Democrats Capitulate on Hedge-Fund Tax

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.

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