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Supercommittee Should Not Hike Capital Gains Rate

October 24, 2011 — Americans for Tax Reform — by Ryan Ellis Bookmark and Share

The Supercommittee will be reporting on a series of policy recommendations in November. One idea they should stay far away from is a capital gains tax hike.

We are now less than one month away from the reporting deadline for the so-called "Congressional Supercommittee." It has a mandate to report out $1.5 trillion of deficit reduction proposals by November 23rd. Failure to do so triggers a "sequester" of $1.2 trillion in spending cuts in January 2013.

Of course, the Left is using the Supercommittee as an excuse to raise taxes. ATR has said from the beginning that the Supercommittee should focus only on spending cuts, since Washington has an over-spending problem, not an under-taxing problem.

One rumor floating around is that the Supercommittee might be looking at a proposal to hike the capital gains tax rate paid by a wide range of investment partnerships, including partners and employees at private equity, venture capital and real estate firms. Needless to say, any hike in the capital gains tax rate should be avoided at all costs, especially in the middle of a deep and persistent recession.

This particular capital gains tax rate hike would be very harmful. In a private equity investment, the partners are paid in part in fees and are taxed at ordinary income tax rates on those fees. In addition, however, the partners are also eligible to receive a profits interest in successful long-term investments via carried interest. Carried interest has been appropriately taxed as long-term capital gains for over 60 years. Carried interest is received only after limited partners in a private equity fund have received at a guaranteed rate of return on the capital they invested in the fund (generally 8 percent). These limited partners tend to be pension plans, charitable trusts, and university endowments. When the partner invests well and makes money for everyone, he gets to keep some of the profits. If the manager does not invest well, he does not receive any carried interest and in some cases may have to claw back previous carried interest payments received on prior profitable investments.

Another term for profits is "capital gains." The money the managing partner receives is not a salary. Rather, it's the capital gains realized from the sale of long-term capital assets. This money is appropriately treated as capital gains under current tax law, and it should remain that way. This is not special treatment--it's the typical treatment one would expect of capital gains income.

The proper tax rate for capital gains should be zero. Under a consumption tax base, which most economists believe would be the best tax base for economic growth and job creation, capital gains would not be taxed at all (since it represents a second, cascaded tax on capital). If anything, the Supercommittee should be recommending a cut in the capital gains rate, not hiking it for certain recipients of capital gains.

What would happen practically if capital gains were taxed as ordinary income for managing partners in investment partnerships? Simply this-- businesses that rely on investments of capital and expertise from private equity, real estate and venture capital firms would face much more difficulty in obtaining support to grow. In addition, investments will become more expensive, with the result that limited partners, including pension plans, charities and universities, would likely face less positive investment options. The resulting revenue increase to the Treasury would likely be negligible given this behavioral shift.