Feeds:
Posts
Comments

Posts Tagged ‘Taxes’

Hillary Clinton and Donald Trump agree on one thing: Managers of private equity funds should pay ordinary tax rates on their carried interest, not the lower rates that apply to long-term capital gains and dividends. They differ, of course, on what those rates should be. But if we made that change today, managers would pay taxes at effective federal rates of up to 44 percent, rather than the up-to-25 percent rates that apply currently.

I agree. Fund managers should pay ordinary rates on their carried interest. In a new paper, I argue that this is the right approach for a reason distinct from, and in addition to, the conventional concern about wealthy fund managers paying low tax rates. Taxing carried interest as capital gains creates a costly loophole when benefits to managers are not offset by corresponding costs to investors. Such offsets exist when investors are taxable individuals. In that case, carried interest merely transfers the capital gains preference from investors to managers. But there’s no offset when investors are tax-exempt organizations or corporations, neither of which gets a capital gains preference. By transferring their capital gains to the manager, rather than paying in cash, these investors create a capital gains preference that would otherwise not exist. Taxing carried interest as ordinary income eliminates that loophole.

This perspective on the carried interest problem yields a second insight: Current proposals to reform carried interest taxation are incomplete. If carried interest is taxed as ordinary income for managers, the investors who provide that compensation should be able to deduct it from their ordinary income as an investment or business expense. That’s how we treat cash management fees. There is no reason to treat carried interest differently.

To see why this matters, consider a fund—it might be a buyout fund, a venture capital fund, or a syndicate of angel investors—that invests in companies, improves their business prospects, and then sells to other investors. The managers receive a cash management fee and a 20 percent carried interest, their share of the fund’s profits from dividends and capital gains.

If the fund generates $100 in long-term capital gains, managers get $20 and investors get $80. Under current practice, managers pay capital gains taxes, individual investors pay capital gains taxes, and endowments and other tax-exempt organizations pay nothing.

Many reformers, including President Obama, would tax carried interest as labor income while making no changes for investors. Under this partial reform, managers pay labor income rates on their $20, and investors pay capital gains taxes on their $80.

Under my full reform, managers would pay labor income taxes on their carry, as under the Obama plan. Investors, however, would pay capital gains taxes on all $100 of the fund’s gains and then deduct the $20 of carried interest from their ordinary income.

For tax-exempt investors, there is no difference between partial and full reform. They don’t pay taxes, so they only care about their net income, not how the tax system characterizes it. The same is true for corporations, which pay the same tax rates on any income.

But taxable individuals do care. As long as they can use most of their deductions, they would prefer to deduct carried interest against their ordinary income. Better to pay capital gains taxes on $100 and deduct $20 from ordinary income than to just pay capital gains taxes on $80.

Individual investors in these funds are quite well-off, so why would we want to give them a bigger deduction? Two reasons. First, our goal should be a tax system that treats private equity funds neither better nor worse than other ways of structuring investments.

Current practice fails that test. Because of the carried interest loophole I described above, overall fund returns are often under-taxed relative to other forms of investment. Partial reform fixes that problem, but pushes the pendulum slightly too far the other way, over-taxing fund returns when investors are taxable individuals. Full reform gets the balance exactly right.

Second, our goal should be a tax system that treats cash compensation and carried interest equivalently. Current practice again fails, encouraging managers to employ various games to convert cash fees into carried interest. Partial reform fixes that, but again goes slightly too far, making cash more attractive than carry. Full reform treats them identically.

Full reform also solves the most legitimate concern of people who defend current practice. They typically argue that lower tax rates on capital gains reward entrepreneurship, financial risk taking, and sweat equity in new or struggling businesses. And they are right. Love it or hate it (that’s a debate for another day), our tax code provides lower tax rates on capital gains and dividends from creating or improving businesses.

There is no reason those lower rates should not be available for investments made through funds. But partial reform eliminates these lower rates for any gains distributed as carried interest. Full reform solves that problem by crediting all the gains to investors. That’s probably not what many defenders of current practice have in mind. But it does ensure that all capital gains are treated as such.

