Setting the Tone: The Broken Windows Theory and Tax Policy

By:
David Tunstall, CPA
Published Date:
Sep 1, 2016

The presidential campaign is in full swing, and with it comes tax policy proposals from each candidate. Both candidates have said they will help middle class families by raising taxes on the wealthy. So what are they talking about? Who is the wealthy? How would they do that? Is it true?

The wealthy = hedge fund managers

As far as I can tell, the only way both candidates would specifically tax the wealthy is by changing the tax rate on “carried interest” from a capital gains rate to an ordinary income rate. “Carried interest” is the portion of earnings that a hedge fund charges investors for “performance fees.” A performance fee in the hedge fund world is basically a 15-20% fee charged to investors on any gains made in the fund during the year. Performance fees are usually in addition to a management fee, consisting of 1-2% each year on the market value of the total assets invested.

Performance fees, or “carried interest,” are currently taxed at the capital gains tax rate—20% on short-term gains and 15% on long-term gains—rather than the ordinary income tax rate, which is 39.6% for the highest tax bracket. Changing the tax on carried interest to ordinary income tax rates would obviously be a hit to the hedge fund managers, but would it bring in more tax revenue?

This is where critics of the change usually get tripped up. It isn’t a big revenue gainer. As such, the commentary that I’ve seen leans toward the apathetic side. The argument goes like this: Because a change in the carried interest tax wouldn’t bring in a material increase in revenue, it is not worth the political capital of a regulatory enforcement or a congressional battle to change the tax policy. What the critics are missing, however—and what the candidates have picked up on—is that this issue isn’t about the revenue. It is about the tone set by making the change.

Do you remember New York City during the 1970s or 1980s? If not, have you read about it? New York was a different place back then—more crime, more vandalism, less safe. One of the reasons there is less crime today is attributed to a policing policy—controversial at the time and still deemed controversial by some—known as the “broken windows theory.”

The broken windows theory deals with norm-setting, signaling, and tone. The theory states that maintaining and enforcing even small crimes such as vandalism, public drinking, and toll-jumping contributes to an atmosphere of order and lawfulness, thereby contributing to a more respectful tone and preventing more serious crimes from happening.

If we juxtapose the theory to this debate, a hedge fund earning millions of dollars that pays a tax rate of 18.4%—when the top tax rate is 39.6% —has a demoralizing effect on other citizens that pay a tax on their ordinary income. Most employees might not be able to articulate it or even pinpoint it, but there is a belief that the tax code doesn't make sense, and that there are tax giveaways availably only to insiders.

Taxing carried interest at the ordinary income rate, as proposed by each candidate, might not bring in a huge amount of revenue; however, it gives each of them street cred on the “taxing the wealthy” issue and might have positive impacts on the tone being set.

Death Tax

This one is a head scratcher. One would think that a general attitude of toughness toward the wealthy would result in wanting to maintain the estate tax. Not so. In Detroit of all places, Donald Trump was able to win the applause of hundreds of people for proposing to eliminate the death tax. Also known as the estate tax, the death tax is imposed on the transfer of assets from deceased people to their heirs. It is considered a tax on the wealthy because only assets greater than $10 million are taxed.

Again, we see a tax that doesn’t have a huge relative revenue impact to the Treasury Department—but does operate on principle and set a tone. In a progressive tax system, like the one we have, the wealthy pay a greater percentage of taxes. Currently, it is mainly the wealthy that pay the death tax.

Is there room for changing the implementation and specifics of the estate tax? Sure. There is probably room for a higher exemption—which is currently at $10.9 million—so that there is less administrative work involved for relatively smaller estates. And yes, the rate—currently at 40%—could probably be lower as well. But, to be consistent with the principle of taxing asset transfers, there should be some kind of tax for estates over the exemption amount. This would offer a more consistent approach to the claim that each candidate wants to increase the taxes on the wealthy.

Do you agree with the author? Please let us know at taxstringer@nysscpa.org


David Tunstall, CPA, is the Principal CPA at The Tunstall Organization, Inc. where they account and advise for SAAS start-up companies and prepare a variety of tax returns. He is also a member of the NYSSCPA C Corporations Committee. He can be reached at david@tunstallorg.com or 212-420-1077.

 

 
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