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Carried Interest is Not Labor Income – The Capital Structure Perspective

A little while back, I was involved in a brief conversation about the tax treatment of carried interest.  As a full-length post is the best way to explain why carried interest represents a capital gain as opposed to labor income or a gift, I wrote one.  I’m assuming that readers know what carried interest is and why the tax treatment is controversial.  If not, please feel free to visit these sources (WikipediaInternational Business Times)

Of all of the posts I’ve written, this one is my favorite.  While the subject material isn’t intellectually stimulating, and perhaps boring as hell, I admit to having a certain level of enjoyment knowing that my position is not only unpopular as hell, both here and elsewhere, but also because the arguments in favor of treating the taxation of carried interest as ordinary income that don’t appeal to tax justice or fairness, are as appealing as they are correct.  Consider this short-yet-sweet excerpt from a recent New York Times editorial by Victor Fleischer, a proponent of taxing carried interest at ordinary income levels.

…carried interest is not a capital asset. It is labor income, the amount of which happens to be determined by reference to a capital asset…

The argument appears unassailable because all phases of an investment cycle (acquisition, management, development, disposition, etc.) require labor.  A private equity firm that acquires a distressed company, re-positions it and sells it via an initial public offering will get money for that asset in part due to labor’s contribution.

Making my job more difficult is that, to be blunt, most of the defenses of the current tax treatment of carried interest that I’ve read suck. Arguing that the issue isn’t/shouldn’t be a big deal (here), that the fiscal impact is small (here), or that capital is capital and this is the way partnerships have always worked (here) fail to address the best argument of the other side – labor’s contribution to capital value.

A very good exception to this rule is a Kevin Williamson article at the National Review.  He deserves credit for trying to address the relationship between labor value and capital value, and he does so by trying to equating carried interest with “sweat equity” and stock options. Williamson writes:

A programmer…decides to go to work for a startup…; …he accepts equity in the firm, in the hopes that it will be successful and he’ll get a big payday down the road…if he ends up making $10 million on them five years down the road, he pays the 15 percent rate, not the top individual-income-tax rate, even though what he put up was his time and work, not investment capital. The case for taxing the carried interest of private-equity firms at ordinary income rates is also the case for taxing those Silicon Valley foot soldiers at the ordinary rate.

While a very good exception, it’s still comparing apples and oranges.  A programmer starts with a capital base (options) that can earn a profit on that capital in the event the options go in-the-money.  Whatever returns the programmer receives on those options will always be proportionate to the capital (market price less strike price).  This is not the same as carried interest, as carried interest represents the return above and beyond invested capital (i.e. a 20% profits interest less a 5% interest = a 15% carried interest).  The programmer’s equivalent would be a bonus, and whether it’s in the form of cash or stock, it’s taxable at ordinary income.  Williamson’s example inadvertently undermines his argument.

The problem remains.  So long as labor is considered a key factor in the carried interest equation, defending carried interest as a return on capital and the tax treatment as a capital gain on that basis is extraordinarily difficult.  Therefore, the solution is to craft an argument that deliberately excludes but does not ignore labor.  The way I’m going to do this is to reconcile carried interest with the basic capital structure of partnerships, specifically with respect to equity.  Seeing as capital structure theory deals with how firms are capitalized (debt, equity, hybrid securities), involving labor is inappropriate.

I’ll start my analysis with this comment from Kolohe:

If you put up a 5% stake your return on capital should be proportional to that 5% stake. If you’re getting back double or triple what the other capital owners are getting as a proportion of their stakes, you are obviously getting a return on labor, not just capital. Or you’re getting a gift, which iirc is taxed like labor at high enough levels to close that potential loophole.

I think it’s a great comment because his argument is based on proportionality.  Consider this simple example: Kolohe and I are 90%/10% partners in a real estate joint venture.  Kolohe is the limited partner, and I am the general partner.  We develop a property for $1 million and sell it upon completion (sales proceeds represent the only cash inflow).

Taking Kolohe’s quote and creating a visualization of the capital structure gives us this.

 

Cap Structure 1

Kolohe and I are investing on a pari passu basis.  We are equal partners that share in the profits and losses on a proportionate basis.  Where I think Kolohe bases his proportionality argument on the amount invested, I think there’s a better explanation:  returns are shared equally because risk is shared equally. I created a visual assuming a single pool of equity because from a risk/return standpoint, in a pari passu structure, all equity is equal.

However, the more typical arrangement in a partnership where higher risk investments are made (real estate development, leveraged buy outs, etc.) is that the risk is not shared equally among the partners.  The reason limited partners invest with a general partner is because the general partner possesses the expertise the limited partners don’t have.  This lack of expertise also translates into lower risk tolerance.  Because the limited partners contribute the bulk of the capital and the general partner will have a greater risk tolerance, the parties can agree to reduce the limited partner’s risk through a distribution waterfall.  Taking the real estate example, assume the following waterfall distribution.  Ignoring time value of money, in the event that we exit the investment, cash proceeds are distributed as follows:

First, 100% to Kolohe until he receives his $900,000 investment plus a 10% return ($90,000)

Second, 100% to me until I receive my $100,000 investment plus a 10% return ($10,000)

Third, all remaining proceeds are split 80% to Kolohe and 20% to me

The visualization changes:

Cap Structure 2

Clearly, I am bearing a much greater share of the risk.  Assume a 1% loss – a sale at $990,000.  According to the above waterfall, Kolohe earns a 10% return and my capital is wiped out.  In fact, it takes a sale of $1.1 million before Kolohe and I have equal returns.

I’m going to take the part of Kolohe’s comment where he mentions labor and gifts and turn the tables a bit.  Assuming the $990,000 sale price, does the fact that Kolohe received a disproportionate share of the return have anything to do with labor?  No (if only because the limited partners contribute no labor anyway).  Did I decide to give Kolohe a gift out of the goodness of my heart?  No. By definition, a gift is something given without the expectation of receiving anything in return.  Given that my capital is now in the higher risk and Kolohe in the lower risk position, our return expectations need to reflect that.  Therefore, the carried interest in the third step, the portion of the payment where I receive a disproportionate share of the profits represents the return on my capital as compensation for it taking a disproportionate share of the risk.  At its core, carried interest is nothing more than the positive relationship between risk and expected returns as applied to partnership structures where the general partner bears a disproportionately higher share of the risk.

