Wall Street Journal, May 14, 2012
Should Carried Interest Be Taxed as Ordinary Income, Not as Capital Gains?
by Michael Graetz [Yes] and David Tuerck [No]
Law Professor Graetz is also the author of the
Compettive Tax Plan. He opined:
... Given the difference between the tax rates for ordinary income and
capital gains—23 percentage points for high-income taxpayers, when Social
Security and Medicare taxes are included—transforming compensation for
services into capital gains is hitting the tax jackpot. That bit of
alchemy is just what managers of private equity and some hedge firms enjoy.
But there is no justification for applying the 15% capital-gains rate to the
money they make for managing companies and selling them at a profit.
...
As a U.S. Tax Court judge said:
"Neither the contingent nature of [carried interest] nor its [current]
treatment as capital gains makes it any less compensation for services." The
judge equated private-equity managers with "stockbrokers, financial
planners, investment bankers, business promoters and dealers"—all of whom
pay ordinary compensation taxes on their income.
Economics Professor Tuerck opined:
...
The fuss over what Warren Buffett and Mitt Romney pay in taxes threatens to
give new life to the bad idea of changing the way carried interest is taxed.
... Private-equity firms invested
some $1.7 trillion in the U.S. economy over the past 10 years. ... In
exchange for putting in its time and effort and for bearing its share of the
risk, the private-equity firm typically demands 20% of the profit, which is
taxed as a capital gain. ... Private-equity managers, on the other hand,
don't collect carried interest unless and until they make a profit for their
investors. That is a risk that no salaried employee faces.
2-4-8 Response: "8% flat income tax rate is a good trade-off for the
elimination of tax expenditures"
Carried interest is only one of over 200 tax
expenditures that cause the income tax rates to be higher than necessary.
Here the attorney cites a case which holds it is like ordinary income (and
therefore it should be tax as such) and the economist speculates with bogus
behavioral economic analysis to the effect that special preference is needed
to attract the very best managers as can be demonstrated by looking at poor
results in the UK and Australia where there is no preference. And the right
answer is … the status quo. Congress is simply not going to spend the
political capital necessary to change it because it would look like a tax
increase (a Republican fear) or class warfare targeted at Mr. Romney
(overkill for the Democrats).
Take all the complex arguments, multiply them by 200,
and rest assured that no president or member of congress has the time to
fairly evaluate each of the tax expenditures within the context of tax
reform. A big political compromise is easier than an almost impossible
review of all the tax expenditures, but the big fixes are limited. The
easiest one for congress is to keep all (or most of) the tax expenditures
but cap the total tax reduction that can be taken by each taxpayer. This
would broaden the tax base, allow some reduction in rates and leave maximum
chaos in the tax code (will full employment for the accountants and
attorneys).
Both Paul Ryan and Herman Cane have suggested using a
Value Added Tax to supplement the tax base and lower the income tax rates.
The problem is that consumption taxes can be regressive (depending in part
how they are implemented) and the addition of a large consumption tax on top
of an income/payroll structure that weighs heavily on the middle class is
political suicide. The consumption-income cure may be almost as bad as the
disease and the expanded tax base would likely result in congress leaving
many tax loopholes. Attempts to bypass income tax exemptions altogether and
to fully rely on a consumption tax such as the FairTax are very appealing.
Unfortunately, the FairTax is so regressive that more than a half trillion
dollar pre-bate program is needed for low earners. The New Flat Tax is no
better.
Better tax reform for both individuals and business can
be described in one sentence. Tax individual and corporate income at a flat
8% rate (with no deductions, credits or loopholes), tax individual net
wealth at 2% (excluding $15,000 cash and retirement funds) and impose a 4%
Value Added Sales Tax (VAT) on business. The 2-4-8 Tax Blend has the lowest
rates and will produce about $500 billion more than current federal revenue
with no need for payroll, estate, and capital gains taxes or deferral of
foreign income.
An 8% flat income tax rate is a good trade-off for the
elimination of tax expenditures. The 2% net wealth tax is not as bad as it
sounds and would work well for the 99.9%.
Eugene Patrick Devany, JD, MPA
www.TaxNetWealth.com
JD Replied
The problem with Government and Vats is that they
ALWAYS RAISE THEM when they want to spend more money..flat tax no loopholes
on EVERYONE..is what it should be
JM Replied
Tax net WEALTH? So for people who hold their wealth in
real estate, stocks, trusts, jewelry, art, etc., will be forced to sell off
their assets every year to pay cash for taxes on items that are illiquid.
Sounds just brilliant. If you're trying to force financial collapse.
2-4-8 Response to JM: Financial Collapse
Which is better? Pay a 30% income tax, or pay an 8%
income tax and 2% tax on the unconsumed amount for the next 11 years. You
can also think of it another way: would it be "financial collapse" if you
saved 18% more of your income for the last 10 years? Or would it be
"financial collapse" if you never had to compute or pay a tax on capital
gains? Please give it a little more thought and you might see economic
mobility and healthy consumers.
