Friday, January 27, 2012

Financial arbitrage is fun when it actually works

According to this article, one aspect of the New York Mets' financial problems is that they owe a huge amount of deferred income to former Mets players. Disastrous former Met Bobby Bonilla is the most famous example, as he is owed almost $1.2 million annually for each of the next 25 years, but there are others as well.

The article offers the following explanation for the Mets' willingness to accept huge deferred salary obligations:

"The Mets once were comfortable pushing salary obligations for their players into the future because the Wilpons were, Picard alleges, getting 18 percent average annual returns on money they invested with Madoff regardless of drastic market fluctuations. So why would it matter if they deferred a player's salary at 8 percent annual interest? They could pocket the sizable difference between the interest owed to the player and what Madoff could make for them."

For that matter, if you can keep on getting 18 percent annually no matter what, why ever pay cash for anything, and indeed why not run up all the debt that they evidently did?

Great financial minds, except for being fatally credulous?

Thursday, January 26, 2012

Tax policy colloquium on 1/24/12 - Amy Monahan paper on healthcare

This past Tuesday, Amy Monahan presented her paper, "Will Employers Undermine Healthcare Reform By Dumping Sick Employees?"

The basic argument is as follows. Under the recently enacted healthcare reform (HCR), employers have an incentive to seek the situation where employees who are likely to be high-cost health insurance customers opt NOT to be covered by the available employer-provided health insurance (EHI), but instead to opt out and seek coverage under the public insurance exchanges that HCR provided for. Employers can't, as a legal matter, directly tell their high-expected cost employees to go elsewhere, but perhaps they can push them in this direction indirectly (without also inducing low-cost or healthy employees to help out - after all, the preexisting tax subsidy for EHI makes this a good deal for employer and employee alike). An example might be not covering diabetes or AIDS at all, and being relatively stingy on hospitalization coverage, but being quite generous with regard to substituting gym memberships.

The paper uses the term "targeted dumping" to describe this strategy of getting the high-cost employees to opt out and use the public insurance exchanges instead. But despite the term's harsh tenor, this seemingly must be good for the employees who opt out, since they do it voluntarily. (Leaving aside scenarios in which the high-cost employees would have been better off still if the employer had designed its plan based on the fact that dumping was impermissible.)

So what could possibly be wrong with targeted dumping? Two groups in particular might be adversely affected: others on the public insurance exchanges if there is an influx of high-cost people whose risks are being pooled with those who are on the exchanges simply because they don't have EHI available, and taxpayers who must fund the subsidies for those exchanges.

My own view is somewhat as follows. Ex ante health insurance given your preexisting health status (high-cost or low-cost) is best accomplished by separating out the distinct expected-cost pools and not having cross-subsidization, in which the low-cost pay net transfers to the high cost. This would address adverse selection by the potential insured, as well as its flipside, favorable selection by the insurers.

As it happens, I also support transfers from low-cost to high-cost people, just as from high-ability to low-ability people through the fiscal system. Only, cross-subsidization is not, at least in theory, the best way to do this. Running it through employer plans is likely to have adverse efficiency consequences relative to financing it through general revenues. In addition, cross-subsidization may have odd and anomalous distributional effects on who ends up paying, relative to running it through general revenues. So targeted dumping may actually produce a better equilibrium - if one ignores the political economy problem of whether explicit taxpayer subsidies to the exchanges will be as close to the right level as the implicit and somewhat hidden ones that are delivered via blocking targeted dumping and thereby achieving greater rather than lesser cross-subsidization within EHI.

So I would offer at least one-and-a-half cheers for allowing targeted dumping, subject to the admitted political economy concern.

Further complications arise from the fact that HCR, for obvious political reasons, was constructed on top of the existing EHI system, with all of its horrendous defects. This makes everything more complicated. One of EHI's many defects is that, by carving out the covered employee group from everyone else, it greatly worsens adverse selection problems outside of its domain. So when you have these two somewhat segregated groups, the people in EHI and everyone else, shifting people around between them can worsen the problems in one sector or the other. Thus, for example, if targeted dumping shifts a significant high-cost population from the EHI to the non-EHI sector, then (with uniform premiums) cross-subsidization may actually become a bigger issue in the latter sector than it would otherwise have been.

Wednesday, January 25, 2012

The White House "Blueprint for an America Built to Last"

In principle, I am in great sympathy with the White House's turn towards a stance of treating high-end wealth concentration as an important tax policy concern. But, like many commentators across the political spectrum, I am less than thrilled by what I know of the details of the White House plan that featured in the State of the Union speech.

Called the "Blueprint for an America Built to Last," it is available here. I guess that label must have beaten out "Making America Ford-Tough" in the focus group sessions. But let's go beyond snark to substance by covering most of the main tax suggestions (they are not quite yet at this stage proposals) in the document.

1. Buffett Rule - The White House favors "measures to ensure that everyone making over a million dollars a year pays ... at least 30%." But apparently this doesn't apply to people who make large charitable contributions to get below 30%.

The purist in me says that this is the wrong way to go about making our system more progressive, although I favor that end. When you start talking about what tax rates people pay, you get into all sorts of side issues that aren’t really of central interest.

The policy is based on a fraction, taxes paid over some measure of income. But for starters, what should be in the numerator? As per the WSJ column yesterday by Berlau and Kovacs that I commented on here, do we need to argue about the case for counting corporate taxes that one arguably indirectly paid as a shareholder? If so, do we have to try to measure them (rather than, like Berlau and Kovacs, conclusively adopting the false presumption that corporations actually pay tax at 35% on their economic income)?

And what should be in the denominator? Is it just adjusted gross income (AGI), which is taxable income prior to taking itemized deductions and personal exemptions? Suppose a hedge fund guy reports AGI of zero, because he wiped out the capital gain from his carried interest by harvesting tax losses through selective realization of the loss assets in his portfolio. Does Congress, as proved so wildly unsuccessful with the alternative minimum tax, need to enact a parallel tax base that is ostensibly broader but then will inevitably be targeted by interest groups for repeated narrowing?

