David R. Henderson  

Five Thoughts About the Tax Bill

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Here are five thoughts about the tax bill: they are from big-picture economic analysis. Later today or tomorrow, I'll post on how I plan to adjust my behavior before December 31, 2017 in response to the tax bill.

1. How economists judge tax cuts.
Economists across the political spectrum, to their credit, do not view the tax bill the way almost everyone else does. Most people look at how much more or less they will pay in taxes. Economists tend to look at the overall effects. I think, by the way, that this speaks well of economists. Whatever you think of Paul Krugman, for example, notice that he never talked about the effect of the tax bill on himself. Without knowing a lot of details about his income and deductions, I'm 99% sure that he will get a huge tax cut, much bigger than mine in absolute dollars, as well he should.

2. The corporate income tax rate cut.
The best part of the tax bill is the cut in the corporate income tax rate. While it's true, as Krugman pointed out very well in my favorite book of his, Pop Internationalism, that nations don't compete economically with each other, they do compete somewhat for capital. By dropping its corporate income tax over the years, from 50.9% in 1981 to 26.5% today (and this includes the provincial tax rates on corporate income), Canada has been saying to the world:

Give me your rich
Your huddled capitalists yearning to invest more freely
The well-heeled investors of your high-taxed country
Send these, the taxed-class, to me
I lift my lamp beside Vancouver, Calgary, and Toronto.
(copyright 2017, David R. Henderson)

Now the United States will compete more effectively with Canada and with many other countries.
With more capital, the capital to labor ratio will be higher and workers' real wages will rise.

3. SALT and the standard deduction.
The second-best (and it's a close second) part of the bill is the twofer: the limit on the deduction for state and local taxes (SALT) and the related increase in the standard deduction. The limit on the deduction for state and local taxes now means that residents of high-tax states like my own California will not get as big a tax break as they were getting and that, in turn, will probably force some fiscal discipline. (Co-blogger Scott Sumner wrote about this here.) The increase in the standard deductible--to $24,000 for a married couple filing jointly--will lead many more people to quit itemizing deductions and, instead, take the standard deduction. This reduces a big distortion in the tax code, a distortion that caused us to buy houses that were too expensive and to go along with state and local tax increases. It also, of course, could reduce the amount we give to charity: more on that when I talk about my own adjustments.

4. Odds and Ends.
There are a lot of things I don't like about the bill. Co-blogger Scott Sumner has done a good job here of listing those things and of listing the things I like and the things that are neutral.
I have two disagreements and one possible disagreement with Scott.
The first disagreement is about the increase in the child tax credit being neutral, and about his reasons for it. Scott argues that this is "pretty simple to handle" and "does provide some needed tax relief to lower income families." I think the increase in the child tax credit is bad--it gives people a credit for having a child and so "wastes" the tax cut where, instead, it could have been used to cut marginal tax rates slightly for everyone. Also, although it is simple to handle, the fact is that lower-income families pay little in federal income taxes.
The second disagreement is about the change in the corporate income tax to a territorial tax being neutral. I think it's positive.
The one possible disagreement is that maintaining the "carried interest loophole" is a negative. I don't understand it enough to say.
I've got to say that, on the whole, though, I'm impressed by so many Congress people being willing to vote for such a bill: it's more reform than I would have expected.

5. The effect on debt must be separated from the effect on growth.
Here's what Robert I. Lerman, an institute fellow at the Urban Institute and emeritus professor of economics at American University, wrote this morning:

Who would refuse an offer that yields about $180,000 in labor and investment income if you agree to borrow an additional $130,000? In a sense, the tax bill embodies this offer to the American public, assuming the Congressional Joint Committee on Taxation (JCT) estimates are accurate. Media coverage of the bill focuses on estimates showing that the tax bill will not pay for itself, that tax revenues induced by the tax bill's stimulus to growth will be less than the gross tax reductions. These reports are important but they ignore the gains in economic growth that exceed the additions to federal debt. While the ratio of debt to GDP will go up, interest payments as a share of GDP will be only slightly higher because of the tax bill.

