Carried Interest, Partnerships, Income Tax Deferrals, and a System More Compatible With Democracy

By Tom Pallow of Third Way Progressives, 4/25/11

The one area that I have covered least on the blog postings and in the literature that can be found at concerns the parts of our tax plan that most relate to taxes on very high income earners and the area of international tax law. These subjects will be covered in this paper.

It is ridiculous that profits from most hedge fund investments, as well as most capital gains, receive a top tax rate of 15%. Our capital gains tax plan would fix this problem, and our capital gains plan is essentially our fix to the Carried Interest Rule. Our Carried Interest Rule fix would generate much new federal revenues, as well as state revenues if they so chose, while simultaneously creating new private sector jobs in the US.

Our capital gains plan would bring tax rates to 15% and 10% for long term gains made from four special investments, while raising the top rate on all other long term investments to 25% or higher. These four special investments are: venture capital funds and projects, stocks bought at IPO or secondary offering, bonds bought at first issue, and the underwriting of any of the above three investments. Very importantly, in order for gains from these four investments to acquire a lowered capital gains tax rate, the venture capital project or business that is doing the VC, the IPO, or the first issue would have to have at least 5% of their overall business expenses as US employee expenses that would qualify for our US Employee Tax Credits that are used in the personal income and C Corporation parts of our tax plan. For more information on all of our tax plans visit

Our capital gains plan, if the top tax rate were only raised to 25%, would raise over 63% more federal revenues than President Obama’s capital gains plan. In fact, under our capital gains tax plan, top long term rates could be taken up to the personal income tax rates and no harm would be done to the US economy. On the contrary, the larger the difference in tax rate between ordinary speculative investments and the four special investments that receive the lower tax rate, the greater would be the incentive to invest in American jobs and the more federal revenues would be collected. Our capital gains tax plan would simultaneously incentivize American private sector jobs while increasing federal revenues, along with creating a fix for the Carried Interest Rule, because, generally, only about 3% to 12% of all gains in the financial markets come from the four above investments that receive the lower tax rate; this includes hedge fund investments (1&2). While it is true that hedge fund moneys retain a higher percentage of this 3% to 12% of financial gains than do non-hedge fund investments, these four investments are still only a small minority of hedge fund gains. Therefore, our capital gains tax plan would raise more federal revenues from these hedge funds while incentivizing them to invest in jobs in the US!

Regarding how partnerships are taxed within the personal income tax portion of our plan, in order for anyone to be considered a “business owner”, and therefore be able to exercise our US Employee Tax Credits against their personal income, a person would have to receive 10% or more of the before tax, net profits of a business. Then, whatever amount of US ETC is awarded to that business is split among all partners who receive 10% or more of the before tax profits of that business, and the US ETC is split in portions that equal the exact portion of the before tax profits that a partner is given.

For example, if a partner in a business receives 20% of the before tax, net profits of a partnership that is taxed as personal income, that “business owner” can then exercise 20% of whatever US ETC is generated from that business. Further, and very importantly in order to prevent fraud, that business owner can only exercise those tax credits against the profits that come from that business entity. So for example, if a person in the top tax bracket were to have income from three separate sources, one of which is W2’d income, and two of which are separate businesses where that person receives more than 10% of the profits of each business, that person would add up all of their income from the three sources to find their top tax rate, then he would exercise the US ETCs generated from each business only against the income generated from that business, and only down to as low as the flour cap for the US ETCs would allow the rate to go. Very important to remember, a “business owner” cannot receive any salary or any form of income that is then used to exercise a US ETC for any business in which he is a “business owner.”

The above, 10% of profits to be “business owner” rule, is set low enough to incentivize private sector capital formations for businesses, but high enough to avoid the tax fraud of every employee claiming be a business owner and therefore wanting a lower tax rate. Also, in order to establish an “active” definition of ownership, no one business can have more than five business owners who qualify for the ETC at any one time. There also may have to be enacted what is called the Captivation Rule. The Captivation Rule simply states that a current employee of a business can not suddenly become their own private business or independent contractor who then lowers their effective tax rate through ETCs when their former employer makes up more than 60% of the total client revenues of the new private business. This rule should have a time limit of no more than 10 years.