My (correct) analysis notwithstanding, I don’t expect my explanation to change the tone of the discussion.  Since tax justice/income inequality reasons are motivating factors, whether or not carried interest is capital or labor is irrelevant.  It can get whatever tax treatment gets written into the tax code.  Also, the argument that the tax treatment of carried interest can be separated from capital gains taxes even if it is capital, is a strong one.   As Victor Fleischer points out in his op-ed:

Because carried interest is labor income, the usual techniques for avoiding capital gains taxes don’t work…

The usual technique for avoiding a tax on capital gains is to hold on to an appreciated capital asset, deferring the tax gain until the asset is sold later…

A fund manager doesn’t have this option. In private equity, carried interest — the manager’s share of fund profits — isn’t earned until an investment is sold. Few fund managers would defer the sale of a portfolio company to avoid tax. Better to pay some tax than risk a decline in the value of the portfolio company and lose the carried interest allocation altogether.

While I don’t agree that it’s labor income, the way carried interest is earned has more in common with labor income than with capital gains in that the avoidance strategies used to defer capital gains taxes don’t work here.  Also, from a policy standpoint, assuming that the goal is increased tax revenue, addressing carried interest through an increase in capital gains may not work given how sensitive long-term investors are to changes in capital gains rates.  Increases in tax revenue via carried interest could get offset through decreases in capital gains revenues from other sources.

I’ll leave it at this because this post is not about how to tax carried interest, but rather an explanation of carried interest as a risk-adjusted return of capital, an explanation completely independent of labor contributions.

Image via Wikipedia Commons


Staff Writer

Dave Regio is a part-time blogger that writes about whatever interests him at that particular point in time. When he is not writing, which is most of the time, he is either gently reminding people of the OT commenting policy or working in the commercial real estate business, primarily in healthcare real estate with a capital markets focus.

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66 thoughts on “Carried Interest is Not Labor Income – The Capital Structure Perspective

  1. Great post Dave. I think one interesting analog to carried interest in “traditional labor” markets is profit sharing bonuses for employees. Profit sharing bonuses have similar risks and alignment to overall firm returns as carried interest, but are taxed as regular income rather than as capital gains or dividends.

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    • But, you say, there’s no risk in profit-sharing plans. You get your base salary regardless, possibly plus a bonus!

      But presumably if there were no profit-sharing, your base would be higher. You’ve risked the difference between the two based on the performance of the company. But since it doesn’t have the form of taking a portion of your salary, investing it in company stock, and selling that stock at the end of the year, it isn’t treated as a capital gain.

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      • I think one interesting analog to carried interest in “traditional labor” markets is profit sharing bonuses for employees.

        It’s a very interesting analog and the reason why I wrote this post was the need to explain carried interest in a manner that was completely independent of labor, which the capital structure is. It’s a fine line to walk because I agree that the value of a capital asset, whether a real estate development or common stock, is partly a function of labor. Capital alone doesn’t drive a company’s performance. At the same time, my argument is that the carried interest portion has nothing to do with labor and is compensation to capital for the risk. Since the cash flows available to compensate the capital are very limited (usually to liquidation proceeds), the only way to make that compensation work is via a disproportionate share of the profits.

        Profit sharing bonuses have similar risks and alignment to overall firm returns as carried interest, but are taxed as regular income rather than as capital gains or dividends.

        I think the differences are stronger in this case. First, profit sharing bonuses are performance-based incentives based on the services provided. That’s clearly labor income. Employees may have “sweat equity” as skin in the game, but it’s not the same as having financial capital at risk in the form of equity in the firm.

        Also, to @mike-schilling’s point, it’s not that profit sharing plans carry no risk but rather the risk is limited. The risk employees face when participating in a profit sharing plan is that the company won’t make a profit and the employee gets nothing. Yet, the salary remains untouched. Salaried employees aren’t subject to a claw back in the event the company loses money. An investor with an equity position subject to carried interest not only has the risk of getting a carried interest payment of zero but also carries greater risk of having its investment wiped out assuming the investor’s capital is subordinate to the other capital partners.

        But presumably if there were no profit-sharing, your base would be higher. You’ve risked the difference between the two based on the performance of the company. But since it doesn’t have the form of taking a portion of your salary, investing it in company stock, and selling that stock at the end of the year, it isn’t treated as a capital gain.

        This is a classic opportunity cost scenario. Whatever the reason, this person is forgoing a higher salary for the services he/she renders (labor) in exchange for a lower salary and possible bonus for the services he/she renders (labor).

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        • There’s a difference between a performance bonus and profit-sharing, The latter is based on company performance, not individual performance, so:

          Suppose my market-value salary is $100K. [1] But I accept a job for $90K with profit sharing, knowing that in a normal year that will be worth $15K. This is perfectly rational: I accept the risk of a bad year in pursuit of a higher return.

          It turns out we have an awesome year, even though I personally spent most of it trying to date one of my co-workers and playing Candy Crush. Nonetheless, I get $30K in profit sharing, putting me at $120K for the year. (And since I can now afford a better wardrobe and a new car, I get the date. Go me!)

          I don’t see this as materially different from taking a job at $100K, putting $10K into company stock, and selling it at a profit at the end of the year. Which is capital gains, whether I’m an employee or not, even if the rise in the stock was due to work I did.

          1. This is of course well-defined because, like everyone else in the world, I am paid precisely the marginal value of my labor. If I were paid any less, my employer would hire more programmers, because output is a strictly monotonic function of the number of employees. I am not making this up.

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          • Thank you for this and I apologize for the late response. This deserved something much sooner, but after business travel, being under the weather and kids stuff…here I am…

            There is a strong similarity between individual and company performance: the labor component. Both individual and company performance are largely functions of the labor effort. The capital assets may aid in the production of products, but labor will be a part of that too.

            Going to your example, I see two different compensation structures: salary with no profit and a salary with profit sharing. Both comp structures are market rate structures since people are willing to accept a lower salary in exchange for profit participation which, in a good year, will better align compensation to the marginal value of labor.

            Going back to my undergrad econ days, at least the 2% or so I care to remember, and using your examples, someone gives up $10,000 is base salary in order to possibly earn an additional $15,000 or more if the firm’s performance is good. Choosing one or the other is rational based on the classic opportunity cost scenario.

            Let’s look at this…

            It turns out we have an awesome year, even though I personally spent most of it trying to date one of my co-workers and playing Candy Crush. Nonetheless, I get $30K in profit sharing, putting me at $120K for the year. (And since I can now afford a better wardrobe and a new car, I get the date. Go me!)

            I don’t see this as materially different from taking a job at $100K, putting $10K into company stock, and selling it at a profit at the end of the year. Which is capital gains, whether I’m an employee or not, even if the rise in the stock was due to work I did.

            If I read you correctly, the profit sharing bonus was a de facto form of passive income because your labor efforts were spent on Candy Crush and trying to date someone. If this is passive income and stock gains/dividends represent a form of passive income, then it follows that they’re similar (pardon my crude form of logic).

            I have two issues with this.

