“Carried Interest” Battle Could Be Precursor to Broader Effort to Increase Capital Gains Tax

Writing for the Wall Street Journal, Phil Kerpen of Americans for Prosperity weighs in on the taxation of the returns to private equity funds. He notes, as have others, that the so-called “carried interest” is a capital gain – even if it is then shared with the fund manager. The key message of the article is that the attempt to raise the tax on this type of capital gains is the first step in an effort to raise the tax rate on all capital gains:

Under current law, individual partners in an investment partnership such as a hedge fund or private equity fund are taxed based on what the underlying partnership income is; if the income comes from a capital gain, it is taxed at the capital gains rate. Ordinary income is taxed at ordinary income tax rates. This tax treatment is consistent with the rationale for a lower capital gains tax rate – to alleviate the double taxation of corporate-source income and to encourage risk taking, entrepreneurship and capital formation. The legislation Congress is considering ends those protections, saying in effect that it doesn’t matter if the income is a clear-cut capital gain, such as proceeds from the sale of corporate stock. What matters is who receives the income, in this case politically unpopular rich guys. All investors should be on notice that if the capital gains tax is considered a loophole for investment partnerships, it can’t be long before the capital gains tax is raised for everyone else. Some leading Democrats, including Oregon Sen. Ron Wyden and presidential candidate John Edwards, are already calling to do just that.

Kerpen’s fears are confirmed by a story in the New York Sun. At a Finance Committee hearing, a number of politicians expressed support for broader tax hikes:

Democrats may dodge a tax hike on private equity managers and instead look to raise other taxes that would generate greater revenue from a broader swath of the American economy. At hearings on Capitol Hill yesterday, Senate Democrats voiced fresh doubts about legislative proposals to increase tax rates in the burgeoning private equity industry, questioning both the fairness of the plans and whether they would yield the revenue infusion lawmakers are seeking for the federal coffers. … Lawmakers indicated yesterday that they might turn their attention to more far-reaching tax shifts, such as increasing the rate on capital gains, to 20% from 15%, and the marginal income rate for the top-earning Americans, to 40% from 35%.

Poole on Friedman’s Monetary Legacy

Like Andrew Coulson, I attended an event in honor of Milton Friedman’s birthday yesterday. This one was in Missouri, and it featured Bill Poole, who’s president of the Saint Louis Federal Reserve Bank and a frequent participant in Cato events on monetary policy. The event was sponsored by the University of Missouri and the Show-Me Institute. In his speech, he credited Friedman with making the case that changes in the money supply are a major factor in the business cycle. However, he noted that modern-day central bankers do not agree with Friedman’s contention that central banks should focus on limiting the growth of the money supply:

Everything Milton argued about money stock control is true, but the effect of inflation expectations on the practice of monetary policy itself was, I believe, a missing element in the analysis. The economy functions differently when inflation expectations are firmly anchored. If a central bank allows expectations to become unanchored, then interest-rate control becomes a dangerous and potentially destabilizing policy. But should the practice of monetary policy depend on how well inflation expectations are anchored? I do not recall Milton discussing this question, perhaps because he believed that the best way to maintain well-anchored expectations over time was for the central bank to commit to steady and low money growth under all circumstances.

How does a central bank anchor inflation expectations? One approach would be for the central bank to commit to low and steady money growth come what may. A problem with this approach is that it may not appear credible to the markets when financial instability and/or recession occurs. If a policy of steady money growth has exceptions, can the exceptions be defined in such a way to retain anchored inflation expectations?

A necessary and sufficient condition for anchoring is that the central bank act vigorously to resist inflation or deflation whenever it becomes evident and particularly when inflation expectations change, up or down, in an unwelcome way. If the central bank is willing to push as hard as it takes, regardless of short-run consequences to unemployment and especially to the bond and stock markets, then market participants will develop firm views on the likely rate of inflation in the future. The Fed must convince market participants who bet against it that they will regret their bets.

However, Poole concludes that “Although Milton did not prevail in his quest to have the Fed maintain a constant money-growth rate, he did prevail in his insistence that policy be apolitical and rely to the maximum possible extent on market judgments. He lost a battle but truly did win the war.”

A Correction

In my post last week on the House farm bill, I quoted a Congressional Quarterly article that said that “[chairman of the Agriculture Committee, Representative Collin] Peterson also worked to stave off a last-minute revolt by Congressional Black Caucus (CBC) members by dedicating $1 million [sic] in extra funding for historically black universities and for black farmers.” (link requires subscription).

Further reporting has disclosed that the figure dedicated to those causes was $100 million (see here). Apologies.

State Government “Financial Implosion”

In prior posts, I noted the problems of rapidly rising state government debt and massive unfunded state health care promises.

I just came across a detailed study by an Illinois group that puts the problem in stark perspective. The report by the Commercial Club of Chicago begins: “Illinois is headed toward financial implosion–Illinois’ debt and unrecognized obligations have grown at an enormous rate.”