The whole thing, which is not long, is worth reading. HT2 Daniel Kuehn on this last.


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CATEGORIES: Tax Reform , Taxation




COMMENTS (29 to date)
Mattb writes:

The link appears to be broken. This one works:

https://economics21.org/html/tax-bill%E2%80%99s-gdp-gains-offset-its-added-interest-costs-2765.html

David R Henderson writes:

@Mattb,
Thanks. I updated accordingly with exactly your link, but it still looks broken.
However, those who want to look at the piece--and I highly recommend doing so--should copy and paste Mattb’s link into their browsers and they will get to the piece.

[ I’ve fixed the link for you. The URL in the post had substituted visible characters for resolving the link such as a curly quote, which is not allowed in a URL and requires other substitute encodings. See https://www.w3schools.com/tags/ref_urlencode.asp for more info of a tech nature.—Econlib Ed.]

David R Henderson writes:

Thanks so much, Econlib Ed.

Zeke5123 writes:

I think these are the big headlines but devil is in the detail. Examine the BEAT — concern is this will muck up supply chains. Add in GILTI and US MNCs really got hammered. Finally, good tax return attempts to encourage capital decisions made on the basis of business; not taxes. I’d say this bill actually exacerbated the issue.

Thomas writes:

Krugman may not talk about the effect of the tax bill on himself, but that doesn't keep him from using loaded terms like "corporate tax giveaway" and "affluent and sneaky". Clearly, he doesn't like the cuts bestowed by the bill because he thinks they're going to the wrong people. He emphatically dismisses what you call the best part of the tax bill. (See today's Krugman column: https://www.nytimes.com/2017/12/21/opinion/tax-cut-santa.html)

mike davis writes:

Robert Lerman concedes that the tax bill increases the deficit by around $1.3 trillion over 10 years. But don’t worry, he says, be happy. This will raise GDP by $1.78 trillion. Shouldn’t we all be thrilled with an offer that “yields about $180,000 in labor and investment income if you agree to borrow an additional $130,000?”

His numbers are consistent with the Joint Committee on Taxation’s calculations. But so what? JCT is an honest outfit but their numbers don’t begin to fully capture the impact of deficits.

Here are three issues:

Issue #1: The Republican tax bill inserts a bunch of sunset provisions into the cuts that basically say taxes will go back up in 10 years. This is—how to put it politely?—sleazy, deceitful and corrupt. (And, no, just because the Democrats do the same thing doesn’t make it ok.) These sunset provisions will not happen! This means that the deficit forecast from JCT is WRONG. The deficit will likely increase by much more than the forecast. This is not JCT’s fault. They have to analyze the law that’s before them. The rest of us do not. We don’t need to pretend that up is down.

Issue #2: (Warning: this next one is hard to quantify and very speculative, but I think it matters the most.) All of this analysis just assumes that how much government spends and what it spends it on is independent of whatever means the government uses to collect the cash. But is that really true? Don’t we need to come to grips with the whole entitlement freight train that is coming directly towards us? Isn’t our indifference towards deficits is being translated into an indifference towards a growth in government. Face it, if the bartender lets you drink on credit, you’re going to drink more.

Issue #3: (This is a bit technical and I’m not even sure how significant it is. But it is an under-appreciated aspect of the tax analysis.) Shifting to a territorial tax may be a good idea but the increases to GDP caused by the change are mostly fake. People talk about the $2.6 trillion in overseas profits as if it were a big pile of money sitting in a bank fault overseas. But in fact those funds are mostly in US dollar denominated assets. That means they’re mostly already here doing what they do. Money is fungible and most of the big US multinationals with lots of un-repatriated overseas earning—think, Apple—aren’t sitting around saying “damn, if only we could get our hands on that cash, we could finally develop some new products.” But here’s the thing: when overseas earnings are repatriated, some of those fund flows will show up as added GDP. What’s more, sales that appear to be credited to a foreign country will now show up as earnings by an American. That means GDP will go up but not in anyway that matters, it’s just a function of the way we compute GDP. (I think I’ve seen one estimate that this phantom GDP growth is almost 1%. I can’t find the source and there’s always a chance I’m making it up. If anyone has better numbers, I’m quite willing to walk this one back. My first two comments, though, stand.)

