Sunday, January 29, 2012

Mitt Romney, Hedge Fund Tax Loopholes,and Partnership Tax Rules on the Nightly Network News

Taxation of partnerships is one of the more arcane subdivisions of the US federal income tax law, one which I've been wrestling with for nearly 40 years. Consequently you can imagine my surprise when the topic effectively becomes the headline news story in the newspapers and the lead story on the television news, causing such a fallout such that the publicity may trigger a change in the tax law. However, it comes as no surprise as how the press has so incorrectly described these rules, and in so doing likely turning public opinion against what really are reasonable tax laws.

The story begins with Mitt Romney releasing his 2010 income tax return showing some $20 million of income and $3 million of tax paid, with an effective tax rate under 15 percent. Now if you earn $20 million in a year, you would pay a marginal tax rate of 35 percent on your wages, interest income, or rental income, but only 15 percent on your dividend income or capital gains. Obviously most of Romney's income fell into the latter categories. Personally I don't see why dividends should be taxed at 15 percent while interest income is taxed at 35 percent. But that's not where the press has focused its attention. Rather, it is the 15 percent rate on Romney's capital gains income from his hedge fund investments (known as "carried interests") that is taking all the flak.

Now the beef doesn't seem to be with the 15 percent capital gains rate per se. Rather the beef is with granting hedge fund owners the ability to treat their income as capital gains using a special tax loophole specially designed to benefit just a privileged few in the hedge fund industry. Now what is annoying is the statement we hear on the news (by financial reporters, no less) that the tax rules that Romney benefited from were a loophole created for the benefit of hedge funds. This is patently ludicrous. As far as I can tell, the tax rule in question goes back to the 1920s, while I don't think hedge funds were even invented until the 1990s, so characterizing this is a special break created for hedge funds is absolutely ridiculous.

Furthermore, by no sense of the imagination can the rule be considered to be a loophole, as can be demonstrated by the historical application of the rule. The classic example of the rule in action arose nearly a century ago out of the real estate industry. Historically, real estate has often been developed under a 50-50 deal--a taxpayer with real estate expertise partners with a money investor to develop property, such as an office building, in an equal partnership. After a period of many years, the parties eventually sell the office building, obviously for a capital gain, and split the profits. To the taxpayer who contributed the development expertise to the partnership, his interest became known as a carried interest. In today's hedge fund world, the office building is replaced by stock of a corporation, which is a capital asset, just like an office building that is held for investment. There is certainly no loophole here. While it is true that the real estate partner received an element of capital gains for services, most of his profit is attributed to the subsequent holding of the asset for appreciation. This isn't much different from corporate executives who are highly compensated by stock options, which likewise give them a large element of capital gains income when their optioned stock subsequently appreciates in value and is eventually sold.

Now the Obama administration has twice attempted to repeal the so-called carried interest rule. However those attempts were thwarted by Congress, led in particular by those right wing Republican protectors of the wealthy, Senators John Kerry of Massachusetts and Chuck Schumer of New York. Wait--Kerry and Schumer are liberal Democrats. If this was really a loophole for rich hedge fund managers, would they be leading the opposition to the repeal of the carried interest rule? And does that mean there is more than meets the eye, and that the press characterization of the issue isn't particularly accurate? I'll let you figure that out.


The Most Wonderful Dream

I have always had trouble sleeping. I was told that as an infant I would not sleep 22 hours a day like most babies, but only the standard eight hours, much to the frustration of my parents. It's not like I'm bothered by insomnia. sleep apnia, sleep deprivation or other medical condition. My trouble merely is falling and staying asleep, but only to the extent I fall out of my routine. If I stay with my routine I'm usually OK. No matter how tired I am, I never fall asleep immediately--it always takes maybe 10, 15 or 20 minutes. If I try to go to sleep before my normal sleep time, I won't fall asleep at all, not even when my normal sleep time passes, particularly annoying when traveling to another time zone. If I have any late mental or physical stimulation (e.g., working, driving home) I won't be able to fall asleep even though it's my normal sleep time. I cannot sleep in an upright position which means I've never slept on a plane, even on a long overseas trip. I cannot sleep if there's more than a little light. So the time I was in the intensive care unit after a serious car accident, and they keep the room subtly lit all night long, I did not sleep a wink the night of the crash. That also usually prevents me from sleeping in the daytime, and on the rare occasion where I might nap a short while in the daytime, that prevents me from falling asleep at night. If I wake up in the middle of the night and stay up for more than a couple of minutes, it's like starting all over again in getting back to sleep (i.e., another 10 or 20 minutes, if I'm lucky). More recently I have been sleeping only in two to three hour segments, waking up two or three times a night. I most cases I do go to sleep again quickly, thanks to a large dose of melatonin. For most people one melatonin pill knocks them out. However I take three to six pills at a time, and they don't always work. The one time maybe 25 years ago I did have a sleep disorder such that I needed medical attention, the doctor prescribed a sleeping pill so strong, seconol, that they would only give me 10 pills and the prescription had to be registered with the government. And it didn't work. And, if I wake up in the 5 o'clock hour, I usually am unable to sleep any more after that.

