Financing Government, Congress Style

Big government keeps getting bigger, and the way Congress is determined to pay for its expansion defies every principle of sound business management.

Take, for example, efforts currently underway to reauthorize the State Children’s Health Insurance Program (S-CHIP). On July 19, the Senate Finance Committee advanced a five-year $35 billion reauthorization package whose expansion will largely be financed through a 61 cent-per-pack hike in the federal cigarette tax.

Cigarette tax revenues are a declining revenue source, and given the size of the proposed tax hike to fund S-CHIP’s reauthorization and expansion, such revenues can be expected to shrink even further. Indeed, as cigarette taxes go higher, smoking declines (with black market activity increasing) correlating to a decrease in revenues for government.

Wanted: New Smokers

According to the Heritage Foundation, in just five years Congress will need more than 9 million new smokers to fund S-CHIP. By 2017, the number of new smokers needed would total 22.4 million.

Of course, what politician in their right mind would call on Americans to “smoke up” for the sake of children’s health insurance? Discouraging smoking is certainly the right thing to do, yet very few in Congress have questioned the wisdom of expanding an entitlement program through an unstable and declining revenue source.

So, where will the federal government get the revenues it needs to fund S-CHIP in the future?

As noted by Small Business & Entrepreneurship Council Chief Economist Raymond J. Keating, “Eventually the taxman will have to expand his sites beyond the original targets. As spending keeps growing and smoking rates continue to decline, tobacco tax revenues simply will not keep pace, and other taxes will have to be tapped.”

Every taxpayer remains a target when it comes to initiatives that aim to “fund health care access,” as we have learned from efforts at the state level. The aggressive revenue hunt on Capitol Hill, which is also being conducted in the name of closing the “tax gap” and to fund new priorities as well as program expansion, has led Congress to search every nook and cranny of the tax code. More specifically, Congress is keen on “closing loopholes,” raising taxes on “the rich” — or otherwise targeting people, companies and industries that are simply making too much money.

Such is the case with the current fascination with the treatment of carried interest in investment partnerships, as embodied in legislation introduced by House Democrats.

Killing the Goose

Some in Congress believe they have stumbled upon a secretly exploited “tax loophole” that has gone unnoticed — until now. H.R. 2834, proposed by Reps. Charlie Rangel, D-N.Y., Sander Levin, D-Mich., and several other Democrats, would amend the tax code to treat investment partnership income as ordinary income. That is, “carried interest” would no longer be treated as a capital gain, and as such would be taxed as high as 35 percent, instead of the 15 percent capital gains tax rate.

“Carried interest distributed to venture capitalists is not a tax scheme or loophole. It is a true capital gain and has been appropriately recognized as such for years,” said Mark Heesen, president of the National Venture Capital Association (NVCA), in response to the introduction of H.R. 2834.

The legislation would alter an area of tax law that has been common practice for decades. As NVCA explains in a media release, carried interest in the venture capital business model has always been consistent with capital gains philosophy:

“Carried interest is only typically paid after all invested capital and all of the management fees have been returned to the limited partners. It is never guaranteed and is entirely contingent upon successful company exits. Given the nature of carried interest, it has been taxed at the capital gains rate.”

NVCA contends that vastly altering this business model will not only hurt U.S. competitiveness, but entrepreneurial companies that look to venture capital as a key source to fund their growth. Critics also point out that taxing capital gains at a higher rate will actually work against increasing government revenues, which is the stated goal of those on the hunt to find new sources of tax dollars.

Cutting the capital gains tax is actually good for government revenues.

Following the 1997 capital gains tax cut, revenues to the government rose from $62 billion to $110 billion from 1996-1999. The 2003 reduction in the capital gains tax produced similar results – the government collected $50 billion, $60 billion and $75 billion in 2003, 2004, and 2005, which surpassed the official forecasts by $45 billion over the three year period.

So, why is Congress ignoring the all-too familiar maxim that the more you tax something, the less you get of it? Thankfully, on the carried interest measure, some Democrats such as Senators John Kerry, D-Mass., and Chuck Schumer, D-N.Y., have expressed concerns about the approach of H.R. 2834. In the House, Rep. Eric Cantor, R-Va., is educating his colleagues and the public about the bill’s effect on capital markets, U.S. entrepreneurship and economic growth.

But few members of Congress have publicly connected-the-dots about how S-CHIP will be funded once tobacco tax revenues fall short of expectations (and, in all likelihood, program costs exceed the budget). Discouraging smoking is morally right, but so are honest budgeting and an open debate regarding the unintended consequences of advancing certain tax policies.

Karen Kerrigan is president & CEO of the Small Business & Entrepreneurship Council, a research and advocacy group based in Washington, D.C. that works to protect small business and promote entrepreneurship. She is also founder of Women Entrepreneurs, Inc. , an association helping women business owners succeed through education, networking and advocacy. Kerrigan can be reached at .