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Paul Abrams

Paul Abrams

Posted: May 24, 2010 04:13 PM

Ignored by Everyone: The Simple, Fair and Correct Solution to Capital Gains Tax Rates

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The 'crisis' of the week for the financial sector is the definition of income that qualifies for capital gains tax rate preferences for fund managers. The noise level suggests the apocalypse is again pending.

As usual, the country's inability to have an intelligent discussion, as opposed to the battling of vested interests, will result in bad policies: neither simplicity nor fairness nor principal nor the expected revenue collection will be enacted or achieved.

There is a reason for treating capital gains more favorably than salaries for labor and services. It coaxes money into long-term investments that create valuable products and American jobs.

That's it. There is no divine right of hedge fund managers to keep a greater portion of their incomes and thus either force up deficits or have others pay for what they are not paying. And, to my progressive colleagues, I would tell them that if someone is willing to put his money at risk, over time, and create jobs and value, they ought to be pleased with the benefits to society and incomes that provides.

The correct and consistent solution to the current brouhaha over taxing "carried interest" -- the amounts hedgies receive if the investments they choose for their partners are successful -- is to correlate capital gains preferred rates to job creation.

The simple way to do that is to provide the capital gains preferences only for direct investments in US companies, where the invested capital goes into the company coffers and not to some other investor with whom all that happened is that the shares have been purchased and traded, and money has gone from the hands of one investor to another.

In financial jargon, that would mean that only investments in "newly-issued" stock by the company would qualify for capital gains treatment.

All other arguments are self-servingly ridiculous. For example, I heard today on a financial network the argument that hedgies are really like homeowners, borrowing from banks (i.e., it is not "their" money invested) and then getting a gain when their home is sold.

Well, no.

A homeowner may have borrowed money from a bank, but he is on the hook for the entire amount over time, and is paying off that loan gradually. By contrast, a hedgie is investing other peoples' money and benefiting if those investments pay off. He is not on the hook for the investment if it goes sour and owes nothing to the investors (those whose money he is managing) if it implodes.

For this year, and this year only, I have previously argued that gains from all investments in "newly-issued stock" be taxed at zero regardless of when that investment is sold. That would cause a rapid rush of capital into companies, and provide them with confidence and capital to hire. After that one year, the capital gains rate should be raised back to, say, 20%, for qualifying investments made subsequently.

But, the basic point is that capital gains tax preferences should be tied to job creation, and the best way to do that is to define a qualifying investment as one that directly provides new money to the company -- i.e., "newly-issued stock" from the company to the investor.

This policy is simple, fair, productive, and consistent with the rationale for a capital gains preference in the first place.

Will it be discussed and considered? Of course not.

It does not pit one set of absurd arguments against another, so it has no value as spectacle.


(Disclosure: I invest and help manage a fund that only makes investments in newly-issued stock and thereby creates jobs. My investment far outweighs my management portion, so this proposal is of no great importance to me personally, but I thought it should be disclosed).