            1. We have may have different perspectives on profit-sharing compensation based on our respective industries, and while I think the language of economics can help explain the real world, sometimes it’s better to not jump into the rabbit hole (1).

            Using your example, you earned $30,000 while playing Candy Crush and trying to date someone. I can look at this one of two ways. The easy argument is that you that were paid more than the value of your labor, both in base salary and bonus. In the language of economics, I would consider this situation a short-term disequilibrium, one easily rectified by your employer no longer employing you.

            I have a better explanation: your labor services were being underutilized due to factors beyond your control (if you playing Candy Crush and not doing your work, you know the outcome). Yet, because your bosses like you, you possess a valuable skill set and are expected to contribute value to the firm going forward, even if your prior year’s output was low, if the cost to lose you and find a replacement is high, you have a value and good management will make sure you’re compensation if only to attempt to retain you. You may have been playing Candy Crush and pursuing extracurricular interests, but in your example, a case can be made that you were still paid the value for your labor based on qualitative rather than quantitative factors. The quantitative factors that are there are based on the expected future performance rather than past performance.

            2. I suppose that on an abstract level, there is $10,000 of risk in both scenarios, but the concept of risk needs a more narrow treatment.

            The material differences in your two examples assuming the $100K plus $10K in stock is 1) source of funds and 2) capital risk.

            If you buy $10,000 in X, that source of funds will be through your savings or perhaps other liquid investments. In any event, those represent assets that will earn passive income as opposed to compensation from active income (labor).

            The other issue that exists in the $10,000 stock that is completely nonexistent in the lower salary plus bonus structure is the existence of capital risk because you are putting up $10,000 with a risk of not getting some, most or all of it back. Still, if I make no gains at all, I get most of that back.

            Taking $10,000 less in salary is not the same thing. You aren’t risking $10,000. Rather, you have accepted taking $10,000 less as the cost of earning potentially more under a bonus structure. In the stock example, the cost would be the loss of income from whatever the $10,000 was invested in before, if it was invested at all. Plus, you’re risking fee income (labor income) and not capital. Those two are more comparable to one another. Capital risk stands by itself.

            I hope this helps…

            (1) The Landsburg article cited discussing why we should view capital gains rates as higher than ordinary income due to the fact that the capital invested was already taxed as ordinary income prior to becoming savings is a textbook example. While academically interesting, it’s functionally useless and is inapplicable to carried interest.

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  2. The Williamson quote seems to assume that if you are granted stock options in a Silicon Valley startup and hold those options for, say, five years, and then, after an IPO, exercise and sell them, you are taxed at 15%. This is not the case. In this case, your gain would be taxed as ordinary income.

    In order to get capital gains, you must exercise the options and hold the stock. Which means (1) you have to put some money in, and (2) you have declare the difference between the option strike price and the market price of the stock when you exercise and hold as income – under AMT, at least.

    Yes, this created a sort of trap for the unwary. I knew of quite a few people who had this problem in the early Oughts.

    Some very forward-looking companies provided a method whereby one could exercise and hold, even though A) the options weren’t vested yet, and B) the stock wasn’t publicly traded yet. This means that the difference between the strike price and the current “market” value is zero, so there is no ordinary income due to this transaction, even under AMT.

    This was a no-brainer to do at certain companies, such as Google, assuming you had some extra cash lying around.

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  3. So, backing up a bit from the technicality of this question…

    Why do we even tax capital gains at a different rate than ordinary income? As best I’ve been able to figure out, the answer is purely pragmatic–that it’s better for the economy if we do.

    But I’m increasingly concerned that “better for the economy” actually means “better for the proxy measure we use to judge the state of the economy”–that is, better for capital investment. Which, of course taxing investment at lower rate is going to better for investment. But when we live in a world where the stock market can boom while labor suffers, that’s not a compelling reason. And the idea of incentivizing risky investment doesn’t appeal given the fallout from the 2007 housing crash.

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    • I think it’s because the system was an attempt to close the loopholes that the previous system identified (and that previous system was an attempt to close the loopholes from the previous system and on and on and back to the Shaman explaining that he needs a choice cut from the deer the hunters caught in order to make sure that the gods are happy).

      This system strikes me as an attempt to deal with the fact that companies don’t mind moving around but workers do… so you can fleece the workers pretty good but the company itself might up and move if you fleece it a little too much.

      So this system is an attempt to calibrate right up to the point where people will be irritated but not up and move.

      And we’re discovering loopholes.

      We should make a new system…

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      • The current system is also ostensibly designed so that small owners of capital (i.e. ‘savers’) can accumulate a nest egg without taxes biting off a good chunk of that egg – and to prevent the egg from just being ‘idle’. It does raise the question whether or not we should put some progressiveness into taxes on returns on capital, and the harder question of what level to implement them, but there’s some good a priori base reasoning to keep preferential treatment on taxes on the returns on capital. (something even Ralph Nader was complaining about the other day).

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          • But contributions are not taxed. There’s a huge value to tax deferral, especially because odds are good that your retirement tax rate will be lower. If it isn’t, you’re better off with a Roth. I have about half Roth 401k and half traditional, which will have the benefit of keeping taxable income low.

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            • Yeah, I’m not agitating to tax 401k income as gains. I’m pointing out that if you’re talking “capital gains” and “small investors” you’re basically BSing.

              Statistically speaking, an American small investor who is actually subject to gains is an outlier. It’s not worth considering in the context of the tax itself, because it’s pretty much immaterial.

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    • Why do we even tax capital gains at a different rate than ordinary income? As best I’ve been able to figure out, the answer is purely pragmatic–that it’s better for the economy if we do.

      I’ll give two reasons:

      1. Lower capital gains rates allows for more capital transactions that convert to cash that can be redeployed into investments other than those used to defer capital gains taxes.

      2. More tax revenue.

      From the Fleischer article:

      A government study conducted jointly by the Congressional Budget Office and the Joint Committee on Taxation and published in 2012 used historical data to estimate generally the behavioral response to changes in the capital gains rate. The study found that investors in pass-through entities like partnerships and trusts pay close attention to tax rates, meaning that they are less likely to sell capital assets that have appreciated in value if capital gains rates are higher.

      The study measured the responsiveness of different kinds of investors to changes in tax rates, reporting a coefficient of almost negative two for pass-through entities. Broadly speaking, this measure of responsiveness, or “elasticity,” means that a 20 percentage point increase in the capital gains tax rate would decrease the rate of capital gains realizations in partnerships and trusts about 40 percent.

