Iowa's Stimulus Plan - Same-Sex Marriage

In an Iowa Supreme Court ruling Varnum v. Brien on April 3, 2009, the State effectively legalized same-sex marriage in the State of Iowa. On April 27, 2009 Iowa joins the likes of Massachusetts and Connecticut and soon to be joined by Vermont as the only states in the US that allow same-sex marriages. Several states, California, Colorado, Maryland, New Hampshire, New Jersey, New Mexico, and Washington recognize civil unions between same-sex partners, each providing varying degrees of benefits to the partners. In Iowa, Massachusetts, and Connecticut, same-sex couples are offered the same rights as opposite-sex couples at both

the state and federal level.

The Economics Policy Review will not make any arguments for or against same-sex marriage based on economic impact or based on morality or religious beliefs. The article serves merely to assess the potential impact on the state of Iowa with same-sex marriages beginning later this month.

Many have regard Iowa as a recession resistant state due to the high reliance on agriculture, low consumer debt, and less dramatic real estate impact. Iowa reported an unemployment rate of 4.9% verse 8.1% for the US as a whole. Despite this, the potential impact on state budgets for major legislation cannot be ignored. The Williams Institute at UCLA provides in depth analysis of same-sex partnerships on state budgets. Following the initial district court hearing on Varnum v. Brien, the Williams Institute published The Impact on Iowa's Budget of Allowing Same-Sex Couples to Marry in April 2008. The study estimated a $5.3 million per year net benefit of same-sex marriage. The study moves step by step through the relevant categories of fiscal impact, income tax, inheritance tax, public assistance, sales from increased tourism, administrative fees, and employee benefits.

The study was published prior to Connecticut legalizing same-sex marriage on November 12, 2008. Additionally, Massachusetts does not allow out-of-state couples to wed, thus eliminating any precedent for tourism revenues. According to the 2005 American Community Survey there were 5,833 same-sex couples in Iowa; extrapolating the 2000 and 2005 data forward at a compound annual growth rate of 9.8%, there is an estimated 7,714 same-sex couples in Iowa at 2008 year-end. Using similar extrapolation, the neighboring states would have 120,728 same-sex couples to draw on for marriages and thus tourism dollars. See Chart below:


The Williams Institute assumes 50% of Iowa's same-sex partnerships and 25% of neighboring, using similar data, 34,039 couples would wed over the next three years; of which, 3,857 would be Iowa residents.

Using the fiscal impact categories above, the Williams Institute assumes inheritance tax (decrease in revenue) and income tax (increase in revenue) effective net. The assumptions seem fairly valid. The study assumes that many same-sex couples are DINKs (double income no kids), thus in a joint filing, Iowa's progressive tax structure would increase the effective tax rate on a large majority of couples, generating an additional $700 per couple. Despite a detailed discussion, it is difficult to reproduce the Williams Institute calculations. The following assumptions will be used: 50% marriage rate and a similar break-down of 85% have an increase in taxes, 5% no impact, and 10%, using 5,833 couples in 2005 and 7,714 couples in 2008E. There is a net income tax increase of $1.7mm with the 2005 population and $2.2mm using the 2007 estimated population.

The inheritance tax requires a number of difficult assumptions to forecast, average death rate, wealth of deceased, etc. The Williams Institute uses a probability distribution of wealth, charity assumptions, and gifts to children to estimate the annual impact is a decrease in revenue of $1.5mm or roughly equivalent to the $1.7mm increase in revenue.

The tourism impact could be the most substantial for Iowa relative to its peers. While Connecticut, Massachusetts, and Vermont (Fall 2008) are the only states with legalized same-sex marriages, many of their neighbors have variations that would limit the population draw; additionally, Massachusetts does not allow out of state marriages. Effectively, Vermont and Connecticut are competing for New York, Pennsylvania, Rhode Island, and Delaware marriages. New Jersey, Maine, and Maryland have a variation of civil unions. Iowa will have a virtual monopoly on same-sex marriages to its neighboring states and a population of over 120,000 couples.

The Williams Institute estimate the increased sales tax based on two groups, in-state and out-of-state. The in-state marriages assume an average opposite sex wedding costs $23,000, but same-sex couples due to lack of family support and social stigmas would spend only 25% on their weddings and out-of-state couples would spend 10%, resulting in $5,750 and $2,300 per wedding respectively. As a result, in the first three years following legalization, it can be assumed that in-state couples will spend $5.5 million and out-of-state couples will spend roughly $140 million on weddings. With the State of Iowa's 5% sales tax rate, the state would yield an additional $7.2 million in sales tax or $2.4 million per year. This neglects the benefits of increased employment or the broader multiplier implied by the increased spending. It can be reasonably concluded that the State will benefit considerably beyond the Williams Institute's roughly $2.0 million in sales tax.

