Debate Over Taxing Hedge Funds
Under the category of “We Told You So,” yesterday’s CongressDaily includes an analysis by Martin Vaughn that makes a point similar to the theme of our last Wire—that the debate over how to tax hedge funds is just the beginning of the debate over how to define and tax all sorts of income from ownership. Here’s how Martin sees it:
Forget Blackstone. Many smart people on both sides of the argument over whether to raise taxes on private equity and hedge fund managers’ profits see this as a proxy debate for whether the tax code should continue to substantially favor capital over wage income. It might play into decisions over whether to let the capital gains rate reset to 20 percent, as scheduled in 2010, or even whether to push that rate higher.
All of the political attention to the tax breaks enjoyed by Wall Street managers is borne, first of all, of a growing awareness of wealth and income disparity in the United States. As pointed out in a New York Times article Sunday entitled “The Richest of the Rich, Proud of a New Gilded Age,” Citigroup founder Sanford Weill and Blackstone Group Chairman Stephen Schwarzman are part of a new class of plutocrats that inhabit a realm far beyond the dearest aspirations of most Americans.
They offer a neat test case for the question: Should the tax code be further leveraged to redistribute the benefits of recent economic growth? The consensus answer among Democrats — even those that harbor doubts about the specific tax proposals on carried interest — seems to be yes.
Smart people? Us? You’re too kind, Martin. Some in Congress frame tax increases under the guise of taxing the rich, but the policies themselves, as often as not, reach deep into the middle class, individuals and businesses alike.
More on Treasury’s Review of Corporate Tax Treatment
As we mentioned, Secretary Paulson will hold a half-day conference examining our corporate tax code and its impact on American competitiveness next week. This past Monday, the Secretary held an informal roundtable discussion with a dozen or so Think Tanks and Association representatives, including your intrepid S Corporation team, in preparation for the conference.
The forum provided an excellent opportunity for us to highlight the fact that the vast majority of businesses in this country are subject to the individual income tax, not the corporate tax. Based on his response, it appears the Secretary and his staff are well aware of the importance of S corporations and other flow-through businesses to economic growth and will keep their interests in mind as they develop their proposals.
The conference itself will explore not just our rules governing the taxation of U.S. corporations but the rules of other countries as well. Simply put, while the U.S. corporate tax code has remained relatively stable for the past couple of decades, the rest of our trading partners have been on a tax cutting binge. Just by staying put, the U.S. today finds itself falling further and further behind. Here’s how Monday’s Financial Times frames the issue:
Americans have long derided Europe’s over-reliance on the state, its comparatively high taxes and its meddling in free markets as the cause for the continent’s structurally high levels of unemployment and sub-par economic performance. France’s 35-hour work week alone gave free-market talking heads enough material to last a generation. But relatively little has been written about the race among many western European nations to attract private investment by cutting corporate tax rates.
For all the chest-thumping about America’s free-market system, a quick scan of corporate tax rates around the world would suggest that America’s success is due to ingenuity and hard work rather than the prescience of its policymakers. While corporate tax rates in the US have remained at 35 per cent, the average corporate tax rate for members of the Organisation for Economic Co-operation and Development has declined from 37.6 per cent in 1996 to 28.3 per cent in 2006, according to KPMG.
America’s corporate tax rates are currently among the highest in the developed world, just as Germany, France, Spain and the UK are all rushing to cut taxes. The markets appear to be figuring this out – the MSCI European stock index is up more than 111 per cent in dollar terms over the past five years, while the S&P is up a respectable 54 per cent. In the context of these higher tax rates and a regulatory regime ushered in by Sarbanes-Oxley, it is no small wonder that London is giving New York a run for its money as the world’s financial capital.