Managers thus pay labor income taxes, and investors get the usual benefits associated with capital gains. And managers and investors are free to negotiate whatever fund terms are necessary—perhaps including more carried interest—to make their funds viable businesses. This being the tax code, there are some pesky details, especially about how investors can deduct carried interest. But the bottom line is that full reform would tax carried interest just right.

Disclosure: I am currently evaluating whether to invest in an angel syndicate. I have family and friends who manage and invest in private equity funds.

Read Full Post »

Britain will soon tax sugary drinks. Whether you love that idea or hate it, you’ve got to give the Brits credit: They’ve designed a better version of the tax than any other government.

Beginning in 2018, the United Kingdom will charge the equivalent of 0.75 cents per ounce for drinks that contain more than 3 teaspoons of sugar in an 8-ounce serving and a full cent per ounce for drinks with more than 5 teaspoons per serving. These tax levels are similar to the penny per ounce that Berkeley, California levies on sugary drinks.

Britain’s innovation is in the tiering. Rather than hit all sugary drinks with the same tax, as Berkeley does, Britain has three levels. Drinks with little sugar aren’t taxed at all, drinks with moderate sugar face one tax rate, and drinks with lots of sugar face a higher one. As a result, many flavored waters will escape any tax, slightly sweet iced teas will face a low tax, and regular soda will usually bear the higher tax.

This three-tier structure will encourage people and businesses to favor lower-sugar drinks over sweeter ones. That’s important because sugar content differs significantly. If you believe sugar is harmful, you should want people not only to cut back on sugary drinks, but to switch to less sugary options. And you’d want businesses to devote product development, marketing, and pricing efforts to lower-sugar options.

Linking the tax to sugar content encourages businesses to do that. Indeed, Britain is delaying the new tax until 2018 to give beverage companies time to avoid or lower the tax by reformulating their products.

Britain’s tiering is far from perfect. Why do the tax rates differ by only a third, when the difference in sugar content is often larger? Why not have more tiers—or even directly tax sugar content? Those are important questions. But they don’t diminish the fact that Britain’s approach makes much more sense than taxing sugary drinks uniformly, as Berkeley (a penny per ounce), Mexico (a peso per liter), and almost all other soda-taxing governments do. Those taxes—and similar ones designed as sales taxes—do nothing to encourage consumers and businesses to favor lower-sugar drinks. (Hungary has a simpler two-tier system; only drinks in the same range as Britain’s upper tier get taxed.)

Soda taxes are at best a limited tool for improving nutrition. Well-designed taxes can discourage consumption of sugary drinks, which clearly contribute to obesity, diabetes, and other ills. But health depends on many factors, not just the amount of sugar one drinks. People may switch to other, tax-free alternatives like juice that also have lots of sugar. Soda taxes are regressive, falling more heavily on lower-income families. And they raise controversial questions about the role of government.

Given those concerns, reasonable people differ over whether these taxes make sense at all. If governments choose to enact them, however, they should target sugar content rather than drink volume. Britain’s tiered tax is a welcome step in that direction.

 

Read Full Post »

Adele Morris co-authored this post.

A US carbon tax could raise $1 trillion or more in new revenue over the next decade. There is no shortage of ways to use it.

Tax reformers want to cut business and personal taxes. Budget hawks want to reduce future deficits. Environmental advocates want to invest in clean energy. Progressives want to expand the social safety net. And so on.

How should we make sense of these competing ideas? In a new policy brief, we suggest a framework for thinking through these options. We identify four basic uses of carbon tax revenues:

  1. Offset the new burdens that a carbon tax places on consumers, producers, communities, and the broader economy;
  2. Support further efforts to reduce greenhouse gas emissions;
  3. Ameliorate the harms of climate disruption; or
  4. Fund public priorities unrelated to climate.

Each has merit, especially as part of an effort to build a political coalition to enact and maintain a carbon tax. But some ideas have more merit than others.

On both policy and political grounds, it makes sense to use carbon tax revenue to soften the blow on lower-income households and coal workers and their communities. Doing so will require only a small fraction (15 percent or so) of carbon tax revenue, leaving substantial resources for other purposes.

