by Linda Beale
crossposted with Ataxingmatter
More on Carried Interest
As most ataxingmatter readers know (Rdan…and Angry bear readers), there is currently under consideration in Congress legislation that would extend some of the Bush tax breaks and in return pay for those extensions by taxing service partners’ profits interests at ordinary income rates (or, under one version now being put forward to mollify the wealthy service partners who don’t want to pay tax on their wages like other people do, partially under ordinary rates and partially under capital gains rates).
Not surprisingly, there are strong lobbyist pushes against the legislation. Although you’d think this would be a no-brainer, it has been hard for Congress, especially the Senate, to pass the reform. The House has proposed and passed a carried interest bill several times, but the Senate has balked. Wealthy interests wield quite a bit of power, and they tend to wield it in their own favor.
Robert Reich notes in his Sunday piece “The Challenges of Closing Tax Loopholes for Billionaires” May 23, 2010.
Who could be opposed to closing a tax loophole that allows hedge-fund and private equity managers to treat their earnings as capital gains – and pay a rate of only 15 percent rather than the 35 percent applied to ordinary income?
Answer: Some of the nation’s most prominent and wealthiest private asset managers, such as Paul Allen and Henry Kravis, who, along with hordes of lobbyists, are determined to keep the loophole wide open.
The House has already tried three times to close it only to have the Senate cave in because of campaign donations from these and other financiers who benefit from it.
Now, if we are going to give more tax breaks to corporations in an extender bill, somebody has to pay. The logical choice is the group that is getting a tax break already that is not justifiable–either because it is just too unfair to leave in place or because it doesn’t even do the job that the tax expenditure was intended to do. Here’s what Reich has to say on this issue.
It’s not as if these investment fund managers are worth a $20 billion subsidy. Nonetheless they argue that if they have to pay at the normal rate they’ll be discouraged from investing in innovative companies and startups. But if such investments are worthwhile they shouldn’t need to be subsidized.
That’s right–the cost of this subsidy is $20 billion in tax revenues. And these investment fund managers argue that if they have to pay ordinary taxes on their compensation like ordinary people have to pay, then they just might not invest in innovative companies and startups nearly so much as they otherwise would. That surely is a weak argument, as Reich notes, since worthwhile investments will call out for someone to make money off them, even if they do have to pay taxes at a slightly higher rate on the profits they make. So there will be decent investments and managers shouldn’t be “discouraged” just because they have to pay more taxes. Will managers have slightly less money to invest? Maybe, maybe not. It depends on what they were doing with those excess millions anyway. They could probably invest the same and just waste less of it on charter flights, limos, and million dollar birthday parties (remember Ken Lay and Enron?). A lot of money invested in startups just goes down the drain. So taxes takes a bite, losing investments take a bite. It’s not that different and nobody is claiming that venture capitalists won’t invest if one of their investments comes up a loser. These arguments are, ikn other words, very weak when they suggest that investment in innovative companies will tank if the people who make millions (or billions) from servicing those partnerships have to pay taxes like the trucker and the teacher and the policeman and the fireman.
And if Congress doesn’t pay for its tax extenders with this provision, it is more likely to hit middle income taxpayers. Which is fairer–taxing carried interest like the compensation income it is, or hitting middle income taxpayers with higher taxes when they’ve already lost value in their primary asset (their home) and are having generally a tough time of it? Again, looks like a no-brainer. Just remember that these investment fund managers make hundreds of millions in one year–with the top twenty five, as Reich noted, taking home a billion dollars each in 2009!
Meanwhile, these ultra wealthy fund managers don’t seem to offer their lucractive compensation arrangements as a target for reducing the federal deficit but rather argue that pensions must be cut (the labor unions are always to blame, according to the right) and Social Security must be cut, and ordinary people should work longer for their benefits, etc. As Reich notes:
The senior chairman and co-founder of the Blackstone Group, one of the largest private equity funds, is Peter G. Peterson, who never tires of telling the nation it faces economic ruin if deficits aren’t brought under control. Curiously, I have not heard Peterson advocate closing this tax loophole as one way to further the cause of fiscal responsibility.
Then there are the academic apologists for the corporatist agenda and the wealth of the ultra wealthy. A good example is John Rutledge, a “senior research professor at the Claremont Graudate University and chief investment strategist at Safanad, an investment firm in Geneva,” who worte an op-ed in the Wall Street Journal todayh on the issue. See Rutledge, Congress’s Carried Interest Tax Folly, Wall St. J., May 24, 2010, at A17.
