A Closer Look at Alexandria Ocasio-Cortez’s Tax Proposal

The freshman Congresswoman recently proposed a new tax rate—is it a bold democratic policy or self-promotion?

(Photo: Getty Images)

 

For at least three decades, conventional wisdom in American politics has been that if one wants to win an election, any change in tax rates can only be in one direction: down. As a result, Democrats have largely ceded tax policy to their Republican rivals by either playing along with proposed tax cuts or staring at their shoes and whistling until they find some other opportunity to distinguish themselves. Rookie Congresswoman Alexandria Ocasio-Cortez changed that dynamic last month by loudly proposing that high-earning Americans be subject to a 70% marginal tax rate. Ocasio-Cortez deserves credit both for boldness and for catapulting herself to the center of a national conversation. But is her tax plan serious policy or merely an act of half-baked self promotion?

From the public statements she has made, it is far from obvious that the Congresswoman knows much about how the American tax system actually works. Most obvious is the fact that she seems unaware of the distinction between ordinary income and capital gains. As a self-proclaimed socialist, Ocasio-Cortez ought to understand that the concentration of capital in the hands of a privileged few is a major source of inequality. Taxing capital gains at a lower rate than ordinary income likely amplifies this inequality. However, the United States is far from alone among developed nations in this regard. The justification for giving a tax benefit to returns on capital as opposed to other forms of income is that investment is inherently risky but essential to economic growth. As a result, governments create incentives for people to save and invest. Whether the current system should be tweaked is debatable.

Take the example of Lockheed Martin CEO Marillyn Hewson, who made more than $20 million in the company’s 2017 fiscal year. Approximately $11.88 million of that amount was in the form of long-term incentives, 80% of which were restricted stock units and performance share units. The tax treatment of stock units is somewhat complicated, but there are a few key features. First, any taxes owed on them are deferred until the units vest. So, for example, if the units vested in 2020 and were worth $5 million, Hewson would pay tax on that amount as ordinary income at that time. If Hewson held her stock for at least a year after that, and the value increased to $15 million, the $10 million profit would be taxed at the lower capital gains rate.  If she felt particularly bold about her company’s prospects, the tax code allows her to pay taxes at the date of grant rather than the vesting date. So, for example, if the units were worth $4 million when granted, the extra $1 million in profit would also be taxed at the lower rate.

This all may sound a bit complicated, but the basic idea is that the value of free stock should be taxed as ordinary pay when given, but after that, executives who hang onto their stock receive the same capital gains treatment as any other investor. It is debatable whether a CEO making a significant amount of guaranteed compensation and other benefits is in fact investing in her company by not selling stock she was given for free. But without fundamentally changing the way the United States treats equity based compensation, Ocasio-Cortez’s new income tax could increase the incentive for companies to dole out stock based compensation rather than salary. Hedge funds and private equity funds would also remain largely unscathed by Ocasio-Cortez’s new tax.

According to Institutional Investor, the 25 highest-paid hedge fund managers in 2017 earned a walloping $15.38 billion, meaning the average member of this group earned $615 million. Much of that amount is carried interest. Carried interest is essentially a bonus paid to a fund manager for wisely investing someone else’s money. The problem from a tax policy perspective is that the people earning carried interest are not risking their own money. So, for example, when the Blackstone Group reported a carried interest of more than $3.4 billion for fiscal year 2017, that amount was earned by investing money that, if lost in its entirety, would have resulted in no loss to Blackstone itself. Nevertheless, as a result of a longstanding tax loophole, carried interest is treated as a capital gain rather than ordinary income. Carried interest has been a convenient punching bag in recent presidential politics.

Barack Obama toyed with the idea of closing the loophole and was quickly criticized by Blackstone Chairman Stephen Schwarzman, who likened the proposal to Hitler’s invasion of Poland. During the second presidential debate in October, 2016, both Donald Trump and Hillary Clinton claimed they would eliminate the carried interest loophole. After winning the election, Trump promptly installed Schwarzman as one of his economic advisers, which was a pretty good signal that the promise would fall by the wayside.

Indeed it did. Without closing—let alone being aware of—the carried interest loophole, Ocasio-Cortez would leave a large number of wealthy Americans largely unaffected by her new tax. Ocasio-Cortez deserves credit for giving Democrats the beginnings of their own tax policy, and indeed, some of her rhetoric is already being echoed in Elizabeth Warren’s wealth tax proposal. But any serious discussion of tax reform needs to do more than stir up a pitchfork wielding mob. Among other things, it needs to take into account the complexity of the current system and the justifications for treating returns on capital differently from ordinary income.

It also needs to address one issue about which progressives seem rather squeamish, namely the widely held suspicion that an inherently wasteful federal government will squander the money and then come back asking for more later. If progressives are serious about their proposals they would also do well to convince those with the largest tax bills of the fairness of higher taxes rather than merely demonize them. If they can do that, the notion of increasing taxes would go from being anathema to something that appeals across the political spectrum. As the debate currently stands, that possibility appears remote.  In the meantime, Ocasio-Cortez has done a great job of making sure people talk about her.

 

 

 

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