Recycling revenue into broader cuts in personal and business taxes also has particular merit. It can help offset the economic burden of the carbon tax and facilitate pro-growth tax reforms. By assuaging concerns that a carbon tax is just another way to expand government, moreover, revenue recycling may be essential to enacting a tax. However, requiring strict revenue neutrality also has downsides. Some policy goals, such as assistance to displaced coal workers, could be better pursued by spending the money directly, rather than indirectly through the tax system.

Policymakers should approach other uses of carbon tax revenue with more caution.
For instance, they should be careful in using revenues to try to cut emissions further. A well-designed carbon tax would do a good job reducing greenhouse gas emissions, so additional policy initiatives should focus on filling in gaps—reducing emissions the tax may miss. Merely duplicating efforts—e.g., supporting clean electricity facilities—would not be cost effective. Indeed, policymakers could roll back tax credits for solar and wind power and other subsidies and mandates that a sizable carbon tax would make redundant. That would free up resources to pursue other, more beneficial goals.

Policymakers should be similarly cautious about tightly linking revenue to specific new spending, whether climate-related (e.g., coastal protection) or not (e.g., new highways). Earmarking risks overspending on any one line item, deploying resources inefficiently, and fueling concerns that the tax would become a slush fund for politicians’ pet projects.

Decarbonizing the economy requires long-term solutions. Many emissions-reducing investments involve large expenditures on long-lived capital, such as power plants and industrial facilities. A carbon tax package that businesses and people believe will endure will be more environmentally successful than one that people think may not survive the next election.

In Australia, for instance, a carbon tax that took effect in 2012 was repealed just two years later, an object lesson in how highly partisan climate policies can be rescinded by future governments. Policymakers should thus give special attention to identifying revenue uses that build ongoing support for a carbon tax.

Read Full Post »

What do indoor tanning, shopping bags, junk food, alcoholic beverages, tobacco, “gas guzzling” cars, ozone-depleting chemicals, sugary drinks, marijuana, gasoline, coal, carbon-containing fuels, and financial transactions have in common? Taxes that discourage them. The United States taxes indoor tanning to reduce skin cancer, for example, while Washington DC taxes shopping bags to cut litter, and Mexico taxes junk food to fight obesity.

Governments hope these “corrective taxes” will reduce harms from pollution, unhealthy consumption, and other risky behaviors. But taxing “bads” can also bring in big money. A US carbon tax could easily raise more than $100 billion annually, for example, and a tax on sugary drinks could raise $10 billion.

How should governments use that money? As you might expect, policymakers, advocates, and analysts have proposed myriad ways to use the revenue to pay for new spending, to cut taxes, or, in a few cases, to reduce borrowing. In a new paper, however, Adele Morris and I argue that all these options boil down to four basic approaches:

Revenue Use Table 2

Advocates often suggest that revenue be put toward the same goal as the tax. Carbon tax revenues might subsidize energy efficiency or clean energy, for example, and sugary drink revenues might subsidize healthier food or nutrition information programs. Using revenue that way may make sense if you believe the tax won’t sufficiently change business and consumer choices. But there are downsides. A successful tax will typically reduce the potential benefits from other policies aimed at the same goal. As a result, it may make sense to roll back other policies, rather than expand them, when a substantial corrective tax is implemented. Directing revenues to the same goal may also limit lawmakers’ ability to build a coalition for a corrective tax, while other uses may attract supporters with other priorities.

Another approach is to use the revenue to offset the burdens that a corrective tax creates. New taxes on food, energy, and other products can squeeze household budgets, particularly for families with lower incomes. Shrinking the market for targeted products may disproportionately burden specific workers, industries, and communities. If a tax is large enough, moreover, it may slow overall economic activity. Tax cuts, expansions in transfer programs, or other spending increases may offset some of these harms while leaving the incentives intact. This is particularly important when taxes are intended to help people who suffer from internalities—health risks and other costs they unintentionally impose on themselves. In those cases, rebating revenue to affected consumers can help ensure that a tax actually helps the people who pay it.

