Close My Tax Loophole
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I don't understand what these pass-through entities do at all - can someone explain it?
Naively it seems like differential tax treatment creates distortionary incentives. Maybe I quit being the sole proprietor of my business in order to day trade, thereby escaping payroll and income taxes. This replaces productive work with non-productive speculation - a loss for the economy and a country. What's the argument against this?
[1] https://tcf.org/content/commentary/10-reasons-to-eliminate-t...
The argument is that, it doesn't work like you think.
If you're day trading chances are you're generating short term gains (or losses). Mist day traders don't hold positions 1yr+.
Second as a sole proprietor your still responsible for payroll taxes, or what becomes known as self employment tax. http://www.marketwatch.com/story/do-you-owe-the-self-employm...
https://www.irs.gov/taxtopics/tc429.html
Any proceeds are taxed as business income, not as capital gains.
It's exhausting and daunting to list all the ways that Klinsky's ELI5 example is meaningfully different from what really happens in PE-land.
What it comes down to is this: PE managers get a success fee for managing other people's money without putting up their own, which is very very normal, and usually counts as earned income (normal tax rate).
However, when certain very specific circumstances apply, a bit of the tax code lets you legally pretend that instead of a success fee, the amount you get paid is a return on invested capital.
Very plainly, the pension funds, sovereign wealth funds, HNWIs, etc. who put up the actual risk capital into the PE funds are putting dollars at risk and earning a return on invested capital.
If one simply does the exercise of asking, "where are the dollars that the PE manager put at risk?" the lie is exposed.
My personal pet peeve on this is that, back in the 1970s, it was actually the case that the general partners would have had unlimited liability and therefore really were, after a fashion, putting the entirety of their capital at risk to earn the carry. But since the 1990s at least and probably earlier, everyone in this game has used a pass-through LLC blocker entity to limit the personal liability of the managers. So they keep all the tax benefit but give up that pesky "risk" part.
(Partnership structures and carried interest actually do have other things to recommend them as ways of aligning interests and making deals work. But pretending that the contingent, earned, success-based portion of income accruing to the manager is a return on risk capital invested for tax purposes is just a total fiction.)
I'd love to see an explanation of why it makes any sense to continue treating capital gains income (i.e. "return on invested capital") any differently than ordinary income. If we fixed that, then the carried interest "loophole" would cease to be relevant because it wouldn't change the tax rates paid.
I don't see why the tax code should incentivize passive investment over actual work.
Another reason is businesses need investment capital. Do you want to incentivize people providing that, or discourage it?
So why incentivize risking own's capital? $1 million could seed a company that grows to dozens of employees, while if that $1 million were taxed at 50% that means that the government has to use the resulting $500k to provide utility for society. $500k could mathematically provide 10 jobs at $50k per year for one year. However, that million dollar seeded startup could create dozens of jobs as well as tax revenue from the resulting profit as well as tax income from all of the employees. A highly highly simplified example but the point is that a million in the marketplace has the potential to become multi-millions in future tax revenue. While that money in government doesn't have the same force multiplier potential unless you profess that we are on the far left of the Rahn Curve and government isn't yet big enough to support maximal economic output.
My long drawn out point: incentivizing capital gains incebtivizes economic growth. Carried interest (on other people's capital) however is another issue altogether: essentially that's a commission when it's being treated like a capital gain.
In any event, from memory, the idea of long-term capital gains was to incentivize the long-term holding of stocks, and it sounded like a good idea, but as I seem to recall no one ever found any real evidence that it provided a benefit.
So I'll re-ask my question: why does the government need to give a specific incentive for long-term holding of equities and similar instruments?
I can give reasons that it's a bad idea:
1. It's very hard to define "long-term capital gains" in a coherent manner. Witness, for example, carried interest. Look at section 1256 for another strange example.
2. The combination of low long-term capital gains rate and the general inability of the IRS to collect corporate taxes from large companies means that US persons who own a stake in a large company can have turn their company's pre-tax profits into post-tax cash in the back at a very low effective rate.
3. It gives people a perverse incentive to hold on to stocks they don't like until they've had them for a year. Similarly, it gives a perverse incentive to do things that aren't quite a wash sale to hedge risks. I'm glad that there's a demand for creative financial engineering that exists solely because of an overcomplicated tax code.
I would much rather see a system in which the US didn't try to heavily tax corporate profits and instead taxed the money when it was recieved by people, which could be achieved by taxing the gains as ordinary income.