Alan Goldhammer writes:

We are not going to know the full impact of the tax legislation for at least a year or more. Once the tax lawyers are finished examining and implementing all the newly created loopholes the impact of tax revenue will be apparent (my view is that it will likely be negative to some degree, primarily because of the way the pass through income is structured). Thomas Edsall has a very good piece in the New York Times on some of the impacts albeit from a liberal perspective.

Of course our corporate tax structure needed to be reformed. However, the various tax preferences were only slightly modified. There is little increased certainty provided as a result of various exemptions being phased in and phased out.

The overseas earnings claims are just hogwash in the same way they were back when this was tried in 2002. Yes, money will come back in and guess what, it's going to be used the same way it was before: stock buybacks and increase M&A. Does anyone really thing Apple, Google, big Pharma are going to use these funds for increased R&D or corporate hiring? If so, you are smoking funny weed. the only companies who will increase hiring will be brick and mortar stores that are somewhat immune to the Internet (home improvement stores are one good example).

I'm not worried about the deficit issue. The amount increase in the deficit relative to GDP is small (even Krugman has made this argument). What will likely happen is that during the next debate about tax legislation, a national VAT will be seriously discussed. It's the easiest way to raise money (I know you Libertarians don't like this :-) ).

I've been living and working in Washington DC too long now and my cynicism only continues to deepen.

Thaomas writes:

I judge tax changes on two dimensions 1) how it distributes income and how it creates/removes distortions in how income is earned and consumed and what I think about such "distortions."

1. I think the child tax credit is a good idea mainly as a way to transfer income to low income families and because I approve of distorting consumption choice toward child care expenditures.

2. I disagree with the continuation of deductions for home mortgages and charitable contributions. These should be turned into partial tax credits, capped for home mortgage interest. (I approve of encourage relatively poor people to invest in housing.)

3. I do not see what consumer or producer choice is distorted by the deductability of SALT. Using the federal tax code to encourage high income people to resist SALT seems illegitimate.

4. Reducing the corporate tax rate is a very good idea; eliminating it would be better. But the revenue loss should have been made up by higher personal income taxes falling on higher income and wealth people.

5. There is no reason that tax reform should increase the structural deficit. Indeed with the economy approaching full employment, we should probably be running a surplus as we were at the end of the Clinton Administration.

Alan Goldhammer writes:

I forgot to mention the SALT issue. I look at this the same way I look at the double taxation of dividends. Capping the deduction at $10K for those who itemize (and we will probably be itemizing for the rest of our tax paying years) is wrong in the same way that the dividend taxation is. I'm not sure if my thinking on this is the same as Thaomas's #3 above which I don't completely understand; I just think it is bad tax policy to double tax any form of income.

R Richard Schweitzer writes:

Fiscal deficits:

The "money" that will be "borrowed" by the U S Fisc will not be paid out to those providing the revenues.

What is "borrowed" will be expended in the expanded functions of government that require an Administrative State.

State governments (and their "programs") are increasingly funded through the Federal fisc.

There are now 70 years of experience showing the increases of Federal and State functions result in deceases in effectiveness and increases in costs.

Therein lies the DEFICIT.

fralupo writes:

I'd be curious to see the evidence on the relationship between Federal and State taxes. Have previous tax hikes caused lower levels of governments to wither? Did the Reagan or Bush tax cuts make local governments raise taxes?

Seems like we should be able to cite empirical examples when analyzing the new SALT cap.

