Like Vic, "I certainly agree that allowing that preferential rate for capital gains on returns to human capital (i.e. labor income) is excessive." So let's go back to the relatively flat, and low, rate structure that Reagan gave us in 1986, and repeal all the junky phase-outs, targeted tax credits, and other gimmicks that Congress has enacted since then.

Isn't the real question that this editorial raises: who is Vic's pr agent and how do I hire him or her?

What taxes to levy on rich people whose skills can move with them is a very hard question, driven as much by what we *can* do as by horizontal equity. Ditto for taxes on income from capital.

The US has gone, over the last 20 years, from having relatively low marginal rates on both income and capital, by world standards, to being toward the high end on both. There isn't much further to go, when our competition is moving (being forced to move) the other way.

I'd rather get a blended rate of, oh maybe 20% from top private equity managers, and have them live here, than try to collect 30% and end up with zero because they decide to live elsewhere.

That competitive reality is absent from the Times article, and from Vic Fleischer's comparison of public equity to private equity. The private equity guys are much more mobile. The capital they manage is almost completely mobile.

I don't know what the right tax rates are today. I believe that inflation adjusted taxes on income from capital are likely to often be better than the US approach of preferential rates. Like Jake, I wish the Reagan compromise of low rates on income and equal rates on capital had been politically stable (though we still needed to index capital gains for inflation) But I do know that analysis that ignores the risk of "we could chase wealth generators away and earn zero tax revenue" won't get us very far.

Bernie Black

Vic,

In the public company context, the tax advantage of stock options is that the investment gain that accrues between grant and exercise effectively goes untaxed. The deferral aspect is a red herring. You could give the company an immediate deduction equal to the fair market value of the option at grant and get the same tax results as under current rules.

In the private equity fund context, the investment gain portion of the manager's pay is taxed correctly but the initial compensatory element is undertaxed because it is taxed at capital gains instead of ordinary income rates. (The investors are overtaxed because they effectively get reduced capital gains instead of ordinary deductions, but as you point out some investors are tax-indifferent.) Again, deferral is not the problem.

Gregg Polsky

Bernie - Thanks for the comment, which is helpful. I will try to address the competitiveness concern more clearly in the next draft. It's not clear from your comment if you've read the paper or are just reacting to the NYT squib.

In the current draft, I address the wealth generation point as an argument for an entrepreneurial risk subsidy. Your comment makes me think that I might want to call it a "competitiveness subsidy" or "competitiveness rate adjustment." In any event, I devote many pages in the paper to alternatives to treating carry as ordinary income, and it would certainly be reasonable for policymakers to choose one of those alternatives.

I certainly hope that economists perform more research that could inform us with more precision on the question of private equity fund mobility vs. public company mobility. In the meantime, though, we have to act with the best information that we have. We know that raising the tax rates will drive away some managers, but not all. Managing a PE fund in the UK or Bermuda isn't a perfect substitute for managing a fund from the US. And the status quo tax regime has its own efficiency costs.

Gregg - I'm still a little confused by the argument that deferral is a red herring. I think I see how it's a red herring under certain conditions IF everything is taxed at 35%. But if we accept a capital gains preference on investment capital as a given, and accept the presence of tax-exempt investors as a given, then I'm not sure it advances the ball (for purposes of my paper) to focus only on conversion.

I'm intrigued by your bifurcation of carry into a compensatory element and investment gain. How would you divide the two? I agree that carry has elements of both compensation and investment, and I suggest a cost of capital method as a proxy to measure compensation, and would allow conversion to cap gain on the rest. What did you have in mind? Suggestions are most welcomed on this point.

Vic,

In the corporate context, deferral is clearly a red herring as Dan Halperin showed in his 1986 Yale LJ article.

In the partnership context, the analysis is significantly more complex because the employee is on both sides of the equation. He is both the employee and--together with the other partners--the employer. Also, as you note the valuation question is difficult. I need to think about this some more but, to tax the compensatory element correctly, I think you could either (i) tax the FMV of the carry at grant as ordinary income, or (ii) tax all allocations with respect to the carry as ordinary income. The difficulty in (ii) would be taxing the investment yield correctly.

Gregg

"I will try to address the competitiveness concern more clearly in the next draft."

Just as an aside, I think I read Vic's paper for the first time during a workshop at Michigan Law School in, oh, say, 1994. Is this thing ever going to go in a journal, or will you continually improve it and publish it as the-greatest-and-most-edited-tax-paper-ever from your deathbed?

Wrong paper, Andy - that was the "Missing Preferred Return," which looked at how tax policy affected the design of the carried interest. That paper tried to understand and explain how the contracts worked rather than explore law reform alternatives. Wait, you don't remember every word of "The Missing Preferred Return?"

Ah, ok. In that case I'll take a look at the 2 and 20 paper and add to its already formidable download count.

"Deferral" certainly is a red herring. It's still all too easy (some think) to make deferral effectively infinite. A case I'm litigating involves tax deferral that, if carried to fruition, will easily outlive me and everyone else associated with the transaction, including the taxpayer/investor. At some temporal point, there is no difference between tax deferral and permanent tax avoidance.