Democrats, fresh from securing a series of tax increases during the fiscal-cliff negotiations, now seek additional tax increases as part of negotiations to avert the sequester, which would impose deep cuts in federal spending, largely on defense.
Many Democrats are especially keen to reopen the fight over what is known as “carried interest,” a tax treatment under which certain kinds of income are treated as long-term capital gains, meaning that they are taxed at a lower rate. The United States, like many developed countries, taxes investment profits at a lower rate than salaries, bonuses, and the like, with risk being the general principle of delineation. In addition to reducing the burden of double-taxation on business profits and rewarding those who choose savings over immediate consumption, the United States wants to encourage economic risk-taking and the entrepreneurial activity associated with it, meaning that $100,000 made by taking the risk of investing long-term in a small business is taxed at a lower rate than $100,000 paid as a straight-up salary. This is probably a good thing, and the policy of taxing risk-incurring capital gains at a lower rate than guaranteed salaries has historically enjoyed widespread, bipartisan support. But the policy also creates incentives for investors and financial firms to structure their businesses so that their income takes the form of capital gains rather than regular income, and therein lies the controversy.
A few things should be noted immediately. The first is that investors already have seen their tax rates raised by one-third as a result of the fiscal-cliff negotiations — the long-term capital-gains tax rate has been raised from 15 percent to 20 percent. That is not insignificant, inasmuch as U.S.-based investors are now in some cases at a tax disadvantage relative to overseas investors in such investment destinations as Switzerland, Japan, and New Zealand. On the more significant measure of the combined take from capital-gains and corporate-income taxes, U.S. firms are at a serious tax disadvantage when compared with those based in the United Kingdom, Australia, Canada, or Ireland — and that was the case even before the tax hike. A company operating out of Switzerland pays a combined rate of about 21 percent, but one operating out of the United States pays a combined rate of more than 50 percent, more than it would pay in Sweden. And while U.S. entrepreneurs selling a business for a one-time windfall are for tax purposes treated as though they made that much money year in and year out, similar investors in the United Kingdom are eligible for “entrepreneurs’ relief,” with earnings up to about $16 million eligible to be taxed at just 10 percent. It is a myth that the United States has an especially advantageous tax climate for investors; what it has is an excellent corporate-tax environment for politically connected and influential firms that arrange exemptions for themselves to avoid the OECD-leading U.S. business-tax rate. That isn’t capitalism, but cronyism.
The second thing to keep in mind about “carried interest” is that as a fiscal matter — meaning its effect on the deficit — it is a non-issue. Democratic proposals to deprive private-equity and other investment firms of the carried-interest tax benefits available to other kinds of businesses would generate less than $2 billion a year in additional tax revenue, according to government estimates — 0.2 percent of the trillion-dollar deficits we’ve been running under Barack Obama, or about twelve bucks shy of bupkis. Never mind whether it is appropriate (or even legal) to single out a particular industry for an act of political retribution enacted through the tax code. (Democrats seek to do the same to oil and gas firms.) As a matter of balancing the books, the carried-interest controversy amounts to nothing.