Published May 27, 2010
The “tax extenders” package is up again this week in the U.S. House of Representatives. The extenders package’s basic purpose is to prevent tax deductions and credits from expiring for businesses and families. But in Speaker Pelosi’s Washington, stopping these tax increases for another year means imposing other, permanent tax hikes somewhere else. By way of this strategy, Congressional Democrats have set up an annual, permanent, new set of tax hikes on legislation that “must pass.” This time, the concurrent tax offsets will take the form of marginal income tax rate hikes.
If there is one thing most economists could agree on when it comes to tax policy, it’s that high marginal tax rates tend to affect behavior and choices. A person facing a 60 percent tax rate at the margin is less likely to seek to earn extra income when compared to a person facing a 20 percent tax rate at the margin. At some point, work just doesn’t pay. There’s plenty of leisure activity out there which can provide intangible benefits, all tax-free.
All tax hikes are bad for the economy, but some are downright catastrophic. The latter is on display in this year’s extenders package as the “pay-fors.” According to published reports, there are two main tax hikes in the bill: taxing “carried interest” capital gains more like ordinary income, and imposing the Medicare payroll tax on service-sector Subchapter S-corporation profits.
The “carried interest” debate is now several years old in Washington. The term refers to the share of investment profits an investment manager has a right to claim. Most of the time, investment partnership managers have a contractual right to 20 percent of the capital gains they are able to generate for the partnership. This is separate and apart from their annual compensation, which is usually 2 percent of assets under management (which, incidentally, is properly taxed as wages).
Democrats argue that the “carried interest” the manager has earned is simply wages in disguise. This is factually inaccurate. In fact, this money is the result of investment appreciation of an asset like a stock or a building—in other words, it is plainly a capital gain. When the investment manager realizes this gain, he rightfully pays taxes at the capital gains tax rate under current law.
In a naked grab for more tax revenue and to foster class envy and Wall Street hatred, Congressional Democrats are pushing for capital gains to be realized as the “carried interest” of an investment partner must face taxes three-quarters at the ordinary tax rate schedule, and one-quarter at the capital gains rate. Once the Obamacare investment surtax is factored in, this will mean a carried interest tax rate of 38.5 percent—over twice the current rate of 15 percent.
Not being ignorant cattle unwittingly led to the slaughter, investment fund managers won’t simply “eat” this tax hike. The most likely scenario is that the rest of the partners—limited parties such as defined benefit pension plans, university endowments, and charitable trusts—will see their share of the profits shrink. The true incidence of this tax hike will come in the form of underfunded pensions, endowments, and charities.
The other marginal rate tax increase on tap this week is on service-sector Subchapter S-corporations. These companies don’t pay taxes at the company level; rather, their owners pay personal income taxes on the business profits. Under current law, only personal income tax is owed on S-corporation profits. The bill under consideration this week will add onto this the Medicare payroll tax. As a result, the top rate on S-corporation profits will rise from 35 percent this year to 43.4 percent.
This tax hike will have one major impact—S-corporation owners will draw more capital out of their companies in order to pay Uncle Sam. The owners themselves won’t be hurt at all—it will be the business which suffers through a capital drain.
Less capital in the business means less money available for investment in new plant and equipment. It means fewer jobs created, and less money available for salary and benefit increases. Over time, a tax on capital is not only a tax on productivity and investment returns—it’s also a tax on workers. Reducing the capital available to a business simply means a proportional reduction over time in jobs, salaries, and benefits.
In both cases—the carried interest tax hike and the S-corporation tax hike—there’s an interesting phenomenon of unintended consequences. In seeking to hike taxes on “greedy” investment partnership managers, Congress actually reduces the value of stocks owned by Americans’ pension plans and the endowments of our universities and charitable foundations. In seeking to hike taxes on those who dare to start profitable and job-creating small businesses, Congress will in fact only impoverish the capital reserves of those businesses, depressing productivity-enhancing investments, killing jobs, and lowering wages for those still lucky enough to have a job.
This is all for the sake of keeping the tax code we already have. In Washington, that passes for accounting. In the real world, it kills jobs and makes us all poorer.
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