Tax Reports: Ways & Means, Private Equity

The Tax Foundation has posted an overview and initial thoughts on Rep. Rangel’s proposed tax bill, which we recently wrote about:

Most true tax reform consists of broadening the tax base in order to lower rates. Rangel does achieve this principle on the corporate side, but it is not realized on the individual side.  At the end of the day, the scheduled expiration of the 2001 Bush tax cuts is the 800-pound guerilla in the room.  They interact heavily with almost all of Rep. Rangel’s proposals, and they dramatically impact the tax liabilities of American families.

TaxAnalysts have posted an accurate and reasonably balanced assessment of the debate over the taxation of "carried interest" in private equity and other partnerships, another issue we’ve written about:

Shifting ordinary income into capital gains income is what Eugene Steuerle, a former Treasury deputy assistant secretary for tax analysis and now at the Urban Institute, calls "tax arbitrage" that allows the recipient of the income to take advantage of the different tax treatment that applies to different types of income. As long as the capital gains rate is lower than the ordinary income rate, there is an incentive to engage in this type of arbitrage. (Capital gains receive a secondary benefit because, unlike ordinary income, gains are taxed only when realized and thus gain the benefit of deferral so that the effective capital gains rate is significantly lower than the statutory tax rate.)

In testimony before Congress, Steuerle said tax arbitrage opportunities reduce national income, drive talented individuals into less productive jobs, and add substantially to the debt in the economy. He also noted that regardless of one’s political view, reducing tax differentials across types of income helps promote a "more vibrant and healthy economy."

Despite this bipartisan agreement on the adverse effects created by rate differentials, the differentials are essentially a permanent feature of the tax code…

…Congress has heard seemingly endless hours of testimony and received reams of reports on how to treat carried interests. No clear consensus has emerged because there is no clear consensus.

How should the tax authorities react in the face of this uncertainty? A responsible step might be for private interests and the politicians to work together to draft a bill that would narrow or eliminate the gap between the taxation of capital gains and that of ordinary income. Whether this step involves increasing one rate, decreasing another rate, or splitting the difference remains to be determined. Other attempts to modify the tax treatment of private equity may be just as likely to introduce more complexity and controversy into the system than exists now. This step would require modifying tax rules that have existed for decades.

Of course, Prof. Steuerle’s claims about "tax arbitrage" raise an obvious point for tax authorities and politicians at all levels of government: if this practice is so harmful to economic efficiency, should politicians give up altogether the well entrenched practice of using tax codes to influence the behavior of individuals and organizations?