Despite the ubiquity of the OPM objection, however, no one has ever been able to explain it to me. It struck me as absurd when I first heard it and after hearing it a hundred times, it still strikes me as absurd.
First, what on earth would be gained by restricting capital gains tax treatment to those who invest only their own money? What policy objective would be achieved by this restriction?
If the purpose of allowing preferential tax treatment for capital gains is to reward entrepreneurial risk-taking, there’s no reason to restrict this to the holders of capital rather than those who conceive of risk-taking investment strategies. If anything, raising taxes on hedge fund managers would increase the cost of entrepreneurial activity—you get less of what you tax—undermining the objective of the preference.
Second, market efficiency would be impaired.
If the holders of capital believe hedge fund managers are better able to allocate investment assets than the holders themselves, why would we want to place additional burdens on this decision? At the margin, this would result in more investment decisions being made by the holders of capital rather than hedge fund managers. But since the accumulation of capital is not correlated with investing prowess, this would mean that sub-optimal investing decisions would be made.
Third, the worst aspects of the capital gains preference would be amplified.
A long-running objection to having lower rates for capital gains is that it allows “old money” to pay lower taxes on income than the “working classes.” Ending capital gains treatment for carried interest just makes this worse by excluding those who need to raise capital from others from the preference.
Think of it this way. If a young man with a talent for investing is fortunate enough to inherit $10 million, he can launch a hedge fund with his own money. He would get 100 percent of the gains, and pay taxes on the portion of his gains after expenses and losses at the 15 percent capital gains rate.
If the very same young man was not fortunate enough to inherit that kind of wealth, he would need to turn to outsiders to launch his fund.
Under the proposal to treat carried interest as ordinary income, he’d pay a higher tax rate than the guy who inherited his wealth. Is this the result U.S. senators like Carl Levin are looking to achieve?
Fourth and finally, it won’t really raise taxes on the wealthiest hedge fund managers. Last year, according to some study or another, the wealthiest 25 hedge fund managers collectively made $22 billion. If you raise taxes on the money they manage for others, a number of them will very likely stop managing that money. They’ve got plenty of their own money to manage, thank you very much. And those gains will still count as capital gains.
The idea of taxing carried interest as ordinary income cannot be justified on the basis that hedge fund managers are using money raised from others. If it can be justified at all, it will need stronger stuff than this.
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