The Williams Institute highlights the large area for potential impact is a reduction in state incurred expenses as a result of same-sex marriage. The Williams Institute estimates the level of assistance given to same-sex couples and likewise the savings by applying data from the lower of the 1999 Iowa Census on same-sex verse opposite-sex couples assistance levels to the estimated same-sex couple population. According to their data, same-sex couples receive $9.5 million in public assistance which would be reduced to $2.8 million when partners become eligible on their spouses benefit plans.

On balance, same-sex marriage should provide economic benefits to all current and future states considering the initiative. Iowa presents an interesting circumstance due to the virtual monopoly on same-sex marriages in the Midwestern corridor. Prior legalizations either of competition from surrounding states or do not allow out-of-state marriages. Whether the impact is $1.0 million or $100 million annually, the opponents can rest assured, they will not be paying for a lifestyle to which they are in opposition.

Carried Interest - Levin's Proposal

In a follow-up to a post in December, on April 3, 2009 a new proposal hit the House floor for the treatment of carried interest, the proposal would result in a significant tax hike for the ever unpopular hedge fund and private equity fund managers. Representative Sandy Levin (D-MI) reintroduced a new version of the carried interest reform bill originally introduced in 110th Congress on a message of fairness.

“This is a basic issue of fairness,” said Rep. Levin. “Fund managers are receiving compensation for managing their investors’ money. They should not pay the 15% capital gains rate on their compensation when millions of other hard-working Americans, many of whose income is performance-based, pay ordinary rates of up to 35%."

The full bill, "To amend the Internal Revenue Code of 1986 to provide for the treatment of partnership interests held by partners providing services" (HR 1935), has not been received by the Government Publishing Office (GPO); however, it appears the entire carried interest will taxed an ordinary income rate of 35%. The prior Economic Policy Review, posting "Carried Interest - Long-Term Capital Gains or Ordinary Income", highlighted multiple options for taxing carried interest, concluding the a hybrid taxation policy would be a good comprise, for example treating the carried interest basis as a non-recourse loan from limited partners.

Rep. Levin marches through various "Myth" vs. "Fact" scenarios, many of which were presented in the prior post. One such "Myth" surrounds the impact of the change on union and state pensions. In the past, many investment professionals would have disregarded the change in taxation as immaterial, arguing incentive compensation fees would increase correspondingly. The current macroeconomic environment is not doing the investment professionals any favors and unfortunately for all but a select few, fees are more likely to decrease than increase. Levin is correct, it is "questionable" if the change in taxation will have any impact on "mom and pop."

While carried interest probably does not have enough "sweat equity" characteristics to be considered in the same light as that of pure entrepreneur, it does not have the same feel as pure incentive compensation either. All too often in the wake of a crisis, politicians over-react and the pendulum swings far past neutral. It probably is not a coincidence that Rep Levin is from the economical troubled state of Michigan, where many affiliated indirectly and directly with the auto companies (UAW pensioners) will be some of the most impacted voters from the current crisis. The bill is in its infancy, but similar legislation was included in Obama's budget, and investment professionals are far from in the good graces of Capital Hill. As such, one can reasonably assume that some change to the current tax policy will be enacted. Here's to hoping congress acts in manner that is truly "fair" and not just popular.

Stimulus 2009 – Tax Relief for Debt Repurchase

On February 17, 2009, President Obama signed into law the American Recovery and Reinvestment Tax Act of 2009. A portion of the bill allows for tax relief to companies that repurchase their own debt at a discount. The bill will provide significant benefits for private equity funds that repurchase debt on behalf of their portfolio companies. The rationale behind the bill is to incent cash strapped, highly levered companies to repurchase their debt; the reduced burden of the high debt service (interest and amortization payments) would leave the companies more nimble and less likely to layoff employees in the downturn. The tax relief is estimated to cost the Treasury $1.6B over the decade; however, it will be more costly in the near term – $42B reduction in tax receipts over the next three years.

Part IV – Rules Relating to Debt Instruments (starting on page 224), Section 1231 lays out the specifics regarding the repurchase of debt; the law firm Sidley Austin LLP provides a good summary of the new legislation as well.

‘‘(1) IN GENERAL.—At the election of the taxpayer, income from the discharge of indebtedness in connection with the reacquisition after December 31, 2008, and before January 1, 2011, of an applicable debt instrument shall be includible in gross income ratably over the 5-taxable-year period beginning (in 2014)

Current tax requires a company that repurchases its own debt at a discount to recognize income in the current year in the amount of the discount of the debt. For instance if the company issued $1.0mm of debt, but repurchased the debt for $700,000 to recognize $300,000 ($1,000,000 - $700,000) of cancellation-of-debt (COD) income -> resulting in a ~$100,000 tax bill if taxed at 34% marginal tax rate.

