The Smart Way to Soak the Rich
Not content to merely spend the record influx of cash coming into the federal treasury, some members of Congress are pushing to hike the capital-gains tax on so-called "carried interest" -- the share of partnership profits, typically 20%, that hedge-fund and private-equity investment managers have not sold to their outside investors. This would be nothing more than a punitive tax on those the congressmen perceive to be making too much money.
This is the same kind of thinking that led Congress in 1969 to enact the Alternative Minimum Tax. An effort to "soak the rich," the AMT was supposed to fall on the 155 households that, because their income was mostly dividends from municipal bonds, paid no federal income taxes. But, because lawmakers conveniently forgot to index the AMT for inflation, it now hits an increasingly large portion of upper middle income folks, especially those in "Blue States" such as New York, New Jersey and California, who write off large state and local income taxes on their federal tax returns.
These two tax issues have become linked recently, with plans afoot to use higher taxes on carried interest to pay for the supposed cost of preventing the AMT from ensnaring more middle-income taxpayers. Because the problems have become intertwined, a workable solution should address both.
The private equity boom has been driven primarily by global market fundamentals, but clear policy errors were also at play. Some examples are Sarbanes-Oxley and excessive litigation, which are pushing companies out of public capital markets and into the arms of private equity firms. Less-mentioned, but perhaps equally important, is the increasing disparity between the individual capital-gains rate and corporate capital-gains rate, the latter of which has remained at a recklessly high 35% while the former was cut to 20% from 28% in 1997, and then to 15% in 2003.
Under current law, individual partners in an investment partnership such as a hedge fund or private equity fund are taxed based on what the underlying partnership income is; if the income comes from a capital gain, it is taxed at the capital gains rate. Ordinary income is taxed at ordinary income tax rates. This tax treatment is consistent with the rationale for a lower capital gains tax rate -- to alleviate the double taxation of corporate-source income and to encourage risk taking, entrepreneurship and capital formation.
The legislation Congress is considering ends those protections, saying in effect that it doesn't matter if the income is a clear-cut capital gain, such as proceeds from the sale of corporate stock. What matters is who receives the income, in this case politically unpopular rich guys.
All investors should be on notice that if the capital gains tax is considered a loophole for investment partnerships, it can't be long before the capital gains tax is raised for everyone else. Some leading Democrats, including Oregon Sen. Ron Wyden and presidential candidate John Edwards, are already calling to do just that.
The driver behind the carried-interest capital-gains tax hike is the need to "pay for" AMT relief, with the Joint Tax Committee likely to score the tax hike as a significant revenue raiser. The JTC has apparently failed to learn from the experience of the past few decades, over which higher tax rates on capital gains have consistently produced lower revenue, while lower tax rates have produced higher revenue.
A better approach, therefore, is to use tax cuts to pay for tax cuts, while at the same time rectifying the advantage private equity has over corporations. How? Cut the corporate capital gains tax.
Corporations currently pay the full 35% rate on capital gains. This has the same principal defect as the proposal to hike the tax on carried interest: It taxes capital gains based on who receives them rather than what they are. To the extent that private equity is enjoying a tax advantage, it is not because its tax treatment is too light, but rather because similarly situated corporations face a more punitive tax on capital income.
Corporate capital gains are not just double taxed but triple taxed -- sitting between the corporate tax of the company whose stock was sold and the shareholders who are themselves taxed. Hong Kong, Singapore and New Zealand don't tax corporate capital gains at all. France and Germany, traditional bastions of big government, exclude 95% of corporate capital gains from taxation. Canada has a 50% exclusion. Japan and Britain have exemptions for capital gains that are reinvested.
Consistent experience with the individual capital gains tax gives reason to expect that cutting the corporate capital gains tax would be a substantial revenue raiser because it would encourage the realization of capital gains "locked up" by current tax rates.
The choice could not be clearer. One is higher taxes on capital, first on partnerships and then likely on everyone else, with profoundly negative implications for the stock market, U.S. economy and federal tax revenues. The other is encouraging growth and prosperity for American workers and investors. Members of Congress should choose wisely, keeping in mind that two-thirds of voters in the last election were investors.
Mr. Kerpen is director of policy for Americans for Prosperity.
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