A third approach is to use revenues to offset costs of the taxed activity. If an activity imposes costs on an identifiable group of people, it may make sense to compensate them for the harm. A US tax on coal does this, for example, by funding assistance to workers who develop black lung disease. Revenues can also cover some costs of providing public services that support the taxed activity. Fuel taxes paid by drivers, airplane passengers, and maritime shippers , for example, help fund the creation and maintenance of the associated infrastructure.

Finally, governments could treat corrective taxes like any revenue source, with receipts used to reduce borrowing, boost spending, or cut taxes in ways unrelated to the goal of the tax. Governments could allocate the money using ordinary budget processes, as Berkeley, California does with its soda tax revenue, or could earmark revenues to specific efforts, as France does by directing some financial transactions tax revenue to international aid.

Policymakers must consider a host of factors when deciding what mix of these options to pursue. Complete flexibility may allow them to put revenue to its best use over time. But surveys suggest that the public is often skeptical of corrective taxes if they don’t know how the revenue will be used. Many worry, for example, that the corrective intent of a tax may just be a cover story for policymakers’ real goal of expanding government.

Recycling corrective tax revenue into offsetting tax cuts can assuage that concern. But revenue neutrality has downsides as well. Matching incoming revenues and offsetting tax cuts may be difficult, given uncertainties in future revenues from a corrective tax and any offsetting tax cuts. In addition, it may be easier to achieve some distributional goals through spending than tax reductions. For example, a new spending program may be a more straightforward way to help coal miners hurt by a carbon tax than some kludgy tax credit. People who generally oppose wholesale revenue increases from corrective taxes should thus be open to modest deviations from revenue neutrality that provide a more effective way to accomplish policy goals.

Read Full Post »

With obesity and diabetes at record levels, many public health experts believe governments should tax soda, sweets, junk food, and other unhealthy foods and drinks. Denmark, Finland, France, Hungary, and Mexico have such taxes. So do Berkeley, California and the Navajo Nation. Celebrity chef Jamie Oliver is waging a high-profile campaign to get Britain to tax sugar, and the Washington Post has endorsed the same for the United States.

Do such taxes make sense? My Urban Institute colleagues Maeve Gearing and John Iselin and I explore that question in a new report, Should We Tax Unhealthy Foods and Drinks?

Many nutrients and ingredients have been suggested as possible targets for taxes, including fat, saturated fat, salt, artificial sweeteners, and caffeine. Our sense, though, is that only sugar might be a plausible candidate.

Sugar in foods and drinks contributes to obesity, diabetes, and other conditions. By increasing the price of products that contain sugar, taxes can get people to consume less of them and thus improve nutrition and health. Health care costs would be lower, and people would live healthier, longer lives. Governments could put the resulting revenue to good use, perhaps by helping low-income families or cutting other taxes.

That’s the pro case for a sugar tax, and it’s a good one. But policymakers need to consider the downsides too. Taxes impose real costs on consumers who pay the tax or switch to other options that may be more expensive, less enjoyable, or less convenient.

That burden would be particularly large for lower-income families. We find that a US tax on sugar-sweetened beverages would be highly regressive, imposing more than four times as much burden, relative to income, on people in the bottom fifth of the income distribution as on those in the top fifth.

Another issue is how well sugar consumption tracks potential health costs and risks. If you are trying to discourage something harmful, taxes work best when there is a tight relationship between the “dose” that gets taxed and the “response” of concern. Taxes on cigarettes and carbon are well-targeted given tight links to lung cancer and climate change, respectively. The dose-response relationship for sugar, however, varies across individuals depending on their metabolisms, lifestyle, and health. Taxes cannot capture that variation; someone facing grave risks pays the same sugar tax rate as someone facing minute ones. That limits what taxes alone can accomplish.

In addition, people may switch to foods and drinks that are also unhealthy. If governments tax only sugary soda, for example, some people will switch to juice, which sounds healthier but packs a lot of sugar. It’s vital to understand how potential taxes affect entire diets, not just consumption of targeted products.