New tax legislation allows companies or related parties (private equity funds) that repurchase debt a discount in 2009 and 2010 to defer the COD income over a five period beginning in 2014. In the above example, the Company would recognize $60,000 ($100,000 / 5) of COD income in each tax year 2014-2018.

The legislation also allows for tax deferral if the debt is restructured via a debt-for-debt exchange, from significant modification of the existing debt instrument, or from complete debt forgiveness – which may the case for ‘debt’ provided by financial sponsors.

The legislation should provide the appropriate incentives for companies to delever and maintain a prudent capital structure. The reduced leverage and cash savings also should reduce the number of bankruptcies and out of court restructurings, hopefully reducing layoffs. Critics point out that companies with enough cash to repurchase debt are not in need of a stimulus, thus the $42B in tax relief could be more effectively placed in other areas of the economy. While these companies may have the cash today, the bill is designed to reduce the likelihood that currently solvent & liquid companies become insolvent and/or illiquid.

Obama’s Fiscal New Year’s Resolution: Don’t Repeat the New Deal Tax Hikes

President Obama is starring the greatest economic problem since FDR took office in 1933. FDR’s New Deal provided America with a few much needed institutions, including the SEC and the FDIC; however, critics of the New Deal highlight stifling tax hikes as a coagulant to the economic recovery. A few of the New Deal-esque policies (oversight, transparency, and employment stimulus) will provide a good template for the new administration; tax policy should be avoided at all cost.

The New Deal and Great Depression coincided with the rise of a new economic theory developed by John Maynard Keynes focusing on demand side stimulus. FDR simultaneously slashed unnecessary expenditures from the Government Budget, while implementing new projects to raise employment. A similar proposition has been presented by Obama, a careful examination of the each budget line item with the promotion of infrastructure projects, most notably the digitalization of medical records. The New Dealers felt a rise in spending with out a coinciding rise in tax receipts would create budget deficits that would impair the economic recovery in the medium term. FDR targeted Corporate America and America’s rich to provide the additional revenue; favoring income taxes over consumption taxes.

FDR took his pound of flesh from corporations through the Undistributed Profits Tax (UPT), essentially taxing corporations on ‘excessive’ retains. The controversial, short lived tax initiative has been widely criticized for reducing investment. Corporations were forced to dividend retained earnings or pay hefty federal taxes (upwards of 80%). The combination of higher taxes on the investment savvy rich and newly cash strapped corporations resulted in a substantial decline in investment in the laste-1930s. Capital investment will be a crucial patch to resurrect the sinking USS Economy. American industries are becoming less competitive in comparison to the low cost countries. Investment in America’s competitive industries, high tech, biotech, and pharmaceuticals can promote job development and hopefully a little labor mobility for the skilled engineers and factory workers in Detroit.

While there is no doubt American could use a little of the Japanese thriftiness, kick starting consumption is one option for short-term stimulus. The Obama administration needs develop tax neutral policies to promote investment and consumption. While it’s possible that the Bush capital gains and dividend holidays provide some incentives, these holidays should be allowed to lapse in 2010. But what to do in 2009? A few alternatives are examined.
- Depreciation and R&D tax credits – the trickle down often proves slow, but investment will increase labor productivity and eventually provide employment for the jobless Americans. Again, the US has proved competitive in biotech and high-tech industries.
- Repatriation Holiday – The American Jobs Creation Act of 2004 included a provision for multi-nationals to take an 85% deduction on repatriated income of foreign subsidiaries. This was a widely criticized move, as it may incent companies to shift jobs overseas. The repatriation would need to be a one-time plan to not have substantial negative revenue impact in the coming decade.
- Payroll tax on foreign nationals – Levy punitive payroll tax on US corporations with a labor force of greater than X% (say 10%) foreign nationals.
- Tax gaming – The US gaming industry has lobbied to be apart of the bailout, but typically when state budgets get tight, the states levy taxes on the gaming industry. A similar federal tax could be imposed on the gaming industry.
- Payroll tax on waistlines – Sedentary lifestyles and poor eating habits have contributed substantial to the healthcare burden on the US government. The US could again borrow from Japan, taxing corporations based on employee fitness.
- Restructure the AMT – The alternative minimum tax was morphed from its original intention to target a few hundred of the wealthiest Americans to more than 23 million in 2007. The AMT is hurting the struggling middle class.

The above list is by no means exhaustive, but is food for thought. The FED is generally thought to be pushing on a string; in the middle of the worst economic crisis since 1930, every sector of the US government appears to pushing on a flimsy string. Obama needs to reduce the wasteful spending proliferating the recent stimulus bill. Prudent spending with thoughtful tax incentives and revenue neutral policies will hopefully mitigate a difficult economic environment.