Are we going to get multiple tax return computations - maybe this plus regular taxable income plus the existing alternative minimum tax - and create silly tax planning incentives for taxpayers to try to equalize their tax liability under each, while also having to maintain multiple tax attributes (such as basis) for each asset, one for each system?

OK, I realize that this is politically salient, and the best shouldn't be the enemy of the good, but without more I'm not even sure how good this is (again, despite favoring the goal of increasing high-end income tax liability).

2. Eliminate tax deductions for those making more than $1 million - This is listed aa separate item, and the items they mention (not all of which actually involve deductions, as distinct from exclusions) are housing, healthcare, retirement, and childcare. The last of these is pretty trivial in this income range. Retirement saving tax benefits are a big and complicated topic, and I'm not entirely sure what they have in mind. Phasing out home mortgage interest deductions and the exclusion for employer-provided healthcare at the high end has potential appeal, especially since these are bad items in a tax policy sense but are both politically sacrosanct and would be a bit economically disruptive to yank away for everyone else cold turkey. Again, one needs more details to really assess this.

3. Extend the payroll tax cut - Though this is far from the best stimulus design (since it is largest for people who are earning at least $110,000, and thus have less marginal propensity to spend an extra dollar than poorer individuals), it does appear to be the best and indeed only one that might currently be available from Congress.

4. Expanded "tax relief" for start-ups and small businesses - Yawn, sigh, groan.

5. Remove tax incentives to locate overseas through an international minimum tax - I suppose the idea is as follows. Compute global taxable income for U.S.-headed multinationals, meaning that we count all of the income of their controlled foreign subsidiaries that would be currently taxable in the U.S. if deferral were repealed. Unclear how foreign taxes play into this. Say the minimum global rate is 20%. I am guessing that the foreign taxes are treated as equivalent to U.S. taxes for this purpose - i.e., they are included in the numerator, taxes paid - but conceivably they might just be deductible (i.e., ignored in the numerator but deducted from the denominator, which is global taxable income).

In assessing provisions that would raise U.S. taxes on U.S. multinationals, I think it's helpful to break out 3 distinct issues:

First, at how high a level do we want to be taxing them, on their true foreign source income and/or as compared to non-U.S. multinationals on all of their global income? As I have discussed here, the correct tax "price" at this dimension is hard to determine, and depends in part on the value that both U.S. and foreign shareholders ascribe to U.S. rather than foreign incorporation. This includes a big transition component since existing U.S. companies are largely "trapped" here (subject to true purchases by foreign companies and keeping in mind that they need not be the ones to issue new equity).

Second, to what extent does the tax change target what we suspect of being disguised U.S. source income, classified as foreign source for tax purposes because the rules are so manipulable? I suppose there is a "proxy" argument here for firms with a significant U.S. presence - i.e., that if they are paying a low global rate that may well involve income-shifting outside of the U.S. tax base.

Third, how does the tax change affect the two awful rules that currently dominate U.S. taxation of outbound investment? These are deferral and the foreign tax credit. I have discussed how bad these rules are elsewhere, and I would distinguish this issue from whether one wants the tax rate on outbound to be low and high. After all, both a pure worldwide system under which foreign taxes are merely deductible, and an exemption system for foreign source income, eliminate both. The rule that the Administration suggests would make deferral less important (since a U.S. company faces some current U.S. tax even if it keeps its money abroad), but its effect on the foreign tax credits depends on whether it treats them as equivalent to U.S. taxes paid.

Here's my suggestion: issue the proposal with a fairly low rate but with foreign taxes merely being deductible. E.g., say we have a 5% or 10% minimum worldwide rate, in the above sense, with foreign taxes merely being deductible for this purpose.

6. Lower tax rates for companies that manufacture and create jobs in the U.S. - More specifically, lower tax rates for U.S. manufacturing, double the tax deduction for high-tech manufacturers, provide a tax credit for companies' "moving expenses" (that's what it says) when they "close production overseas and bring jobs back to the United States." This, I must say, sounds really stupid on all fronts.

A couple of last words on Romney's taxes

As many people have said, the Romney tax return story is in the end less about him as an individual than about how it shows and dramatizes the workings of the current U.S. income tax system.

I considered the biggest revelation of his 2010 tax return to be the net capital loss carryover, showing that he had zero net income from capital gains (including carried interest) in 2009. I noted that no doubt he had a lot of genuine loss stocks given the stock market price drop, but that (even without tax sheltering to create fake tax losses) he may have engaged in "loss harvesting," or selling losers while holding winners.

Should one add the Seinfeld line, "Not that there's anything wrong with that"? Yes if one is evaluating Romney's behavior - why wouldn't anyone engage in perfectly legal loss harvesting when the system permits it to work. (Although again, the fact that it could work against carried interest income shows a second aspect of the favorable tax treatment - capital gain not only gets a lower rate than ordinary income, but can be offset by harvestable capital losses.) But it shows a big problem with our tax system. Suppose we even stipulate that Romney had an overall loss on his investment portfolio in 2009, not just losses on one side of the ledger that he was able to harvest. Income is a "net" rather than a "gross" concept, so of course he should be able to deduct losses against gains, all else equal. But suppose we are looking at the 1990s massive run-up in stock prices. In that scenario, Romney, along with any other sensible investor, would have had huge gains that he would have taken care to avoid realizing for tax purposes unless absolutely necessary.

Another issue: in yesterday's Wall Street Journal, John Berlau and Trey Kovacs argue that Romney's tax rate was actually as high as 44.75%. This is a pretty simple calculation. You take the 35% corporate tax rate, and then layer a 15% dividend or capital gain rate on top of it. Thus, $100 earned through a corporation drops to $65 after paying corporate tax, and then to $55.25 after paying a 15% shareholder level tax. So, if we ignore the myth of separate corporate personhood, we should realize that the whole thing is really paid by the shareholder.

Let's leave issues regarding the incidence of the corporate tax to one side, since they are actually equally raised by a tax that is levied directly on business owners. Berlau and Kovacs are entirely right to suggest that the corporate level tax matters to the analysis. I frequently noted this point in the carried interest debate a couple of years back. But they are of course wrong (in classic WSJ fashion) to simply assume that corporations are actually paying tax on 35% of their income. The average or effective rate, not the marginal rate, is what matters if one is thinking about distributional effects (although efficiency issues turn on the marginal rate, which may effectively be 35% in many cases even if the company's average rate is much lower).