David R Henderson writes:

@mike davis,
Issue #1: The Republican tax bill inserts a bunch of sunset provisions into the cuts that basically say taxes will go back up in 10 years. This is—how to put it politely?—sleazy, deceitful and corrupt. (And, no, just because the Democrats do the same thing doesn’t make it ok.) These sunset provisions will not happen! This means that the deficit forecast from JCT is WRONG. The deficit will likely increase by much more than the forecast. This is not JCT’s fault. They have to analyze the law that’s before them. The rest of us do not. We don’t need to pretend that up is down.
You raise a good point. I think, but am not sure, that it cuts both ways. My understanding--and I emphasize that I could be wrong here--is that when the JCT “scored” the tax cut, it did so relative to current law, not relative to current policy. What’s the difference? Current law was for some tax provisions to expire, most of which would have raised tax revenues. But pretty much everyone understood, like you, that when those provisions were set to expire, Congress would renew them. In other words, people assumed that current policy would prevail. That means that the impact on deficits during the 10-year window was overstated. I’m pretty sure that Alan Reynolds and Chris Edwards would know whether I’m right here, but I haven’t seen them discuss it.
Issue #1: The Republican tax bill inserts a bunch of sunset provisions into the cuts that basically say taxes will go back up in 10 years. This is—how to put it politely?—sleazy, deceitful and corrupt. (And, no, just because the Democrats do the same thing doesn’t make it ok.) These sunset provisions will not happen! This means that the deficit forecast from JCT is WRONG. The deficit will likely increase by much more than the forecast. This is not JCT’s fault. They have to analyze the law that’s before them. The rest of us do not. We don’t need to pretend that up is down.
Again, good points.
I do worry a lot about deficits. I have predicted elsewhere, along with Jeff Hummel, that the federal government will default. If so, I worry less.

David R Henderson writes:

@Alan Goldhammer,
I forgot to mention the SALT issue. I look at this the same way I look at the double taxation of dividends. Capping the deduction at $10K for those who itemize (and we will probably be itemizing for the rest of our tax paying years) is wrong in the same way that the dividend taxation is.
So, by that reasoning, the Social Security (FICA) and Medicare (HI) taxes are double taxation also. Would you make them deductible also?
@fralupo,
Did the Reagan or Bush tax cuts make local governments raise taxes?
“Make” is a strong word. All we would ever be able to do is see whether local and state governments raised taxes after the Reagan and Bush cuts.

Jonathan Hackman writes:

I think the bill was rushed thru so the cuts to insurance payouts would not be questioned. Before Obamacare emergency rooms were used as primary care for the uninsured. The result was the closing of emergency rooms and in many cases the hospitals. This was a huge concern as many cities lost hospitals. Phoenix AZ lost 3. In a country where our medical care ranks as some of the worst. The USA is BELOW Costa Rico.Republicans seem unconcerned. If a medical emergency occurred country wide there would be no way to treat. I hope everybody stays well.

Alan Goldhammer writes:

@David - I'll be a contrarian in terms of the point you raise on FICA and Medicare tax and say no they should not be deducted. They are payments to a trust fund (I know a lot of people have difficulty understanding the purpose of how the trust fund is structured and don't accept its premise) in return for a future payout of benefits. SALT only provides indirect benefits to those paying taxes and not all of those benefits are used by every citizen (best example is public school funding which may or may not be used). Maybe the argument sounds illogical.

I will take a hit on SALT but it would not cause us to move from our home in Maryland. You may take a greater hit living in CA (as does Scott Sumner who is a recent arrival); is this making you contemplate moving?