Long term capital losses first offset long term capital gains. Short term capital losses first offset short term capital gains. After that, capital losses of either type offset capital gains of the other type. It's quite common (and beneficial if the timing works out) to use long-term capital loss carryover to offset short-term capital gains.
Well it doesn't.
It incentivises savings over spending, and working over not-working.
For example of the latter, I receive an income: What should I do with the money I do not spend on rent, food, transport, and education? Should I just work less because I don't need that money?
Why don't I just invest it? If I work more, then I will have more money to invest!
However because of inflation, any money I put into savings evaporates if I have to pay both income tax on the new earnings and have to suffer the loss in buying power due to inflation. The difference must be at least what the actual inflation turns out to be over however many years we want people saving. Darn.
If we work backwards, we can see the reasons: If we give up gold, we can control inflation with maths instead drilling, and with a lower capital gains tax then people can spend and work more.
See, this isn't as simple as you want it to be, but it makes more sense than you might think. Our tax code is based around thousands of little tests and questions like this that, and a big part of why it is so complicated has to do with the sheer amount of time we have spent arguing about how much tax is fair.
> I'd love to see an explanation of why it makes any sense to continue treating capital gains income (i.e. "return on invested capital") any differently than ordinary income
You can use Google to search for exactly that. You will get a lot of results because there are a lot of different reasons.
You're assuming that investment actually happens. The widening wealth gap refutes that assumption; wealth is accumulating at the high end and not being re-invested back in the rest of the economy. The poor recovery from the last few financial crisis is more evidence, "You can lead a bank to liquidity, but you can't make it lend."
> If we give up gold, we can control inflation with maths
Giving up the gold standard is orthogonal to the tax rate for capital gains. This is completely off topic.
> See, this isn't as simple as you want it to be
The economy is fantastically complex. It's also very unpredictable due to the inter-dependencies, even if some people like to pretend otherwise. Hubris doesn't make inherently unstable models[1] into a useful result.
[1] "Understanding economics well impedes an understanding the economy." -- Yanis Varoufakis[2]
Of course! I am assuming that investment actually happens because I put money in my savings account and I receive interest.
You do? I think you're an outlier there. Is that rate beating inflation?
I count the .15% rate on my savings account as a joke, rather than any sort of meaningful interest.
A widening wealth gap can only occur if the wealthy are investing their money and getting good returns on it.
If the wealthy were hoarding their money, then it would not be growing and the wealth gap would shrink (since worker's wealth would increase, and the wealthy would consume some of their wealth).
That's simply not true. If the rich are reinvesting all of their wealth... we wouldn't have a wealth gap. This is almost a tautology.
Why do you think interest rates have been kept so low? Regulators (e.g. the Fed, ECB) have been doing everything they can over the last few years to add liquidity into the market in the hope that it get banks to lend again.
> If the wealthy were hoarding their money, then it would not be growing
Life is rarely black and white. We're talking about people that have more than enough money to both invest as they desire and hoard a lot of money. The ability to do both increases as the wealth gap widens.
> since worker's wealth would increase
This is pure fantasy. How would worker wealth increase? They don't have enough money to invest, and they don't have the political power they once had. Worker wealth is going down as money accumulates in the hands of the few.
> and the wealthy would consume some of their wealth
Consumption (even large amounts) costs are insignificant when your wealth is sufficiently large.
Rich guy has wealth X. He invests it all and 1 time period later he has X(1+R).
If the poor guy has worse investment opportunities (as Piketty claims), then the poor guy will have wealth only x(1+r). Here x < X is the poor guy's wealth, and r < R is the poor guy's investment growth rate.
The gap grows by (1+R)/(1+r).
In contrast, if the rich guy hoarded he would only have wealth X, while the poor guy would have x(1+r). The gap would shrink by 1/(1+r).
If, as you postulate, the rich guy invests k of his wealth and hoards (1-k) then the gap would change at the rate (1+kR)/(1+r). More hoarding = smaller k = slower growth (or shrinkage) of wealth gap.
Life is rarely black and white.
Try doing the math and you'll see it sometimes is.
> the poor guy's investment
Except in rare cases, this doesn't exist.
> Try doing the math
The math is simple. The problem is your data seems to be based more on wishful thinking than actual experience and research.
Why don't you do your own arithmetic to demonstrate my error?
And listing commonly discusses taxes from lowest to highest deadweight losses, it goes: Land value tax, property taxes, consumption taxes, income taxes, capital taxes.