Regarding how US multinational businesses and foreign businesses in the US are taxed under our tax plan, keep in mind that within our C Corporation tax plan, in order to keep that part of the plan revenue neutral, the tax credits have a value of only $.04 on the dollar, while in the personal income portion of our plan the tax credits have a value of $.07 on the dollar. However, we also propose that we should give the US ETCs in our C Corporation plan a higher value and more “power”, if a business is paying above the prevailing wage and the degree to which it is paying above that prevailing wage for a geographic area, or if the business is paying for employee pensions or healthcare. The “power” of the US ETC refers to the degree to which the US ETC is allowed to lower an employers flour cap tax rate for the US ETC. For example a pass through business could go from a top tax rate of 35% to 30%, and a C Corporation could go from 35% to 25%. The plan also proposes making the value and/or power of the US ETCs worth more if a business has a comparatively high percentage of their total global expenses that are employee expenses that would qualify for our US ETCs. Our tax plan also proposes that these elaborations of the plan could be incorporated for businesses and US multinationals that are taxed as personal income. With or without these elaborations to our tax plan, the US could then use a world-wide tax system or a territorial tax system. However the US, as well as the rest of the world, would do best by moving to a modified world-wide tax system.

Under a territorial tax system, the ETCs would be calculated, but not taxed in final, as though a world-wide tax system was being used, then a territorial system would be used for the final tax bill. That is, within the C Corporation part of our plan, and maybe even the personal income part with further elaboration of that plan, a US business would have its final tax bill calculated on a territorial basses, however, the value and power of the US ETCs would be calculated using a world-wide system. The US ETC would be more valuable and/or powerful, the higher the percentage of a US multinational’s total worldwide expenses are US employee expenses that would qualify for the US ETC. After the value and power of a US multinational’s US ETC is calculated, the US multinational would be taxed using a territorial method while exercising its US ETCs.

However, the optimum policy for the US and most other nations of the world would be to use a world-wide tax system, with the caveat that the tax for foreign profits would be set at a lower rate than the C Corp or personal income rate. That is, let us suppose that the US’s top C Corporation statutory tax rate is brought down to 30% after a Wyden-Coats type bill and our tax plan is enacted. Let us suppose further that a US C Corporation must pay US taxes on profits made in Ireland. Ireland has a top statutory tax rate of 12.5%. If income tax deferrals were ended, this US C Corp would have to pay a 12.5% tax to Ireland, and then it could credit this tax bill paid to Ireland against the rest of the 30% US tax bill for a payment of about 17.5% to the US government. The problem with this extra 17.5% payment is that it might be so large as to cause this US C Corp to move completely out of the US and to Ireland, or some other tax haven nation. Therefore, the extra percentage of tax that is paid to the US due to the world-wide tax system should be set at no more than 10%. Moreover, as a greater incentive to hire in the US, those US businesses with powerful US ETC, because they have a high percentage of their global expenses as US employee expenses, would be able to have a tax rate as low as 3%. Therefore under a world-wide system, a US business would calculate the value and power of their US ETCs using a world-wide system. Then, they would take that power of their US ETC to calculate the tax they have to pay on their foreign profits, whether the tax is set at 10%, 3%, or somewhere in between.

Under the above world-wide tax system several developments would occur. More tax revenues to the federal government would be raised, there would exist much less of a motivation for US businesses to relocate overseas, there would be an increased tax incentive to hire in the US, and under a world-wide tax system most other forms of international tax avoidance, like transfer pricing, are much easier to detect for the IRS so even more federal revenues would be raised.