Obamanomics arrives: policy priorities for the new President

President Barack Obama faces a long economic "to-do" list in his first term. The first 100 days must focus on stabilizing the economy by fixing the financial sector and passing a well-crafted stimulus bill. These policies will set the tone for the longer-term reforms required to address budget deficits, regulatory reform, and waning U.S. competitiveness.

President Barack Obama faces a long economic "to-do" list in his first term. The first 100 days must focus on stabilizing the economy by fixing the financial sector and passing a well-crafted stimulus bill. These policies will set the tone for the longer-term reforms required to address budget deficits, regulatory reform, and waning U.S. competitiveness.

1. Fix the Banks
Obama must first fix the nation's banks if he hopes to fix the American economy. Wall Street is directly linked to Main Street: businesses unable to obtain credit cannot make payroll, service debts, or invest in new job creation. President Obama must recapitalize the banking sector, clearly articulating principles for when and how the government would intervene. Bailouts should be used only when market-failure could trigger a contagious downward spiral, and should be structured to prioritize limiting economic damage first, safeguarding taxpayer investments second and minimizing inefficiencies and distortions third. With this commitment to stability and Federal Reserve liquidity flooding into banks, lending and job creation will return as the economy stabilizes. Public opposition to the first bank bailout program may make President Obama hesitant to act, but failing to do so is a recipe for failure.

2. Craft a smart stimulus bill
If the President's first economic challenge is courage in the face of opposition, the second will be to seize the opportunity - and avoid the pitfalls - that his stimulus plan presents. How the $825 billion of proposed funds are spent - on tax cuts, transfer payments, local government grants, or investments - must balance boosting employment with investing in future growth prospects, while easing the burden on those most impacted by the recession. Numerous interest groups, some of which expect payback for votes delivered in November, will seek to push their constituents' interests over these national priorities. Succumbing to these interests or trying to make the recession painless is the fastest way to ensure that government inefficiency and the rejection of free markets stain Obamanomics with the mark of failure. The President proposed significant accountability to minimize these failures in implementing the policy but first must determine the optimal mix of tax cuts, transfers, grants and spending.

Taxes
Tax cuts that incentivize investments in future GDP growth deliver tremendous value. They act quickly, align the nation for the future, and prioritize free-market efficiency. Obama's earned income, college tuition, and first-time homebuyer credits for individuals and his business tax credits all meet these criteria. These should be retained and expanded. Conversely, Obama's plan to provide lump-sum tax cuts unrelated to GDP boosting investments - similar in nature to the failed 2008 rebate check strategy - is $140 billion better used to bolster government investments in infrastructure and education.

Spending
The $550 billion of spending outlined by President Obama includes transfer payments, grants to local governments, and investments. Transfer payments (largely extended unemployment insurance, food stamps, and college aid exceeding $100 billion) provide an immediate boost to growth and a cushion to those most impacted by the recession. Obama should extend these transfers, but must ensure that individuals have a clear path back to fruitful employment by creating jobs and providing education and job retraining programs.

The $200-plus billion in grants to local governments to maintain healthcare, education, and public safety service levels shield governments from recession much as transfers shield individuals. These grants advance worthy goals, but they allow government officials to avoid reducing costs or increasing efficiency as recessions normally force officials to do. Obama should only deliver grants to local governments that are willing to improve efficiency and cut costs before turning to grant money.

The remaining $200-plus billion is allocated to a laundry list of investment projects. Projects should be reprioritized using an investor's mindset, calculating the amount and timing of future benefits produced relative to the cost of the project. High return-on-investment projects should be prioritized, whether the return comes as GDP growth, better healthcare outcomes, or a cleaner environment.

Implementing this approach will require political courage, for some projects may be politically unpopular. To cite but one example, the plan devotes $650 million to subsidizing TV converter boxes, generating minimal economic benefits but politically popular amongst recipients. Those funds would be better spent boosting the measly $25 million allocated to charter schools - a move that benefits predominately inner-city students but might anger teacher unions who strongly supported Obama. President Obama must muster the courage to demand sacrifices from close supporters as well as those with different ideological views to pass the most effective stimulus bill.

3. Start planning to fix the deficit -- including entitlements
President Obama's short-term economic challenges seem formidable until confronted with the long-term problem of balancing the government's budget deficits - including the rapidly growing entitlement programs. President Obama rightfully notes that the issue has been ignored for too long. With near-record high popularity - and hopefully a track record of competence, cooperation, and fairness gained from his stimulus bill - the President has a strong position to negotiate long-term solutions for the consolidated Federal budget. While the President's chances for re-election may hinge on the success of his stimulus plan in diverting economic decline, the history books will focus on his resolution - or lack thereof - of this critical issue.

