Carried Interest Is A Capital Gain And Should Be Maintained As Such

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Posted by Alexander Hendrie on Wednesday, October 25th, 2017, 1:59 PM PERMALINK

The Republican tax reform framework contains numerous provisions which will increase economic growth, raise wages, and create new or better jobs for American families.

For instance, the plan reduces taxes on all businesses by 42 percent, resulting in a 20 percent tax rate for corporations and a 25 percent rate for pass-through entities. The framework also implements a territorial system of taxation so that American businesses operating overseas compete on a level playing field against foreign companies.

In combination with the reforms to individual taxation such as cutting and consolidating the income tax brackets and doubling the standard deduction, the tax reform plan will result in bigger paychecks for taxpayers across the country.

One area, the framework is silent on is capital gains taxes, which directly hinder economic growth by disincentivizing investment. Because the plan contains many other pro-growth provisions, it is not necessarily a problem that there is no reduction in the capital gains tax, given the constraints faced by budget reconciliation. However, increasing this tax, either through a direct increase in the rate or by narrowing the base of the tax, would limit economic growth and contradict the goals of tax reform.

One way that lawmakers may increase taxes on capital gains is through taxing carried interest capital gains as ordinary income, rather than capital gains income.

This would be a mistake – there is no difference between carried interest and any other type of capital gain. Carried interest is the investor’s share of an investment partnership between the investor and individuals providing expertise on investment decisions. These partnerships generate income through a long-term investment in the same way as any to which the capital gains tax applies – individuals do not benefit from any special treatment. There is no sound basis for taxing these returns as ordinary income.

A carried interest tax increase is also bad policy. It would reduce investment and savings while damaging the economy and America’s economic growth prospects. The Joint Committee on Taxation estimates that a carried interest tax increase will raise a paltry $19.6 billion in revenue over a decade, with Tax Foundation estimating that this number would be just $13 billion due to the negative macroeconomic effects. Both numbers are a small fraction of the $41.7 trillion that will be raised over the same time period, according to the Congressional Budget Office.

In return, the impact of this tax increase will be felt by pension funds, charities and colleges that depend on investment partnership structures in order to meet savings goals. Small businesses would also be badly affected, as investment money available from these partnerships dries up.

The better policy would be preserving the base of the capital gains tax to promote investment by maintaining current law (or reducing taxes on all capital gains). Multiple layers of taxation under our tax code mean that there is little rationale for taxing income derived from a capital gain, as investment in capital is derived from income which has already been taxed at the individual level prior to reinvestment in the economy. Double taxation discourages savings, suppresses productivity, and discourages investment. It acts as a barrier to job creation, wage growth, and economic growth.

America’s capital gains taxes are already among the highest in the world.  The top rate has increased from 15 percent to 23.8 percent in the last 8 years alone. A study by Ernst and Young placed the top U.S. integrated rate at 56.3 percent after accounting for the corporate tax, federal and state capital gains taxes, and the Obamacare net investment income tax - far in excess of the average integrated rate of other OECD nations and the five BRICS countries which sits at just 40.3 percent.

The Republican tax reform framework is strongly pro-growth and will turbocharge the economy. Lawmakers should be sure not to undermine the framework through pay-fors that hinder economic growth.

Photo Credit: Madeleine Tsol