Felix Salmon

Former Fed vice chairman Alan Blinder doesn’t

get it, and neither, frankly, do I.

Why do we have a preference for capital gains in the first place? The main

argument is that lower taxes on capital gains boost investment. But the evidence

on that point is iffy at best, and there are better ways to spur investment,

like, say, the investment tax credit. Besides, lower taxes on capital gains

reduce the tax bills of the rich relative to the rest of us — after

all, they own most of the capital. But in this age of hyper-inequality, shouldn’t

we be making the tax code more progressive, not less?

A far more important objection is that the tax preference for capital gains

undermines capitalism — a system in which capitalists, not the state,

are supposed to make the investment decisions. When I discuss this issue with

my Economics 101 students, I show them an example of a proposed investment

that loses money before tax (and which, therefore, should be rejected) but

which actually turns a profit after tax because of the preferentially low

capital gains rate. (Accountants and tax lawyers live this example every day.)

The government thus induces people to make bad investments.

Justin Fox, on the other hand, says

that "In economic theory it’s pretty clear what a capital gain is and

why you would want to give favorable treatment to capital investment."

And Brad DeLong says

that he’s "’much more sympathetic to the capital gains tax preference

than Alan Blinder is".

The way I see it, when you’re rich enough, you can pretty much always structure

your income so that it turns into a capital gain. (In its simplest form, you

just found a company with a little bit of money, redirect your income into that

company, and then sell the company.) So having a capital gains tax rate much

lower than the income tax rate is tantamount to giving the rich a massive tax

break – even before accounting for the fact that it’s the rich who generally

have capital gains in the first place, and not the poor.

But I’m not an economist, so maybe one of them can explain to me how economic

theory, and/or economic practice, shows that capital gains should indeed be

taxed at a lower rate than income.

This morning’s WSJ fronts

some Democrats’ second thoughts about taxing hedge-fund managers’ income as,

well, income. And the paper almost makes it sound as though those second thoughts

are principled, as opposed to the result of a calculated desire to maximize

campaign donations:

Some prominent Democrats are beginning to rethink proposed tax increases

on hedge-fund and private-equity managers’ earnings, after an aggressive pushback

by industry lobbyists and arguments that the impact could extend far beyond

Wall Street…

Among other things, lawmakers say they worry a tax boost could take a bite

out of public pensions’ investment returns, adversely affect financial-sector

profits and employment or, more broadly, disrupt investment incentives.

Well, I’m sure they say that. But the arguments are ridiculous: we’re talking

about fund managers’ income, here, not investment returns or corporate profitability,

none of which would be affected. And the arguments about public pension funds

are disingenuous in the extreme:

A concern raised by some Democrats is whether a new tax increase on fund

managers will hurt returns for public-employee retirement plans. Joe Dear,

executive director of Washington state’s largest government-employee pension

plan, predicted that any tax increase would be passed along to investors in

the form of higher management fees. If so, pension funds and other investors

would see a decrease in their returns.

"The private-equity general partners are the cleverest people in the

world. Does anyone really think that they will end up paying the tax bill

that is aimed at them?" he said.

Mr Dear simply hasn’t thought out the logical consequences of his premise.

These private-equity general partners, and hedge-fund managers, might well be

the cleverest people in the world; they’re also capitalists to the bone. They

are going charge whatever the market will bear, regardless of how much tax they

pay. If they can charge higher management fees, they will charge higher management

fees – but that has nothing to do with the tax code.

And then there’s the famous "unintended consequences" argument.

"When you first hear about it, it seems like, ‘Yes, this looks like

an appealing way to generate a lot of revenue,’ but when you study it more

it seems like there are some serious unintended consequences," said Rep.

Brian Baird of Washington, a member of a coalition of centrist Democrats who

often play a deciding role on business and tax bills.

I’ll leave it to Justin Fox to demolish

that one:

It’s true: Any tax increase can have unintended consequences. They don’t

necessarily have to be bad consequences, though. Raising taxes on private

equity and venture capital partners and some hedge fund managers (many hedgies

don’t get the tax break) might cause our rivers to run with chocolate and

our air to smell minty fresh, all the time. Hey, you never know.

And I just feel the need to repeat that, if you’re talking logic and consistency,

there is no conceivable reason for these people’s carried interest to be taxed

as capital gains (at 15%) instead of earned income (35%). It’s compensation–just

like CEO stock option gains and investment banker bonuses, both of which are

taxed as income. The private equity people have no argument. So they

go instead with "unintended consequences." It’s the last refuge

of the tax code scoundrel.

The private-equity types have comprehensively lost the argument about whether

they should pay income tax on their income. But they’ve also won the battle,

by sheer force of money. This is exactly the kind of legal corruption that Larry

Lessig is now looking into; I’ll be fascinated to see whether he can

come up with any proposals for improving matters.