Sunday, March 4, 2012

A Weak Defense of a Low Tax Rate on Carried Interest

Mark Thoma links to two articles that should be read at the same time. First up is Greg Mankiw:

WHAT is carried interest? And why does it get the tax treatment it does? … If we are going to tax capital gains at a lower rate, one question necessarily arises: What is a capital gain, and how can we distinguish it from ordinary income? The answer seems simple. If you have a job, the money you are paid for your work is ordinary income. If you buy an asset at one time and sell it later for a higher price, the profit you made from holding it is a capital gain. But is it really that easy? Consider five examples, and see if you can identify what is ordinary income and what is a capital gain:

His fourth example was:

Dan is a real estate investor and a carpenter, but he is short of capital. He approaches his friend, Ms. Moneybags, and they become partners. Together, they buy a dilapidated house for $800,000 and sell it later for $1 million. She puts up the money, and he spends his weekends fixing up the house. They divide the $200,000 profit equally.

In his defense of the current treatment of carried interest, he writes:

This brings us to Dan and his partnership with Ms. Moneybags. The tax law treats this partnership as exactly equivalent to Carl’s situation. In this case, however, the $200,000 capital gain is divided into halves: some of it goes to Ms. Moneybags, who provided the cash, and some goes to Dan, who provided the sweat equity. Once again, nothing is treated as ordinary income. In some ways, this treatment makes sense. After all, Dan is doing half of what Carl did, so why should he have to pay a higher tax rate than Carl did on that half of his income?

As I read this question, my first thought was – maybe we should raise the tax rate on capital income to equal the tax rate on ordinary income. David Cay Johnston provides an interesting discussion of whether the proposed reduction in the corporate profit tax rates is really a reduction in the taxation of capital income or is indirectly a reduction in the tax burden on wages with this gem:

On the face of it, the AEI argument suggests workers should be joining the calls for Congress to cut corporate income tax rates. But, if the argument is correct, then workers should also be calling for cuts in their own income taxes and an end to reduced rates on dividends and capital gains.


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