4. Get the regulation right
History is less likely to remember the President for regulatory reform, but the economy will certainly notice. The financial sector regulatory failure of the past two years exemplifies the need for reform. Institutions overseen by numerous different agencies failed, and the response from the Federal Reserve, Treasury Department, FDIC, and various smaller agencies seemed muddled at best. Instinctively, politicians called for more regulation. But it is not more regulation that is necessary but better regulation. Consolidating regulators, assigning exclusive jurisdiction, and focusing on fewer but more important rules lowers costs and increases effectiveness. The potential for dramatic (if underappreciated) impact on the economy earns regulatory reform a place on the President's to-do list.

5. Put government on business's side
That to-do list has so far focused on government bailouts, stimulus, and regulation. However, business, not government, drives long-term economic prosperity, and America's business environment has deteriorated relative to other nations. American businesses seem constrained by the government instead of supported by it. This must change; supporting business competitiveness should be an explicit government goal. The Obama Administration should enlist the private sector in developing a strategy to address American competitiveness. Whether investing in education and infrastructure, reforming regulatory, administrative, and judicial processes, or tailoring tax laws, government support of business is critical to growth. Encouraging businesses to invest and innovate is the only way to ensure long-term economic success. The new Administration must find ways to encourage private investment and innovation to sustain the recovery the stimulus will hopefully spark.


The President has noted that in crisis lies opportunity. Mr. Obama should seize the opportunity before him to not only lead a short-term recovery but enact policies that set a course for generations of American prosperity.

Carried Interest – Long-term Capital Gains or Ordinary Income

The carried interest debate has taken a back seat given the current turmoil on Wall Street. The carried interest question was lead by Senator Chuck Grassley (R-IA), ranking member on the Committee on Finance. During private equity’s heyday and subsequent Blackstone IPO, politicians began to examine the method of taxation on a piece of PE professional’s compensation – carried interest. Carried interest is designed to align the interests of the general partner and the limited partners in the fund. A private equity fund (LBO or venture) typically has a “2 & 20” structure, 2% annual management fee on committed capital and a 20% incentive fee where after the return of initial capital the general partners and limited partners split every dollar of profit 80 / 20. With Harvard Management rumored to be selling $1.5B in private equity investments at 50¢ on the dollar, it’s unlikely for the carried interest debate to gain much momentum. That said, Barack Obama is in favor of changing the taxation of carried interest, which could be lumped into a broader change in US tax policy.

Capital Gains Supports
Supporters of LTCG treatment stand behind the original intent of LTCG treatment of partnership interest – promoting investment and growth in American business. Eric Solomon’s testimony to Senator Grassley provided support of taxing carry as capital gains. Two reasons are highlighted in defense of the status quo, (i) venture capital and growth private equity promote small business and (ii) changing to OI would make US private equity less competitive in World markets. There is fairly sound logic behind the first argument; treating carried interest as capital gains promotes entrepreneurship through the pooling capital, skills, and ideas as well as risk taking. Gordon Gecko promoted the negative stereotype of private equity investors as corporate raiders, but many private equity firms partner with management to grow business creating and maintain jobs in America.

It is difficult to argue with a venture capital investor that venture and angel investments are providing necessary capital for smart growth. The VC industry was at the heights of its popularity during the tech boom of the late 1990s. The asset bubble the burst in 2002 and subsequent recession provided substantially more good than bad for American business. While many dot coms measured operating results in cash burn, the dot coms created a new industry where the US remains globally competitive and created new technologies that make other industries more competitive. Furthermore, venture investing provides necessary capital for growth in biotech and medtech firms that substantially improve US healthcare; a more recent phenomenon, clean-tech, may help reduce US
dependence on foreign oil.

LBO firms create returns for their LPs, commonly terms are internal rate of return (“IRR”) and cash-on-cash return, using three mechanisms, (i) financial engineering or leverage (a debt-to-equity mix consistent with a home mortgage 10-20% down), (ii) multiple arbitrage or expansion (buying a business at a purchase price multiple of 5x earnings and selling it for 10x earnings) and (iii) earnings growth by way of either revenue growth or operational improvement of the business. A recent BCG study of the viability of the private equity industry highlighted decade long eras in the industry; the 1980s were the leverage era, the 1990s were the multiple expansion era, the 2000s were the earnings growth era, and the 2010s will be the operational improvement era. Through operational improvements, LBO funds may improve the job security of many US workers as well as drive new operational expertise that will transfer to many other firms and industries.

The structural argument for carried interest to be taxed as capital gains surrounds partnerships accounting. The partnership or sole proprietor model was established to avoid double taxation. If the carried interest were taxed at the time of receipt as a profits interest, the partner would be taxed as ordinary income on the present value of the income stream and would again be taxed when the income is recognized by the partnership in the future. Additionally, the carried interest is analogous to an entrepreneur that puts “sweat equity” into a business; with a little seed capital, good ideas, and hard work, entrepreneur’s increase in equity value is taxed at the capital gains rate. It has been further highlighted that lawyers and artist sell skill (ordinary income) while private equity professionals are selling sweat equity in a firm, similar to an entrepreneur. Carried interest differs from options in that options do not have an economic right, cannot vote, and do not have a right to dividends, where as with carried interest, individuals are immediate owners, are taxed on their share of income, and are treated similar to owners.

