Congress’s Carried Interest Tax Folly
Posted By thestatedtruth.com on June 3, 2010
JOHN RUTLEDGE,   The Wall Street Journal…..Nero fiddled while Rome
burned, but at least he didn’t strike the match. Members of Congress are
doing Nero one better. In the middle of the second global financial crisis
in two years, Congress is preparing to dramatically raise a key tax rate
on long-term investment. This is sure to discourage capital investment,
increase the cost of money to start and grow businesses, and depress
real-estate and stock prices, all at the worst possible time.
Last week, Senate Finance Committee Chairman Max Baucus (D., Mont.) and
House Ways and Means Chairman Sander Levin (D., Mich.) released joint
legislation that would among other measures significantly raise the tax on
“carried interest.” Now the tax rate on these long-term capital gains
earned by the general (managing) partners of investment partnerships is
15%. The new law would raise the rate to as high as 38.5% (three-fourths
of the gain would be taxed at ordinary income tax rates and one-fourth at
capital gains rates, both of which will be increasing as well).
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Tax rates matter. And what matters about them is what activities get
taxed, not who gets taxed. When you increase the tax rate on an activity,
you get less of it. The only question is how much less of it you will get.
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Congress should be asking one question: “Is long-term investment something
we really want less of, especially now?” Unfortunately, in today’s
political climate, tax policy discussions focus almost exclusively upon
who, not what, gets taxed. This means singling out specific groups of
people—bankers, Wall Street, “the rich,” the owners and executives of
insurance, oil and drug companies—to punish for our economic difficulties.
This may be politically popular but will have bad consequences for the
economy.
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Carried interest refers to the share of the capital gains (typically 20%)
earned on long-term investments in real estate, venture capital, private
equity and other investments organized as partnerships that is allocated
to the general (managing) partner. Limited partners (i.e., passive
investors) pay this share to align their interests with those of the
general partner and to provide incentives for him to increase capital
gains.
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Both general partners and limited partners pay taxes based on the
character of the income earned by the partnership: ordinary income rates
on dividends and short-term capital gains, and the long-term capital gains
rate on the long-term capital gains. Some partnerships, such as hedge
funds, earn mostly short-term gains, and pay ordinary income tax rates.
Other partnerships, such as real estate, venture capital and private
equity, make long-term investments. Their profits are mostly made up of
long-term capital gains and are taxed at lower long-term capital gains tax
rates as a way to encourage long-term investment.
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The economic impact of the proposed tax rate hike is unequivocally
negative for long-term investment. It will lead to changes in the terms of
investment partnerships that will reduce after-tax returns for all
investors, including the limited partners.
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Before partnerships are formed, the fees, carried interest, governance and
other provisions are heavily negotiated. The proposed tax increase reduces
the after-tax value of carried interest compensation. A material change in
the after-tax economics of something as critical as general partner
compensation will result in an entirely different set of terms in which
both general partners and limited partners share the pain.
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The resulting drop in after-tax returns for all investors will reduce
capital committed to long-term investments in partnerships of all sorts.
This means less capital formation, less construction activity, less
manufacturing activity for capital goods makers and their suppliers, fewer
start-ups, fewer jobs, lower productivity growth, and lower wages. The
direction of these changes is not in question. The only question is how
much less of these things we are going to get….
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 Taken From The Gilder Letter
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