links for 2007-08-01
John Berry on the Fed's Decisions This Week

Alan Blinder on Taxing Private Equity Managers

Very nicely done:

The Under-Taxed Kings of Private Equity: AN arcane debate is raging in Congress over the appropriate taxation of the bountiful incomes of people who manage private-equity and hedge funds.... [O]ne thing is easy to understand, though hard to swallow: Some people who are richer than Croesus are paying 15 cents in federal income taxes on the marginal dollar, while you may be paying 25 or 35 cents.

To be clear, I hold no brief against the kings of private equity. Their clients are consenting adults who sign up with full knowledge of the lush fees that private equity managers receive. Some of these managers may even earn their rich rewards. My question is simply this: Why shouldn’t they pay taxes like the rest of us?... [I]s the low 15 percent tax rate justified? For better or, as I will argue shortly, worse, capital gains are taxed far more lightly than wages. Since carry stems mostly from capital gains, defenders of the status quo argue that it deserves the low tax rate. Critics, however, object that carry looks and feels like payments for managing money, that is, like earnings.

Who’s right? It’s true that carry is mostly derived from gains on capital — but it’s mostly someone else’s capital. Which is presumably why former Treasury Secretary Robert E. Rubin said at a conference last month, “I think what they’re doing is getting paid a fee for running other people’s money.”

Sounds right to me. This judgment does not dispute the fact that fund managers’ compensation is risky. But so are the incomes of movie actors, the royalties of authors and the prize winnings of golfers — none of which is treated as capital gains....

Why do we have a preference for capital gains in the first place? The main argument is that lower taxes on capital gains boost investment. But the evidence on that point is iffy at best, and there are better ways to spur investment, like, say, the investment tax credit. Besides, lower taxes on capital gains reduce the tax bills of the rich relative to the rest of us — after all, they own most of the capital. But in this age of hyper-inequality, shouldn’t we be making the tax code more progressive, not less?

A far more important objection is that the tax preference for capital gains undermines capitalism — a system in which capitalists, not the state, are supposed to make the investment decisions. When I discuss this issue with my Economics 101 students, I show them an example of a proposed investment that loses money before tax (and which, therefore, should be rejected) but which actually turns a profit after tax because of the preferentially low capital gains rate. (Accountants and tax lawyers live this example every day.) The government thus induces people to make bad investments...

I'm much for sympathetic to the capital gains tax preference than Alan Blinder is, but the article is very good.