Ordinary Income
The primary argument to tax carried interest as ordinary income is that carried interest in effectively performance-based compensation. With the huge sums of capital raised in the past decade or so, private equity no longer is flying under the radar; many believe the financial services industry is too highly paid, fleecing public pensions, endowments, and charities. The ordinary income crowd was lead by Peter Orszag, former director of the CBO and Obama’s Office of Management and Budget Director, and his presentation to the Senate Committee on Finance. The carried interest is compensation for services provided by the general partners and not a return on invested capital. At grant, general partners are only required to invest a nominal amount of capital to achieve capital gains taxation. The fund’s limited partners provide all of the capital and bear all of the risk on the downside for the fund. The general partners simply provide sweat equity, thus the limited partners have a right to capital gains and general partners are receiving a performance-based compensation. The main focus of the argument is on the lack of capital at risk.

Alternative Taxation Methods
There are three basic suggested alternative taxation methods for carried interest. The first method would be to tax the carried interest at grant, similar to a non-restricted stock option. The carried interest would be valued similar to an option using an option pricing model (Black-Scholes); the general partner would pay ordinary income tax on the value of the carried interest at grant and the limited partners could take a deduction for the amount. The taxation would accelerate tax receipts for the US government and general partners would pay net capital gains or losses upon revaluation. The method would be slightly cumbersome to value the carried interest, potentially costly to have a third party value, and would leave room for general partners to favorably set assumptions to lower the value. US tax code abides by the notion of convenience, without a corresponding income stream, it may prove difficult for some private equity professionals to pay the tax bill.

A second proposed system would be to pay taxes at distribution as ordinary income – carried interest is entirely performance-based compensation. The carried interest would be treated similar to a nonqualified corporate stock option. The tax deferral would continue as with the current system. Many economists feel carried interest is a mix between incentive compensation and capital gains, full taxation as ordinary income is likely imposes too stringent of a tax.

The third option, which appears to have some merit, is to treat the carried interest as a non-recourse loan from the limited partners to the general partners. In this system, the general partner would pay ordinary income on the implicit interest rate on the loan; the interest would have to be a market rate. In a $100mm fund, the general partner would in effect be receiving a $20mm loan from the limited partners; each year the general partner would have to pay tax on the implicit interest (5% of $20mm = $1mm of interest @ 35% à $350,000 tax bill). This option more closely reflects that a portion of the carried interest is performance compensation and a portion is capital appreciation. Opponents of this option would again point to the convenience factor; it may prove difficult to pay the $350,000 tax bill without an income stream. Limited partners receive a distribution from the fund each year to pay their portion of the annual tax bill to mitigate the convenience issue.

With the US staring down a long recessionary road, incenting providers of capital to continue to prudently deploy the capital for growth is necessary. While it may be difficult to explain to your grandmother why carried interest is not performance-based compensation, it may be best for the US economy to delay an action on carried interest. With all likelihood, policy makers will take action to shift a portion of carried interest to ordinary income. Given a change, the non-recourse loan appears to be the best option. To mitigate the convenience issues, the implicit interest taxation should continue to be delayed until realization. Keep the US entrepreneurial spirit alive.

Review of the CBO’s Annual Report to Congress

In September the Congressional Budget Office (CBO) published The Budget and Economic Outlook: An Update (“The Update” references the September 2008 report).  The piece is developed to provide US Congress with a basis for comparison of current legislation to the proposed changes in tax law and spending allocations.  The report is developed in accordance to section 202(e) of the Congressional Budget Act of 1974; the CBO is instructed not to make recommendations, to simply report impartial analysis.  In addition to the annual report, the CBO publishes monthly results.  While the CBO may not be able to explicitly make recommendations, implicitly the CBO recommends that congress reign in spending, increase receipts, or both with the following statement regarding the long-term outlook, “Over the long term, the budget remains on an unsustainable path.” 

The Update paints a grim picture for the United States in terms of both the budget and economic outlook; two items that cannot be viewed in isolation.  The Update predicted a FY2008 deficit of $407B, which was actually $455B per the November 2008 Monthly Budget Review, verse $161B in 2007.  The deficit widened in 2008 as expenditures rose 8.3% year-over-year with flat revenue.  The revenue was flat primarily due to the February 2008 stimulus package.  Absent the rebates and depreciation tax credits, revenue would have increased 2.5%, lagging the growth in outlays.  The deficit is expected to remain greater than $400B (~3% of GDP) through 2009.

