Conservatives break with GOP leaders on a tax bill

Some prominent conservatives are coming out in favor of a Democratic proposal to raise taxes on the private equity and hedge fund industries, signaling a break with anti-tax groups and Republican lawmakers on the issue.

William A. Niskanen, the chairman of the libertarian Cato Institute and a former member of President Reagan’s Council of Economic Advisors, called the share of investment profits, or “carried interest,” earned by hedge fund and private-equity managers “basically fees for managing other people’s money” and said it should be taxed as ordinary income rather than as a capital gain.

{mosads}John Chapoton, the Treasury’s former assistant secretary for tax policy under Reagan, called the current treatment of carried interest “a policy mistake”: “It was earned by the work of promoters [in the private equity industry] and it should be taxed as compensation.”

Irwin M. Stelzer, the director of economic policy studies at the right-leaning Hudson Institute, said flatly: “I don’t think there’s an argument on the equality side for the current tax treatment.”

A partisan fight erupted last month after Rep. Sandy Levin (D-Mich.) introduced legislation to raise taxes on carried interest from the capital gains rate of 15 percent to ordinary income rates of as high as 35 percent.

The private equity industry has locked arms with Republican lawmakers and such right-leaning and conservative groups as the U.S. Chamber of Commerce, Americans for Tax Reform and the Club for Growth to try to defeat the proposal, which they claim would harm the economy and begin a slide toward the outright repeal of the Bush tax cuts on capital gains.  

No Republicans have signed onto Levin’s legislation, but Sen. Chuck Grassley (R-Iowa), the ranking member of the Senate Finance Committee, has been probing the issue for months and is expected to introduce legislation, along with Finance Chairman Max Baucus (D-Mont.), on carried interest soon.

Stelzer said he agreed with many opponents of Levin’s bill that the labor — sometimes called “sweat equity”— as well as the intellectual capital that fund managers pour into investment deals should be regarded as equity capital.

But he said that maintaining the perception of fairness in the tax code trumps such concerns. “The ultimate goal of conservatives ought to be to preserve the sense that the capitalist system is fair,” he said. “That feeling has been somewhat diluted in recent years.”  

Phil Kerpen, the director of policy for Americans for Prosperity, suggested in an email to The Hill that conservatives were largely unified to defeat the proposal. “The center-right is united to stop any tax hike on carried interests capital gains, and this is a priority for the conservative and free-market movements,” he wrote.

But there are signs that conservatives are torn on the issue. The libertarian-leaning Economist magazine wrote in a recent editorial that the tax breaks benefiting partners of private equity firms “should be withdrawn.” Meanwhile, The Wall Street Journal’s conservative editorial board has weighed in strongly against the tax increase.

The conservative Heritage Foundation, usually a vocal opponent of tax increases, has not yet taken a stance on carried interest. A spokesman declined to comment for this article.

One Republican tax aide lamented that sound bites from the lobbying war have overshadowed a rigorous debate over how carried interest should be taxed. “What has surprised me in this discussion has been how quickly some people have accepted wholesale what the folks downtown are saying without being a little more intellectually curious about it,” the aide said.

Alex Brill, the former chief economist and senior adviser on the House Ways and Means Committee under former Chairman Bill Thomas (R-Calif.), said he is still mulling what he described as a complex issue. “It’s certainly something that’s worthy of examination,” he said, adding that “a lot of what is making people upset is that we have two tax rates in the tax code.”

Grassley has suggested that not drawing a clear line between income that is generated because capital was put at risk versus regular compensation could imperil the preferential tax treatment for capital gains.

 “As a Republican who supports lower capital gains rates, I am concerned that to the extent we permit the dilution of the investment concept, we risk undermining the arguments we have made for the lower rates,” he read in a statement before the Finance Committee in a hearing last week on carried interest. “We can’t allow the carried interest tail to wag the capital gains dog.”

Chapoton said that Treasury’s treatment of carried interest was never intended to spur a certain economic activity, such as dealmaking in the private equity industry, as several opponents of the legislation have suggested. “The argument that it was an incentive for capital formation is ludicrous,” he said.

He also warned that, if allowed to continue, the special treatment of carried interest could erode compliance with the tax laws: “We have a self-assessment tax system. It operates only if taxpayers believe it’s basically fair.”

Niskanen said that while he supported taxing carried interest as ordinary income, he favors far lower tax rates on corporations. He argued that the brouhaha over carried interest provided an opening for lawmakers to reduce the corporate income tax rate at the same time they raised taxes on fund managers.