> I don't see why the tax code should incentivize passive investment over actual work.
Because to do otherwise causes real harm to all of us, because while even a large tax on, eg, land doesn't notably change the supply of land, a small tax on investment income does reduce the supply of investment. And reduced investment lowers productivity across the industry, reducing worker compensation and making us all as a society poorer.
In short: You get less of what you tax. That makes taxing eg, CO2 production a great idea (we want less of that!), and taxing investment a pretty bad one.
(More generally: The tax code is the worst possible way to do income redistribution, and the American obsession with trying leads to really poor outcomes. If you want to help the poor, try giving them actual money. Regressive taxes funding a progressive welfare state works; the reverse does not.)
Northern Europe would like to disagree, and to point out that Americans are far from obsessed with this. Take Mitt Romney: in 2012 he disclosed paying 15% taxes on his around $15 mill./year income. In a reasonable country he'd be paying at least 35%!
Actual progressive taxation without loopholes, together with a properly implemented public health service, ending the health insurance industry, government-funded parental leave for the first year of a child's life, and otherwise socially responsible policies (ending the prison industry that disproportionally targets the poor and non-whites, ending the war on drugs etc) is a great way of doing income redistribution and society improvements.
The overwhelming majority of Northern European countries have a lower top marginal tax rate than that that on dividends and capital gains. So apparently Sweden, France, Germany, Finland, Norway, etc. aren't "reasonable countries"?
The top 10% in the US pay a substantially larger share of taxes than their share of income. In Sweden they pay the same share of taxes as their share of income.
PS: ROI directly relates to the supply of capital.
Citation very, very much needed.
So why do we still incentivize investment more than work? Perhaps we don't need transfer payments to offset wealth inequality, perhaps we just need to stop giving the wealthy so many advantages.
Here are two of the reasons for a separate capital gains tax rate. First, when you say sell a house or piece of property or really anything, some of the difference in price is due to inflation or deflation. When I bought my first house in 1980 the rate of inflation was around 14%. If I had sold a $100,000 house one year later for $114,000 I would have more dollars but each would be worth less and I would in effect made nothing on the investment. It makes sense to normalize the gain with respect to inflation over the holding period. They don't do that and this has a large impact on investments of all types held for many years. The lower capital gains rate helps, but doesn't erase the fact that you are being taxed on nominal income not real, inflation adjusted income.
A second reason is that an investment in a company (by say buying it's stock) goes up and down in value. In theory (at least according to some people) the stocks value should represent the net present value of the future dividend stream from the company issued to the shareholder. Dividends are uncertain and it isn't always clear that a company will ever get around to issuing dividends, but that's the theory. Nevertheless, this is how shares of a stock are tied to the value of the company.
The company itself is trying to make revenue. This revenue is split into three parts: (1) salary and benefits to employees, (2) dividends issued to shareholders or (3) retained for future spending, improvements in the company's machines (etc.) and cost reductions (driven by competition) to its products. The profits are taxed at the corporate tax rate, the dividends are taxed, and the salaries to employees are taxed. Thus, there are already taxes holding back the "value" of the company to shareholders. Indirectly, before shareholders see a gain in a stock's price, taxes are already being taken out of company profits somewhere.
For these two reasons, it doesn't make sense to tax capital gains at the same rate as ordinary income.
I know that this explanation might engender all kinds of fairness arguments, but please, dear reader, understand that I'm not saying this this fair. I'm only trying to point out some of the convoluted reasons that are used to justify our current tax system. I would love to see the tax system completely overhauled.
Misallocation of economic resources towards tax-effective financial activities over other more productive, but less tax-effective, activities.
Increasing wealth disparity in this country--so much so that the Fed is basically afraid to raise rates because it would lower asset prices.
You still get punished if you're a day less than legal drinking age and get caught. So you can't have it both ways.
If they're not following the law then punish them.
For example, you can manufacture losses for yourself to offset profits. You can instead of realizing some income, loan money to yourself and spend it and enjoy it while never paying taxes on it. You can wrap up dubious transactions in layers of opacity such that you end up legally deducting your expenses on hookers and cocaine.
The set of primitives exposed by the tax code, quite legitimately in order to meaningfully address the real underlying economics of modern business and finance, are also by necessity sufficient to build arbitrary shenanigans.
In hacker terms, it's like trying to create a "safe sandbox" for executing arbitrary user-specified code. Once you allow a few things, like say recursion or system calls, there's just no way to keep it truly "safe."