Rutledge repeats several times the corporatist and business right wing’s standard view–if you raise a key tax rate on long-term investment, you will “discourage capital investment, increase the cost of money to start and grow businesses, and depress real-estate and stock prices.” He says that the “economic impact of the proposed tax hike is unequivocally negative for long-term investment”. He claims that carried interest is clearly a tax on capital gains merely because the capital gains on investments in the partnership is passed through to the service partners, and the service partners have taken the position that those gains should retain their character. In fact, most of the op-ed piece involves several repetitions of these same old things, with a parade of horribles that will ensue, he says, from causing service partners to pay ordinary rate tax on their compensation income instead of getting the (undeserved) capital gains preferential rate that they’ve enjoyed through 20 years of the booming equity fund business;-“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.”
First, there is not indication that increasing rates on real capital investment actually discourages capital investment. What are you going to do with all that excess cash? Hide it under a mattress to avoid investing it for a return because the return will be taxed? I don’t think so. Yes, the manager who pays tax will have somewhat less money after taxes. That is true of anyone who pays tax. But will that reduce investment by huge amounts? Depends on what else that manager ordinarily does with after-tax income, and whether there are lots of sound investment opportunities to use it for. It might decrease the amount that is reinvested or it might not. It certainly won’t make investment funds quit functioning or make managers of those funds quit managing. Their after tax income is still in the top 1% of the country.
Second, of course, is the point that the carried interest is not itself a return on a capital investment. A carried interest is usually 20% of the partnership’s profits which is the agreed upon compensation for the general manager of the fund (hedge funds, private equity funds, etc.) on top of the management fee which is generally 2% of assets under management. Managers’ payments are set up this way in order to let the service partner claim a lower tax rate on the vast majority of the compensation paid to it for its services. But service partners who receive an allocation of partners in payment of their “carried interest” are not receiving a return on a capital investment. They generally have made no capital investment (and even if they have, that is separate from the carried interest allocation). They are receiving compensation for services but attempting to use the partnership pass-through to arbitrage that ordinary income into capital gains treatment at a much lower tax rate. In other words, the game with carried interest is to claim that a partner who provides services to a partnership can be paid a percentage of the profits (income or gains) from the partnership and be treated as getting a pass-through of partnership income and gains rather than being treated as getting compensation for services taxable at ordinary rates, even though that partner has made no contribution to capital on which to get an allocation of partnership income. The tax treatment of such profits interests has been unclear in the caselaw and authorities, so it is time to resolve it and do so in a way that prevents this ordinary-capital arbitrage use of partnerships. It’s a fairly easy question to see that fairness and economic efficiency favor taxing that compensation at ordinary rates just like other workers are taxed.
Rutledge argues that the carried interest provision would go against “two long-accepted tax practices” of the preferential capital gains rate and the pass-through treatment of partnerships. I’d counter that
1. the preferential capital gains rate has had ups and downs, ranging from complete elimination in the 1986 tax reform act, to rates much closer to ordinary income rates at various times. The capital gains preference is difficult to justify, has no clear scope, and creates arbitrage opportunities that make enforcement difficult. It would be just as good to say that the preference for capital gains has had a troubled history and this is one place where it behooves Congress to make clear that it doesn’t apply.
2. the pass-through treatment of partnerships works for those who have a capital interest in the partnership, but the treatment of profits interests has a long history of uncertainty, in part because it seems to convert what should be ordinary income into capital gains, counter to fundamental tax principles about maintaining characterization of income. It behooves Congress to clarify that such a profits interest is ordinary income taxable at ordinary income rates.
3. further, there is a fundamental concept of equity in the income tax system, and equity demands that those who provide services be treated similarly. If an hourly worker is taxed at ordinary rates on the compensation he receives, then a fund manager should be taxed at ordinary rates on the compensation he receives for providing services. Those fairness principles are more important than the uncertain and weak arguments Rutledge provides ostensibly from economic efficiency in favor of tax subsidies for long-term investments (even though, as I have said, there is no long-term investment to be subsidized in the profits interest in the first place; not to mention that a more efficient tax system would, of course, tax all income at the same rate, and avoid the possibility of mischaracterization, characterization disputes, or arbitrage between character types).
PS if you want to get into the mind of a hedge fund manager, you might enjoy this. Mark Ames, Top Billionaire Hedge Funder Sees Himself as a Hyena Devouring Wildebeests, The Exiled, May 22, 2010 (discussing Ray Dalio, the hedge fund manager that made $780 million in 2008) (hat tip to The Something Awful Forums).