06/11/2010 11:34 am ET Updated May 25, 2011

Opponents of Closing "Carried Interest" Loophole Actually Make Opposite Case

Policymakers would be well-advised to read a new Tax Notes piece by Douglas Holtz-Eakin, Cameron Smith, and Winston Stoody, which argues against closing a tax loophole that enables investment fund managers to pay taxes on their income - their "carried interest" - at the preferential capital gains rate rather than ordinary income tax rates.

Ironically, the authors actually make a persuasive case for doing just the opposite of what they propose - that is, for closing this loophole, as Congress would partly do under a pending compromise proposal.

Specifically, policymakers should:

Ponder the main point of this article:

"Perhaps most damaging, the higher taxes on carried interest will re-allocate managerial talent, as the entrepreneurially-inclined are deterred by these higher taxes and seek their outlets elsewhere in the economy."

That begs the obvious question: Should the tax code, as it now does through the carried interest loophole, encourage the best and brightest to become private equity managers or real estate developers as opposed to, say, scientists, engineers, or brain surgeons? We think not. The compensation of private equity managers should be taxed just like the compensation of all of these other important callings.

And heed its warning:

The authors do an important service when they highlight that these sophisticated financial players will "re-structure their investment vehicles so that the overall impact of the new tax on carried interests can be minimized or avoided altogether." That's a warning to policymakers to make sure that whatever proposal they enact is drafted as tightly as possible so that financial players cannot circumvent its intent.

Chuck Marr is director of federal tax policy at the Center on Budget and Policy Priorities and regularly blogs on the Center's blog, Off the Charts.