Absent a few years in the last 1990’s and early 2000’s, the United States has been effectively running deficits since the 1970.  The CBO’s An Analysis of the President’s Budgetary Proposals for Fiscal Year 2009 saw an end to this deficit spending, forecasting a net surplus of $0.3T over the ten year period ending 2018; unfortunately, The Update in September was in sharp contrast with an estimated aggregate deficit of $2.3T for the same period.  $1.0T of which is related to revised forecasts of outlays for defense spending in Iraq and Afghanistan; an additional $850B is a result of a downward revision in economic projections.  Outlays during the upcoming decade are forecasted in excess of the historical 40 year average of 20.6% of GDP.  While outlays are anticipated to rise during the period, receipts are anticipated rise as well from 17.3% of GDP in 2008 to 20% in 2012, resulting in a reduction in the annual deficit.

The unsustainable path is exacerbated by the aging US population.  Outlays for the foreseeable future will be categorized in three forms, Mandatory, Discretionary, and Net Interest; in Camelot not only would it only rain at night, but Net Interest would be a receipt.  Mandatory Outlays are established based on eligibility rules and benefit levels which are set in law (Medicare, Medicaid, Social Security, etc).  Mandatory outlays are the largest source of increases in outlays; healthcare costs are expected to increase from 4.6% of GDP in 2008 to 6.0% in 2018, a 30% increase over the decade.  Healthcare costs are expected to continue to explode to 12% by 2050.  Less substantially, Social Security is expected to increase from 4.3% of GDP to 5.0% by the end of the forecast period.  Over the near term, the CBO anticipates spikes in outlays for deposit insurance, unemployment, food stamps, and other payments related to the current economic recession.

Discretionary outlays are set a new each year in accordance to appropriations acts.  Discretionary expenditures are divided into defense (59% of discretionary) and non-defense (41%).  As noted earlier, defense spending was revised upward by $1.0T over the forecast period as a result of a nearly $0.1T increase in the 2009 budget, which was anticipated to continue annually during the forecasted period.  Discretionary outlays are subject to sharp swings and are difficult to forecast with substantial uncertainty in the composition of Congress and Presidential Suite.  The Update projects Net interest to jump 17% over the next year, which was developed prior to the passage of the Emergency Economic Stabilization Act of 2008.  The Update projected the national debt balance at $9,568B at the end of 2008, growing to $10,247B by the end of FY2009.  After recent treasury auctions totaling roughly $1.0T in prior three months, the US debt burden has swelled to $10,618B as of November 14, 2008.  The increased debt burden with further add to the previously forecasted 6.4% annual growth in net interest outlays reported in The Update. 

With forecasted increases in outlays, receipts will need to increase to narrow the projected deficit.  The projected deficits begin to fall in 2012 with the expiration of many tax provisions set in the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) and Jobs And Growth Tax Relief Reconciliation Act of 2003 (JGTRRA) as of December 31, 2010.  Absent Congressional action to extend the provisions regarding capital gains, dividends, and ordinary income, statutory rates will increase for the 2011 tax year.  The elimination of such provisions will increase receipts to roughly 20% of GDP in 2012 and individual tax receipts will increase from 8.2% to 10.9% by 2018.  Over the prior decade capital gains has increased as a percent of receipts substantially, absent the dramatic decline in financial markets, this increase would be expected to continue until the expiration of the temporary decrease in capital gains rate to 15%.  Depressed asset prices and an increased statutory rate will decrease the level of receipts from capital gains. 

The November 7, 2008 Monthly Budget Review provided preliminary insight on the US post-TARP.  October 2008 saw receipts decline $13B with a $63B increase in outlays, resulting in a $77B increase in the monthly deficit year-over-year.  Included in the $63B increase in outlays was $17B related to TARP.  The CBO is reporting TARP payments based on the net present value of the Government’s investment in the troubled institutions.  The Government disbursed $115B in October, which according the CBO has a net present value of $98B, thus a $17B outlay. 

With the overall macroeconomic environment worsening, unemployment at 7.5% verse a predicted 6%, rising national debt burden, and evaporating consumer confidence, the likelihood of budget surpluses in the near-term are increasingly unlikely.  The unsustainable path of budget deficits and ballooning debt burden will continue to weigh on US citizens and global citizens.  Parents are no lot saving for their children’s education; instead they are borrowing against their children’s future income.

The U.S. tax system: sacred cow or bum steer?

One of the FEW benefits of a major financial crisis is that it gives policy makers the chance to drive sacred cows to the slaughterhouse. In the last month we've seen politicians, business leaders and academics posit ideas that heretofore bordered on political blasphemy. Grass-root, rural Republicans are calling for bank nationalization. Anti-corporate, urban Democrats are opening up the government coffers to buy reams of corporate paper. Global investment gurus are calling for tighter regulatory oversight, and environmental champions are calling for domestic drilling to ease energy prices.

