Taxation in the national interest

Douglas Holtz-Eakin Former Director, CBO
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The simultaneous, impending sunsets of the 2001, 2003, and “stimulus” tax provisions at the end of this year portend a prolonged tax policy debate. Sadly, we can learn a lot about the quality of that debate by looking at the rhetoric and reality surrounding the taxation of carried interest.

Carried interest is an integral feature of the financial arrangements of partnerships, a management structure broadly utilized in the United States and especially prominent in finance, insurance, and commercial real estate. This structure provides the general partners with profits more than proportional to their capital contribution only if those general partners meet investment goals. The business model permits entrepreneurs to match their expertise with a financial partner, assume risks, and align the parties’ economic interests.

Carried interest is currently taxed upon the sale of the partnership’s real assets as a long-term capital gain at a maximum rate of 15 percent. The House-passed bill, effective Jan. 1, 2011, would for the first two years tax 50 percent of such income as ordinary income at the (soon-t0-be) 39.6 percent rate and the remainder at the 20 percent capital gains rate. Beginning Jan. 1, 2013, and thereafter, 75 percent is taxed as ordinary income and 25 percent as capital gains for an effective rate of 34.7 percent.

What is wrong with this proposal is that it is utterly unprincipled, significant in its scale and scope, and threatens harmful economic consequences.

Principles of Tax Policy

Advocates defend the proposal on the grounds of fairness, namely that it is “unfair” to accord a particular form of compensation preferential tax treatment. However, it seems a greater unfairness to tax similar investors differently depending upon whether they invest as an individual, C corporation, or via the limited partnership structure.

Even worse, changing tax treatment in midstream imposes retroactive tax increases on investments originally undertaken assuming that carried interests would be characterized as capital gains. Fair?

The other key metric of tax policy is efficiency. Differential taxation of capital income across sectors and business forms introduces tax-based decision-making and sub-par allocation of national wealth. The desire to reduce those inefficiencies has been at the heart of proposals to shift toward a pro-growth policy that taxes consumption and eliminates taxes on the return to saving, investment, and entrepreneurial innovation. Under a consumption tax, one could tax the full principal and earnings on an investment, but only if one permits full deduction of the original investment (the traditional IRA is the clearest example of this approach). The tax proposal for carried interest doesn’t comport with principled consumption taxation.

Worse, it doesn’t match the principles of income taxation, for which the tax base is the potential to consume during the tax year – i.e., the actual consumption plus any net saving. Under an income tax, the partner should be taxed on the basis of the expected increase in consumption in the year in which the project is begun, not at the end of the investment.

Close examination reveals that this is simply a money grab unrelated to sound principles of tax policy.

Size matters

Partnerships are a pervasive feature of the economic landscape. Data for 2007 drawn from the Internal Revenue Service indicate that there were roughly 3.1 million partnerships comprising over 18 million partners. These enterprises managed over $21.4 trillion dollars (in 2010 dollars) in assets and generated net income of roughly $718 billion. Partnerships are most prominent in real estate (47 percent), finance and insurance (10 percent) and retail trade (5 percent). Viewed from the perspective of total assets, the finance sector (57 percent) dominates real estate (20 percent). A lot of economic activity is at stake.

Moreover, the tax implications are substantial. A rough estimate is that up to $148 billion of income could be subject to re-characterization with a static impact of the higher taxes reaching $29 billion. For the partners affected, the rough estimate is that increased tax liability would range between 14 and 32 percent of their partnership income.

Economic harms

The first impact will be wasteful legal engineering to restructure partnerships in response to the new, higher level of taxation. Significant additional time and capital will be spent by finance, insurance, and real estate partners so that the overall impact of the new tax on carried interests can be minimized or avoided altogether. This outlay and use of time will not improve economic performance overall, and will not contribute to the objectives of investment managers’, their institutional investors (such as pension funds) and their individual clients.

Legal adjustments alone will not avoid the entire tax. If so, the real economic activity will be affected as it will not be possible to pay the additional tax and offer a competitive return to the equity partners in the investment. The projects that don’t make the cut will be dropped – projects that likely will be in the more marginal locations or burdened with greater risk. In modern, competitive global financial markets, even small changes in margins move trillions of dollars of financial capital; the taxed partnerships would be at a clear financial disadvantage and would lose capital to other investment opportunities.

The loss is a clear cost to the economy as a whole. By driving capital from more productive to less productive activities, the tax reduces overall productivity of capital, and shrinks the economy.

Potentially even more important than the capital misallocation is that the tax will also drive away the key element of economic success – entrepreneurial talent. Taxed (partnerships) and untaxed business forms are competing for the same entrepreneurial management talent and producing the same ultimate product (investment services). Common sense suggests that the imposition of the additional tax on carried interests will diminish not only the ability to attract capital, but also the same quality of managerial talent to make the capital productive in partnerships.

These channels of influence suggest that the economic costs of crowding out partnerships projects plus the lower performance that comes from diminished entrepreneurial zeal will impair the economy as a whole. These economic costs are losses representing foregone income in the economy – a cost to everyone.

I cling to the sentimental notion that a tax code should reflect real principles of desirable economic policy. The carried interest debate shows little more than a larcenous desire to pick a politically weak pocket. Let us pray that Congress raises its game or the nation is in deep trouble.

For more information, see a newly released study by the American Action Forum here.

Douglas Holtz-Eakin is president of the American Action Forum.