Being able to set up notionally arms length entities which you effectively control is the tax code equivalent of shelling out to the OS.
So, no, the existence of a sufficiently complex tax code guarantees loopholes and unintended consequences.
See also, DAO.
Note that tax evasion/fraud[1] is illegal, which may be difficult to distinguish in some cases.
[1] not to be confused with tax avoidance
[2] services like national security, various types of infrastructure, verification and enforcement of safety regulations (e.g. no melamine in your food). You may not like all of these services - I certainly disagree strongly with some - but citizenship is not à la carte[3]. If you don't like some things your tax money is going to, I encourage you to participate in the political process so your opinions are heard, or even run for office yourself.
>If your poor, the IRS won't throw you in jail. However, if you have a reasonable source of income, you will be asked to pay your share of the services you're using.
This is false. The government does not ask. The government demands and punishes non-compliance with expropriation of private property and or prison.
Of course. You still have to file tax forms, and if you have the money you have to pay it. The situation I'm referring to is how not having the money to pay taxes is only a civil offense. Failure to file or filing fraudulently are, of course, offenses that risk jail time.
> This is false.
I suspect you're conflating filing the tax paperwork (i.e. 1040 and related forms) with the actual payment. These are separate requirements with different potential punishments for non-compliance.
> The government does not ask.
Obviously.
So the income tax is a grotesque violation of Human Rights and should be abolished.
To even categorise refusal to disclose one's personal income as "fraud" (which is an entirely different behavior) is political language to rationalise this human rights violation.
In your ideal world, when you legitimately owe someone money and you're past due, what should happen when you refuse to pay, and you're willing to escalate as far as possible? You seem to object to the idea that repeated noncompliance can increase the severity of punishment. But what's the alternative? To not enforce small crimes at all?
Or in other words: You started the discussion by saying it's terrible to "threaten to throw someone in prison" for X. The normal interpretation of that phrase is that the direct punishment you get is prison. But that's not true, the direct punishment you get is a fine. The sense in which you could go to prison is equivalent to the statement "the law is actually enforced". You have to fight pretty hard to end up in prison over it. It's not a violation of human rights to have some fees for things, and it's not a violation of human rights that laws are actually enforced.
I'm arguing that this interpretation is wrong, as it ignores the violence and force that ultimately backs all government mandates.
The violent/forceful quality of government mandates is why we should not be making morally legitimate behavior, like refusing to honour a debt that one did not voluntarily assume, or refusing to surrender one's privacy, a civil or criminal offence.
(And to predict a common argument, I do not consider taking someone else's property without the use of force to be a violent act.)
But let's not get hung up on a semantic argument. I am drawing a distinction between what you are calling "theft of body" and theft of anything else. I can use whatever terms you like, as long as you accept the distinction. (I will use "violence" and "theft" for now.)
Most people think violence is bad because it causes direct physical suffering. Theft alone causes no such direct suffering. It may cause suffering as an indirect outcome, but this depends on a lot of factors. To take an absurd example, if one person owns all the resources, and refuses to let others access them, theft will lead to better outcomes than letting everyone else starve to death.
Now it gets murkier when the inequality is less pronounced, but many people would argue that taking some resources from the rich to help the poor leads to better outcomes in a similar way. If you want to argue against that, you need to talk about outcomes as well. Just asserting that something is a "human rights violation" is not going to be very convincing to people who don't believe the action has bad outcomes.
This is unlike the force used against those who refuse to comply with income tax laws and hand over a share of the currency they receive in private trade, which is morally unjustified.
> Most people think violence is bad because it causes direct physical suffering. Theft alone causes no such direct suffering. It may cause suffering as an indirect outcome, but this depends on a lot of factors.
That's an immature standard for morality. Theft is wrong. It's depriving someone of something that they are morally entitled to. You're not entitled to alleviate your suffering with someone else's resources. And theft does absolutely cause direct and immediate suffering for the victim.
> To take an absurd example, if one person owns all the resources, and refuses to let others access them, stealing will lead to better outcomes than letting everyone else starve to death.
There is absolutely no proof that violence backed theft against the rich leads to a higher standard of living in the long run.
And even if there were, social outcomes cannot in any sane justice system justify violating someone's rights.
In the scenario I'm describing, it's a certainty. Without theft, everyone starves to death because they have no property which would enable them to acquire food. If they steal from him, they survive.