Another point that I made in the carried interest debate, and that is relevant here (again, much more for assessing the broader issues than with regard to Romney himself) is that people realizing capital gains from selling corporate stock do not necessarily bear, even implicitly, the corporate tax. And this may be especially true for private equity, quick-turnaround firms like Bain (wholly aside from the issue of what one thinks of Bain's activities).

Let's take 3 cases in which a private equity firm swoops in, buys a company for a low price, and then reaps large profits by selling it for a high price.

Case 1: They figured out how to make the company more efficient and profitable. These increased profits will bear the 35% corporate tax (if the average or effective rate is actually at that level), so the Berlau-Kovacs analysis holds. (Note, however, that per the famous article by Shleifer and Summers, it's possible that this involved breaking implicit long-term employment contracts with the workforce, rather than generating true efficiency gains.)

Case 2: They figured out how to make the company more tax-efficient (i.e., to lower its tax rate), and thus it sells for more. This time their capital gain does not reflect income that has already been taxed at the corporate level. (The corporation is not taxed for the after-tax profit from lowering its tax rate.)

Case 3: They are smart traders, and figured out that the company was under-valued. Here the profit is a return to their labor in figuring out true value (or for that matter in skillfully playing the Keynesian beauty contest game), and it is not being double-taxed by reason of the 35% corporate tax rate, which was a constant.

One last point about all this: It is striking how many of the better commentators across the political spectrum draw one of the right lessons, which is that a well-designed progressive consumption tax could work far better than the current income tax. David Frum made this point recently, and I believe so has Matt Yglesias from time to time. But this point continues to lack any apparent political traction at any point in Washington political debate.

Tuesday, January 24, 2012

Death of Ursula

One thing about cats, if you have a typical human lifespan and your norm is to have 3 cats in the house, you will repeatedly experience their mortality, which is not pleasant (although the journey is still very much worth it as a whole).

Today Ursula died of kidney disease. There's an element of relief to this, because for the last few days we had been operating a hospice. It was horrible to see how gaunt and skeletal she looked, and how inert she was becoming. By the last few days (though not before that) her quality of life appeared clearly to be approaching zero. But at least we had 9 good years with her first.

She first got kidney disease, from an infection, about 2 years ago. She was briefly at death's door, but we got her restored with antibiotics, IV fluid for a week, etc. Then she was fine for a while, until a more recent stint at the vet at which it became obvious that her time was growing short. But she still had a couple of good months after we took her back home - although I don't think she much enjoyed the water shots that we gave her nightly. Finally in the last couple of weeks she sank fast. She stopped eating a few days ago, stopped using the stairs shortly after that, and today, I suppose mercifully, her body completed its shutdown.

An extremely sweet-tempered animal, known (among other monickers) as Ursee, the Lovely One, Ursulina, Princesska, and the Little Gal. Spirited although small, and the much larger Seymour (who is a peace-lover) would let her shove past him to eat at his food bowl. She didn't much like people whom she didn't know, but when she decided you were OK, you would feel really honored by her trust, affection, and regard. Not much for being picked up, but she loved being petted while on the ground, and would purr loudly (as well as fluttering) and groom you back, at least if you were on her Special Friends list. I often used to say that I wished I could get her to write me a letter of recommendation that I could present to other cats, stating "This one's OK," as I knew that was how she felt. She was also a very clever little gal - remarkably astute, for example, in divining when we were planning to pack her up for an unwanted ride in the car.

Look at the markings. She had great stripes. We adopted her at a shelter, ostensibly as just another brown tabby, but she was a dead ringer for a breed we saw in a book, called the Wild Abyssinian. Very smooth and silky soft fur. So long as you were not a mouse, she was a friend worth making and cherishing.

Romney's 2010 and 2011 tax returns

Last night, courtesy of a media organization that got some materials in advance, I was able to spend a short time looking at some of the information from Governor Romney's 2010 tax return, along with some tentative and preliminary 2011 items. As I will be colloquiumizing, so to speak, while this story is bright and fresh today, I am writing up my main preliminary reactions in advance and will post them when the story has gone public.

1) Roughly speaking, Romney shows annual adjusted gross income (AGI) in the range of just over $20 million per year, and is paying income tax on this at a rate of about 15% or perhaps a mite below. This is as expected, and raises a set of issues not about his compliance or tax planning activity, but about the merits of the underlying rules that yield this result. A key reason for the low average tax rate (computed relative to AGI) is that about half of his income comes from long-term capital gains that are presumably mainly or wholly Bain carried interest payouts. Taxing these as capital gains rather than ordinary income may have saved him about $2 million a year, all else equal. He also lowered his average tax rate through significant charitable contributions, in particular to his church and with a higher amount in 2011 than 2010. Obviously he can argue that paying less tax due to charitable contributions is different than doing so by reason of tax planning or favorable tax rules for what is classified as capital income.

2) He appears to have had the full measure of disallowed miscellaneous itemized deductions under the "2% of adjusted gross income" floor, and thus apparently did not use Caymans entities to avoid this problem, as David Miller's NYU Tax Policy Colloquium from last year suggested may be common practice in some circles.

3) Not to bury the lede, but the single most interesting thing I saw is that he had a $4.8 million capital loss carryover in 2010. In other words, for 2009, his capital losses exceeded his capital gains (including from the Bain carried interests) by $4.8 million. So he had zero net capital gains, and zero tax on his carried interest income, in 2009. I had speculated in an earlier post that the fact that the carried interest gives rise to capital gain might benefit him not only by lowering the tax rate on the income from 35% to 15%, but also by permitting it to be offset by capital losses, and now we see this confirmed.

The really interesting question is: What was the reason for these sizable capital losses? An obvious possibility that comes to mind is that 2009 was not exactly the greatest year ever in the history of the stock market. But it would be interesting to know more about this. It would also be interesting to know more about whether he had capital losses offsetting his capital gains in 2008, which of course is when the current financial crisis broke out, and for that matter in 2007 and earlier.