David R Henderson writes:

@Jonathan Hackman,
I think the bill was rushed thru so the cuts to insurance payouts would not be questioned.
Which cuts do you have in mind? The decreases in payments for people in Medicaid and Obamacare who don’t want health insurance?
Before Obamacare emergency rooms were used as primary care for the uninsured. The result was the closing of emergency rooms and in many cases the hospitals. This was a huge concern as many cities lost hospitals.
Good point. One of the worst laws Reagan signed was EMTALA, which led this.
In a country where our medical care ranks as some of the worst.
I don’t think so.
If a medical emergency occurred country wide there would be no way to treat.
Pretty sure that’s false.
I hope everybody stays well.
Thanks. You too, Jonathan.
@Alan Goldhammer,
You may take a greater hit living in CA (as does Scott Sumner who is a recent arrival); is this making you contemplate moving?
No. Also, I’ll explain in a post later today how the big increase in the standard deduction makes the SALT limit irrelevant for many people. I’m one of them.

Vivian Darkbloom writes:

@Goldhammer

"Yes, money will come back in and guess what, it's going to be used the same way it was before: stock buybacks and increase M&A."

If so, in either case, the money (net of tax) will end up in the hands of shareholders. Is that a bad thing? Will those shareholders just put the money under the mattress? From an efficiency standpoint, would not the corporation be in the best position to know how best that capital should be allocated?

As it previously stood, those earnings could not be reinvested in the US (or returned to shareholders) without incurring a large tax liability. The money could be sitting in a bank account (increasing global liquidity for the marginal benefit of borrowers everywhere), or reinvested abroad, but that is not much use to the US economy specifically.

Before anyone replies, please review IRC Section 956 and the regulations thereunder.

Vivian Darkbloom writes:

Also, speaking of "big picture" issues, I'm surprised our economist bloggers have not mentioned the amendment to section 163(j). That section previously limited a corporation's net interest deduction to 50 percent of modified adjusted gross income. The old provision only applied if the interest was paid to related tax-exempt persons. In effect, this applied almost exclusively to US subsidiaries and branches of foreign entities who used leverage to "strip out" US earnings by way of deductible interest payments to foreign parents and other related parties not subject to US tax on interest paid to them. Thus, the provision was commonly referred to as an "earnings stripping" rule.

The change applies a 30 percent limit (again, measured against modified AGI) on a corporation's net interest expense (exceptions for small corporations, financing for sales floor inventory, e.g., cars, as well as real estate developers). My understanding is that economists (e.g., Cochrane) frequently complain about the difference in tax treatment of debt versus equity. This change, while it does not alter the treatment per se, effectively discourages the use of too much leverage. As such, I would think this would be welcomed as a step in the right direction.

The theme of "less leverage" also resonates in the change to the mortgage interest deduction---my amateur economics suggests that both these changes make the US economy just a bit more stable.

Alan Goldhammer writes:

@Vivian - I am happy for money to come back to shareholders. My retirement is partially dependent on it. I just don't see much job creation.

Michael Byrnes writes:

1. On competing for capital more effectively with other countries... doesn't our huge trade deficit imply that we already do? I also wonder about the wisdom of cutting the rate to 21%. In 2012, Romney proposed 25%. The Business Rountable asked for a 25% rate. Obama wanted to do revenue neutral reform with a rate of 28%. Why is 21% better than 25%? That difference could have been used to make some or all of the individual provisions that are set to expire in 10 years permanent. If political sustainability was the goal, wouldn't that have been the right answer? Such a plan might even pick off some Democratic Senate votes from the red state Dems who are up in 2018.

2. On SALT and the standard deduction... with one exception (which I'll hit in #3), I think these are mostly good. Before this law, the tax code made it a lot better to buy/own than to rent, via mortgage interest deduction and property tax deduction. Now that those have each been curtailed, many if not most homeowners will just end up taking the standard deduction (which is also available to renters) anyway. I like the minimizing of the bias towards ownership in the tax code.

3. The child tax credit. This is one place where I do think some bias in the tax code is a good thing, and the changes to the standard deduction actually work against parents. The standard deduction went up from $6,300 to $12,000 (incidentally, I think it is dishonest to call that "doubling"), but at the same time they get rid of personal exemptions ($4,050 per dependent, available to itemizers and non-itemizers alike). So where the code previously gave an extra $4,050 deduction per child, now parents and people without children are treated the same. I guess the child tax credit offsets this to some extent. But I think the tax code should favor parents. Businesses get to deduct their investments, don't they? Children are, in a sense, the ultimate in human capital.