      The implication is that it would be largely self-defeating to increase capital gains rates on investment partnerships because many investors would defer realizations or adjust their investment strategies to avoid paying tax. As the authors of the government study write, the data on long-term capital gains realizations from partnerships and trusts show a “markedly high sensitivity” to tax rates. “Possibly,” they write, “those results are associated with partnerships in the finance industry, such as hedge fund managers, that may be extremely sensitive to tax changes.”

      I have no doubt that when investors hold capital assets in a partnership or trust, say shares of stock in the family business put away in a trust for a grandchild’s inheritance, realization rates are highly sensitive to tax. But the same is not true for carried interest.

      People holding long-term stock investments can continue to hold them until they pass them on to their heirs and their heirs get a step-up in the basis. Real estate investors can unlock the value of a property and still defer the capital gain via a 1031 exchange (like-kind exchange) or through other tax deferral strategies (i.e. structures when properties are sold to REITs in exchange for units as opposed to cash).

      We saw far more real estate deals using tax deferral strategies prior to the tax cuts during the Bush Administration than we see today.

      While a capital gains rate increase would generate more tax revenue from the private equity and hedge fund industries (since they can’t/won’t defer gains if only due to time value of money), the potential for revenue loss from long-term investors may be too much to make it worth the while, assuming that a net increase in tax revenue is the goal.

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      • Hm.

        The study found that investors in pass-through entities like partnerships and trusts pay close attention to tax rates, meaning that they are less likely to sell capital assets that have appreciated in value if capital gains rates are higher.

        I’ll have to read that study.

        Two immediate questions (before seeing the methodology) are:

        Is this due at least in part to the perceived elasticity of the capital gains tax rate (i.e., because we do not take a longer term monolithic approach to capital gains, meaning everyone also has an incentive to wait until next year – if they can – because tax rates might be lower next year)?

        and

        Since this is a general study, are there cohorts of investors that behave differently inside the population of the investment class?

        I can think of three general members of the investment class.

        The first is nearly everybody with a retirement account, but they are largely (and partially by design) disengaged actors contributing capital to the capital markets in some aggregation method and getting a slice of return for long-term investment. Basically, they aren’t actors in the classical sense; they could dump their money in an index fund and call it a day.

        The second is (I’d guess) the rising middle- and upper-middle and lower-upper class, who have a wage income that is sufficiently large that they’re developing an investment pool of money. They are investing particularly for the long run, probably can be somewhat more risk accepting than the previous group as they have reason to believe that they have income security, etc. They’re going to be actors in the regular market sense (although they probably also have things like retirement accounts) as they will be making individual decisions to invest or not to invest in various companies.

        The third is (I’d guess) the middle-upper class and the upper-upper class who may have a wage income but it’s in most cases dwarfed by investment income, with a lot of the sorts of investment behavioral patterns of the previous class (again, I’d guess) inverted.

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    • I think the practical reason is to make returns from capital in the ballpark of the returns from labor. If you think of equity value gains as the NPV of all profits. An additional dollar of real profit will be taxed at the corporate rate and then taxed again as a capital gain. So the theoretical overall return of capital would be lower than the return on labor. This is why small very closely held firms will just pass profits through as income. However, we do not live in a theoretical world and so corporate tax rates rarely end up at the statutory rate. Ideally, you would have corporate tax rates be a small to zero flat rate on profits and tax everything as income.

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    • There are several reasons to tax capital gains differently. Among them:

      1. Double taxation via the corporate income tax. I’ve seen many arguments for why this isn’t really double taxation. Most of them are terrible. Even the respectable ones are wrong.

      2. Investment income is more elastic with respect to tax rates, creating greater deadweight loss. Which is to say, the returns from raising taxes on investment income diminish much faster than than they do for taxes on wage income.

      3. I’ll outsource this one to Steve Landsburg. That’s part two; follow the first link for part 1. A lot of people just don’t get this, and offer terrible arguments for why it’s wrong. The only good argument against this I’ve seen is that above-market returns from active trading are returns to labor rather than returns to capital, and should be taxed as such. But the implication of this is not that investment income should be taxed as the same rate as ordinary income, but rather that investment income should be untaxed up to the rate return on broad market index and then returns beyond that point should taxed as ordinary income.

      4. Investment income is not indexed to inflation. That’s not a big deal right now, but only because inflation is exceptionally low. Suppose that one year you make a 10% nominal return on a $100,000 investment and inflation is 3%. Your real return is about 6.8%. If you’re taxed at 40% on your nominal return, that leaves you with $106,000 after tax. But $3,000 of that was just keeping up with inflation, so your real, after-tax return is 2.9%. Although your nominal tax rate was 40%, taxes ate up 57% of your real return.

      5. This is somewhat related to Landsburg’s point, but the Chamley-Judd result shows that the effective compounded rate of taxation on investment income approaches 100% as the investment horizon approaches infinity. Of course people don’t actually invest for eternity, but even given realistic assumptions, the effects of compounding make the long-run effective rate of taxation on capital substantially greater than the ostensible rate.

      6. Also see Garrett Jones on another implication of Chamley-Judd.

      Some important background that you need here is the Solow growth model. Capital increases labor productivity, which is how we get long-run wage growth. Well, that and technological improvements, but you need capital to implement them, and to pay researchers to develop them.

      This is where Rod jumps in to say that there’s a global savings glut and none of that matters, but it’s not actually clear that this is the case, as Bernanke himself acknowledges (Bernanke was either the originator of the idea or the first prominent proponent). Granting for the sake of argument that the issue is a savings glut rather than structural stagnation, there’s no particular reason to believe that this is a permanent state. I’m not even sure a long-run savings glut is possible in any practical sense. Note also that taxing away savings is a long-term solution to a short-term problem. Those savings don’t magically come back when they’re needed.

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      • I agree with the logic for 1. However, the double taxation case of #3 is overstated. Using that same logic, income should not be taxed because the employer was already taxed on the money s/he received that was used to pay the employee. That sort of analysis fails because it is quite selective in which activities are considered legitimate double taxation vs. those that are not.

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      • 1. Double taxation via the corporate income tax. I’ve seen many arguments for why this isn’t really double taxation. Most of them are terrible. Even the respectable ones are wrong.

        The way it should be:

        (a) a corporation generates revenue
        (b) if the corporation generates more revenue than it can claim expenses in a tax year, that remaining revenue is pre-tax profit.
        (c) if that profit is disbursed to investors in the form of dividends, it is now written off as a corporate expense (because it is an expense, after all, you’re paying people for the privilege of having used their capital investment). The dividend is taxed as income on the folks who received the money
        (d) if the profit is not disbursed to investors in the form of dividends, it is now taxable corporate income.

        The money is taxed once, in the year in which it was earned, by a tax assessment on the entity that wound up with the money, whether it be the investor or the corporate entity.