JM 2nd
Reply “most dangerous I've ever seen postedâ€
Oh, I've given it plenty of thought, Eugene. As a CPA
I've thought about and study this concept for years, not just after reading
your comment. Short of Communism, your proposal is one of the most dangerous
I've ever seen posted on these comment pages. You forget that capital is
mobile. Your net wealth tax alone would absolutely facilitate hundreds of
billions, if not trillions, of dollars in assets leaving the country or
being liquidated annually to pay taxes, collapsing domestic markets.
2-4-8 Response to JM 2nd
Reply: Not Communism
As a CPA you know the US has a worldwide tax
jurisdiction. This year all foreign assets in excess of $10,000 were
reported to the Treasury (under penalty of a felony). Your suggestion that
trillions would move out of the country is not correct. Right now we have
trillions in profits of multinational corporations that are differed because
Apple, Microsoft, GE, etc. don't want to pay the 35% C Corporation tax rate.
If we changed the C corporation rate to 8% trillions would flow back to the
US - especially since there would be a full tax credit for taxes already
paid overseas ...
You are also correct that "capital is mobile" but you
don't want to hide it under a mattress lest you miss out on the 2% or 3%
interest that is easily available. You can send it to Switzerland (which has
a wealth tax) or put it on the moon but you cannot avoid Uncle Sam and stay
out of jail.
JP Replied
Re your statement, "The 2-4-8 Tax Blend has the lowest
rates and will produce about $500 billion more than current federal
revenue". The $500 billion additional revenue will not cover the current
budget deficit. Increasing your formula to something like 2-6-10 would be
required to satisfy the profligate spending of the current Administration.
Of course, replacing the current Administration and Legislature over time
........
2-4-8 Response to JP: Easy to Raise Rates
The 2-4-8 Tax Blend is approximately 18.5% of GDP - the
level used most often to compare large scale tax reform. I agree that that
is not enough for Mr. Obama but it is more than enough for a capable
executive. The 2-4-8 also represents about 40% from wealth, 40% from
individual income and 20% from business income/VAT. If Mr. Romney is elected
perhaps each of the example rates can be lowered and if Mr. Obama is elected
- well at least you are on notice of what might happen.
DJ Replied
@Eugene. You dismiss the FairTax as regressive when, in
fact, the pre-bate makes it progressive for everyone, not just low earners.
The effective tax rate is 0 to 23% of consumption, which is significantly
less than your income. It is fair because everyone pays at the same rate
after the pre-bate with no exceptions or loopholes. Individuals pay based on
what they CHOOSE to and can afford to spend on consumption. No more
individual income taxes, no more regressive payroll taxes, no more hidden
taxes that businesses fully pass on to consumers in the price of their goods
and services, no more taxes on savings, investment earnings or on estates.
Also, no more $346 million of tax compliance costs and we would all be
released from the tyranny of the IRS
Most individuals would pay less FairTax than under the
current complex system of multiple taxes. Who would pay more? Those who
under-report income like criminals, cash-based businesses, and illegal
aliens. The underground economy is estimated at around 15%.
The USA would become an tax haven magnet for
manufacturers, world headquarters, earners, savers and investors (i.e.job
creators). Our exports would no longer have payroll and income taxes
embedded in them and imports would be taxed an additional 23%. The biggest
import we would have is foreign manufacturers who sell here bringing jobs to
the USA to take advantage of the lack of taxes on business.
The FairTax would obviously make this carried-interest
debate irrelevant. Therefore, our goal should be to reform the tax code to a
consumption-based system instead of arguing over what should be the tax
rates on differing types of income.
2-4-8 Response to DJ: The FairTax
I love the simplicity and beauty of the FairTax but I
dismiss it for the same reasons most legislators no longer sponsor the bill
- we don't want another large entitlement program. It also lacks a wealth or
means test and most oppose giving handouts (a/k/a "prebates") to those who
won the lottery, inherited large sums or don't have easy to measure income.
Most also feel that business should pay tax (even if
the consumer pays for it in the end). The suggested 4% VAT is the type
levied against all gross sales (retail and wholesale, used or new) with
credit given for VAT taxes paid in the supply chain. It operates more like a
small surtax on business gross income but it is spread out and shared with
all business in the chane of production and distribution. It is small enough
not to require a pre-bate or to seriously interfere with state and local
sales taxes.
Lastly, the FairTax does not get the economy moving.
Under 2-4-8 the middle class and poor keep 92% of income - that's about
$7,700 more per year ($641 per month) for a typical family earning $70,000.
If you save or accumulate to much money (over $60,000 for a family of four)
you will have to start paying 2% of the additional net wealth - big deal. If
you earned $844,585 and were worth about $5,000,000 (like Mr. Obama) you
would pay about $5,000 in taxes - big deal. Mr. Romney would pay about
$3,000,000 more (but this is only $500,000 more than he might pay under the
Buffett Rule). When one reaches the $5,000,000 level of net wealth the 8%
income tax rate still allows wealth to grow faster than a 2% wealth tax
could diminish it.
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