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Welfare for Billionaires

June 4, 2007

An editorial in the New Republic, prompted me to respond with a long comment, that I thought I would reprint here. The gist of the editorial and comments is that allowing hedge fund managers capital gins treatment for some of their income is some kind of crazy "welfare for billionaires" and a "loophole."

It may be wrong, but taxing capital gains at a lower rate than ordinary income is not as crazy as the article and commenters would have you believe. Nevertheless, the compensation in this case does seem to have more of the characteristics of ordinary income.

The fundamental problem is that we have an income tax rather than a consumption tax. To understand why that is a problem, one must first understand a couple of principles of the tax system:

First, any tax system that taxes anything other than consumption artificially reduces the incentive to invest over what that incentive would be in the absence of taxes. Such a system creates ARTIFICAL disincentives to investment.

Second, not taxing returns on an investment of money on which tax has already been paid is mathematically equivalent to providing a deduction for the initial investment and taxing the returns (assuming all the tax rates are the same).

Assuming no deduction for the initial investment, only a tax exemption for returns on investment would produce a system that did not artificially retard incentives to invest. The lower capital gains rate reflects a political compromise that IN THEORY decreases the artificial disincentive to invest rather than consume. Ideally, the capital gains rate would be 0% and a 0% rate would apply to other returns from investment such as interest.

I said "in theory" above because there is a big catch: it is very difficult to distinguish between returns on investment and returns on labor. As a result, (i) huge amounts of resources are wasted trying to get income classified as capital gain (gain from investment) rather than ordinary income (income from labor); and (ii) people are often successful in getting income that in theory should be ordinary income, classified as capital gain. The capital gains treatment of the carried interest of hedge fund managers seems to fit into this category. This isn’t the result of a "loophole", it is jsut very hard to distinguish the two.

This problem is one that is inherent in a tax on income rather than on consumption. If consumption were taxed, no longer would people expend effort trying to reclassify income.

The consumption tax is not a panacea, with it you have issues of whether expenses are really consumption or whether they are investments– some are both (e.g. a business lunch), but at least you then have issues with respect to a tax that is focused on what tax theorists agree should be the focus of the tax system, rather than an income tax– which exists as it does for political, rather than economic reasons.

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