‘Carried interest’

Raising the tax rate on a financial practice known as "carried interest" -- a tax hike that Congress hopes will raise $1.7 billion per year in new revenues -- may be an interesting study in just the kind of thinking that has the economy largely frozen in its tracks.

This "little" tax hike has already been enacted by the House as part of HR 4213 and is up for a Senate vote soon.

Let's say a group of investors hopes to acquire a run-down shopping center and fix it up for $10 million. If the plan works out, the goal is to sell the gleaming "new" retail center for $12 million, five years down the road.

These investors need a general contractor to ramrod the project. In a fairly traditional arrangement, to give that contractor some incentive to bring the project to fruition, they offer said contractor a 20 percent share of their profit.

A contractor agreeing to such an arrangement is working for "carried interest." If any of a hundred things go wrong and the deal is never completed, he'll get nothing. But if it all does work out, and the contractor finally gets $400,000 for his five years' work, how should that be taxed?

Up till now, it's been taxed as capital gains, at a current rate of 15 percent -- though congressional Democrats are eyeing a rate hike to 20 percent.

But HR 4213 specifies such income would instead be taxed at the prevailing personal income tax rate -- for which the top rate could soon jump from 35 to 39.6 percent.

"Supposedly this is going to get those bad guys on Wall Street. But who it really affects is small entrepreneurs," explains Ralph Murphy of Las Vegas' Circle M Development.

"It's going to hit projects that are right on the margin. A lot of those projects just won't get done. What they should be proposing if they want to get some of these projects moving is to go in just the opposite direction, to cut the capital gains tax rate in half."

The tax rate on proceeds from such "carried interest" arrangements in India today is zero. In Red China, it's 10 percent. Even in grossly overtaxed England, it's 18 percent. And those with capital are perfectly free to invest it in such locales. Yet the Congress now proposes to push the tax rate on such at-risk enterprises in this country to something approaching 40 percent -- a 157 percent effective tax hike?

It would be a mistake to enact HR 4213 in its present form.