        As it stands, dividends are taxed twice, which is a disincentive to pay dividends and an incentive for companies to sit on cash rather than dispense it to investors. Which in turn probably contributes to our stupid tax code as companies that now have cash to be taxed have an incentive to lobby for tax exemptions for their cash.

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        • As it stands, dividends are taxed twice, which is a disincentive to pay dividends and an incentive for companies to sit on cash rather than dispense it to investors.

          I don’t think this is quite true as phrased. If we did with the corporate income tax, that wouldn’t exactly increase the incentive to pay dividends in particular. It just increases the total amount of money available for everything the corporation might want to do (including paying dividends). The tax on dividends on its own creates the disincentive to use what money they have for dividends.

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        • Why would you want to tax retained earnings at the corporate level, but not money returned to investors as dividends? First, I don’t see any particular reason why they should be treated differently. If management decides that it’s in the company’s best interest to hold onto cash now for later use, why should that be taxed, but not returning it to investors?

          That aside, I can tell you right now what happens if you implement this rule: Every December the company issues enough dividends or buys back enough stock to zero out profits. Then at the beginning of the year it issues stock or borrows money to get the working capital it needs.

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          • If management decides that it’s in the company’s best interest to hold onto cash now for later use, why should that be taxed, but not returning it to investors?

            If I return it to investors, it is the investor’s income. If I hold onto it, it’s the company’s income. The company is a legal entity. Income is income.

            Look, ultimately, the collective tax scheme that I find least objectionable is the one that aims at taxing aggregated wealth. This means a collection of property, income, and capital gains taxes. If we’re enabling a scheme where moving wealth from one bucket to another to avoid taxes works, we’re distorting the economic activity of the economy. If we have an economy where we tax income a lot and capital not much, we are (relatively speaking) giving an advantage to folks who have capital over the folks who labor for a living. If we tax income and capital too much and real estate not enough, we are giving an advantage to folks who have massive amounts of property.

            It’s just not really arguable that if we allow fairly free movement of capital and goods across borders but we don’t allow labor the free movement, we’re advantaging capital in a worldwide economic sense. There’s arguments to be made that this is great for folks who rely on labor income elsewhere (yay, less worldwide poverty!), and produces some benefits for the folks who rely on labor income *here* (yay, the price of goods goes down!) … but the folks who have the money and the freedom to invest it across borders are going to be the biggest winners.

            If we’re also allowing very small capital gains taxes while relying heavily on income taxes to run the government, we’re creating a pretty predictable engine that produces… hey, the economy we have now, where wages are flat for twenty years in real dollars and the economic gains go to the folks who already have money. This works for me, I’m high enough on the income scale that I’m on the border of becoming one of those guys, don’t get me wrong.

            But all the normative assessments aside, there are several practical reasons to treat income as taxable in the year it is earned regardless of whether the entity that collects it is an individual or a corporation, based upon the converse principle.

            Let’s say we allow companies to collect cash without paying income tax on it, and we instead only tax disbursements to investors.

            Well, for starters, we have
            (1) created a disincentive to pay dividends to investors
            – why would I pay my investors out cash now. Indeed, why would they want me to do so, when I can wait until next year when the individual income tax rate for my investors may go down? Unless they’re a single investor who needs the cash, and now they have a collective action problem where the risk averse-ness of the collective (the corporate investment pool) affects their investment outcomes?
            (2) created an incentive for companies to sit on cash
            – why would anybody do anything with cash money that may be taxed if you do anything with it, whereas if they let it sit they have it for all sorts of contingencies?
            (3) created a tax advantage for anyone who can work on a contracted basis vs. a standard employee, because they can incorporate, sign contracts for pay, collect the payment as corporate income, only pay themselves out the cash they want to cover expenses, and then sit on the rest of the money (earning interest) tax-free. This effectively gives them the ability to decide *when* to pay tax (when I *decide* to call it “income”) vs. the schmucks who get withholding taken out of their paycheck. You don’t think this is an *enormous* advantage that would benefit about 15% of the population over the other 85%?
            (4) And that last leads to… more volatility in our tax revenues, and basically make the Federal government’s default revenue collection look an awful lot like California’s… which sucks, with feast-or-famine years depending up whether or not the capital class thinks it is to their advantage to take the tax hit this year as opposed to next year.

            Every December the company issues enough dividends or buys back enough stock to zero out profits. Then at the beginning of the year it issues stock or borrows money to get the working capital it needs.

            Well, I doubt it would be quite that monolithic and universal, but… so the income passes through to the folks who own the stock or sell it back to the company… who pay taxes on it. And then the following year they issue stock, and folks who want to buy the stock do so.

            So… uh, what’s the problem here?

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  4. Certainly any comparison that involves options or stock grants given to employees would be suspect. Those aren’t investments by the employee, those are (deferred) compensation provided by the employer. The key question in your second example boils down to “Is Kolohe, a purely passive investor, hiring you to provide special knowledge/labor/whatever?” The middle-class outrage over the tax treatment is because in most cases, they think the answer is “Damn right he is!” no matter how the paperwork may be structured.

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    • Those aren’t investments by the employee, those are (deferred) compensation provided by the employer.

      I’m not sure that’s true. As an employee, I can choose to work for a company that offers high cash wages, or one that offers lower cash wages plus stock options. My agreement to accept lower cash wages is to all intents and purposes an investment in that company, and in every sense but the most literal, I’m trading cash for stock grants or options.

      Edit: On the other hand, it is worth noting that if I had chosen the high-wage option, I would have to pay taxes on those wages before investing them. So there’s that. But then, double taxation.

      Although it is kind of funny seeing people saying that it’s an outrage that investment income is taxed at a lower rate than wage income (though it really isn’t—see my reply to Alan), and also an outrage that some wage income is taxed at the same rate as investment income.

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    • The key question in your second example boils down to “Is Kolohe, a purely passive investor, hiring you to provide special knowledge/labor/whatever?”

      I’m not sure that’s the way I’d frame the question that way. If Kolohe was an investor in one of Blackstone’s private equity fund, as he would own a relatively small interest in the overall fund, he will be closer to purely passive than not.

      In our example, he is a 90% partner so he probably wouldn’t be purely passive. There are ways that Kolohe could exercise control provisions in a joint venture that he couldn’t in a private equity fund (i.e. he could force the sale of the asset).

      He’ll also have some expertise in the real estate business and understand enough about the parameters of deals in order to make informed decisions on behalf of the money he represents. In my example, what he does not have, is the access to the deal flow that I have access to as a developer. Since I need co-investment capital, I approach Kolohe with an opportunity to co-invest and we work out the terms accordingly.

