So Congress may actually take on the big tax break, if you want to call it that, enjoyed by investment partnerships like private equity, venture capital and hedge funds. According to today’s NYT:
At the heart of the newest proposal is an attempt to bar private equity and hedge fund operators from a longstanding, but little understood, practice that has allowed them to pay a lower capital gains rate of 15 percent instead of the ordinary top income tax rate of 35 percent on their performance fees, which typically represent most of their annual income.
The industry argues that the portion of profits they receive from investments should receive preferential treatment because of the risk involved. But critics contend that the fees are effectively bonuses because private equity firms have little, if any, of their own money at stake.
This is actually something that’s been talked about for a couple of months. The point of the Times article is that it’s now suddenly being taken seriously by some people on the House Ways and Means and Senate Finance committees. Last week, Senate Finance top dogs Max Baucus and Charles Grassley introduced a bill that would raise taxes for publicly traded investment partnerships (which private equity giant Blackstone Group is about to become) by treating them as regular corporations. This seems hard to argue against: If you’re publicly traded, you’re a corporation, right? Except the Baucus-Grassley bill doesn’t require that all publicy traded partnerships be taxed as corporations, just those “directly or indirectly deriving income from providing investment adviser and related asset management services.”
The logic is perhaps even clearer on taxing fund managers’ paychecks as regular income instead of capital gains. But lots of people have been arguing against it–partly out of pure self-interest, partly out of a concern that it will discourage behavior that appears to have been pretty good for the U.S. economy. Venture capitalist Fred Wilson took this on back in April:
[T]o my mind the biggest issue with changing the way VC carried interest is taxed is the unintended consequences. If angel investors who put up their own dollars at risk continue to get capital gains treatment (as they should) and venture capitalists who are investing institutional money lose capital gains treatment, the best venture investors will simply choose to invest their own capital instead of others.
This would mean, I guess, that pensions, college endowments and the like would no longer be able to invest in the best venture capital (and private equity and hedge) funds–and that those funds would make fewer investments. Which would presumably be bad.
The lesson I’m taking from all this is that as soon as you start taxing different kinds of income differently, you inevitably get into really messy situations like this. There’s a reasonably persuasive economic argument for favoring risk-taking behavior in the tax code, which we (and lots of other countries) try do by taxing capital gains at a lower rate than regular income. But as soon as you create such a differential, you create a strong incentive for people to try to disguise regular income as capital gains. And it can be really hard to draw a line between the two. The Tax Reform Act of 1986 strove to remedy this by taxing both kinds of income at more or less the same (low) rate. But that didn’t stick. So what do we do now? As is so often the case, I’m not at all sure. You got any good ideas?