A final concern, beyond the scope of our report, is whether taxing sugar is an appropriate role for government. Some people strongly object to an expanding “nanny state” using taxes to influence personal choices. Others view taxes as acceptable only if individual choices impose costs on others. Eating and drinking sugar causes such “externalities” when insurance spreads resulting health care costs across other people. Others go further and view taxes as an acceptable way to reduce “internalities” as well, the overlooked harms consumers impose on themselves.

Policymakers must weigh all those concerns when considering whether to tax sugar. If they decide to do so, they should focus on content, not proxies like drink volume or sales value. Mexico, for example, taxes sweetened drinks based on their volume, a peso per liter. That encourages consumers to reduce how much they drink but does nothing to encourage less sugary alternatives. That’s a big deal because sugar content ranges enormously. Some drinks have less than 10 grams of sugar (2 ½ teaspoons) per serving, while others have 30 grams (7 ½ teaspoons) or more. Far better would be a content-based tax that encourages switching from the 30-gram drinks to the 10-gram ones.

Focusing on sugar content would bring another benefit. Most sugar tax discussions focus on changing consumer choices. But consumers aren’t in this alone. Food and beverage companies and retailers determine what products they make, market, and sell. Taxing drink volumes or the sales value of sugary food gives these companies no incentive to develop and market lower-sugar alternatives. Taxing sugar content, however, would encourage them to explore all avenues for reducing the sugar in what we eat and drink.

Note: I updated this post on December 15.

Read Full Post »

Should you face an extra tax if you drink soda? Eat potato chips? Uncork some wine? Light up a cigarette or joint? Toast yourself in a tanning booth? Many governments think so. Mexico taxes junk food. Berkeley taxes sugary soft drinks. Countless governments tax alcohol and tobacco. Several states tax marijuana. And thanks to health reform, the U.S. government taxes indoor tanning.

One rationale for these taxes is that some personal choices impose costs on other people, what economists call externalities. Your drinking threatens bystanders if you get behind the wheel. Tanning-induced skin cancer drives up health insurance costs.

Another rationale is that people sometimes overlook costs they themselves face, known as internalities. Limited self-control, inattention, or poor information can cause people to eat too many sweets, drink too much alcohol, or take up smoking only to later regret the harm.

In a new paper, Should We Tax Internalities Like Externalities?, I examine whether the internality rationale is as strong as the externality one. Economists have long argued that taxes can be a good way to put a price on externalities like the pollutants causing climate change, but does the same logic apply to internalities?

People who look down on certain activities sometimes think so, with taxes being a way to discourage “sinful” conduct. People who prioritize public health often favor such taxes as a way to encourage healthier behavior. Those who emphasize personal responsibility, by contrast, often oppose such taxes as infringing on individual autonomy—the overreaching “nanny state.”

Economists don’t have much to say about sin. But we do have ideas about balancing health and consumer autonomy. One approach is to focus on efficiency: How do the benefits of a tax compare to its costs? Internalities and externalities both involve people consuming too much because they overlook some costs. Taxes can serve as a proxy for those overlooked costs and reduce consumption to a more beneficial level. In that way, the logic of taxing internalities is identical to that for taxing externalities.

But that equivalence comes with a caveat. Internality taxes should be targeted only at harms we overlook. If people recognize the health risks of eating bacon but still choose to do so, there is no efficiency rationale for a tax. Informed consumers have decided the pleasure is worth the risk. Efficiency thus differs sharply from sin and public health views that would tax harmful products regardless of whether consumers appreciate the risks.

Economists often temper cost-benefit comparisons with concerns about the distribution of gains and losses. At first glance, taxes on internalities and externalities generate similar equity concerns. Both target consumption, so both may fall more heavily on poor families, which tend to spend larger shares of their incomes. But there’s another caveat. Internality taxes do not target consumption in general. Instead, they target products whose future costs consumers often overlook. Nearly everyone does that, but it may be more of a problem for people with low incomes. The stress of poverty, for example, can make it more difficult to evaluate the long-term costs of decisions today. As a result, taxes aimed at internalities are more likely to hit low-income families than are those aimed at externalities.

