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August 9, 2007
Taxing carried interest
This morning's Washington Post has an editorial on the issue of taxing "carried interest" income, especially of private equity and hedge fund partners (Taxes Owed - washingtonpost.com). Carried interest is the technical term for income that is deemed to be a capital gain (even though it is from a fee) rather than earned income. The editorial commends the House approach:
Sen. Charles Schumer (D-N.Y.) criticized the Senate bill for singling out private equity and hedge funds without raising taxes for other industries that use similar tax structures. On Wednesday, he came out in favor of the House bill, which he says is "broader" and "fairer," and he said he probably will introduce a bill modeled on the House legislation. Other Democrats should join him, supporting the principle of fairness rather than their bankrollers.
In general, I agree that this is more like earned income and should be taxed at normal rates. Even the Economist has taken that position. But I also think that Schumer is right -- we need to look at the entire tax structure in this issue, not just hedge funds and private equity.
Likewise, we need to take a careful look at how the tax structure affects the creation of intangible assets -- and taxes on the income from those assets. There is something to be said for the fact that input of skills and knowledge is as important a factor in the success of long term growth as the input of risk capital (an argument made in defense of carried interest). The purpose of a lower tax rate for capital gains is to promote risk capital. But it is a blunt instrument that does not do a good job of differentiating between short term speculation, long term patient capital or simply general market gain (such as the value of your house). The standard income/capital gain distinction also does not allow for a clear understanding of rewards for risk taking and the importance of intangible inputs in that process.
It is time to rethink the tax code on the entire capital gains concept. I realize that this is exactly what some are hoping to avoid. But the logic of the debate over the carried interest provisions – and the rise of the I-Cubed Economy – inextricably point to that as the proper conclusion.
That is not to say that it will happen, given the political realities. But it is important to keep raising the question. The President has raised the issue of corporate tax reform (see Bush May Try to Cut Corporate Tax Rates - washingtonpost.com and Bush Aims to Pacify Investors, Touts Economy - WSJ.com). This follows on Secretary Paulson's summit and the Treasury Department's white paper. I say: let the debate begin. But let's put everything on the table, especially an understanding of how the economy has changed and that the tax code needs to change with it.
Posted by Ken Jarboe at August 9, 2007 8:52 AM
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