Taxes Owed
Democrats should support higher rates even if doing so pinches their contributors.

Thursday, August 9, 2007

WE EXPECT many Republicans to reflexively oppose anything that sounds like a tax increase. It's more surprising to find some Democrats opposing two bills intended to close a tax loophole for some of the nation's richest people.

The bills would force industries that use a carried interest compensation structure -- in which a general partner manages an investment, about 1 percent of which is his own money, and in exchange takes 20 percent of the return -- to pay higher taxes. Right now, income from carried interest is taxed at the long-term capital gains rate (maximum 15 percent) even though it is compensation for services and thus should be taxed as regular income (at the highest bracket, 35 percent), just like compensation for providing services in any other industry.

A House bill would require carried interest income received by private equity, hedge fund, venture capital and real estate partnerships to be taxed as earned income. A more limited Senate bill would require some partnerships that rely on this structure -- namely, private equity and hedge funds -- to pay corporate income taxes if they're publicly traded.

Why Democrats are balking at these attempts to make the tax code fairer is unclear, but it may have something to do with the generosity these industries show their party. Of course, they don't say that. Instead, they waffle or offer weak rationalizations. Some, for example, say that closing the loophole will discourage capital formation. But taxes wouldn't rise for investors who contribute capital, only for those who make their livings investing for others.

Some, such as Sen. Maria Cantwell (D-Wash.), say that increased tax costs might be passed along to investors, such as public employee pension funds or university endowments. This concern is also overblown, as some pension fund managers have acknowledged. Plenty of competing industries would not be affected by this bill, so if those affected by the bill raised their rates, they would lose their investors. And if private equity funds were going to pass along their higher tax costs to investors, it would logically follow that when their taxes were cut (as when the long-term capital gains tax was decreased in 1997 and 2003), they would have passed along their greater profitability to investors. Instead, the compensation structure appears to have remained steady.

Sen. Charles Schumer (D-N.Y.) criticized the Senate bill for singling out private equity and hedge funds without raising taxes for other industries that use similar tax structures. On Wednesday, he came out in favor of the House bill, which he says is "broader" and "fairer," and he said he probably will introduce a bill modeled on the House legislation. Other Democrats should join him, supporting the principle of fairness rather than their bankrollers.