All this is background to what happened this morning. I woke up at 5 am, and as per usual I could not go back to sleep again, though I did take melatonin since I didn't have to get up at my regular workday wakeup time. Some period of time later I hear music, which I assume is my alarm clock. I open my eyes and Mrs. Chandavkl and the kids are in the room. Except the kids are small again, maybe two and three years old, instead of 29 and 30. Now I had written once before about dreaming about waking up and ultimately discovering it was a dream. But this morning was an extraordinary situation, since in this dream I knew I was dreaming, and made it a point to savor the moment of seeing the kids little again. I kissed them and hugged them, knowing that the dream would last only a short while longer. And it was the most wonderful feeling in the world, as I felt like I really went back in time for a beautiful short moment!

Wednesday, January 18, 2012

The Law of Unintended Consequences - Taxing The Rich Imperils State Finances

The law of unintended consequences is an interesting thing. Laws are passed with an idealistic expectation of what the effect of the law is going to be, but the real world steps in and turns everything upside down when the law goes into effect. A good example of this is the thought of fixing state and local government financial woes by increasing taxes on wealthy taxpayers. This is something a large group of people, from Occupy protesters to Democratic politicians would currently agree on. Republican politicians oppose such measures, largely on the basis that wealthy taxpayers create jobs and higher taxes are a disincentive for such taxpayers to expand their economic activity. I personally don't buy that argument since at this point in time, marginal tax rates are not so high to cause that effect. It's not like some 50 years ago when there was a 90 percent marginal federal income tax bracket, which bordered on being confiscatory and indeed likely did produce a stifling economic effect on high earnings taxpayers

Which brings us to the recent news that Gov. Brown hopes to close the ongoing California budget shortfall by a combination of an increased sales tax and an additional state income tax on millionaires. This was then followed up by the news that an analysis by the nonpartisan budget legislative analyst concludes that the amount of money that would be raised by the millionaires income tax is not what its backers claim it would be. The problem is that California's richest taxpayers already pay a disproportionately high share of the state's personal income tax collections. Prior to the recession, the top 1 percent earning California taxpayers paid a stunning 50 percent of the state's personal income tax revenues. And it's not like they earned 50 percent of the state's personal income or anything close to it. Far from it, as many lower income Californians pay no state income tax and many others pay at miniscule rates.

Now the issue from a fiscal point of view isn't that rich taxpayers pay disproportionately more income taxes than lower income taxpayers. The problem is that the amount of income that rich taxpayers earn is extremely volatile. When times are good people cash in stock options and earn huge profit based bonuses, but when things turn bad, these taxpayers have a larger proportionate drop in income than lower income taxpayers. In just the first year of the recession, the income of rich taxpayers in California dropped by 16 percent, while the income of average taxpayers dropped by only 4 percent. Since the personal income tax rate levied on rich taxpayers is much higher than the rate paid by average taxpayers, all an increased tax on rich taxpayers does is ensure an even larger budget shortfall the next time the economy turns down.

Now you can't expect people like Occupy protesters, who think Bank of America and American Airlines are rich and powerful corporations, when in real life they are hanging on for dear life, to understand this relationship. However, you would think that the politicians know enough to catch on. But you would be wrong. Back in the days of the dot com boom, when tax revenues soared as internet millionaires and others in Silicon Valley and throughout California rode the wave to prosperity, Governor Davis and the Legislature made a commitment to spend these windfall revenues on a permanent basis. This was done largely with generous increases in the pensions paid to state and local government workers, which may now be as much as double the pension earned by a comparable federal government worker. (And many people think that pensions for federal government workers are excessive.) Pensions for state and local government workers is a large contributing factor to the huge budget shortfalls in state and local government. And it should be pointed out that at the time California increased its pension benefits, no objection was raised by Republican politicians, as these pension increases were essentially approved unanimously, so one cannot put the blame merely on the Democrats.

In any event we see that with California government revenues so dependent on the unstable income levels of its richest taxpayers, California state finances were more negatively impacted than other states by both the dot com bust as well as the recent financial meltdown. Adding an additional tax on wealthy taxpayers only will set California up for an even bigger fall in future downturns.

Tuesday, January 10, 2012

John Wooden Was Right Again--Alabama Wins BCS Championship

As great of a coach as John Wooden was, one of his most astute observations about sports is largely overlooked by most sports fans. Wooden is one of the few sports figures who publicly said that a loss can be a good thing for a team in the proper context. Specifically, the context is losses when teams are on a long winning streak. Now winning streaks were something that John Wooden was very familiar with. His UCLA basketball team from the early 1970s once won 88 games in a row, still the longest winning streak in men's college basketball history and one of the longest streaks of any kind in sports. Yet, Wooden said that for a team on a long winning streak, a loss can be beneficial. Wooden's explanation was that keeping a winning streak alive creates a pressure to continue a streak, which is a distraction from a team's being able to to play at its best level of performance. Consequently, losing a game having relatively less meaning will refresh a team, enabling it to win when it really counts. In contrast, going into an important game riding a long winning streak increases your chances of losing that game.

