Just before its Memorial Day recess, the House passed a bill that, according to The New York Times, would raise the taxes that investment managers pay on carried interest, just at the moment new long-term investment is most needed.

General executive partners of long-term investment partnerships, including investments in real estate, venture capital, private equity, and other investments, are paid a management fee based on the assets they are managing, plus a share of the capital gains (typically 20 percent) earned on the investment. The management fee is taxed as traditional income, but the the limited (passive) partners pay the general partner a share of the profit—called “carried interest”—as an incentive for the general partner to maximize investment performance, which is taxed at the 15 percent capital gains rate, much lower than the individual income tax rate.

This rate is already scheduled to increase to 20 percent in 2011, but the American Jobs and Closing Tax Loopholes Act, which passed the House yesterday by a vote of 215 to 204, would tax three-fourths of carried interest profits at the regular individual income rate, up to 38.5 percent.

This proposal, as the Wall Street Journal’s John Rutledge points out, is the latest consequence of a Washington mentality that focuses on who is taxed rather than what activities are taxed. The rate hike would of course reduce income for investors; this includes both general and limited partners, since the latter would have to pay a greater share of their after-tax returns to compensate the general partners. But even if one accepts the political and moral legitimacy of a government playing the role of Robin Hood, robbing from the rich to give to the poor, the policy would have adverse consequences for the economy as a whole, including poor and middle-class citizens.

Rutledge explains that the law would “discourage capital investment, increase the cost of money to start and grow a business, and depress real estate and stock prices.” Reduced after-tax returns on investment diminishes investors’ willingness to take risks, which is especially true in this case since long-term investments do not begin generating profits for years after the initial investment. This makes it more difficult for small businesses to acquire the capital needed to establish themselves and expand, which in turn means fewer jobs. The diminished value of after-tax returns on assets would drag down asset prices. As Rutledge notes, “The direction of these changes is not in question.” The only question pertains to their magnitude.

Given that partnerships are America’s “primary vehicle for funding long-term investments,” the decline in such investment is likely to be substantial. Rutledge cites the most recent Treasury Department data, which indicate that there were more than three million partnerships, representing 18.5 million investor partners, in 2007. Altogether, the 2.3 million partnerships required to report their asset balances to the IRS financed $20.5 trillion in investments that year.

There is reason to believe, moreover, that net revenues would actually decline as a result of investment reduction. As ABC’s Charlie Gibson noted in an April 2008 debate between Senators Barack Obama and Hillary Clinton, President Clinton signed legislation in 1997 reducing the capital gains tax rate to 20 percent, and President Bush subsequently reduced it to 15 percent; in each instance, when the rate dropped, revenues from the tax increased. When the rate had been increased to 28 percent in the 1980s, revenues went down. In a sound bite that never ceases to amaze me, then-candidate Obama said he would “look at” raising the capital gains tax in spite of this “for purposes of fairness.” He then reverted to his usual class-warfare rhetoric, noting the unfairness of an economy that allows the top 50 hedge fund managers to earn $29 billion in 2007. The President and House Democrats are apparently so determined to punish the rich that they will do so even if it means less jobs and capital formation, and has resulted in reduced revenues in the past.

Incidentally, yesterday’s vote to raise taxes on carried interest was partly sold as a tax on wealthy hedge-fund managers, but Rutledge notes that such funds generate short-term capital gains, and their managers already pay taxes at ordinary income rates. The tax will instead affect those who make the long-term investments that generate long-term capital gains.

The ostensible purpose of this provision, other than to redistribute wealth, is to partially offset extensions of various tax credits (despite aforementioned evidence that this could reduce revenues, and despite the name of the bill itself). A few of the most egregious of these, the vast majority of which, as Tax Foundation president Scott A. Hodge has noted, amount to earmarked spending through the tax code, are catalogued on the Tax Foundation’s Tax Policy Weblog. The current Congress, of course, has already substantially increased spending, much of which is permanent and likely to easily outlast the current economic downturn. In the majority party’s mind, tax revenues must be vigorously maintained, but the same standard does not seem to apply to spending.

The good news is that the bill is unlikely to pass in its current form due to serious concerns in the Senate. Sen. John Kerry (D., Mass.), for example, has expressed strong reservations about the provision, likely because of the venture capital community in Massachusetts. Still, the fact that such a proposal is even being considered speaks volumes about the current Congress’s idea of fiscal policy.

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