      In light of this framing, the answer to your question on the most important point (the hiring) is no. I’m not being hired. Had Kolohe hired me as a merchant builder to develop a property he wants built, I would get paid on a fee basis and invest no capital. Any compensation received for that service, from the fee to any profit participation, is 100% income.

      If I didn’t make that clear from my scenario I apologize. I don’t get to describe these kinds of deals to people outside of the industry that often.

      The middle-class outrage over the tax treatment is because in most cases, they think the answer is “Damn right he is!” no matter how the paperwork may be structured.

      I think the outrage is rooted in a disdain for the financial industry’s callous disregard for the middle class (if not an outright disdain for the private equity and hedge fund industries) as well as the fact that the carried interest earned by private equity and hedge fund managers involve obscene amounts of money. Perhaps it came to the forefront when capital gains rates decreased year ago and the deal sizes started to rise.

      I walked a very fine line with the tax treatment issue. Just because I believe (rightly) that carried interest represents a return on capital doesn’t mean that people should accept its taxation as capital gains. Even if carried interest is not labor income doesn’t mean it can’t get separate tax treatment. I deliberately avoided this issue because I’m not sure where I stand, largely because of the potential impact on the real estate industry.

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      • I think the outrage is rooted in a disdain for the financial industry’s callous disregard for the middle class (if not an outright disdain for the private equity and hedge fund industries) as well as the fact that the carried interest earned by private equity and hedge fund managers involve obscene amounts of money.

        I’m also not sure that a hedge fund manager has quite the same structure you described above. As far as I’m aware, he’s not taking on additional risk that justifies a capital payoff incentive on the back end. In that case, it genuinely just looks like they’re calling his proceeds “capital gains” because they can, not because he’s had additional skin in the game. In the example you provided above, I’m satisfied that the additional payoff is compensation for the risk structure. Not so much in the other cases.

        I suppose it’s possible that these funds are structured such that the manager can have “skin in the game” but I suspect that the ratio of skin to “capital gains” payoff means that they have skin in the game in the same way a multi-level marketing company sells products: just enough to make it not quite legally a pyramid scheme.

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        • My understanding is that hedge fund managers will typically be invested in their own funds at some level in order to persuade potential investors that their interests are aligned, but that they are not required to do so in order to take advantage of the loophole.

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          • It would surprise me if they weren’t at least somewhat invested themselves, but are their claims on the fund’s returns junior to the other investors in the same way as Dave’s example is above? I’m betting not. Although if the ratio of investment to return is right, it wouldn’t really matter one way or another.

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        • I’m also not sure that a hedge fund manager has quite the same structure you described above. As far as I’m aware, he’s not taking on additional risk that justifies a capital payoff incentive on the back end.

          I’m glad you brought up hedge funds because I deliberately avoided them in my post due to the fact that they do in fact have one difference in their structures: hedge funds typically don’t have a hurdle rate. It’s a straight 20% cut of the profits.

          The question for hedge funds is this – in the event a fund liquidates all of its positions and returns capital to the investors, do the limited partners receive their capital first? If the answer is yes, my example applies because their capital is in a greater risk position. Given that their capital is typically in the 1-5% of the total equity range and that they use considerable leverage, there’s considerable risk in that position. The capital should be compensated for that. How much should be left up to investors to decide but obviously the major institutional investors are sleeping at the wheel.

          Whether or not hedge funds or private equity firms deserve a 20% cut of the profits over some or no threshold is a whole other can of worms. However, that has less to do with the carried interest issue and more to do with their performance and some of their more obnoxious business practices.

          I suppose it’s possible that these funds are structured such that the manager can have “skin in the game” but I suspect that the ratio of skin to “capital gains” payoff means that they have skin in the game in the same way a multi-level marketing company sells products: just enough to make it not quite legally a pyramid scheme.

          Managers will have skin in the game. How much skin depends on a number of factors. Your exaggerations aside, if the ratio of skin to payoff is too high, it’s because the funds typically don’t beat the market. If you want to think investors are getting hosed, you wouldn’t be alone. However, as I mentioned to DavidTC in a discussion about private equity, put the blame on institutional investors. To the extent they are getting hosed, they deserve it for their incompetence.

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          • With that, I’m satisfied that carried interest is more accurately described as compensation for capital risk than as labor or other income. I’m convinced.

            I’ll stick with your plan of not getting into whether it should be treated that way for tax purposes.

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  5. Brandon Berg:
    Edit: On the other hand, it is worth noting that if I had chosen the high-wage option, I would have to pay taxes on those wages before investing them. So there’s that. But then, double taxation.

    Unless I misunderstand your point, I don’t see how this would be double taxation. You get your income, pay taxes on it, and then use some of that post-tax income to engage in a capital transaction. Then you make a profit on it. So of the proceeds from the sale of the asset, you’ve got the value of your basis, which should in theory be equal in value to the post-tax dollars you used to purchase the asset, and the remaining profit. But only the profit is taxed, not the basis, and the profit is exactly that money that can’t be accounted for with your post-tax earnings. Where’s the double taxation?

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    • This is why I find the “double taxation” argument pretty unconvincing. Dollars get taxed multiple times for all sorts of reasons. For example, I pay state income tax and state sales tax on dollars I spend that I already paid income tax on. The idea that “double taxation” is somehow unique to corporate tax or that it’s a particular moral evil in this one case strikes me as very odd, especially if we’re to entertain the notion that the corporation is separate from its shareholders. I’m all for abolishing the corporate income tax for practical reasons (the most important one being that it’s very hard to get entities that exist only on paper to pay taxes at all), but double taxation isn’t one of them.

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      • “I pay two kinds of taxes” is not the same thing as double taxation. Please read up on what the term actually means before you tell us it doesn’t exist.

        Note, too, that when calculating your Federal income tax you’re allowed to deduct State income taxes paid.

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        • Wait a minute.

          As a layperson, I have studiously avoided commenting, since I don’t have a strong opinion on the matter.

          But this is the point- you are asserting how it is blindingly obvious that this is double taxation, while that is simply a different kind of taxation.

          It isn’t blindingly obvious to me, or lots of other people.

          Is it really that arcane, that it can’t be described simply, without resorting to the huffy “go away and read a book” stuff people do on the internet? Isn’t there some sort of clear explanation for it, without lapsing into esoteric jargon?

          As someone wrote upthread, We the people, erect these different tax rates on the premise that it is somehow good for the economy.

          So its perfectly reasonable for us to ask, OK, howz that working out for Us, the People?

          Because right now, it doesn’t look like its working out for Us, at all. We see billionaires paying a lower rate than working people, while a the government runs a deficit and cities are turning out the lights for lack of revenue.

          And then we get told, it Has To Be This Way, because reasons.

          Because right now, double taxation or no, I am not seeing any downside- moral, legal, economic- to taxing the bejesus out of capital gains.