As the financial crisis extends into an economic one, hopefully we’ll begin to cull the herd of sacred economic policies. One possible output could be a complete reevaluation of our national tax system. In this presidential election, the battle over taxes between Obama and McCain has rarely evolved beyond locker room comparisons (see: "My tax cut is bigger than yours, part I"). One can only hope that severity of the times will force us to go deeper, and perhaps question some of the underlying tenets of our tax system:

-Are interest tax shields too generous? In particular, have mortgage interest tax shields helped to fuel the residential real estate bubble?
-Is the corporate/personal tax burden weighted appropriately, or should it be inverted?
-Is a progressive income tax system the right approach for funding the federal government, or like state governments do we need to utilize a mix of income, consumption and property taxes (the so-called "three-legged stool") to more equitably distribute wealth without impeding its creation?

On this last point, it is worth touching on the WSJ’s discussion of the marginal tax rates offered by Obama’s plan.

Their analysis highlights one of the underlying deficiencies of a progressive income tax system coupled with wealth redistribution programs- the marginal disincentive to work. Starting from the middle, as individuals move towards the right end of the curve the increasing tax rate provides a marginal disincentive to work. Starting on the left, as individuals move towards the middle and price themselves out of social welfare programs, they face a similar disincentive. Republicans have traditionally fought to decrease the right hand slope of the curve, while Democrats focused on flattening the left hand side of the curve. The Obama and McCain tax plans reinforce this trend.

While battle has raged on the poles, the equator has remained remarkably stable. The tax rate for median income households has remained relatively constant over the last 40 years, ranging from 25-28%. (It should be noted that despite the mutual animosity between the poor and the rich, both groups have proven remarkably adept at gaming the system through political influence; rich constituents press their Senators to create tax loopholes that violate the spirit of the tax code, while poor constituents lobby their Congressmen to expand and extend spending programs well beyond their original purpose).

Fast-forward to our current crisis. Over the last decade, the greatest relative decrease in earning power has been felt by the middle class. Stagnant growth in real wages, coupled with increased costs of living and the recent collapse in the value of homeowner's equity has left the middle class scrambling to bridge the gap between their lifestyle and their income. The prevailing reaction- largely from Sen. Obama and the Democratic party, but joined by an ever-increasing chorus of Republicans- has been to ante up on our progressive tax system. Crank up marginal tax rates on the rich while raising the threshold used to qualify recipients of wealth redistribution. Get as much money as you can (either from the rich or off of the Fed’s printing presses) and pump it into Peoria. While the short-term, Keynesian effects will likely reduce the depth of the recessionary trough we are sliding into, the long term consequences will be dire.

Those consequences are two-fold. First, increased upper-income tax brackets will create the aforementioned marginal disincentive to work for wealthy individuals. In reality this will be manifested in a small but noticeable exodus of the most productive employees to countries with better tax structures. While the “brain-drain” threat is real, it will likely be concentrated in the financial sector. Frankly speaking, that sector can afford to lose some weight.

The second, much more deleterious effect will occur as the welfare pool (not to be confused with the welfare class) expands. Households making $40,000 a year might suddenly find it economically advantageous not to work longer hours or take on another job to move their income to say, $45,000. In doing so they may decrease their government program eligibility by greater than the salary increase of $5,000. This is precisely what occurred prior to welfare reform that took place in 1996. The record shows that people- irrespective of tax bracket- act rationally to maximize their income, even if that means working less.

But in a time when the productivity of the American middle class is decreasing relative to the rest of the world, we can scarce afford to encourage working less. This could force a destructive cycle, with ever-increasing benefits needed to maintain the same quality of life. The middle class could eventually become a welfare class, a frightening proposition for a country whose economic, political and cultural identity is built on an aspirational middle class.

This is in no way meant to suggest that McCain's proposed tax plan would prove any more effective. The idea that the fruits of wealthy American's labor will- taken alone- sustain economic growth throughout the rest of the economy has been disproven over the last two decades. As the U.S. Gini coefficient sprints towards .5, we find ourselves leaving behind a pack of peer nations and joining the company of such prosperous oases of egalitarian opportunity as Mexico and Brazil.

With the tax plans currently on the table, American middle class voters have the dubious privilege of choosing to become a welfare queen or a member of the working poor. Hopefully, whomever emerges victorious from this election will think about alternative taxation policies, policies that promote savings, discourage conspicuous consumption and asset speculation, reward workers who create real economic value and limit social safety nets to those Americans who truly need a helping hand.

Something radical needs to be done, but as of yet we have not heard any new ideas. The public's negative perception of the federal government seems to suggest that the solution, whatever “it” is, will require turning a few sacred cows into hamburgers.

Weekend Update expresses this sentiment perfectly. (Go to 4 minutes in on this clip)