I was on NPR’s On Point today – my segment begins around 23:30.

Peter Brooke: Private Equity Now | WBUR and NPR – On Point with Tom Ashbrook.

I was pleased to hear Mr. Brooke agree with me that paying tax on carried interest at 15% wasn’t appropriate.  In fact, we seemed to agree about an awful lot.

Theodore W. Schultz, Investment in Human Capital (American Economic Review, 1961)

I’m using this article as an introductory reading for my tax policy seminar.   My seminar will focus on the taxation of human capital.

Why focus the seminar on the concept of human capital investment?  Understanding the impact of human capital investment is perhaps the most important question of all in law and economics, as it has the power to explain why some societies thrive and others fail.  It’s well understood (now) that having a lot of natural resources or financial capital isn’t enough to guarantee success in the long run.  Conversely, many countries succeed without great resources or financial capital to begin with.  Schultz argues, persuasively, that investment in human capital has more explanatory power.

It’s tempting, perhaps, to point to cultural explanations to explain variations in GDP or other measures of economic output.  But I don’t think culture gets you very far analytically.  It’s too broad and undefined.  Schultz’s framework of investment in human capital provides a way to study these questions in more detail and with more precision.  Becker’s book, Human Capital, contains a great deal of theoretical and empirical research advancing the ball on these questions, but for introductory purposes it’s useful to focus on Schultz’s pioneering work.

Schultz’s thesis is that investment in human capital accounts for most of the rise in the real earnings per worker observed in the US (and many other countries) in the middle of the 20th century.  Schultz points to a variety of facts to support his claim, including differences in earning power based on education, on-the-job training, and selective migration.  As the US economy strengthened after WWII, income in the US rose faster than the standard economic inputs of land, man-hours and physical capital.  Perhaps part of the increase could be explained by better physical inputs — technological advances in materials, say — but the more likely explanation is an improvement in the quality of the labor input.  Schultz’s point is that this isn’t a “windfall,” but the product of investment in human capital.

Schultz breaks investments in human capital into 5 categories:

• health care
• on-the-job training
• formal education
• (agricultural) extension programs
• migration

One of the challenges is that each of these expenditures is a blend of investment and consumption.  If you go to the doctor to get a flu shot, it’s an investment in human capital (protecting your earning power) but also consumption (it’ll keep you from feeling lousy).  Similarly, going to graduate school to study French philosophy could be characterized as an investment (if it’s likely to lead to a job) or consumption (if it’s a substitute for going to see artsy movies).  As we will see, this distinction between investment and consumption is critical for tax purposes, as well as for many economic measures.

Schultz ends his essay with a series of points about how social and economic policy should be revised to account for the importance of investment in human capital, and his very first charge is against the tax law.  Schultz claims that “our tax laws everywhere discriminate against human capital” because, while investment in human capital depreciates (as an economic matter) like any other investment in a capital asset, the tax laws do not recognize this fact.

Now, Schultz is partly right and partly wrong.  Many educational investments, like some scholarships, expenditures from 529 plans, and forgone earnings while in graduate school, are excluded from the tax base.  This is important:  If you can pay for your education using pre-tax dollars, that’s roughly equivalent to paying with after-tax dollars, capitalizing the expense, and depreciating the educational “asset” over the expected useful life.  On the other hand, Schultz is right that if you use after-tax dollars to invest in your education, health care, and so on, you do not receive a basis in that investment which would allow you to depreciate that investment to offset a portion of your future income.

In the coming weeks, my seminar class will be exploring the critical foundational questions of how to define the tax base and how to tax labor efforts and investments in human capital, as well as some specific applications.  Schultz’s framework begs more questions than it answers.

But what’s so remarkable about the framework is just how accepted it has become.  There’s no longer much resistance to the metaphor of human capital– the idea that each of us makes investments in ourselves, as if we’re putting a new solar roof on a house.

Darian Ibrahim has posted a new paper describing the market and function for venture debt.  One key insight is that venture lenders rely on the reputation of the VC investors in making the loan — they are relying on the VC coming back to fund the next stage as the source of repayment of the loan.  It seems odd that, in an environment where information is costly and highly uncertain, the parties would introduce another party to the transaction.  But the cost of equity capital is so high, it must be cheaper to get venture debt than to sell additional equity to VCs.

It’s also a system that might work better when returns are good (and so VC funding the next stage is fairly routine).  Now that VCs are pulling back a bit, the “implicit contract” to fund the next stage is presumably less reliable, and VC lenders may have to look to more traditional exits (cash flow from the borrower!) before making the loans.  I would predict the venture debt market to dry up pretty quickly in the current environment.

Very interesting, and another great contribution to the VC literature from Darian.

Venture debt, or loans to rapid-growth start-ups, is a puzzle. How are start-ups with no track records, positive cash flows, tangible collateral, or personal guarantees from entrepreneurs able to attract billions of dollars in loans each year? And why do start-ups take on debt rather than rely exclusively on equity investments from angel investors and venture capitalists (VCs), as well-known capital structure theories from corporate finance would seem to predict in this context? Using hand-collected interview data and theoretical contributions from finance, economics, and law, this Article solves the puzzle of venture debt by revealing that a start-up’s VC backing and intellectual property substitute for traditional loan repayment criteria and make venture debt attractive to a specialized set of lenders. On the firm side, venture debt helps entrepreneurs, angels, and VCs avoid dilution, improves VC internal rate of return, assists VCs in monitoring entrepreneurs, and follows from capital structure theories after the first round of VC funding.

via SSRN-Debt as Venture Capital by Darian Ibrahim.

Interesting abstract – I’ll have to read the paper to figure out why the hostage strategy can’t be replicated by contract outside the nonprofit form.

In a well-functioning stock market, issuing firms publicly disclose all relevant information to investors and prices approximate the true value of those firms. This disclosure generates liquidity as investors large and small engage in trading. While it is tempting to take this “good equilibrium” for granted, the current banking crisis suggests a “bad equilibrium” in which disclosure is suspect so banks stop lending to each other and small investors flee the market.

In this paper, we argue that a good equilibrium was in place when the New York Stock Exchange (NYSE) operated as a non-profit organization. We argue that far from being an outdated and elitist holdover, the mutual form allowed underwriters, who dominated NYSE membership, to extract hostages from managers of firms listed on the NYSE. That is, managers were expected to invest personal funds in shares of other listed firms, including new issuers (“IPOs”).

Since the hostage arrangement was tied to the non-profit form of the NYSE, we predict a decline in information quality after the NYSE became a for-profit firm in March 2006. By comparing the bid-ask spread before and after demutualization, we show that information quality did indeed decline. This finding holds after controlling for market-level variation measured by the bid-ask spread of the NASDAQ National Market. We believe our results can help shed light on the current banking crisis, which originated in areas of the financial system that lack a hostage structure.

via SSRN-Using Hostages to Improve the Quality of Financial Disclosure by Jennifer Kuan, Stephen Diamond.

After many years with Typepad, I’m finding wordpress a breeze.  But it still takes a long time to update links … it could be weeks before I update all of these links …

Hey – I’m currently re-working the site.  Check back soon.