A third, paternalistic perspective focuses on people who overlook harms. Do internality taxes help them? To meet that standard, the benefit consumers get from reducing purchases must exceed their new tax burden. That can be a high hurdle. If consumers only buy a little less, they may end up with small health gains but a large tax bill. That might be a success from an efficiency perspective since the tax revenue ultimately helps someone. But it’s a loss from the perspective of affected consumers.

The economic case for taxing internalities is thus weaker than for taxing externalities. Internality taxes raise greater distributional concerns, and they place a new burden on the people they are intended to help. Internality taxes can still make sense if consumers find it easy to cut back on taxed products (so health gains are large relative to the new tax burden), if overlooked health risks are very large (as with smoking), or if governments rebate revenues to affected consumers. But when those conditions do not hold, we should be skeptical.

Read Full Post »

Climate change is hot. From the pope’s encyclical to the upcoming United Nations conference in Paris, leaders are debating how to slow and eventually stop the warming of our planet.

We economists think we have an answer: put a price on carbon dioxide and the other gases driving climate change. When emissions are free, businesses, consumers, and governments pollute without thinking. But put a price on that pollution and watch how clean they become.

That’s the theory. And it’s a good one. But translating it from the economist’s whiteboard to reality is challenging. A carbon price that works well in principle may stumble in practice. A real carbon price will inevitably fall short of the theoretical ideal. Practical design challenges thus deserve close attention.

To help policymakers, analysts, and the public address those challenges, Eric Toder, Lydia Austin, and I have published a new report, “Taxing Carbon: What, Why, and How,” on putting a price on carbon.

Some highlights:

  • Lawmakers could put a price on carbon either by levying a tax or by setting a limit on emissions and allowing trading of emission rights. These approaches have much in common. Politically, however, a carbon tax is on the upswing. Cap and trade failed in 2010, while interest in taxing carbon is growing, including three bills in Congress and endorsements from analysts of diverse ideological stripes.
  • Carbon prices already exist. At least 15 governments tax carbon outright, and more than 25 have emissions trading systems. Those efforts have demonstrated that the economists’ logic holds. If you put a price on carbon, people emit less.
  • Figuring out the appropriate tax rate is hard. The Obama administration estimates that the “social cost of carbon” is currently about $42 per metric ton. But the right figure could easily be double that, or half. That uncertainty is not a reason to not tax carbon. But it does mean we should maintain flexibility to revisit the price as new evidence arrives.
  • Taxing carbon could reduce the need for regulations, tax breaks, and other subsidies that currently encourage cleaner energy. Rolling back those policies, in particular EPA regulations for existing power plants, may make policy sense and will likely be essential to the politics of enacting a carbon tax. But the details matter. Rolling back existing policies makes more sense with a carbon tax that’s high and broad, than with one that’s low and narrow.
  • By itself, a carbon tax would be regressive: low-income families would bear a greater burden, relative to their incomes, than would high-income families. We can reduce that burden, or even reverse it, by recycling some carbon revenue into refundable tax credits or other tax cuts focused on low-income families.
  • By itself, a carbon tax would weaken the overall economy, at least for several decades. That too can be reduced, and perhaps even reversed, by recycling some carbon revenue into offsetting tax cuts, such as to corporate income taxes.
  • Unfortunately, there’s a tradeoff. The most progressive recycling options do the least to help economic growth. And the recycling options that do the most for growth would leave the tax system less progressive.
  • A global agreement on carbon reductions would be preferable to the United States acting alone.  Given the nation’s size and contribution to global emissions, a unilateral tax would make a difference, but would damage the competitiveness of some US industries. Special relief for these sectors could reduce the benefits of the tax, but may be necessary both practically and politically.

A carbon tax won’t be perfect. Done well, however, it could efficiently reduce the emissions that cause climate change and encourage innovation in cleaner technologies. The resulting revenue could finance tax reductions, spending priorities, or deficit reduction—policies that could offset the tax’s distributional and economic burdens, improve the environment, or otherwise lift Americans’ well-being.

The challenge is designing a carbon tax that delivers on that potential. We hope our new report helps elevate what will surely be a heated debate.

Read Full Post »

Older Posts »