It appears Secretary Paulson is eager to shoulder the burden of bringing the US back into the forefront of aggressive tax policy. As his opinion piece in yesterday’s Wall Street Journal states:
Tax systems have one fundamental purpose — to raise revenue — and the best systems minimize the drag on the economy. Therefore, we should ask: For a given level of revenue, what business tax regime best promotes U.S. economic growth and creates jobs? At a time when markets change rapidly, requiring businesses to be ever more flexible and swift, they are burdened with a business tax code complicated by parochial political interests. Government should not pick economic winners or losers; the marketplace has proven itself more than able for that task.
Business tax policy levers, such as the corporate tax rate, depreciation rates and investor taxes, as well as the taxes levied on small businesses through the individual income tax, should strive towards a similar purpose: to encourage economic growth by reducing the tax burden on additional investments. Yet, the current tax code distorts capital flows, hurting productivity, job creation and our global competitiveness.
We’ll be attending the Treasury conference, and look forward to the opportunity to discuss further the various ways in which Congress can improve the tax treatment of all businesses, large and small, to help U.S. companies stay competitive with the rest of the world. We’ll let you know how it goes.
Accountants Weigh in on Tax Gap
First, the “Big Four” accounting firms weighed in on the Tax Gap. Now, the American Institute of Certified Public Accountants, the trade association for the accounting community, has added its input.
While only 1.3 percent of accountants believe that honest errors are the main source of the Tax Gap — no surprise there, since these are the same folks who prepare our taxes — nearly half suggested the small business community was responsible for the underpayment of the remainder of taxes owed.
The survey is on their website, but just one more reason for the small business community, and S corporations in particular, to be concerned.
Should S Corps Worry about Taxing Hedge Funds?
As you may have heard, both the House and the Senate are taking a hard look at how hedge funds are taxed. The concern is that wealthy hedge fund managers are subject to lower tax rates than most middle class families.
Hedge funds make their money generally through a 1 to 2 percent management fee plus a 20 percent share of any trading profits. This 20 percent “carried interest” is treated as a capital gain and is currently taxed at a top rate of 15 percent. Congress is considering treating carried interest as regular income, which would be taxed at rates up to 35 percent.
How much money is at stake?
According to the Managed Funds Association, there are approximately 8,000 hedge funds with total assets of about $1.2 trillion dollars. If the funds make an average rate of return of 10 percent, then the carried interest earned by hedge fund managers would be about $25 billion a year (20 percent of $120 billion in earnings). Raising the tax rate from 15 to 35 percent on $25 billion would raise $5 billion a year.
Even in Washington, that’s a lot of money.
Should S corporations care? As far as we know, there are no S corporation hedge funds. At its very core, however, the issue before Congress touches on the very difficult question of separating capital income from labor income. Here’s an example:
Two investors partner with a famous chef to start a restaurant. The investors put up money, while the chef puts up his name and reputation. Each receives one-third ownership in the venture. If they sell the restaurant for a profit ten years later, the gain from the sale is treated as a capital gain for federal tax purposes — even the chef’s share.
Although the chef did not put up any money, his investment is considered to be the reputation he has as a chef. Moreover, the gain on the sale of the restaurant was not guaranteed. If the venture failed, the investors would have lost their money, and the chef would have lost his reputation.
Carried interest received by hedge funds has similar qualities. The hedge fund managers do not put up any money of their own, but they are risking their reputations and proven talents. Moreover, they earn carried interest only if the fund makes a profit.
Obviously, there are significant differences between the tax treatment of carried interest and the treatment of small business sales, including the politics of the issue. The Joint Committee on Taxation just issued a comprehensive report highlighting these issues. But the broad theory behind the tax treatment of the two transactions is similar enough that S corporations and other small businesses should pay attention. As with the tax treatment of hedge funds, there’s a lot of money at stake.
Another Tax Gap Hearing, Another Standoff
In case you didn’t already catch the Senate Finance Committee hearing featuring Treasury Secretary Henry Paulson yesterday, here’s a quick summary.
