Redstate

Chairman Rangel Floats a Few Balloons

By blackhedd Posted in Economy — Comments (5) / Email this page » / Leave a comment »

Tax legislation has been on the middle burner for the last few weeks, as House Democrats try to decide what do to about the Alternative Minimum Tax. The key individual is Ways and Means Chairman Charles Rangel (D-Harlem). Some clues to his thinking are starting to come out.

The basic idea is to "patch" (eliminate) the AMT for many middle-class taxpayers, and sharply increase taxes on investment managers. It's shrewd politics on Rangel's part, although it has the potential to strongly curtail future growth in the US economy. But as Rangel himself has occasionally pointed out, at 77 years of age you tend not to take the long view.

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There should be no need to tell this audience why the AMT is a problem. It's a high-rate flat tax intended to ensure that truly wealthy people would never be able to reduce their income tax bills to zero in any given year by taking advantage of deductions. Although the numbers were small, the news headlines were ugly. ("Daddy Warbucks pays no taxes while the woikin' man carries him on his back!") We know Congress responds to headlines rather than to reality, hence the AMT.

But back in 1969, when the AMT was enacted, Congress saw no reason to index the tax for inflation. Consequently, as the years go by, the tax snags more and more people at lower and lower levels of real income.

So the Democrats would like to eliminate the AMT for the middle class. I'm going to leave aside that Republicans have been howling about this tax for many years, since it amounts to an "automatic" annual tax increase that requires no vote in Congress and no electoral accountability. But let's concentrate on the Dems, since they're in power now.

I've said here on several occasions that the shrewdest possible tax strategy for Democrats would be to seek the elimination of all income taxes (except FICA/FUTA) on as large a slice of the middle class as they possibly can. Rangel's proposal fits this model precisely.

It's already true that perhaps half of all taxpayers pay quite small amounts of income tax, both absolutely and as a percentage of income. That has the effect of making big government seem like a sweet deal to all of these people. And with a whole raft of new middle-class entitlements being proposed by Democratic Presidential contenders, big government will only continue to get bigger.

Something has to relieve the pressure from those troublemakers (viz., us) who still believe that small government is a virtue. Hence, the beauty of eliminating the need for the beneficiaries of middle-class entitlements to actually pay for them.

Now Rangel is actually pulling a bit of jujitsu on Congressional Republicans. The AMT patch must become law in the next two weeks, if it's to become law at all, because the IRS will need time to reprogram their computers.

House Republicans have (ironically) been urging Rangel to scrap the pay-go rules that require tax cuts to be offset with spending cuts or other tax increases. Rangel has refused, saying in effect: "you Republicans made the fiscal-discipline bed, now you can sleep in it."

So since spending cuts will never, ever happen in a Democratic Congress, that leaves tax increases to pay for the estimated $48 billion shortfall caused by eliminating the AMT for middle-class taxpayers. Where's Rangel going to get all that money?

By increasing taxes on "carried interest" from their current 15% to well over 35%.

There are several different terms for carried interest, depending on the type of investment vehicle, but this essentially refers to the amount by which investment managers get compensated for increasing the value of the assets they manage.

Here's how it typically works: let's say you manage a hedge fund, and it's a medium-sized one with perhaps $1 billion under management. (The $1 billion comes from your limited partners, who are usually pension funds, insurance companies, university endowments, and other such large investors.)

You get paid 2% of assets just for coming to work every day. That's $20 million a year. This gets taxed as ordinary income. So far, so good.

Now let's say you're a screaming success with your investment activities, and you manage to turn $1 billion into $1.4 billion in a year. Your limited partners are of course thrilled to pieces, and they are happy to you pay you a fee of $80 million on top of the $20 million. That's 20% of the increase in value that you created in their assets.

Now of course, the $400 million that you created through your investment activities is a capital gain. Up until now, the 20% of this capital gain that you (the general partner of the investment fund) keep as your compensation for success, has also been taxed as a capital gain.

That's what Charles Rangel wants to change. He wants to tax the capital gains earned by fund managers as ordinary income, thus raising the rate on them from 15% to perhaps 37% or more. And that's how he wants to fund the patch to the AMT.

There's another side-piece to the proposed legislation, negotiated by Treasury Secretary Paulson: the proposals will include a cut in the corporate tax rate from 35% to about 31%. This may seem like a huge concession, but remember that Congress calculates the impact of tax policy using static analysis. And the total profitability of American corporations is a very low number, usually in the same range as the Federal budget deficit alone. So cutting taxes on this small number has a low static effect, which is probably why Rangel felt good about giving it.

Of course, you could imagine that corporate profits aren't really taxed at 35%. If you add state and local taxes, and (crucially) the double-taxation effect, business profits are really whacked at maybe 75% or 80%. This explains why businesses contrive to be less profitable than they perhaps could be, and also suggests a surprisingly large Laffer-curve effect from cutting the business tax rate.

Back to the carried-interest levy, however.

Mr. Rangel is undoubtedly playing some very shrewd politics, by making big government seem like a much better deal to its immediate beneficiaries. But what happens to all those rich fat cats who suddenly face a big tax increase?

No problem! They'll simply change their fee structure from the "two-and-twenty" that I described above to perhaps "two-and-twenty-eight." Their take-home pay won't change. They'll pass the increased taxes on as reduced investment returns to their limited partners. Many of these, of course, are tax-free entities like pension funds, so they don't face an increased tax liability.

But by reducing the returns to capital, the Rangel proposal ultimately will strongly attenuate the general level of material well-being in the United States. Just exactly who are the beneficiaries of all that investment activity that Rangel wants to raise taxes on?

Well, who is it that benefits from portfolio holdings by pension funds and insurance companies? That would be none other than the retired teachers, firefighters, and government employees that voted Democratic in the first place.

Charles Rangel is going to pay for a middle-class tax cut by reducing the value of the retirement savings of those same middle class people. And how do you think they'll respond at the ballot box? My guess would be: "don't tax you, don't tax me, tax that guy behind the tree!" Except the guy behind the tree is you and me.