The presidential campaign season is in full swing, and with it, ideas for revamping the federal tax code. Hiking taxes on “carried interest” is one such proposal, casually discussed by a few candidates, but little understood.
Increasing taxes on carried interest is simply taxing capital gains as labor income, acting to reduce work and profits that generate economic activity.
Carried interest is the share of capital gains allocated to a professional investment manager on top of his regular wage for managing a fund. His fees, as with ordinary wages, are subject to all the taxes that any American worker pays. But, if the fund he manages is successful, and he returns a profit for his clients, he may be allocated about 20 percent of that profit. Current tax law treats this as a capital gain with a 20 percent tax rate and a 3.8 percent Obamacare surcharge.
But, Wall Street isn’t popular with Main Street these days, and those “hedge fund guys” are an easy target. They’re not paying taxes, the charge goes, and, if taxes on them are hiked, taxes on everyone else can be cut.
Not so fast.
The Obama administration has proposed taxing carried interest that could raise almost $1.6 billion annually — or less than 0.4 percent of total projected tax revenues. As a revenue generator, taxing carried interest would be a complete bust.
Even so, it feels good to raise taxes on those greedy hedge fund guys. So, if their carried interest earnings were taxed at a higher rate on ordinary income, so what? They can afford it, right?
As with most government proposals, there will be unexpected consequences.
Many investment funds managed by professionals are alternatives to the usual stocks and bonds. These investment vehicles are a way to diversify and reduce risk and are heavily used by charitable trusts, pension funds, colleges and universities, and private investors.
If the investment professional sees his marginal tax rate on capital gains from carried interest almost double, from 23.8 percent to 43.4 percent, he’ll change his behavior and charge more for his services. Pension funds and colleges will get less; the IRS will get more — less than 0.4 percent of tax revenue more, but still more.
Regardless, it certainly feels good to nail those hedge fund guys, right? Even if increasing taxes on the portion of capital gains they generate does nothing to their bottom line.
Of course, whatever government taxes, there will be less of it. Increase taxes on income and there’ll be less work. Doubt that? Imagine how much work would occur if the government took 100 percent of your labor earnings.
Increasing taxes on investment success would mean less investment and consequently, fewer jobs, less innovation, and less prosperity. According to the Tax Foundation, the U.S. already levies the 6th-highest capital gains taxes among the 34 developed nations of the Organization for Economic Co-operation and Development (OECD). Of these nations, nine entirely exempt capital gains from taxation.
Successful investing should be celebrated, not condemned by a person seeking votes for public office. Generating capital gains means that money was used efficiently, benefiting not just the professional investment manager, but savers and the world. Losing money, on the other hand, is nothing to celebrate.
DeVore is a vice president with the Texas Public Policy Foundation. He served in the California State Assembly where he was vice chairman of the Committee on Revenue and Taxation.