An editorial in this morning's Times mentions my paper, Two and Twenty: Taxing Partnership Profits in Private Equity Funds. The editorial, Taxing Private Equity, explains how the presence of tax-exempt investors in private equity funds raises the stakes on both deferral of fund manager compensation and its conversion into capital gain. In the public company context, by contrast, the revenue stakes are lower, since every dollar of income deferred or converted by executives is roughly offset by a corresponding reduction in the company's tax deduction.
The editorial continues:
The deeper question in all this is whether capital gains — which are currently taxed at less than half the top rate of ordinary income — should continue to be so lavishly advantaged. The answer there is no. Today’s preferential rate for capital gains is excessive, with no mechanism in the tax code to ensure that it is not overused. Excessively favoring one form of income over another encourages wasteful gamesmanship, creates inequity and crowds out other ways to foster risk-taking. Tackling the too-easy tax terms for private equity is a good way for Congress to begin addressing that bigger issue.
Unlike the Times, I'm agnostic about whether the preferential rate for capital gains on returns to investment capital is excessive. But I certainly agree that allowing that preferential rate for capital gains on returns to human capital (i.e. labor income) is excessive, at least when coupled with the absence of substitute taxation and the deferral benefits of the 2 & 20 structure.
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11. Posted by Jake on April 3, 2007 @ 20:10 | Permalink
"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.