functioning. If this is fine when you continue to hold the stock, selling it and paying tax at 15 percent while the corporate-level tax continues certainly doesn't make things worse.

But the hedge fund manager who outsmarts the market by anticipating in advance where value is headed looks to me a bit different. He (or she) hasn't increased corporate profitability, but merely discerned it faster. This may have social benefits, as it is part of having an efficient marketplace in which people can get the portfolios they want and in which money moves around to track true value, but the private gain from being one second faster than anyone else (and thereby generating a huge profit) substantially exceeds the social gain. Lots of it is simply an externality, via the shift of profits from those who discern value a bit more slowly to those who discern it a bit faster. And this analysis doesn't apply to the private equity fund case unless we view that as a tournament-style competition to be the one who gets to add the value.

One way of looking at it is that the private equity fund manager's efforts really are taxed by the corporate tax system (again, assuming its effectiveness), while the hedge fund trader's efforts aren't taxed in this sense. But, since we could easily start splitting hairs about whether it matters that the values discerned by the hedge fund manager are after-tax values (since this is what investors presumably care about), perhaps it's clearer to say instead that there is an incentive to over-invest in what the hedge fund manager does, but not necessarily in what the private equity manager does, so we should want to tax the former at a higher rate than the latter. Once again, of course, I have transmuted the distributional issue into one of efficiency, reflecting that, when activities are lightly taxed, they attract extra input that may bid down the pre-tax return.

Final point for now: the point about inequity being converted into inefficiency depends on efficient markets. But is this entirely the right assumption here? Capital markets do strange things that the standard Chicago-style ECMH (efficient capital markets hypothesis) cannot easily explain. The hedge fund managers, of course, are directly posited to be exploiting market inefficiencies. Or else perhaps they are being paid in some cases on the fiction that they can do better than monkeys throwing darts at the wall to determine investment choice. In general, how competitive is this market, with its arguably strangely uniform structure for arranging compensation? I don't want to argue here against using conventional economic tools to understand what is going on here, but the possibility of big anomalies should not be prematurely ruled out.

Tuesday, July 24, 2007

Back in NYC

Yesterday I returned from a month in Singapore & SE Asia (with spouse & kids), responsible for the paucity of recent posts. Definitely an interesting experience.

Singapore, where we spent the first 2 weeks, is better as a place to live than touristically. But there are a few good sites there. Most memorable, perhaps, was a feature at their aquarium that my kids were not alone in liking. The Singapore aquarium has a petting tank (!) with various small sharks and rays, including sting rays (presumably juveniles from their size) that have had their stingers removed.

The sharks pretty much just sit there on the bottom of the tank - these apparently don't have to keep moving in order to breathe - and let you feel their skin, which feels a bit like that of a snake. But the rays, which feel amazingly silky and smooth, keep surfacing and butting their heads against you in the hope of being fed small bits of fish. Quite a novel experience.

The other activity in Singapore that I enjoyed most was going to neighborhoods such as Chinatown, Little India, and Arab Street to wander around & then dine in small restaurants with very good and authentic food.

The class I was teaching in Singapore ended up being a great experience. It made me a lot more anxious than teaching usually does, because I was going solo for 3-1/4 hours a day, 4 days in a row on successive weeks, trying to teach very complex economic and tax policy ideas to a class of 17 or so students who were very good, and also very engaged, but who had next to no background either in tax law & policy or in public economics. This made it feel, the evening before each class, like I was going to be high-diving without a net. Would I be able to explain things well? Would the class run too fast or slow? Definitely an intense experience, but one that worked out really well. I felt that I was in reasonably good form on 7 of the 8 days, with a couple going really well. And on the day that I thought went badly, it was clear that I was unhappy about this & not blaming them, establishing a bit of credit for good faith.

After that stage we flew to Ho Chi Minh City, aka Saigon. For an American who grew up during the Vietnam War, definitely a notable experience to be there. It's a hectic and chaotic place. Crossing the street is a bit like playing a video game, only lots more dangerous. Continual hubbub with cars and millions of motorbikes. No one yields more than an inch short of collision. Touristically not that great from the standpoint of individually memorable sites, although the War Remembrance Museum was interesting. But my wife and I have always liked the aspect of traveling where you are trying to navigate in a foreign city, e.g., just trying to find a travel agent's office, and thus dealing with the map, crossing the streets, seeing the life there, going to markets, etc. So from that standpoint it was quite good for us though not for our kids.

Our big mistake on the trip was falling between two stools, the one that would have worked for my wife & me and the one that was best for our kids. E.g., if you go Ho Chi Minh or Hanoi (which we did later, see below), a central touristic focus should be getting out of town to some interesting sites nearby. From HCM, the obvious place to go is the Mekong Delta. From Hanoi, Sapa (mountains and hill tribes) and Halong Bay (limestone caves). But these side trips didn't seem feasible from the kids' standpoint, so we ended up just going to HCM and Hanoi.

Anyway, from HCM we proceeded to Siem Reap, Cambodia, the access point for Angkor Wat. We saw lots of amazing temples in different states of preservation. We also had a riverboat tour, seeing very poor people who live on the river or near it. Cambodia is a desperately poor country, beyond anything we'd seen apart from hill tribes in Thailand some years ago, and our guide was telling us about the corruption there, which has led him to be a tour guide even though he has a law degree. Highly recommended as a travel site.

Hanoi was less ramshackle than Saigon, a bit more appealing aesthetically (e.g., it has a nice lake in the center of town, maybe a mile walk to circumnavigate). Crossing the street here is even harder than in Saigon, however. One memorable bit involved the marketplace where they sell roast dog. Think of a skinned & barbecued whole pig if you've seen that, only it's definitely a dog, the whole body, which they slice with a giant cleaver if someone just wants part ... Our kids declined to go see this, and I can't say I blamed them, but I myself wouldn't have missed it.

Our final stage, definitely chosen for the kids though we enjoyed it too, was a beach resort in Phuket. The place we went, Le Meridien Phuket, has a private beach, so you can avoid the insane hubbub that makes most of Phuket so unpleasant, although for dinner you pretty much have to deal with it. One high point, I suppose, was taking second place in the resort's weekly ping pong championship. 15-year old Abdul of Bahrain, a tall, gangly kid who had a devastating forehand slam and seemingly a 20-foot wingspan, was the winner, although I had two match points against him. Good PR for America that I lost?

It is a bit awkward to be an American abroad in the age of Bush. I kept introducing myself as from New York City, to which they would answer "Oh, you're American." I realized that hardly anyone out there would understand the cultural distinction that I meant to draw by identifying myself as a New Yorker, rather than as an American, but I kept on trying anyway.

Monday, July 02, 2007

The Libby pardon

A clear obstruction of justice and act of monstrous if utterly unsurprising hypocrisy. I believe it is literally impossible to support this act unless you do not believe in the rule of law. Then again, that covers about 80 percent of the D.C. policy elite, such as the pathetic David Brooks, who has already fired up a yes-sir column.