On the Democrats' (or even Gingrich?) side, I would be tempted to make a lot of this: "He didn't pay ANY tax on his Bain carried interest income in 2009 and perhaps earlier!" But of course our income tax employs a net rather than a gross concept of income. If you make $10 million here but lose $10 million there, your net is zero and you are supposed to pay tax of zero.

But - taxpayers can be quite artful about the losses that appear on their returns. Thus, suppose you have a stock portfolio with both huge gains on some stocks and huge losses on others - reflecting diversification and perhaps a willingness to take a wide array of risks. Then you sell the losers and hold the winners, and you get huge loss deductions (offsetting the carried interest income) that misrepresent the actual economic performance of your portfolio as a whole. This would involve entirely legitimate tax planning, which I might do as well if in Romney's tax position, but then it would indeed mean that he was paying zero tax on his carried interest income despite not actually having net losses from his portfolio holdings.

Another possibility is that one can create fake capital losses (or at least take a reporting position that one has done so) through aggressive tax planning tricks that, for example, create fake basis in assets to permit the deduction of fake losses. There is no evidence whatsoever that Romney did this, but the possibility underscores the point that one might really like to know more about the source and reality of the capital losses that Romney claimed or perhaps harvested in 2009.

If I were on the other side of this politically, I would use the 2010 capital loss carryover as grounds supporting the demand to see earlier years' tax returns, as well as perhaps non-tax return information that might shed light on what was really going on here economically. Again, it may just be a matter of having an exceptional year in which the recession and stock market collapse gave him large losses that he realized, but one can't tell for sure from the information that has thus far been released.

4) Romney has lots of PFIC investments on which he reports, and on which he takes the QEF election - but there's something baffling to me about what's reported. Oops, a lot of jargon in that last sentence. Let's explain. In general, passive foreign investment companies (PFICs) are foreign corporations in which one owns shares, and which are primarily engaged in passive portfolio investment rather than actively running controlled businesses. To prevent U.S. individuals from incorporating their stock portfolios abroad and avoiding current tax, the PFIC rules require current year taxable income inclusion of one's share of the income thus generated, or its deferred (but with interest) equivalent. The QEF election means that you elect to be taxable currently, since the deferred alternative is generally worse. Romney has lots of PFICs - some Bain, some Goldman Sachs, and others as well - that are incorporated all over the place: the Caymans, Ireland, Luxembourg, Switzerland, Germany, I believe the U.K., etcetera. But the odd thing about it is that the PFIC income he reports for 2010 tends to be really trivial amounts, like $2,000 here and $800 there. (I.e., not just trivial in his specialized sense, a la the $370,000 in speech fees that he mentioned.) What I don't understand is why this is. Were the PFICs doing poorly in the 2010 economic environment? Is most of his real money in tax-deferred IRAs, so we are only seeing a tiny piece in the taxable realm? Is there tax planning going on off-screen, at the PFIC level, such that he might have more economic income than taxable income from all these PFICs? Someone who knows more about practice in this area might have a better sense of it than I do.

5) For 2010, Romney filed several Form 8886, Reportable Transaction Disclosures with the IRS. These were generally for investments through a Goldman Sachs hedge fund. I couldn't see what the transactions were, since the forms stated that a full textual explanation was being provided on separate pages that were not available, at least in what I saw.

Reportable transaction disclosures generally pertain to transactions that the IRS and Treasury find suspicious as potentially improper tax shelters. They typically have a high ratio of tax benefits to cash invested and/or economic substance, and the government thus wants a chance to look them over more carefully. Or they may have triggered the disclosure requirement in other ways, such as by reason of being offered confidentially. The fact that you have reportable transactions doesn't by itself support any definite conclusions. For example, the IRS may end up agreeing that all of these transactions were reported properly and had the tax consequences that were claimed. Or it may disagree but lose in court. Or it may disagree and win in court, but you believed in good faith that your positions were valid.

So no definite conclusions of any kind can be drawn from Romney's having reportable transaction disclosures - especially since I don't even know what these transactions were or what tax benefits they may have produced. Nonetheless, the fact that his return includes these things is of interest, and raises the question of whether he was engaged (mainly through Goldman, it seems) in aggressive tax planning.

Monday, January 23, 2012

Romney's latest talking point about how policy should be directed by people who have had a "job"

Romney appears to be doubling down on his talking point about how Obama and lots of people in the Administration have never had a "job," by which he means a private sector business job. Apparently that is what you need to decide, for example, on the merits of the case for Keynesian stimulus, or to evaluate global warming, or for that matter to set our policy towards Iran.

Back in the 1990s, I was once called as a witness at some sort of House sub-committee hearing on raising the minimum wage. The Republicans were in the majority, and I was one of their two witnesses. The other was Doug Holtz-Eakin. I had been called because of a recent article I had written in the U of Chicago Law Review, in which I skeptically compared min wage increases to their equivalent in explicit tax and transfer terms (i.e., a tax on low-wage employment that was used to fund a subsidy to people with low hourly earnings, and with no focus on household income over any longer period). The article was balanced, and I noted that some of labor markets' peculiar features made it plausible that modest minimum wage hikes would have genuinely ambiguous employment effects (as suggested by then-recent empirical work by Card and Krueger).

The background for the hearing was that the Republicans were not having any of it, so far as a minimum wage increase was concerned, but that they didn't feel they could just not hold the hearing. (Obviously they would never hold it today.) So it was a day for the Democrats on the sub-committee to beat up the Republicans a bit, since this was an issue on which the Dems would definitely poll better. They had their own witnesses, including I believe Jared Bernstein.

Anyway, at some point the Democrats started saying stuff like: What do we need these academics here for. Let's get some witnesses who actually know something about the minimum wage - minimum wage workers! Holtz-Eakin, while trying to tamp down his reaction, couldn't help being a bit sarcastic and irate. He suggested to the Democrats that, if that was how they defined expertise (rather than, say, by asking experts about the state of empirical knowledge), why not just fire their staffs and have all the issues decided by people who don't know anything.

