I think it makes sense to tax capital gains at a lower rate than ordinary income. However, that does lead to the question what is a capital gain? In an op-ed in the Wall Street Journal John Gordon Steele argues that carried interest is not a capital gain and, consequently, should be taxed as ordinary income:
To defend the favored treatment of carried interest, private-equity and hedge-fund owners argue that their share of the customers’ gains is analogous to “founders stock,” which is granted to the founders of a company when it goes public, even though they may not have personally invested money in the venture.
This analogy is bogus when the companies in which a fund is invested are not actively managed. A founder has a bright idea. He works hard to convince others of its worth so that they will invest in it. He works hard to get the company off the ground, investing his time and his sweat equity in the business (not to mention the forgone income from the 9-to-5 job he could have had instead). He is risking a lot: a substantial portion of his working life, his reputation, his potential current income, etc.
What does a hedge-fund manager risk? His is an on-going business, not a start-up. His business is, in effect, giving investment advice to clients. If his advice nets to a profit he is rewarded with a portion of the gain. How does that differ from, say, a lawyer taking a case on a contingency basis and sharing in the award when the case is successfully settled or won? The lawyer is giving legal advice and being compensated for giving good advice. But that compensation is taxed as ordinary income.
This returns to a point we should keep in mind: in terms of how much tax is paid the marginal rate is a lot less important than how you calculate income. And, since not all income is taxed at equal rates, how the income is classified.
Somebody get Drew up off the floor before he chokes on his dudgeon.
Waldman made a couple of important points, at least one of which Drew might agree with. First, if you dont tax capital, you need to tax something else to make up for it. (Yes, I know, but if you can lower spending do so, it is a separate argument.) Next, not all cap gains is the same. Steele talks about carried interest. What about gains on stocks or Treasuries? Does that really merit no tax the same way not taxing real investment in a start up business would merit no tax? Last of all, doesnt human and institutional capital matter? Japan and Europe got destroyed in WWII. Back up and running in relatively short order. The quality of the people really does matter. Try pumping money into Pakistan or Afghanistan and see what happens. Maybe we should not be taxing income so much.
Steve
Sorry, sam. Unlike you, reflexively idiotic, the man starts with a valid point.
The key concept is active management. (And let’s skip with founders stock and personal investment. I bet I’ve written more checks for investments in portfolio companies than you have paid in taxes your entire life.)
So the basic debate revolves around a dishonest portrayal of private equity as mutual fund manager. Here is the truth: both mutual fund and private equity fund managers get a management fee based upon assets under management. Both types of income are treated the same: ordinary income. Legitimately so. This is the fee to run the firm. The divergence comes in carried interest.
Mutual fund managers do not get carried interest – a piece of the profits. Why? Because they are passive invetors. They pick stocks or whatever out of the pages of the Wall Street Journal and hope. That is, they let managment do the managing.
Private equity managers – active investors – get carried interest. Why? Because they source and sell the businesses, sit on the boards, take the attendant risks, hire key managers, participate in strategy, visit with suppliers and customers, sometimes take key management positions and on and on. They are effectively management. They are the business owner. The business of buying and selling businesses is their business……..just like a widget business owner.
A business owner has an account on his balance sheet for his tax basis in the company. He/she gets capgains treatment on the gain above and beyond that basis when he/she sells, just like a PE guy.
If you want to argue against the capgains treatment of capgains or carried interest then do so legitimately; don’t be dishonest like a Paul Krugman – who preys on dumbshits like sam – and argue that PE business owners should not get capgains treatment but “regular business owners” should. Don’t pull the NYC 42nd street shell game and fool hayseeds like sam that the carried interest gains are just like a passive mutual fund manager.
steve
I think what you are getting at is double taxation. If so, that is a totally separate argument from carried interest. I’m not in favor of double taxation, as you might imagine, but the arguments are different from cap gains treatment of capgains/carried interest vs considering carried interest “fees.” They are not.
The “correct” treatment of capgains taxation is a whole subject unto itself, and legitimately debatable. What is fascinating to me in this thread is sam’s utter lack of understanding. Like Krugman’s puppet.
Well, here’s a guy who seems to know what he’s talking about:
The Rape of Persephone.
He ends his illuminating piece with this:
.
Drew:
“They are effectively management.”
OK. But do they get CE on the income they earn for managing the company?
“They are the business owner. The business of buying and selling businesses is their business……..just like a widget business owner.”
No problem with capgains on a profit made from selling the business. The problem is with getting CE on income from managing the business.
sam
Your ignorance is now starting to amuse. What do you, or did you do, for a living? It is clear you are clueless.
Your citation is irrelevant, it is an opinion, not an argument.
The last part of your comment shows you are just drowning, because it is incoherent. Carried interest by definition comes from capital gains upon selling the entity vs what you paid, just like your average entrepreneur.
And let me help you out, you poor dear, management fee income from MANAGING the day-to-day business (which PE firms do charge), and with which you seem to be pre-occupied, it treated as ordinary income, as it should be. All is well with the world.
Take two aspirin and call me in the morning, loser. Gawd.
I understand what the management fee is. The question is, how shall we characterize the rest of your compensation. Here is someone defending the status quo by way of this analogy:
The conceptual problem is, how are we to understand the word ‘investment’ in the penultimate sentence. Isn’t a better analogy Gordon Ramsey’s Kitchen Nightmares? Ramsay goes into a failing restaurant, or at least one performing below its potential, and whips it into shape, then leaves. Now, wouldn’t the PE analogy here be, Ramsay finds such a restaurant. In addition to needing his culinary and management expertise, the restaurant also needs some repairs, new furnishings, etc. Easier to buy the business. So he gets some folks to pony up some money, by telling them that under his expert direction, they will make a profit on their financial investment. They buy the restaurant, he installs himself as head chef, and whips the place into shape. It’s a success, and the restaurant is sold at a healthy profit. Now, perhaps Ramsay himself puts up 5% of the money to buy the business. He’s entitled then to 5% of the profits. to be taxed as a capital gain. But why should anything he receives in compensation on the sale beyond that 5% be characterized in any way other than straight, fully taxable, compensation? How is not like a lawyer’s contingent fee? A lawyer says to a client, “I believe you have a case, and I can get a settlement. My fee will be a certain percentage of the settlement.” That fee is is taxable as straight income. How does Ramsay’s involvement in the restaurant deal differ in kind from the this?
Yikes. Sorry for the bad html. My argument should not have been in the blockquote. It starts with the words, ‘The conceptual problem is’/
sam
I just don’t know what to say. This argument is ludicrous. Do you have any business acumen at all??
You know, that’s no answer at all. You could at least to show me how that argument is faulty.