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          • “you are asserting how it is blindingly obvious that this is double taxation, while that is simply a different kind of taxation.”

            Because “double taxation” is a term that has a specific meaning.

            A stockbroker who pays income tax is not being charged “capital gains tax” even though the money he receives as commissions came from the sale of stocks. (and it isn’t “double taxation”, either, even though the stockholder pays capital gains tax on the money he made from selling the stock and the stockbroker pays income tax on the commissions that he’s paid from that money.

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        • “I pay two kinds of taxes” is not the same thing as double taxation. Please read up on what the term actually means before you tell us it doesn’t exist.

          Fire away with your explanation of how corporate income taxes on a corporate entity and individual capital gains taxes on shareholders are, in fact, the same tax rather than a sequence of taxes that happen to land on the same stream of money.

          Note, too, that when calculating your Federal income tax you’re allowed to deduct State income taxes paid.

          That’s why I didn’t use that as an example. And I’m willing to bet that I can find several other examples without digging particularly hard. There are so many separate taxes and fees at different levels for different reasons that expecting a particular dollar to be taxed only once when it moves through your possession is just bizarre. It’s an appeal to some fundamental law of the universe that never existed.

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      • The issue here is not the number of times income is taxed, but the total effective tax rate paid. The point of the double-taxation argument is that the effective rate on capital gains and qualified dividends is greater than the ostensible 10/15/20/23.8% rates, not that there’s something uniquely evil about double taxation.

        Comparing the federal tax rate on wage income to the federal tax rate on capital gains and qualified dividends is misleading because it doesn’t reflect the cost to investors of the corporate income tax. If you want to include state income taxes, sure, we can do that, but there are state taxes on corporate income and personal investment income, too.

        Sales taxes? Investors pay those, too, when they spend their investment income.

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        • Above you advocated for the point that being taxed on investment dollars should be looked at in conjunction not just with the corporate tax, but that it is double taxation when made on after tax money (Part 1 of the Landsburg link above). So you don’t seem to have an issue with conflating different taxation with double taxation.

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        • Now the argument is just that it’s a sneaky way to make rates look lower than they really are. I’ll totally buy that. Along the same lines, it’s also pointed out from the other side that the rate on paper is often not the effective rate that corporations pay (my primary reason for being totally fine with ditching the corporate income tax). For a lot of major taxes, it’s pretty hard to look at “income” and “tax rate” and decide what the individual or company will actually pay because those rates aren’t even close to being the whole story.

          But until we dump things like the AMT, “double taxation” will show up all over the place. It’s not especially insidious and it’s not a problem critically in need of a solution on its own. I’d argue that this one particular instance of multiple taxation just comes up most often because of whose toes it steps on. It’s a lot like the estate tax in that way. We talk a lot about it because the people who pay it have a huge voice, not because its particularly problematic for moral or legal reasons.

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          • So this is exactly where people like me suspect the issue is, all along.

            The objection isn’t that there is some essential unfairness going on.

            As Brandon notes, whether its “double taxation” or just “overall rate of taxation”, there isn’t some violation of universal moral rule that we can all agree upon.

            Really, its just a bunch of guys saying “the taxes are too damn high”, and everything else is just a longwinded elaboration of the point.

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            • I think that’s a reasonable summary of it.

              My problem with the corporate income tax is that depending on your corporation, you can do all sorts of crazy things to avoid it, so it raises very little revenue at a very high cost. Nobody benefits from some of the stupid things corporations do do avoid the tax (except maybe accounting firms), so if we can raise the money a different way, it makes sense for us not to give them the incentive to do those stupid things. Why tax the ball in the middle of the shell game when you can just tax it at the end when it’s sitting there on the table?

              Has anybody floated a proposal for a revenue-neutral elimination of the corporate income tax offset by an increase in the capital gains tax? It seems like it might be politically possible to pass as a tax simplification reform, assuming you could get Grover Norquist to pretend it wasn’t a “tax increase.”

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  6. Okay, I don’t have time to go into this right now, but the premise presented here is utterly wrong.

    Why?

    Because there are almost *no situations* where the ‘carried interest’ doesn’t get paid.

    The ‘risk waterfall’ is a complete and utter lie. The GPs always always *always* get paid most of their share, because *they are in charge of the money*, and have a dozen different tricks to get paid.

    This article is operating on the lie that their ‘investment’ is actually at risk.

    Edit: I’m talking about the large private equity funds. I’m sure there are *some* sort of funds where this isn’t true…but those people probably aren’t the people using carried interest in the first place.

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    • Okay, I don’t have time to go into this right now, but the premise presented here is utterly wrong.

      …Edit: I’m talking about the large private equity funds. I’m sure there are *some* sort of funds where this isn’t true…but those people probably aren’t the people using carried interest in the first place.

      You need not spend any time. You’re predictable. I know exactly how this is going to play out.

      The premise isn’t utterly wrong (you’d be the first to successfully make the case – which you won’t by the way) but rather you can find business practices within private equity to claim that in practice, the capital really isn’t at risk (whether it is or isn’t is debatable and subjective enough to give you way too much wiggle room, which is of course your strength). In response, I will point out my examples where the the capital is at risk . At the end of the day, the problem isn’t the premise but rather the way business is conducted and the proper solution may be regulation
      .
      For example, if you really want to increase the risk of GP capital in private equity fund, I would have no problem requiring that carried interest get calculated at the fund level vs. the deal level. If you’ve read enough Yves Smith, you’d know the problem with the latter and who holds the bag and why. Carried interest on profitable deals will more than offset the capital invested so if the poorer deals don’t do well, it’s little sweat off the GP’s brow if that.

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      • To reiterate our last conversation, I do not support many of the fee practices in the private equity industry and to the extent that those practices truly do disrupt the risk structure enough to make the risk exist on paper only (i think deal-level carried interest can do this), i’d have no problem revoking carried interest status at the fund level.

        So long as the GP capital is in the riskier position, I am content leaving carried interest alone. However, since I made my argument based on a risk difference, I’m content with penalizing funds that use fees and other practices to blur that distinction. How that gets put into practice I don’t know, but I’m receptive to the idea.

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      • For example, if you really want to increase the risk of GP capital in private equity fund, I would have no problem requiring that carried interest get calculated at the fund level vs. the deal level

        You have this weird thing going on every time we talk about private equity, where you say things like ‘The system is wrong but could easily be fixed’ inside your *defense* of the system.

        ‘Yes, pension funds are being ripped off but that could be fixed by not allowing incompetent idiots to invest in private equity’, ‘Yes, there are business practices that result in a lot of this ‘carried interest’ not actually being at risk, but that could be fixed by not allowing carried interest’, etc, etc, etc.