Now the comment that a loss can be a good thing is heresy to most observers and participants. Who doesn't want their team to go undefeated all the time? Yet, the fact is that many of the most stunning upset losses in sports involves teams on a winning streak, sometimes losing to a clearly inferior team. For example, a few years ago I predicted that the unbeaten New England Patriots would lose in the Super Bowl to the New York Giants on the basis that their 17 game winning streak was unsustainable. Similarly, I think that because the Green Bay Packers lost their undefeated season when they surprisingly lost to the Chiefs (a good example of the winning streak rule itself), their chances of winning the NFL championship this season are greater than had they gone undefeated into the Super Bowl.

Indeed, this college football season provided a number of examples of Wooden's rule of teams on a winning streak being ripe for an unexpected loss. Obviously we have the decisive 21-0 loss last night by 13-0 LSU to one loss Alabama in the BCS Championship game. This was a game which many observers thought LSU would win, as they appeared to be the clearly superior team based on their earlier season win over Alabama on Alabama's home field. We also have the Conference USA championship game where unbeaten Houston was thrashed by two touchdown underdog Southern Mississippi. Then there was the talk in late October about how the BCS championship could be a mess with so many unbeaten teams having a reasonably clear path to an undefeated season. Well guess what--all these teams, except LSU, had their unbeaten strings broken. Note particularly the loss by Oklahoma State to Iowa State. Another recent example would be Ohio State's lopsided loss to Florida in the BCS game from a few years ago. Of course unexpected losses by teams on a winning streak could also just be a matter of the law of averages, i.e., the longer the winner streak, the more likely the team will have a bad game, but that's a minor influence.

Now this does not mean that a team will never have an unbeaten season or that an unbeaten team will always lose to a one loss team in a championship game. The Miami Dolphins did win the Super Bowl with a 17-0 record, unbeaten Tennessee did beat one loss Florida State for the BCS championship, UCLA's basketball team did win 88 straight games and Oklahoma did win 47 straight football games. However, there are corollary rules to the basic winning streak rule which explain these happenings.

The first corollary is that the application of the winning streak rule is a function of how good the team in question is, and how long its winning streak is. When you get a team like UCLA's 1972 basketball team which beat its opponents by an average of 30 points per game, you can see that clear superiority over your opposition may more than offset any reduction in performance that may be attributed to sustaining a winning streak. But this level of superiority is quite rare. Also you see teams on winning streaks struggling to keep the streak going--they're good enough to keep winning, but as the streak goes on the performance has clearly dropped off.

On the other hand, not only is a "shaky" team with a winning streak likely to be beaten, it may be quite decisively. Perhaps the classic example of this occurred in the 1990s when somehow the South Carolina football team managed to start off the season with nine or ten wins, including a number of unimpressive wins over teams of questionable quality. With two easy projected wins left on the schedule, everybody was penciling them in for an undefeated season. But then a very average Navy team ran South Carolina out of the stadium, ending South Carolina's winning streak. An example that hits closer to home involved my 2005 UCLA football Bruins. That year the Bruins started off 8-0, with a number of close, last minute wins, over mediocre teams. Now pulling out these wins, particularly on the road, indicated that the Bruins were a pretty good team. But playing close games against less than average teams like Washington, Stanford, and Washington State, showed the Bruins weren't that good. Consequently, even though they went favored in their next game at Arizona, the 52-14 thrashing they took wasn't that surprising under Wooden's rule, though most observers were shocked, if not disgusted by that game.

The other corollary is that the winning streak rule only applies to wins within the current season, and that carryover wins from prior seasons are not relevant. This is because the prior season may have involved different players, coaches, and dynamics. However an exception to this corollary appears to exist for notoriously long winning streaks. This would explain Miami's loss to Ohio State in the BCS championship where Miami had a 34 game winning streak, compared to Ohio State at 13, and perhaps the loss by Connecticut women's basketball team's 90 game streak.

Perhaps the amazing thing about the winning streak rule is that it has gone so unrecognized by fans and players alike. John Wooden's observation is that the winning streak negatively impacts the performance of the team on the streak, yet I'm sure this is something that none of the players on a team that is on a winning streak is even aware of. Just as amazing is how often the underdog comes through to beat the team on a winning streak. All teams have a range of performance, so for the underdog to upset the better team, it will have to play at the high end of its range. Again, nobody on the underdog team is thinking that their opponent might be a little more vulnerable because of its winning streak, yet the underdog team does come through and pull off the upset. So nobody thinks about this--it just happens!