The study puts the state’s pension debt at $10 billion, its unfunded pension costs at $46 billion, its unfunded employee health care costs at $48 billion, and its unpaid Medicaid bills at $2 billion. The total costs that will be pushed onto tomorrow’s taxpayers without reforms is an enormous $106 billion, or $8,800 per every person in the state of Illinois.

As the report notes, the Illinois state constitution requires a balanced budget, but state policymakers are routinely abusing that requirement by financing spending with debt and imposing growing unfunded obligations on future generations.

The Commerical Club’s report is not libertarian by a long shot, and indeed calls for tax increases as part of a solution. But the report does a good job describing the excessive benefits received by state bureaucrats and the irresponsible growth in unfunded spending that has become the norm in legislatures across the nation in recent years.

For background see here [.pdf].  

Japanese Voters Send Anti-Tax Signal

Elections in Japan do not have much ideological or philosophical content, but the recent defeat for the Prime Minister’s party in upper-house elections was a clear sign that voters do not want higher taxes. As reported by Tax-news.com, Prime Minister Abe has been advocating a big hike in the value-added tax to finance more transfer spending, but the election results mean that Japanese voters may be spared this irresponsible outcome. The one distasteful element of the story is that the reporter refers to Abe’s commitment to reform. In the real world, raising taxes to finance more spending is a way of dodging reform:

Japanese Prime Minister Shinzo Abe’s plans for fiscal and tax reform have been dealt a blow after the opposition Democratic Party, which opposes a hike in consumption tax, won a substantial majority in Upper House parliamentary elections on Sunday. While the Democrat Party’s victory does not give it control over the government, analysts expect their influence in the upper house to raise a barrier to an early rise in consumption tax - thought to be central to the ruling Liberal Democrat’s plans to raise the revenue it needs to meet growing spending requirements and balance the budget. It was thought the government would legislate to increase the tax in 2008, with the hike going into effect in 2009, but this is now an increasingly distant prospect. … However, despite the electoral setback, Abe resolved to forge ahead with fiscal reforms.

Happy Birthday, Milton

Today is the 95th anniversary of the late Milton Friedman’s birth, and I’ll be celebrating his contribution to the school choice movement this evening in a presentation at the Evergreen Freedom Foundation in Washington state (to be available via live web-cast).

Here are some opening thoughts I have for that presentation:

In the spring of 1998, I was wrapping up four years of work on my book “Market Education: the Unknown History.” The publisher asked me come up with a list of prominent people who might be willing to write blurbs for the jacket, and so I sat down and mulled over the possibilities. The first name that came to mind was Milton Friedman.

I’d read Dr. Friedman’s 1954 essay on “the Role of Government in Education” and been deeply impressed by it. Of course, I didn’t seriously think that he would have the time to read a hefty manuscript by an author he’d never heard of, but, I thought, what’s the harm in trying?

In what still seems to me a minor miracle, Dr. Friedman decided to give the manuscript a read, and in doing so helped to launch my career in education policy. In fact, just weeks after I had contacted him, and before I knew what he thought of the book, I received a last-minute invitation to share the stage with him, along with his wife Rose and economist and columnist Thomas Sowell, at the gala launch event of the Milton and Rose Friedman foundation in San Francisco. Of course I was incredibly excited, not to mention moderately terrified, at the prospect.

Just as we were about to walk onto the stage at that event, Dr. Friedman leaned close to me and whispered “It’s a fine book,” but then added in a somber tone, “except where you run-down vouchers in Chapter 10.” He looked at me earnestly for a moment, and my heart nearly stopped. For a second I thought that my as-yet-unreleased manuscript was about to be carved up by a Nobel laureate economist in front of a live audience of several hundred people. Then he smiled and added, “but we can talk about that later.” And so we did, on and off, until his passing late last year.

Dr. Friedman was always quick to say that he was a monetary economist by profession, and that his interest in school choice was more avocation than vocation. But though he wrote only a few non-technical works in the field of education, he was a seminal force behind the modern American school choice movement.

To understand his impact on this field, you have to go back to the early 1950s. At that time, even more so than today, advocacy of limited government and individual liberty had been outside the philosophical mainstream. Not just outside it. Not just on the shore looking into the mainstream. But buried in the bushes entirely out of view of it.

Milton wrote of this period that “Those of us who were deeply concerned about the danger to freedom and prosperity from the growth of government, from the triumph of welfare-state and Keynesian ideas, were a small beleaguered minority regarded as eccentrics by the great majority of our fellow intellectuals.”

Consider that barely 20 years before Milton wrote his essay on “the Role of Government in Education,” the National Education Association had declared that the time had come for, quote, “the frank acceptance of the collective economy.” Not only did early 20th century education philosophers oppose the privatization of their own industry, they advocated nationalizing most of the others.

It was into this intellectual milieu that Milton ventured his modest suggestion: that the goals and ideals of “public education” would be best fulfilled though the private sector, with the government intervening, only if and as necessary, to ensure universal access to the independent educational marketplace.

Milton has passed, but that modest suggestion has become an international movement backed by an ever growing body of interdisciplinary empirical evidence.

Thank you, Milton, and happy birthday.