Tax Bill Sends Wrong Message

In the fine print of the $110 billion tax "extenders" bill that is due to come before the Senate is an obscure provision that would do three things at once: turn the tables on decades of business tax law and practice, impose a penalty on more than a million entrepreneurs and further stall the country's economic recovery.

If passed, it would single out more than 1.5 million business partnerships--mainly those that invest in real estate--for punitive and discriminatory tax treatment.

At the same time, the bill would levy a heavy penalty on the owners of these businesses--and potentially destroy billions of dollars in value created by years of hard work.

The bill would achieve all this by, for the first time, denying capital gains tax treatment to investment partnership owners when they sell their stake in the business.

Why would Congress decide to take such an unwise step at this critical moment in the economic recovery, when capital markets are still fitful and the most recent government reports show job growth sputtering?

The answer is neither clear nor simple.

The proposal would unfairly change the rules of the game for entrepreneurs who have struggled to build value in their businesses, by subjecting them to punitive new taxes.

Proponents of the proposal say that they are trying to prevent the owners of real estate, venture capital, private equity and other investment partnerships from evading another, equally ill-considered tax provision contained in the extenders bill.

The provision in question would tax as ordinary income the "carried interest" profits earned by the general partners in these ventures when they buy an asset like a building or company, increase its value over time and then sell it at a profit.

This would more than double the tax rate on carried interest profits earned by general partners.

The appropriateness of taxing carried interest as a long-term capital gain is often misunderstood. In fact, providing lower rates for carried interest produces the same behavioral responses to favorable tax treatment of dividends and capital gains.

Consider $100 of long-term capital gains income. Carried interest of 20 percent allows the swap of $20 between the manager and a tax-exempt investor.

But carried interest is not unique in producing tax savings. Suppose the manager sold bonds producing $20 of interest income, taxed at 39.6 percent in 2011--and bought stocks that produced $20 of capital gains, taxed at 20 percent in 2011.

At the same time, suppose the tax-exempt investor bought bonds and sold stocks. This portfolio reallocation results in the same tax savings (19.6 percent x $20 = $3.92) as carried interest.

The supporters of the additional carried interest tax grab believe that once the tax increase on carried interest becomes law, the general partners would sell their ownership stakes in their firms to avoid the new tax increase.

So they've decided to "fix" the problem by taxing the entire gain on the sale of shares in the investment firm as ordinary income. Not only would carried interest be taxed as ordinary income but so would any gain attributable to increases in the "enterprise value" of the business arising from brand, market share and superior performance.

This shift would make these investment partnerships the only U.S. businesses whose owners would be denied capital gains tax treatment when they sell shares in their business.

Consider two businesses, exactly alike but for the product that they sell. One is a partnership that buys, builds and sells apartment buildings. The other, a partnership that sells and services automobiles. Both are structured in the same manner, with the same ownership allocations.

But when the owner of the real estate firm decides to diversify by selling shares, he or she would pay a tax of approximately 40 percent on any gains. The owners of the auto dealership, in the same situation, pay the lower ca

The truth is that there is no valid policy reason to treat investment partnerships differently from other types of businesses when their owners decide it is time to sell a piece of the business they built.

The proposal would unfairly change the rules of the game for entrepreneurs who have struggled to build value in their businesses, by subjecting them to punitive new taxes.

It sends the wrong message to our nation's innovators. Instead of rewarding their risk-taking and hard work, we are telling them that their work is worth less than that of others.

This might also be the opening shot in a campaign to eliminate the preferential tax treatment of capital gains--at least on the sale of businesses.

Congress long ago understood the importance of capital investment and created a tax differential to reflect this. A lower capital gains rate provides a strong incentive for entrepreneurial risk-taking and higher-risk, cutting-edge investment--essential for strong economic growth.

That tax treatment--long-term capital gains--recognizes that funds are more valuable to the economy when invested in our future. There is much Congress needs to do to reform the nation's tax code. The proposal to deny capital gains tax treatment to owners of investment partnerships goes in exactly the wrong direction.

Glenn R. Hubbard is a visiting scholar at AEI.

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R. Glenn
  • Glenn Hubbard, a former chairman of the President's Council of Economic Advisers, is currently the dean of Columbia Business School. He specializes in public and corporate finance and financial markets and institutions. He has written more than ninety articles and books, including two textbooks, on corporate finance, investment decisions, banking, energy economics, and public policy. He has served as a deputy assistant secretary at the U.S. Treasury Department and as a consultant to, among others, the Federal Reserve Board and the Federal Reserve Bank of New York.
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