4. I think the huge pass through incomes deduction for busineses structured much like the President's is horrible, both for what it does (unjustifable tax cut that will make the overall tax code less equitable) and for the precedent it sets (having a President and Congress shamelessly work the tax code to their own personal financial advantage).

mike davis writes:

@ David Henderson. “I do worry a lot about deficits. I have predicted elsewhere, along with Jeff Hummel, that the federal government will default. If so, I worry less.”

David. I’m interested in your prediction about default. I guess it depends on what you mean by default but I find it really hard to describe a likely scenario for any sort of default.

By default do you mean, you mean inflating away the real value of a significant part of the debt? This could happen, but it’s trickier than it seems. (To really work the inflation has to be unexpected. And once inflationary expectations are built in, the government can’t borrow at an unrealistic real rate until it reestablishes monetary credibility. This could work in a place like Venezuela or Zimbabwe—they could inflate and then dollarize. But it would be tough for the US.)

By default do you mean to renege on social security and other “entitlements”? This is legally possible and, arguably, morally acceptable. But the politics? Not so much. (Although you might think that even though Baby Boomers like us are safe, the X’ers and Millennials lack our clout.)

By default do you mean an actual, honest-to-god default? In other words, when the widows and orphans show up to cash in their bonds, the Treasury tell them to go back to the homeless shelter. This only makes sense if you think the dollar has lost it’s special status as an international reserve currenc and not even a delusional reality-star/president would give that up, especially when it’s easy to manufacture more dollars to redeem debt. (And if your answer is “no, we just refuse to pay back the Chinese widows and orphans” you’ve got to explain how that is even technically possible and also, again, why we would sacrifice the special status of the dollar.)

mike davis writes:

@ David Henderson. “I do worry a lot about deficits. I have predicted elsewhere, along with Jeff Hummel, that the federal government will default. If so, I worry less.”

David. I’m interested in your prediction about default. I guess it depends on what you mean by default but I find it really hard to describe a likely scenario for any sort of default.

By default do you mean, you mean inflating away the real value of a significant part of the debt? This could happen, but it’s trickier than it seems. (To really work the inflation has to be unexpected. And once inflationary expectations are built in, the government can’t borrow at an unrealistic real rate until it reestablishes monetary credibility. This could work in a place like Venezuela or Zimbabwe—they could inflate and then dollarize. But it would be tough for the US.)

By default do you mean to renege on social security and other “entitlements”? This is legally possible and, arguably, morally acceptable. But the politics? Not so much. (Although you might think that even though Baby Boomers like us are safe, the X’ers and Millennials lack our clout.)

By default do you mean an actual, honest-to-god default? In other words, when the widows and orphans show up to cash in their bonds, the Treasury tell them to go back to the homeless shelter. This only makes sense if you think the dollar has lost it’s special status as an international reserve currenc and not even a delusional reality-star/president would give that up, especially when it’s easy to manufacture more dollars to redeem debt. (And if your answer is “no, we just refuse to pay back the Chinese widows and orphans” you’ve got to explain how that is even technically possible and also, again, why we would sacrifice the special status of the dollar.)

mike davis writes:

@Michael Byrnes. I couldn’t agree more with all of your points, with one small quibble on the child care tax credit.

For parents, kids are mostly consumption goods, not investments. (My 2-year old is awesome, but she’s never going to pay me back for what I’ll spend.) They are an investment in the sense that they will produce substantial benefits for others in the futures. (By the time she’s 30 my daughter will have won Wimbeldon, developed a cure for malaria and sung the role of Mimi in La Boheme at the Met.) To the extent you believe that such externalities are real, there’s a role for subsidizing investment in human capital. But one could argue that a direct subsidy is better—say spending on early childhood education or music in schools. (Of course, the counter argument is that parents are better shaping those investments and so some sort of tax credit for kids works best.)

