Rep. Charlie Rangel is bent on including a carried interest capital gains tax hike in the must-pass patch to the alternative minimum tax.
This bad idea will carry tax implications for every American.
With such a strong push behind it, this is a plan that we need to take seriously, because the stakes are high. This tax hike would, in itself, cause a significant economic disruption by sending capital offshore and discouraging the creation of new venture-backed businesses.
Even worse, however, is the precedent that would be set for raising the capital gains tax for everyone, which many Democrats are now openly advocating.
Carried interest refers to the portion of the profits interests that the general partner who sets up an investment partnership retains. The general partner is the entrepreneur who has the ideas and connections to make investments. When a partnership is formed, the general partner will bring in limited partners by selling them a stake in the fund, typically 80 percent, in exchange for them putting up all or most of the money.
It’s really no different from the founder of a small business who has the ideas and know-how bringing in an outside investor. This structure — where general partners retain a carried interest in the fund’s profits — is common not just in private equity, but also in venture capital, real estate, oil and gas, and hedge funds.
Under current law, when the partnership has income, it flows to the partners and they pay tax on it based on the character of the underlying income — if it’s ordinary income they pay ordinary income tax, and if it’s capital income they pay capital gains tax.
Under Rangel’s bill, the character of the underlying income no longer matters. Even if the income is from the sale of corporate stock, the portion that general partners retain as a carried interest would be taxed at the full ordinary income tax rates.
This goes against every rationale for having a lower capital gains tax rate.
The primary rationales are to alleviate the double taxation of corporate source income, to avoid taxing inflationary gains, and to encourage capital formation, entrepreneurship, and investment. All of these rationales obtain in the carried interest case, because the income really is capital income. This is about hiking the capital gains tax for a particular group of politically unpopular taxpayers, with serious economic consequences.
Scaring Capital Away
Private equity has been a key source of prosperity in recent years, as our public capital markets have been increasingly hampered by excessive litigation and overregulation under Sarbanes-Oxley. Private equity and other alternative investment vehicles like venture capital and real estate partnerships have kept capital fleeing our public markets from going overseas and providing financing for innovative companies to grow and create jobs.
Higher taxes could choke off this engine of prosperity and encourage capital to flee abroad.
If all this is not bad enough, the trend is toward something much worse: There is a Democratic effort underway to raise capital gains taxes for all investors. In House Ways and Means Committee hearings on carried interest, Chairman Rangel asked panelist after panelist whether raising capital gains taxes across the board would solve the so-called problem of carried interest taxation.
The majority of the witnesses on the stacked panel said it would, but it’s hard to see how imposing punitive double-taxation of capital across the board can be considered a solution to anything except continued American prosperity. All of the major Democratic presidential candidates have come out for higher capital gains taxes, with both Barck Obama and John Edwards calling for a return to the pre-Clinton tax cut rate of 28 percent, a whopping 87 percent tax hike.
Capital gains tax hikes would dramatically reduce the after-tax return on stock investments, which would be a great impediment to stock markets. They would significantly raise the cost of capital, drying up investment in many innovative, entrepreneurial companies.
They would hit the U.S. Treasury hard, contrary to the conclusions of the static-revenue scorekeepers. History is an excellent guide here: Every capital-gains tax hike in the past 30 years has led to lower federal revenues, while every cap-gains tax cut has led to higher revenues.
Yet Democrats and tax-scorers are repeating this mistake yet again in the carried interests fight at hand.
What's at Stake
One reason the tax hike is attractive to Democrats is that it scores as a major revenue raiser, which helps them meet their self-imposed pay-as-you-go rules, which require them to offset tax reductions with tax hikes or spending cuts (they never choose the spending cuts). But an excellent study by University of Pennsylvania professor Michael Knoll found that the tax hike would raise negligible revenue because of legal avoidance strategies — and that’s without even considering the supply-side effects that we always see with changes in capital gains tax rates.
In other words, we could be looking at a major economic disruption without any federal revenue to show for it.
The stakes are high. Let’s stand on principle now and defeat a capital gains tax hike on general partners in investment partnerships before we’re looking at higher investment taxes for all of us.
Phil Kerpen is policy director for Americans for Prosperity.
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