Guest Author
It’s the second answer to the famous line “only two things in life are certain.” No subject is possibly more confusing, more infuriating, and at the same time more consequential to the American public than that of taxes. The Bible contains about 700,000 words. The federal tax code? More than 3.7 million. Albert Einstein once declared, “The hardest thing in the world to understand is the income tax.” Against this backdrop, the discussion of taxes occurs.
The presidential race is now beginning to take shape, and candidates for both the Republican and Democratic nominations will inevitably outline their positions on the future of tax policy. You will hear musings on marginal tax rates, corporate taxes, and offshore taxes. You’ll hear promises of reducing rates, increasing revenue, and expanding the tax base.
Buried in much of this will be the discussion of a little known, but very important facet of tax policy – called “carried interest.”
Carried interest is the capital gain resulting from when an equity manager, typically managing pools of resources invested by universities, charitable trusts, and pension funds, among many others, realizes gains on their investment pool. In the most common arrangements, the equity manager receives 20 percent of the gains on the pool, which is then taxed at the normal rate for capital gains (currently 23.8 percent). The remaining 80 percent belongs to the investors, who are also subject to capital gains taxes on their results. Simply put, carried interest is nothing more than capital gains on investments.
Some want to tax “carried interest” as ordinary income – income that is subject to the tax rates borne by typical wage earners. This is both bad policy and misleading in its aim. The tax rate for capital gains is currently lower than that for most ordinary income, as it is a direct tax on savings and investment. In other words, that saving and investment have often been taxed as ordinary income already.
It’s important to note those who would ultimately be affected by this tax hike. If you are one of the tens of millions of individuals with 401K funds, or with a pension, or who give to a charitable foundation, you would bear the cost of this tax hike. If you are attending college, or a parent of a college student, and you receive any form of financial assistance (scholarship, grant, loan), you would bear the cost of this tax hike. If you invest in a mutual fund or a Roth IRA because you want to have a more secure retirement, you would bear the cost of this tax hike.
Last year, the federal government collected about $3.5 trillion in tax revenue. Raising taxes on carried interest would amount to $1.5 billion in additional revenue for the federal government – just 0.04 percent of the total – and would have a far greater negative effect on savings, investment, and long-term economic growth. Florida would also be affected more negatively than most. Consider the following:
•About 170 private equity firms are headquartered in Florida.
•About 1,400 private equity-backed companies are headquartered in Florida, employing more than 825,000 people.
•Over the past 10 years private equity firms have invested $225 billion in Florida companies.
•More than 1 million current and former state employees enrolled in the Florida Retirement System benefit from the $7 billion of FRS assets in private equity funds.
Is reform of an almost 4 million-page tax code needed? Absolutely. You will hear no argument from anyone with common sense on the need to reform a tax system that only serves to benefit the politically connected. However, the key to economic prosperity is not in raising rates on investment gains, thinking that more revenue for the federal government is the panacea. The real solution is to unlock the power of savings and investment by reducing overall rates and bringing them in line at the lower end.
Government doesn’t need more money; it needs more restraint. Let’s make sure that both Republicans and Democrats understand, as a matter of policy, we should be seeking to encourage savings and investment for the long-term growth of the economy. The best way to do that is to maintain low rates for capital gains.
Sal Nuzzo is vice president of policy of The James Madison Institute.
