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Targeted Taxation: Dems Hone In on Carried Interest



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In 2004, Mikhail Khodorkovsky was the wealthiest man in Russia and the 16th wealthiest man in the world. In 1993, he was the deputy minister of fuel and energy. Khodorkovsky acquired Yukos oil in 1995 at state auction for $350 million, well below market value. After seizing control of Yukos, Khodorkovsky remained active in politics, funding several opposition political parties, and taking particular interest in the Communist Party of the Russian Federation.

On October 25, 2003, the Russian government had Khodorkovsky arrested on trumped-up charges of fraud. The following week, the Russian government, headed by Vladimir Putin, froze 44 percent of Yukos’s ownership shares. Khodorkovsky was later sentenced to nine years in prison.
 
In December 2004, in an alleged effort to reclaim unpaid taxes, the Russian government sold Yuganskneftegaz (Yukos’s main production unit) at auction, netting $9.4 billion, half its market value. Yuganskneftegaz was purchased by the previously unknown Baikal Finans Group, which turned out to be a group of Kremlin insiders. Baikal then sold Yuganskneftgaz to the Russian state oil company.

In retrospect, Khodorkovsky made two fatal errors. First, he acquired an enormous amount of wealth that became alluring to those with the power to take it from him. Second, he became politically active rather than use that wealth to assuage and co-opt the political elite.

There was a time when businesses in the United States did not have to fear the kind of blatant seizing of assets that Khodorkovsky endured. A footnote in the Democrats’ new tax rules for carried interest signals that, for now at least, that time is over.

The carried-interest bill is sold as a measure to increase taxes on what Democrats characterize as a tax dodge, the tendency for hedge funds and private equity firms to compensate managers with a share of the profits. As my colleague Alan Viard and I exposed in a recent paper, the existing tax treatment of compensation is fully consistent with U.S. partnership law, and consistent with the tax treatment of just about every other business in the U.S.

But the Democrats do not stop at that. In addition, they have decreed that founding partners — the entrepreneurs who started the businesses and built them into thriving enterprises — must also pay a higher tax rate if they ever sell their equity in the business.

Suppose you built a private equity firm up from nothing, and are currently sitting on an equity stake that is worth $1 billion. If you sell the equity, then under current law you would pay a 15 percent capital gains tax. Under the new law, that tax rate rises to 39.7 percent. Thus, for every $1 billion of founders equity sold, the tax bill rises from $150 million to $397 million.

While one is tempted not to weep for the millionaires and billionaires facing such tax hikes, the fact that our government can target a relatively narrow and politically unpopular group with such an aggressive taking should give anyone who believes in the rule of law pause. It is one thing to increase taxes across the board, another thing altogether to hone in on a particular pile of cash with such predator-missile precision.

This taking is, of course, fully consistent for the sanctimonious leftists, who believe it is government’s divine right to seize property from Peter and hand it over to Paul, all in the name of social justice. But the brazenness of this act is truly disturbing. Last month it was insurance companies who were demonized and targeted, this month its hedge funds and private equity firms. Next month, it may be you, provided you have enough property to be an attractive target.

And even if you do not, you should bewail the fact that you now live in a country that has informed all men and women of vision who believe that they can create a new and thriving enterprise that they had better not do so here, at least not if they want to keep it.

Kevin A. Hassett is a senior fellow and director of economic policy studies at the American Enterprise Institute.



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