Then we had to sit through some stuff about how "you people" just "don't get it," which was funny for me because I certainly do want to help low-wage and unemployed people but would not assume that they know the most about how to raise employment and wage levels.

When it was over, outside the hearing room a leading Democrat (I believe it was John Dingell) winked at me as if to say, hey, don't take it personally, it's all just show biz.

But now we have Romney basing an entire presidential campaign on essentially the same type of definition of expertise, only it relies on the perspective of the bosses rather than the workers.

Gingrich's tax planning trick

According to Forbes (courtesy of the Tax Prof Blog), Newt Gingrich's tax return shows that he purported to avoid $50,000 of Medicare payroll taxes by using the so-called John Edwards Sub S tax shelter - a scam that Forbes says the IRS has "consistently and successfully attacked." The trick is to avoid the 2.9 percent Medicare payroll tax by forming a shell entity that supposedly employs you. Then, when others pay for your services, the money goes to the entity, which underpays you from a reasonable compensation standpoint. This ostensibly results in converting the lion's share of your compensation income into business profits, which do not face the Medicare payroll tax. If you actually need the cash, you can still ask the entity to pay it to you (and it will probably say yes to its 100% owner), but you label the payments as dividends, which also are exempt from the Medicare payroll tax (and indeed are tax-irrelevant, given that a subchapter S corporation is taxed as a flow-through entity whose profits accrued to you anyway).

Essentially, the trick is the same as if I were to make a deal with NYU whereby I formed a subchapter S corporation, charged NYU my entire salary, and then had my S corporation pay me just a pittance under the salary label. If this worked, I could avoid all payroll taxes (except on the pittance that I admitted was salary) - Social Security as well as Medicare. And I suppose NYU could avoid paying its half of the Social Security payroll tax. But needless to say this wouldn't actually work, in particular given the personal service corporation rules (Internal Revenue Code section 269A).

The John Edwards Sub S tax shelter typically comes closer to being legally defensible, avoiding the terms of section 269A and being contested by the IRS on "reasonable compensation" grounds, which in this setting is a version of substance over form. That is, if Gingrich the sub S owner were dealing at arm's length with Gingrich the star employee, he would have to pay himself pretty much the entire profits, since he is the asset. The IRS has had prominent recent wins lately in litigating this issue.

It's only fair to compare Gingrich's Sub S tax shelter to Romney's use of Caymans entities to avoid unrelated business income tax (UBIT) with respect to his pension investments. Romney's strategy appears clearly to work as a legal matter, and the tax he is avoiding (the imposition of UBIT on debt-financed exempt entity investments) has contested merits, which may be one reason why Congress has not revised the rules to defeat the strategy (an almost absurdly simple one, based on not "looking through" a meaningless blocker entity). Gingrich's tax planning trick strikes at the heart of taxing earned income under the rules that are supposed to apply to it. Like so many abusive tax shelters, it appears to be based on mischaracterizing actual transactions, rather than merely exploiting a legally relevant technical lacuna in the law. What is more, if audited, Gingrich (unlike Romney) might face a risk not just of losing the case, but of owing penalties.

Friday, January 20, 2012

New article on financial sector taxation

I have now posted on SSRN a first draft of my just-completed article, "The Financial Transactions Tax Versus (?) the Financial Activities Tax."

It is available for download here.

The abstract reads as follows:

The 2008 financial crisis has provoked widespread interest in developing new taxes to apply to the financial sector. In particular, the Staff of the International Monetary Fund has suggested enactment of a financial activities tax (FAT), while the European Commission has proposed a financial transactions tax (FTT). This article discusses the FAT and FTT models that have featured in historical and more recent discussion, and evaluates them in light of the objectives stated by the European Commission, along with broader tax policy considerations. It concludes that there is a strong case for enacting an FAT, and that two alternative versions of this tax have competing pluses and minuses. With respect to the FTT, it concludes that the rationales advanced by the European Commission are unpersuasive, but that an argument could perhaps made for the tax – subject to concern about its clear inefficiency at certain margins – based on the goal of discouraging the socially excessive pursuit of trading profits (or if better instruments for raising revenue and increasing progressivity are politically unavailable).

Thursday, January 19, 2012

But enough about taxes and politics, what about the weather?

Every winter - even uncommonly mild ones, such as winter 2012 so far - I keep asking myself: Have we bottomed out yet? When does the average daily temperature stop falling and start to rise?

Today I finally thought to do an online search that would enable me to answer this question. According to the relevant link at, the average mean daily temperature in New York City declines from 34 degrees to 33 on January 1. Then on January 10, it drops another degree to 32. There it stays until January 24, when it rises back to 33. It goes to 34 degrees on February 4, 35 on February 11, and whee, up we go back towards ranges where human beings could biologically survive indefinitely even without clothing and shelter.

Bottom line, we are more than halfway through what is on average the very coldest stretch.

Romney Caymans tax planning follow-up

A Wall Street Journal article suggests that Romney's use of offshore entities in the Caymans, permits him to avoid the unrelated business income tax (UBIT), which can kick in when tax-exempt entities (such as pension funds) have debt-financed portfolio income.

This raises the question of whether we should view Romney (a) as having been engaged in disreputable tax avoidance behavior, demonstrating how the rich and well-advised can avoid intended income tax liability - or instead (b) as merely avoiding traps for the unwary and/or structuring his investments rationally and in a tax-efficient manner, as any well-advised investor would.

The question has no clear answer. Those who would like to plunge into the thickets a bit should definitely consult the article on using overseas entities that David Miller presented at the NYU Tax Policy Colloquium last year, which you can find here. At pages 40 through 48 of the article (following the numbers on the bottom of each page, rather than the overall document numbering at the link), he explains in detail both (a) the underlying UBIT rules and how they might have created a tax liability but for the apparently standard strategy that I gather Romney followed (investing through Caymans "blocker entities"), and (b) how the strategy eliminates the UBIT liability (which is pretty simple - the US tax-exempt doesn't itself borrow, but just gets dividends from its Caymans creature which does the borrowing).

