The Senate is currently debating the American Jobs and Closing Tax Loopholes Act of 2010. Among the means of paying for the extension of various expiring tax provisions, it would raise revenues by changing the taxation of carried interest and restricting use of the foreign tax credit.
General
A May 28 report from the Joint Committee on Taxation of Congress provides a technical description of the proposed changes in the taxation of carried interest and the foreign tax credit.
Carried Interest
This is a term used to describe the special tax treatment of hedge funds, a type of highly risky and highly profitable investment vehicle generally available only to very wealthy investors. In effect, its managers are taxed at the maximum tax rate for capital gains—currently 15%--rather than at much higher ordinary income tax rates. The Fiscal Times reported details of the proposed change in taxing carried interest yesterday. Following are some important academic discussions of this issue.
In the first issue of the Columbia Journal of Tax Law for 2010, University of San Diego law school professor Karen Burke argues that the complexity of the carried interest problem would be better handled by Treasury regulations than legislation.
A September article in the National Tax Journal by economist Alan Viard urged caution in taxing carried interest because it would not improve the allocation of capital.
A July Congressional Research Service report provides an introduction to the carried interest issue and details about the nature of hedge funds.
Writing in the Summer 2008 issue of the University of Chicago Law Review, University of Pennsylvania law professor Chris William Sanchirico argues that the tax advantage of carried interest essentially exploits differences in marginal tax rates between hedge fund managers and hedge fund investors. He finds the idea that hedge fund managers’ profits are comparable to “sweat equity” is groundless.
A May 2008 article in the Virginia Law Review by University of Chicago law professor David Weisbach argues that hedge fund managers are essentially investors in their own enterprise and ought to receive capital gains treatment on their income just as other investors in the fund do. He urges that the current tax treatment of carried interest not be changed. (Note: this research was supported by the Private Equity Council, which is essentially the trade association for hedge funds.)
In an April 2008 article in the New York University Law Review, University of Colorado law professor Victor Fleischer argues that whatever reform is adopted, maintaining the status quo is untenable as a matter of tax policy. Taxing hedge fund managers less than their secretaries is too contrary to our notion of tax fairness.
In July and September 2007, the Senate Finance Committee held extensive hearings on carried interest.
Foreign Tax Credit
When U.S. companies do business in foreign countries they are subject to foreign taxes on their profits as well as U.S. taxes. To prevent double taxation, companies receive a foreign tax credit (FTC)—a direct reduction in their U.S. tax liability—for the taxes they pay to foreign governments. Economic theory generally considers the foreign tax credit as providing tax neutrality rather than a tax advantage for multinational corporations (MNCs). See this summary in the National Tax Association Encyclopedia of Taxation and Tax Policy. Historically, a principal justification for scaling back the FTC has been to increase domestic investment and exports. However, analysis shows that this is unlikely to be the case.
In a paper posted on June 3, New York University law professor Daniel Shaviro argues that the FTC is excessively generous and that it would be better to give companies a deduction for foreign taxes paid instead.
In a June analysis, Peterson Institute economists Gary Clyde Hufbauer and Theodore Moran are highly critical of proposals to raise taxes on the foreign source income of U.S.-based MNCs. They argue that the revenue increase will be elusive because such corporations will adjust their organization and operations to minimize it and that it will reduce domestic investment and exports.
● An August 2008 Government Accountability Office report found that 60% of the activity of U.S. MNCs is located in the U.S.
● A May 2005 article in the American Economic Review by economists Mihir Desai, Fritz Foley, and James Hines showed that increased foreign capital investment by MNCs is associated with increased domestic capital investment as well.
● A July 1999 study by economist Theodore Moran found that MNCs tend to export more than firms that have only domestic production facilities.
Bruce Bartlett is an American historian and columnist who focuses on the intersection between politics and economics. He has written for Forbes Magazine and Creators Syndicate, and his work is informed by many years in government, including as a senior policy analyst in the Reagan White House. He is the author of seven books including the New York Times best-seller, Impostor: How George W. Bush Bankrupted America and Betrayed the Reagan Legacy (Doubleday, 2006)
Previous posts from this week:
Focus on Health Reform 6/9/2010
Focus on Fiscal Stimulus 6/8/2010