The hearing itself was pretty entertaining and highlighted the on-going stand-off between Paulson and Finance Chairman Baucus. Baucus set a timetable for results saying that he wants a 90% voluntary compliance rate by the year 2017 – placing the responsibility on the Treasury to come up with this plan and deliver it in 90 days – July 18th – to the Committee. Paulson responded that he would be more than happy to come back in 90 days to present their current plan again. Paulson also stressed the difficulty of reaching the 90% rate without delving into the under-reported income area that is responsible for over 80% of the current tax gap – which will cause a lot of pain and require draconian measures.
Other highlights:
- Tax havens were a hot topic during the hearing – raised by Senators Conrad, Stabenow and Baucus. Baucus said there is “a lot of angst in Congress” over these issues.
- Senator Wyden asked Paulson about the status of Treasury’s response to the Tax Reform Panel’s report. Paulson stated that there “isn’t a major tax reform proposal being put forward and I don’t see it happening in the near future” and that the Treasury is focusing on more incremental steps toward tax reform.
- Senator Grassley raised hedge funds with Paulson. He asked if Treasury studied hedge fund tax policy in its financial markets study. Paulson said no, but Assistant Secretary Eric Solomon added that Treasury and the IRS are independently looking at hedge fund issues.
More AMT News
Meanwhile, CongressDaily reports that House Democrats are closing in on their plan to permanently address the Alternative Minimum Tax. For our new members, the AMT is an alternative tax system originally designed to ensure that a few rich taxpayers pay at least a minimum level of income taxes, but the combination of poor design and lower tax rates under the regular code have resulted in the unprecedented growth of the AMT among taxpayers whose incomes are decidedly middle class.
As outlined, the plan right now would eliminate the AMT for all taxpayers earning below $250,000 and reduce it for taxpayers with incomes between $250,000 and $500,000. Presumably, the AMT would be left in place for taxpayers earning above $500,000. To offset the revenue impact of AMT relief, the House is apparently looking at raising income tax rates on taxpayers earning more than $1,000,000 a year. Chairman Rangel’s comments also suggest they may still look at adjusting the rate thresholds, as we reported earlier.
While the story to date has focused on the trade-off between reducing taxes for middle-income AMT taxpayers and raising regular income taxes on wealthier taxpayers, we think it’s important to point out that the math simply doesn’t add up. The reported cost of the AMT plan is about $1 trillion over ten years. It will be simply impossible to raise that much revenue by just focusing on millionaire taxpayers. According to our friends at Statistics of Income, of the 132 million taxpayers who filed in 2004, only 240,000 reported incomes exceeding $1 million. To raise $1 trillion, the annual tax increase for each of these taxpayers would exceed $400,000 a year. To achieve that, the top tax rate of 35% would have to be raised to something around 50% for this group.
You don’t have to be a disciple of the Laffer Curve to recognize that marginal tax rates in the vicinity of 50% will result in serious economic dislocation. It will also hurt small businesses. As we’ve mentioned many times before, S corporations pay their taxes at the individual rates, so raising tax rates on millionaires means raising tax rates on successful small and closely held businesses — the very businesses we rely upon to create most of the jobs in this country.
Marginal tax rates of that magnitude are also politically unfeasible in today’s environment. The last time Congress raised the top tax rate (from 31% to 39.6%) in 1993, the majority lost both the House and the Senate in the subsequent elections. Many House members, including Ways and Means Chairman Charlie Rangel, were around in 1993, and they are unlikely to go down that path again.
Nevertheless, the current rhetoric is beginning to sound very much like 1993, when President Clinton promised to raise taxes on millionaires only and wound up signing a bill that raised taxes on just about everybody. The old line about robbing banks because “that’s where the money is” is overused, but it definitely applies here. Taxing millionaires to cut taxes on the middle-class makes for nice press releases, but when Congress seriously looks to raise revenue, it inevitably looks to the middle class, because that’s where the money is.
As long as the House insists on offsetting any changes to the AMT, the story will not be about rich verses middle class. Instead, it will be about how Congress rearranges tax collections on the same group of taxpayers — those in the middle and upper-income tax brackets. Some will see their taxes fall, and some will see their taxes go up. S corporations need to stay on alert.
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