The paper also tackles the further question of whether we should think there is anything wrong with allowing the strategy to work. The suggested conclusion (see pages 47-48) is that (a) Congress really did intend to apply the UBIT in situations where Romney's tax planning strategy permits him to avoid it, but (b) the provision that he is avoiding "was crafted less by prudent tax policy and more by politics," and hence one might not object strongly to its being avoidable.

UPDATE: I discuss the UBIT tax planning angle in a Christian Science Monitor article by Ron Scherer, available here.

Wednesday, January 18, 2012

What is Mitt Romney's effective or average tax rate?

He now says that it is 15%. But if that is his opening claim, I would say that the smart money is on an over-under that is considerably lower.

Romney appears to believe that he can get away with releasing only the 2012 return, which obviously is being prepared with current campaign circumstances in mind. I myself would regard it as preposterous if he is not compelled by political pressure to go several years back, in keeping with what is otherwise universal practice in presidential campaigns.

Would his tax returns for, say, 2007 through 2011 look about the same as that for 2012, given that he has been running for president (or preparing to) throughout this entire period? If he has made good decisions, clearly yes. But he appears so clueless about the difference between his circumstances and those of average voters that I suspect the answer is no. He may simply have figured: this (i.e., extremely aggressive tax planning) is how you do it, and how everyone does it.

But suppose he releases his tax returns. How should we interpret them? There will be a lot of discussion of what his average or effective tax rate is, and how that compares to that for more average taxpayers. Indeed, he himself engaged in this analysis by quasi-endorsing the 15% figure.

An initial question is whether to benchmark the number we end up with against average taxpayers' income tax liabilities, or their income plus payroll tax liabilities. And if we include payroll tax liabilities for average taxpayers, should that include the employer share? (This would require grossing up the income measure to which one's tax liability is being compared.)

There certainly is an argument for including payroll tax liabilities. But it is true that, when you earn wages that are subject to the Social Security portion of the payroll tax, you may also be earning expected retirement benefits from Social Security. (Technical note: you only pay Social Security tax on your first $110,000 of wages, and the formula for determining retirement benefits counts only your 35 highest-earning years, excluding amounts earned that were above the tax threshold.) So arguably your net payroll tax liability is lower than your gross payroll tax liability. Then there's also the lifetime perspective (Social Security and Medicare benefits versus payroll tax liabilities overall in present value, rather than current year). This is an important perspective but obviously well beyond what we can imagine focusing on here.

Now let's get to Romney's income tax return itself. One possibility would be to compare the bottom line income tax liability to his adjusted gross income (AGI). This may be the source of his 15% estimate, if he is paying mainly capital gains tax based on the highly controversial income tax treatment of "carried interest" paid to private equity managers.

But suppose he also has a bunch of tax shelter losses that reduce AGI. Then there would certainly be a strong case for grossing up AGI, for purposes of the effective rate measure, to reflect the noneconomic character of such losses.

Suppose further that, since so much of his income took the form of capital gains, he used an aggressive "strategic trading" strategy to generate offsetting losses. The basic trick is as follows. You hold a huge stock portfolio, figuring that some will go up in value while others go down. You then hold the winners and sell the losers, generating sizeable capital losses. In one sense, these are not fake - the stocks you sold actually did generate the losses claimed. But it may radically misrepresent your overall portfolio results.

Strategic trading has the potential to wipe out income tax liability for rich people with large stock portfolios. It is combated by the capital loss limitation, which limits individuals' net capital losses claimed to $3,000 per year. But this is not a constraint insofar as the income you want to shelter is taking the form of capital gains.

Thus, there would be an argument for grossing up Romney's income measure, for purposes of the effective tax rate computation, to disregard capital losses, insofar as we suspect that this is going on. But the right answer depends on the rest of his stock portfolio, which will not be directly observable from his tax return.

A related issue, which came up in public discussion of Warren Buffett's effective tax rate, pertains to unrealized asset appreciation generally. It's a bedrock rule in our tax system that this stuff generally isn't taxed. But it is a part of economic income, so if you are interested in tax liability relative to that, it oughtn't to be ignored.

Now let's take the unrealized appreciation issue one step further. Suppose Romney has huge unrealized gains that have accrued economically overseas, in particular in tax havens, without being currently taxable in the U.S. Suppose that his not including all this stuff in his income reflects the very aggressive, but (under current law) perhaps legally defensible, tax planning that reports I have seen on-line suggest is characteristic of Bain investments. This, like tax shelter losses, might be viewed as unrealized appreciation plus. Excluding it would give a false picture, making his tax liability seem higher than it really is as a percentage of economic income.

Finally, let's consider a deduction that would reduce taxable income but not AGI. I have seen reports suggesting that he gives millions of dollars in annual charitable donations to the Mormon Church. At least if they're done in cash rather than reflecting tax gimmicks such as the use of appreciated property, this really does reduce his remaining cash out of pocket. But on the other hand, it is a voluntary and discretionary outlay, best viewed as how he chose to spend his economic income rather than as a reduction thereto. And it does reduce his contribution to the public fisc. So arguably the income measure that we use to compute his effective tax rate should not be reduced (relative to AGI) by his charitable contributions. But on the other hand, the size of his charitable contributions may be relevant to the characterological conclusions that we would draw from getting to see his tax returns.

There are some complex issues here, not all of which have an absolutely clear right answer, and not all of which would be entirely illuminated if he consented to the level of disclosure that all other major presidential candidates have accepted for decades. But I say, release the returns and we can let the debate begin.

Tax policy colloquium on 1/17/12 - Michelle Hanlon paper on offshore investment

Yesterday was the first session of the 17th (!) NYU Tax Policy Colloquium. I am doing it with Alan Auerbach again, for the 3-½th time, and we have 27 students (the max allowed). Our Week 1 guest was Michelle Hanlon, with respect to her paper (co-authored with Maydew and Thornock), Taking the Long Way Home: Offshore Investments in U.S. Equity and Debt Markets and U.S. Tax Evasion.

The paper seeks to get a handle empirically on the existence and magnitude of illegal tax evasion by U.S. individuals that takes the following form. You want to invest in U.S. securities without paying U.S. income tax, so you establish a corporation in a tax haven (say, the Cayman Islands) and have it invest in U.S. securities. But you ignore the fact that such "round-tripping" gives you current year tax liability (or its present value equivalent) under the passive foreign investment company (PFIC) rules, obviously counting on the prospect that the U.S. tax authorities will not learn of your ownership interest in the offshore company.