        I’m not quite sure what you *think* I’m arguing, but is not something that can be refuted by that. I am arguing, in fact, that we *need to change those things*.

        You then proceed to argue that such problems are not as common as I think they are, something you really have absolutely no evidence of, because basically all general private equity fund agreements are *secret*. (Which really is a *huge* part of the problem. And, no, complaints about disclosing a ‘proprietary investment strategy’ is nonsense…it’s easy enough to require the *numbers* and *end result* to be disclosed without the investment strategy being disclosed, which would show us the magnitude of the problems.)

        Granted, you do work in the industry, but you work in a specific part of private equity that has been standardized for decades, real estate, a part that generally has *rules*, even if they’re just rules everyone agree upon. It’s not the same as the hookers-and-blow universe of ‘corporate purchasing and management’ private equity.

        You want to launch into a spirited defense of core real estate capitalization, you feel free, but I’m not sure you even need to do it…no one really has any problems with it, at least not with 90% of it. (I’m sure there is some scammy behavior at the edges, but that’s true in any investment type.) Hell, if I had millions of dollars, *that* is where my money would be.

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        • You have this weird thing going on every time we talk about private equity

          It’s a weird “Pros vs. Joes” finance things we have going on. We see the world from two completely different perspectives and politics has little to do with it. There’s also that small matter of hypocrisy…

          You then proceed to argue that such problems are not as common as I think they are, something you really have absolutely no evidence of, because basically all general private equity fund agreements are *secret*.

          This after…

          Edit: I’m talking about the large private equity funds. I’m sure there are *some* sort of funds where this isn’t true…but those people probably aren’t the people using carried interest in the first place.

          Shouldn’t the same standard apply to you? If the agreements are secret, how can you know carried interest isn’t being used? What kinds of investors are entering into these transactions? Which private equity funds aren’t using carried interest?

          You’ve made claims about the capital markets that you have no way to substantiate.

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          • It’s a weird “Pros vs. Joes” finance things we have going on. We see the world from two completely different perspectives and politics has little to do with it.

            Actually, I suspect we’re usually thinking about *different* private equities.

            You think about what you do every day, which is real estate and, like I said, something I have no problem with, and you extrapolate all of PE from that. And think ‘Those other guys just need to operate more like us’, which is a fine point, if sorta like thinking ‘Those pickpockets need to just provide *services* for the money they get, then they could stop stealing’.

            OTOH, when I hear private equity, I think of ‘buying companies to disassemble them’, which is something I *inherently* am reluctant to like even if I know that can be necessary, so I’m not incredibly happy when it turns out, on *top* of that necessary evil behavior, they’re scamming public pension funds. (And that, in turns, makes me wonder how much of that necessary evil actually *was* necessary, and how much of it was just to operate their scam.)

            Shouldn’t the same standard apply to you? If the agreements are secret, how can you know carried interest isn’t being used? What kinds of investors are entering into these transactions? Which private equity funds aren’t using carried interest?

            I didn’t say they weren’t using carried interest.

            I said that you explained how their result was at risk, and as such they should get be under the same ‘investment’ tax rules as other investors, aka, carried interest.

            I pointed out that while they were using carried interest, they actually had rigged the game where, if the investment *wasn’t* doing well, they could (And do) pull money out via random additional management fees.

            Which, yes, they’d have to pay normal taxes on, but that’s a pretty crappy definition of risk: They either get X dollars taxed at capital gains rate if their investment does well, *or* they get X dollars taxed at normal income rates if it fails and they have to make up some bogus management fees to suck the money out.

            The uncertainty! The sheer amount of risk! It boggles the mind!

            You’ve made claims about the capital markets that you have no way to substantiate.

            Weird. It’s almost as if the claims ‘they are scams’ and ‘they aren’t scams’ are both assertions and we can’t assume either by default. So let’s figure out what *could* tell us:

            a) We could check who is attempting to keep all the terms of them a total secret, because while that doesn’t *prove* any sort of scam, it is something that scammy behavior *requires*, otherwise people will point it out.
            b) We could notice that the people apparently in charge of these investments at the public expense are complete and total incompetent morons. Which, again, is not *evidence* they’ve fallen for a scam, but, uh, it certainly created the possibility.

            I think you see my point.

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              • What is the “scamming public pension funds” thing to which you keep referring?

                …are you serious?

                Dave and I have been talking about this basically every time private equity comes up.

                And, not to speak for Dave, but we generally both agree that *some* private equity funds out there are taking advantage of public pension funds with various fees they’ve invented, and the total opacity with which they keep their contracts under keeps anyone in the public from actually noticing where their pension money is going, or from noticing how they don’t actually appear to be getting a rate of return much above the market, at least not the rate they should be getting with their lack of liquidity.

                I think it’s fairly rampant, he thinks it’s just a basically a case of a few bad apples ripping off incompetent investors, and points out that private equity is actually a great deal larger then these sort of general PE funds, which is a fair point.

                We both agree that it’s scammy, and that there should be more transparency to stop this sort of scamminess, at least when public money is involved.

                You want a discussion about what’s actually going on, that’s a whole nother post.

                Basically, the PE fund sets up the system where they handle the money, and they can pay *themselves* out of the funds of the corporation they purchased and are managing….often, inexplicably, they pay themselves for hiring people and companies to manage said corporation, which is, of course, what they were already paid a huge fee to do in the first place! It’s nickling and diming the investors to death, except by ‘nickling and diming’ I mean ‘millionsing and millionsing’.

                And because of how the system is set up (It’s the general partner having the corporate property write checks to the general partner.), the limited investors, if they are stupid, never even notice it’s happening, never notice that their ‘investment’ just kept handing money to the general partners, which obviously cuts into profits! And apparently a lot of public pension funds are run by very stupid people.

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                • See, when I think private equity, all I think of is “plans that are longer than 3 months”. That’s all.

                  Besides, around here, a lot of the equity is German. They have 50 year plans, for god’s sake!

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          • Thing is? Real Estate is the province of the “would be millionaires”, not people who actually have a lot of money (because it’s such low risk/low reward).
            Kinda like how restaurants are for “would be businessmen.”

            A bit of a sucker’s game, both of them.

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              • You don’t get rich with real estate… you get rich by using political connections, graft and corruption to artificially enhance real estate’s value.

                DC, unsurprisingly, is a good market for that sort of thing.

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                • You don’t get rich with real estate… you get rich by using political connections, graft and corruption to artificially enhance real estate’s value.

                  If I showed this to some of my clients, they’d thank you for the laugh. You’ve just described less than 1% of total transaction activity. The reality of the other 99% is much different.

                  You and DavidTC would make a cute couple in the way that you two distort reality.

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