How busting Madoff cost the U.S. government billions

Over at the American Interest editorial blog, economist Peter Heller looks at where the money from Bernard Madoff’s $50-billion ponzi scheme might have gone:

First, one must assume that some of the capital simply went to support Mr. Madoff and his life style of an apartment in Manhattan, fancy houses in Montauk and Palm Beach, and if I recollect from the news, a house or apartment in Europe. I also seem to recall yachts with the name of “Bull,” as well as country club memberships in Palm Beach and the Hamptons. All of this does not come cheap, and one may assume that Mr. Madoff pocketed and spent, after tax, at least $25 million a year—or $35 million pretax– (my ignorance of this standard of living may mean that I have underestimated what such a life style costs by a factor of two or three even). But there is also significant overhead to the production of Ponzi income of this magnitude. Add three floors of rent in the so-called Lipstick building of Manhattan, as well as the overhead costs of the employees and other running costs of his legitimate securities transactions business (presumably including at least two well-paid sons and other relatives), and we can potentially account for another $40 million in expenses (again, my numbers are completely arbitrary). So this would imply that Madoff would have had to have annual inflows of capital to his operation of at least $75 million to cover these costs.

It’s interesting because, like Heller, I’ve always wondered how billionaires spend their loot. You can only buy so many helicopters and build so many indoor pools, no? But what’s most interesting is Heller’s suggestion the federal government is perhaps the biggest loser:

…for each $1000 reportedly earned by Madoff for his clientele, at least $150 was presumably paid to the Federal government in taxes (assuming all of it was declared as dividends and subject to the 15 percent tax rate on dividends). However, in many cases, even more was probably paid, since some earnings would have been declared as interest and taxed at the recipient’s marginal tax rate. Most likely, the Federal government received, on average, about 20 percent of Madoff’s fictitious reported earnings for his clients. So most likely, if roughly $47-50 billion was “earned” over the time frame of the Madoff scheme, and this was all declared as taxable income, the Federal Government was probably the beneficiary of about $10 billion. So one could say that this was Madoff’s implicit contribution to preventing the Federal deficit from being even higher over the period. Of course, now that the losses are revealed, it is likely that many of the losers will now be able to write off some of their losses, recouping some of their previous payments in lower tax liabilities in 2008 and 2009, and thus adding to the already high fiscal deficit!

The point is compelling because it highlights the perverse incentives boom periods can create. There’s nothing to suggest the authorities consciously allowed Madoff to rip people off just because they needed the tax revenue, but Heller’s figures show how it might have been in everyone’s best short-term interests to look the other way—that is, so long as the money kept coming.

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