Now obviously this is not a very realistic scenario, but my point is that strict enforcement of property rights can cause direct harm in certain situations.
And I would argue that lesser inequality still exhibits the same kind of failure mode, where the poor become incapable of acquiring resources, because they have nothing the rich need.
>That's an immature standard for morality. Theft is wrong.
Moral absolutism seems a lot more immature to me. Almost any category of act can be good in the right circumstances.
>And even if there were, social outcomes cannot in any sane justice system justify violating someone's rights.
But now you're talking about a justice system. Enforcing rules at the expense of short term outcomes can be beneficial, but only if people respecting the rules causes better outcomes in the long term.
Rights are only as valuable as the outcomes they lead to.
There is no scenario where they have the political/legal/military power to rob him, but don't have the power to feed themselves.
>And I would argue that lesser inequality still exhibits the same kind of failure mode, where the poor become incapable of acquiring resources, because they have nothing the rich need.
I would argue the ability to exert political influence is indicative of the ability to generate value. The same kind of intellectual feats are required in both cases.
Moreover, the historical trend is that of the standard of living of the poor rising. There is nothing at all in the economic trends seen to suggest the poor would be doomed without welfarism. Technological progress is creating an age of abundance, and this abundance is massively enriching every income class, in ways that are not even captured by traditional measures of economic consumption.
So no, I don't think there is any argument whatsoever for the instutionalization of theft.
>Moral absolutism seems a lot more immature to me. Almost any category of act can be good in the right circumstances.
Moral absolutism prevents the slippery slopes that the population at large has slid down over the last 100 years, where a massive share of economic activity is restricted by regulatory prohibitions that harm the economy, welfare programs have tens of millions of multi generational dependents, and income taxes demand over 30% of people's income.
Imagine how absurd a justice system would be if it let someone off for theft because the victim was rich. That's effectively what you're arguing for for the political system. I see it as extremely immature.
>But now you're talking about a justice system. Enforcing rules at the expense of short term outcomes can be beneficial, but only if people respecting the rules causes better outcomes in the long term.
I disagree. The outcome of a society accepting theft is bad, in and of itself. Theft is bad. Principles matter. Murdering an innocent person to save a thousand is wrong. Even engaging in a lesser evil, like theft, against one, to save many, is wrong.
Moreover, even if we accepted your moral framework, there would be no argument whatsoever for welfarism. Economic theory and the historical data strongly suggests minimising taxes levied to pay out welfare maximises economic development and the rate of increase in standard of living.
>I disagree. The outcome of a society accepting theft is bad, in and of itself. Theft is bad.
So what exactly do you mean by "theft" in this context?
Normally theft is defined in terms of the property system of the society it occurs within. Such property systems vary in the extent of control they allow individuals to exert over resources. Some involve limited time periods (copyright) while others require social contribution to maintain exclusive control (property taxes).
So in order to call something "theft" even if society accepts it, you have to define a property system outside of society. And to say such theft is morally bad, you have to elevate this one property system to the level of morality.
And this seems extremely dubious to me. We can say murder is intrinsically bad because life is evident in the universe, but there is no intrinsic notion of property in the universe. The only way I can consider one property system morally superior than another is to talk about outcomes, at which point we're making economic arguments, not moral ones.
As you said, let's not get hung up on semantics. It's taking property from someone that they are morally entitled to. If John gives me a widget, you have no moral right to take it from me without my consent because you happened to sign a piece of paper saying it's the law, and get Bob and Alice to add their signatures as well. Government does not have any rights that a group of people do not have. If it's wrong for a group of people to deprive you of your property, it's wrong for a government to do so as well.
>We can say murder is intrinsically bad because life is evident in the universe, but there is no intrinsic notion of property in the universe.
What about slavery? What about predation, or parasitism, where one animal lives off of the life of another? The predator/parasite robs the prey/host of their bodily resources. Property is absolutely evident. Every bit as evident as freedom/self-ownership. Animals will fight against attempts to prey/parasite off of their body, just as they'll fight against attempts to steal their kill.
First Possession is a principle observed in animals to reduce conflict, and it is the basis of property rights. It is also found to lead to a stable equilibrium in game theory experiments.
(Edit: Also, there are plenty of problems with the Federal Government size already. Pick a local cause such as Education, Low Income Families, Veterans, etc. and you will find plenty of non-governmental state or county-level groups and organizations who can put your money to a great use. Simply do the math that would leave you with the income you should have if the tax rate applied to your carry, and donate the rest).