Politics & Policy

Caring about Carried Interest

Under Obama, tax increases are for punishing people who make money in ways Democrats disapprove of.

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.

#page#There are tax deductions whose elimination would generate more substantial amounts of new tax revenue. For instance, the tax-free treatment of municipal bonds (an arrangement beloved by many Democrats) is estimated to deprive the treasury of some $30 billion a year, while the deductibility of state and local taxes hoovers about $50 billion a year out of Washington’s coffers. The two combined cost the treasury more than 40 times what the carried-interest treatment for private equity does. Democrats are a great deal less excited about those. Why?

For Democrats in the age of Obama, tax increases aren’t really about feeding Leviathan. They are about punishing people who make their money and live their lives in ways that Democrats do not approve of. There is deeply embedded in their souls a puritanical streak that recoils at the thought of Mitt Romney’s car elevator. Some people in private equity make a great deal of money, and some lose a great deal of money. Your average guy parking his money in tax-free munis is well-off, too — thus making the tradeoff between returns and taxes desirable — but, unlike the private-equity firm, he is entirely passive. But he is putting money into government, while private equity puts money into building companies seeking profit, and so those investors must be punished.

At issue is the question of “sweat equity,” whether we should encourage people to trade their labor and expertise for an ownership stake in a company or enterprise. How people feel about sweat equity in any given circumstance seems to be driven almost entirely by emotion, by whether they are inclined to like or dislike the taxpayer in question. Everybody is familiar with the case of the “Microsoft secretary,” employees of startup firms who agreed to forgo higher salaries (or, in some cases, any salary) in exchange for a share in the company. In some cases, those bets were wildly successful, and people ranging from technology specialists to administrative assistants and receptionists were suddenly able to retire at 40 with millions of dollars in the bank. (The great majority of cases are of course much less dramatic.) Typically, the Microsoft secretary does not put any of his own capital at risk — contributing only his time, his work, his expertise, and his willingness to forgo a guaranteed paycheck today for the possibility of a larger payday down the road. How big a piece of the company he received was the subject of negotiation between him and his employer. Private equity firms do the same thing on a larger, more organized scale, but also put up some of their own money. They contribute work and expertise in exchange for a share of the profits (usually 20 percent) generated by a particular investment, either in an individual company or a group of companies. Those profits are not guaranteed — they do not come automatically; 20 percent of nothing is nothing.

There is very little in the way of persuasive argument for treating the startup worker’s sweat equity differently from the private-equity worker’s sweat equity. You might make a principled argument for treating all income the same (and I am sympathetic to that view), whether it is from salary or investments, or you might make a principled argument for treating sweat equity differently from money-out-of-pocket investments. But it is difficult to make a principled argument that some kinds of sweat equity should be rewarded and others should be punished, which is precisely what the Democrats are pressing for.

Punishing private-equity investors will do almost nothing to balance the books. It would upset a longstanding model of doing business and would put American investors — from Wall Street houses to teachers’ retirement funds — at a distinct disadvantage. That’s a cost-benefit matrix that makes sense only if your bottom line is resentment.

— Kevin D. Williamson is National Review’s roving correspondent.

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