Since researchers, no less than the IRS, can 't directly observe this illegal activity, one needs an empirical strategy to try to estimate it. The Hanlon paper finds two main things. First, when relevant U.S. tax rates go up (such as for individuals' ordinary income or long-term capital gains), inbound investment to the U.S. from tax havens tends to go up. The suggested explanation is that the higher tax rate increased U.S. investors' incentive to engage in fraud, but did not directly affect investors from other countries. Hence the surmise that perhaps the increased inbound capital flow may actually reflect round-tripping, and associated tax fraud, by U.S. investors.

Second, when certain agreements are reached between the U.S. and a tax haven country that may indicate an increased probability of detection for fraudulent evasion of the PFIC rules, inbound capital flows to the U.S. from the haven tend to decline. Once again, the surmise would be that, if only U.S. investors are being affected, it is a decent surmise that they are responsible for the change.

The paper makes a nice contribution by shedding some light on this issue, but it remains hard to tell just how much fraudulent round-tripping is going on. For example, one could concoct a scenario in which the U.S. tax rate increase induces U.S. investors shift to municipal bonds and tax-favored housing. So they sell securities to non-U.S. investors, who may invest through tax haven entities if they have other reasons for doing it this way.

Also, a higher U.S. tax rate could lead to round-tripping that is not associated with tax fraud. A paper that David Miller presented at the colloquium last year explored the various reasons why U.S. investors may choose to use tax haven entities, even when fully complying with the law (including the PFIC rules). For example, this structure may enable them to avoid itemized deduction disallowance or limitation rules that only apply to individuals. So we could potentially have the round-tripping story that the paper shows, minus the implication that it is mainly about tax fraud.

Likewise, suppose that there are U.S. taxpayers who have figured ways to engage in legal tax avoidance with respect to the PFIC rules, rendering them inapplicable in circumstances where one might argue that as a matter of policy they ought to apply. Once again, we would have the round-tripping story without the fraud.

Insofar as the data do indeed show non-trivial levels of tax fraud, the issue of what to do about it remains. Open questions include what sort of revenue estimate one might get for particular crackdown measures, and how things will change when the Foreign Account Tax Compliance Act (FATCA) takes effect next year.

Still, the paper presents a suggestive initial look at an area where there have been large gaps in our empirical knowledge.

Monday, January 16, 2012

Martin Luther King Day

Though I was only 10 years old at the time, I well remember my shock, dismay, and disbelief (sorry for the cliched word choice, but those are the ones that fit) when Martin Luther King was shot. I learned of it from my parents (who must have had the TV or radio on), I would think in the early evening.

Recently I was reading a very compelling book, Hampton Sides' "Hellhound on His Trail," about Dr. King's last days, the assassination, James Earl Ray, and the FBI's pursuit. When reading about the horrific deed itself, even all these years later, I found myself getting choked up as if it had just happened.

At the time of King's death, his primary mission of combating legal segregation was pretty much done. He was struggling to define and advance a secondary mission, pertaining to poverty and economic opportunity as well as to U.S. military involvement abroad, but in a much more fragmented political environment, with fewer allies or good choices, and with less of a clear sense of how (or towards what ends) to proceed. But he certainly didn't think he was done.

The issues in his secondary mission faded from politics for a while in the decades after his death, and probably he would have had a hard time changing that. But today they arguably are even more pressing than in 1968. Something to think about on a day devoted to his remembrance.

Financial sector taxation

I have just completed a first draft of a paper, entitled "The Financial Transactions Tax Versus (?) the Financial Activities Tax," that I will be submitting within the week for inclusion in a conference volume to be published by the International Bureau of Fiscal Documentation (IBFD). The underlying conference is the one in Amsterdam that I attended last month, which I discussed in an earlier blog entry here.

Once I've looked it over a bit more, I'll be posting it (with an abstract) on SSRN. I may also consider publishing it in either U.S. or International Tax Notes, which the conference organizers have given me clearance to do.

Further details, including abstract and an SSRN link, to come shortly.

I'll also be presenting it (leaving aside the point that speakers don't actually present their papers) at the NYU Tax Policy Colloquium on Tuesday, February 28, as we had to make a change in our previously announced schedule.

Saturday, January 14, 2012

Those quiet rooms where we can discuss tax policy

"QUESTIONER: Are there no fair questions about the distribution of wealth without it being seen as envy, though?

"ROMNEY: I think it’s fine to talk about those things in quiet rooms and discussions about tax policy and the like."

I guess I should thank Mitt for this, what with the 2012 Tax Policy Colloquium starting in 3 days and all. We certainly plan on discussing distribution and tax policy in our quiet room in Vanderbilt Hall. This may be our first ever explicit endorsement by a leading presidential candidate.

Outside our quiet room, however, the comment has rightly attracted the mockery that it deserves.

Though it's shooting fish in a barrel, let me briefly explain why. Government economic policies matter because they can affect how well off people are. Each person might end up with more or with less, depending on what policy is adopted and on how it works out. It is analytically convenient to divide all this into issues of efficiency and distribution. Efficiency is the size of the pie. Distribution is how the slices are divided between different people. You're always facing distribution issues unless it is a pure Pareto (and hence efficiency) case in which someone could gain without anyone else losing. Those issues are pretty easy to resolve - it's not hard to like policies that would make someone better off and no one worse off. The rest of the time, distribution is a key part of the story, and often this is about richer individuals as opposed to poorer ones.

So there are two basic dimensions in economic policy, and one of them, which is involved almost single time, Romney says can't be discussed in public. Would he hire an architect to design his 11,000 square foot house, and say "We can only talk about the size of the house, and not about how we are going to divide up the space between the rooms"?

Another point, of course, is that the government cannot help but affect distribution. It's not a matter of deciding whether or not to simply retain the (wholly fictional) preexisting, non-government distribution. We aren't living in a state of nature, we're in an actual political and economic world with centuries of government policy and ongoing effects on everyone. The question isn't whether to address distribution or not, but what it's going to be, and how different distributional outcomes will be traded off given efficiency (size of the pie) differences between them.

