Darryll Jones, who writes a regular column on Subchapter K (i.e., partnership) taxation for Tax Notes, set out this week to "debunk" the carried interest myths. While several tax profs have been concerned that some analysts had brought up the general merits of the capital gains preference as a way to derail the discussion of the proper taxation of carried interests, Jones wants us to think about the purpose of the capital gains preference and whether the variable income of fund managers is the thing Congress had in mind in establishing the preference.
At least for purposes of this article, Jones accepts the basic claim about the capital gains preference--that it serves as a remedy against "double taxation" of investment income, thereby benefiting economic growth. He doesn't buy the other argument, made by Kate Mitchell and Eric Solomon at the July 11 Senate hearing,--that the capital gains preference is designed to encourage entrepreneurial activity (risk-taking), without which society would suffer a lack of innovation.
The legitimate concern of the capital gain preference, Jones is reminding us, is to prevent the deleterious effect of taxation on nominal gain (appreciation, for example, at the inflation rate) as opposed to on real economic gain. But that isn't what the rate preference for fund managers is all about. There, we are talking about "sweat equity." And "we don't have to worry that people will not get a job when the market compensates them for doing so."
The notion that normal or even enhanced risk taking justiies the application of capital gains tax rates to fund managers is both novel and bizarre. The notion proves too mcuh. Every entrepreneur is a risk taker but only entrepreneurial investors of previously taxed income are taxed at lower rates, for the reasons discussed above and not because they are risk takers. ...LaRon Landry, an intimidating, 'bring the pain' defensive back, signed a five-year, $42 million contract to play for the Washington Redskins. Only $17 million is guaranteed; the rest he will get only if he can consistently get the better of Terrell Owens (TO) during the heated Redskins-Cowboys games. The risk of loss is substantial...Lndry would be at no risk of loss, and his motivation to work harder would decrease--if the tax rates subsidized the risk. ...Risk ...spurs the market onward and upward. None of that, however, has anything to do with capital gains taxation, particular because nobody would seriously argue that if Landry earns the $25 million bonus for knocking TO's head off he should get a tax break.
Jones reminds us that fund managers don't have anything much at risk, and whatever risk they do have shouldn't be removed by granting them tax preferences. Another good argument for the US government to stop carrying the "carried interest" burden.
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