OH Anarcho-Capitalist writes:

Here's the way to look at the carried interest debate. When you invest your own money, you are able to claim cap gains and dividend rate breaks because your income has already been taxed at the corporate level of the businesses you own.

When you invest other people's money as a service to them, your income is wage income, no matter the form the payment takes: flat fee, % of income, income from total cap gains earned, etc. The distinction that SHOULD apply is ownership of the invested capital.

Owners get tax breaks, 3rd party managers with fiduciary duties to owners should pay self-employment taxes + normal income tax rates.

The Carried Interest rate reduction is simply an unjust political favor granted to Wall St investment advisors not available to all service fee earners...

Alec Fahrin writes:

Why not cut all taxes to zero? Wouldn’t that make the economy boom? It’d literally pay for itself through welfare gains to the average citizen. Why not raise government spending to 100% of GDP? We could raise GDP immensely.

Now of course these questions are rhetorical, but it gets to the point in these “tax cuts pay for themselves” arguments.

The real question here is one of margins and one of opportunity costs. Does our GDP grow more than our debt level as the JCT estimate implies? Or does it not? When exactly has the US economy grown for 20 straight years? The JCT estimate assumes that. They completely ignore the possibility of a recession.

What happens if Democrats take office in 2020 and reverse most of the tax cuts to pay for the rapidly rising GDP/debt ratio, leading directly to a recession?

The problem with tax cuts worth 10% of annual GDP is that the projections and estimates of the future are almost always more optimistic than it turns out.

David R Henderson writes:

@Alec Fahrin,
Now of course these questions are rhetorical, but it gets to the point in these “tax cuts pay for themselves” arguments.
I’m not sure whom you’re referring to as having made a “tax cuts pay for themselves” argument.
The problem with tax cuts worth 10% of annual GDP is that the projections and estimates of the future are almost always more optimistic than it turns out.
I’m not sure where you get the 10% number. The annual net tax cut, assuming no dynamic revenue effects, is about $150 billion, which is 3/4 of 1 percent of GDP.

James Forrest writes:

David, most people do not understand carried interest, especially the fact that it was developed to protect LIMITED partners, not GENERAL partners. why? here is a simple example:
I give someone $10 MM to manage. There is not carried interest provision, and they invest $1MM in ten companies. If an individual investment returns more than 8% annually, the manager gets 20% of the upside. This 20% is in the form of cheap common stock, so the cap gains clock starts to run.
So let's say all the money is invested on Day 0, and on the fifth year anniversary all ten companies are sold. 5 are sold for $2MM each for a total of $10 MM, five are complete writeoffs. The manager gets 20% of the gain ($2MM), all at capital gains rates. i get the remaining 80%, or $8MM. What? The money manager makes $2MM for doing exactly nothing for me? Yep, that's the way it really works.
So what did LP's do? They invented carried interest. That means the manager only gets paid if the entire bundle of investments makes over an 8% return. In this case, the manager would get zero, the correct outcome. it is a provision that protects Limited Partners, it is NOT for the benefit of VC, PE, and Hedge fund managers.
I was a PE manager for 20+ years, and have been an LP for the past 10 years. Keep carried interest the way it is. It works.
Jim Forrest, Hoover Overseer

James Forrest writes:

For clarity, I should have said, above, "The manager gets 20% of the $1MM gain for each of the five successful investments for a total of $2 MM". The manager pays no penalty for losing $5MM invested in the five companies which went bankrupt."

David R Henderson writes:

@James Forrest,
Thanks for the explanation.
I’m a little lost, though. You write, in your clarifying comment, "The manager gets 20% of the $1MM gain for each of the five successful investments for a total of $2 MM.” My arithmetic says that the manager gets $1 million, not $2 million. Am I wrong? (20% of $5 million is $1 million.)

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