Then of course we have Romney proposing huge tax law changes, not just for the quiet rooms but for the actual halls of Congress, that would include vast, unfinanced tax cuts for people like himself, and apparently tax increases for the bottom 50 percent. But he evidently thinks, from his political handlers, that the "envy" talking point will permit him to dodge discussion of what he wants to do distributionally.

And of course it's not just tax policy. The legal environment in which Bain Capital operated led to a set of transactions around the country that had various efficiency and distributional consequences, which are certainly fair game for discussion. Now, as it happens, I might agree with Mitt that allowing takeovers, refinancings, and plant closings is better than trying to ban them - although we should (a) seek to ensure well-functioning capital markets, without which all bets are off about the ability of a free market economy to yield value-increasing outcomes, (b) keep in mind the effects of tax biases that may have helped drive the transactions, such as that for debt over equity, and (c) consider what policies could help the people who are the casualties of the process. Is that envy too?

If you cannot defend your own policies in terms that have some connection to how you might actually rationalize them to yourself, and instead show the world that you can only defend them publicly in terms that are laughable and (since you must know better) insulting, then perhaps you are in the wrong business.

Friday, January 13, 2012

A critique of Bain Capital

The film denouncing Mitt Romney's work at Bain Capital, which apparently is playing in South Carolina but is also available here via youtube, may appear at first glance to be longer on story than coherent critique. But in fact it makes a specific claim about Romney's private equity career that deserves broader attention and assessment.

The claim is that Bain's business model under Romney was as follows. They would buy a business and boost its short-term profitability through measures that did not actually increase, and might indeed reduce, its long-term profitability. A specific example mentioned is demanding swifter production at the cost of much lower quality, which could increase sales for the first six to twelve months but then destroy a product's reputation and longer-term sales. Another is slashing wages, where they were previously higher for "efficiency wage" reasons, generating immediate savings but over a longer period reducing workforce productivity (e.g., due to higher turnover costs, change in the quality of the workforce, and morale effects).

The short-term profit jump would immediately be cashed out via higher debt, in many cases accompanied as well by a public stock offering. Bain would then cash out, leaving the business to fail because profits, once they reverted to lower levels, couldn't handle the debt burden.

While I don't know for sure that this story is (at least generally) true, it hangs together and makes logical sense. Note that, in bankruptcy, it might make sense to break up the business rather than simply refinance and keep it going, even if before the arrival of Bain Capital this would not have made sense even with a high debt overhang. Once they have destroyed intangible value (goodwill, workforce in place, etcetera), the company they purchased is no longer optimally using resources.

Obviously, the story requires a healthy dose of asymmetric information and capital market gullibility to get off the ground. (The suckers, after all, are not just the workers but also the lenders and the public offering stock purchasers.) But this is entirely believable. Think of Goldman conning its customers, AIG offering what was effectively an insurance product that it would never be able to make good if the insurance was needed, or mortgage securitizations that offered sham diversification benefits and were priced based on credit ratings that they did not deserve. Bain, under this view, is simply one more member of the rogue's gallery of players that found ways to generate enormous profits by causing the U.S. economy to work worse, not better.

This of course would be a story not of capitalism's "creative destruction," but of destructive destruction and the use of information asymmetries (pertaining here to the short-term profitability jumps that apparently drove the ability to borrow and drain out cash) to undermine the sound functioning of capital markets. And the extent to which it is true certainly deserves serious scrutiny in the months ahead.

Monday, January 09, 2012

On the road again

I am sitting in Charlotte Airport, en route to Gainesville, Florida and the University of Florida Law School, where I am scheduled to give a talk this afternoon on international tax policy. I will be using (as a handout) the slides from my talk in Brazil, which I posted here early last month, but for discussion purposes minus thr Brazil parts.

Thursday, January 05, 2012

2012 NYU Tax Policy Colloquium schedule with paper titles

Just 12 days from now, the 2012 NYU Tax Policy Colloquium will be getting under way. I'll be doing it this year with Alan Auerbach. I've previously posted the schedule with speakers and dates, but here for the first time I can do so with almost all of the paper titles (some of which, however, are still tentative). Anyway, it will go something like this:

1. January 17 – Michelle Hanlon, MIT Sloan School of Management. "The Effect of Repatriation Tax Costs on U.S. Multinational Investment Efficiency."

2. January 24 – Amy Monahan, University of Minnesota Law School. "Will Employers Undermine Health Care Reform by Dumping Sick Employees?"

3. January 31 – Alex Raskolnikov, Columbia Law School. “Not Close Enough: Accepting the Limits of Tax Law and Economics.”

4. February 7 – Victor Fleischer, University of Colorado Law School. "Tax and the Boundaries of the Firm."

5. February 14 – Heather Field, Hastings College of Law. "Binding Choices: Tax Elections & Federal/State Conformity."

6. February 28 – Dhammika Dharmapala, University of Illinois Law School. “Taxes and the Real Option of Delaying Incorporation.”

7. March 6 – Edward Kleinbard, USC Law School.

8. March 20 – Susan Morse, Hastings College of Law. “Worldwide Corporate Income Tax Consolidation and a Corporate Offshore Excise Tax."

9. March 27 – Stephen Shay, Harvard Law School. “Unpacking Territorial.”

10. April 3 – Jon Bakija, Williams College Economics Department.”Jobs and Income Growth of Top Earners and the Causes of Changing Income Inequality: Evidence from U.S. Tax Return Data."

11. April 10 – Lane Kenworthy, University of Arizona Sociology Department. "Getting taxes right: What can we learn from the comparative evidence?"

12. April 17 – Yair Listokin, Yale Law School. “’I Like to Pay Taxes’: Lessons of Philanthropy for Tax and Spending Policy” (with David Schizer).

13. April 24 – William Gale, Brookings Institution. “Fiscal Therapy.”

14. May 1 – Rosanne Altshuler, Rutgers Economics Department, and Harry Grubert, U.S. Treasury Department. “A New View on International Tax Reform.”