Naturally, the next question that arises is, how is the value and power of a US ETC calculated for foreign multinationals that are doing business in the US now or foreigners who want to do business in the US for the first time? The answer to this question is the most delicate of all perhaps in our entire tax plan. The issue here is that the US government will want to find a value and power of US ETC that is strong enough to entice foreign multinationals to invest in the US for the first time, but not too valuable and powerful that too many US companies that have weak US ETCs are left with higher effective tax rates than foreign multinationals who have far less employee expenses that would qualify for the US ETC. Therefore, a happy median must be found here. The best happy medium would be to immediately set the value of the US ETC for a newly US hiring foreign multinational at 30% of the fullest value that any US ETC could achieve. For example, if, all things being equal, a US ETC could be worth anywhere from $.04 on the dollar to $.07 on the dollar, a newly American hiring foreign multinational would upon entree into the US have a tax credit worth $.05 on the dollar. New US foreign multinational would have US ETCs with a power equal to their American counterparts. Once that foreign multinational hires for more than one year in the US, and this goes for today’s foreign multinationals in the US, the value and power of their US ETCs would be calculated using a comparative average between the US’s foreign and US’s domestic employers. Foreign owned businesses that are not C Corporations would be taxed just as if they were domestically owned non-C Corporations.

Again, the above would happen only if we decided to enhance our C Corporation tax policy, or even our personal income tax policy, so that in the case of C Corporations the US ETC would be worth more than $.04 on the dollar. However, even if these elaborations to our tax plan were not made, using a world-wide tax system that has a tax rate set at 10% or 3%, or something in between, would create an incentive for US multinationals to hire in the US. This is because, let us suppose that US C Corporations can use US ETCs to lower their tax rate from 30% down to 20%, if a US business is very socially responsible and has a top US tax rate of 20%, then with a lower tax rate on what they have to pay on foreign income, they will continue to be rewarded for being socially responsible in the US. This would not be true under our current world-wide tax system without income tax deferrals.

Therefore, our tax plan would promote the use of a world-wide tax system for the US and for most other nations. We also believe that our tax plan would work best if it were married with a plan much like the Wyden-Coats Bill. It would also be very beneficial if these plans were incorporated with some of the proposals to make our tax policy and the IRS much more computer friendly, where taxes can be done for most Americans and American businesses easily over the internet.

With our tax plan enacted, a world-wide tax system would be promoted, and with computer improvements by the IRS, and with other nations taking on our tax plan, and therefore more nations taking on a world-wide tax system, and with their computer improvements, all global and US tax enforcement will improve. Global tax policing will be improved, so more revenues will be raised to all governments, without raising enforcement costs. Also, the issues of immigration and security will be more easily solved and enforced. Nearly world-wide we would be bringing tax policy into the 21st century global economy.

On top of all this, our tax plan, or Keynesianism for a global economy, or qualityism, would have the effect of making the world more peaceful. This is because qualityism is more compatible with democracy then is socialism, the current solution on the far left. Socialism involves expropriating businesses and property from many people. This comes in conflict with democratic freedoms. Yet qualityism is about empowering and uplifting, not taking businesses away from individuals, so it is much more compatible with democratic rights. Plus, qualityism does better than any economic philosophy at creating competition in the economy. This is because it works to decrease oligopolies, something that conservatives dont’t always fight hard enough against. Plus qualityists are not for government monopolies, except for the police and the military. Qualityists are only for government options in some economic sectors. Because qualityism is more compatible with democracy, and once the rest of the world takes on qualityism, there will be more democracies world- wide, and therefore, there will be less of a need for military spending, both world-wide and for the US.

In such a world, once again, just like with most of the 20th century during the era between the progressive era that really began in 1913 and the advent of the global economy that came with the fall of the Soviet Union, political parties would once again compete in productive ways over the size of government. Between 1913 and 1989, developed capitalist democracies where able to primarily debate and enact policies related to the size of government and the tax rates on its wealthiest people. With qualityism we will be able to go back to such simple debates and policy changes, although we now need to move the rest of our government into the highly competitive global economy of the 21st century. But this is exactly what societies do; before they transform or reform their governments they generally start with tax policy. Let’s get this tax stuff done, put the credit markets as ease, and get on to working on the other stuff!

1. “Recent Changes in US Family Finances” Federal Reserve Bulletin.

2. Jay R Ritter, University of Florida, “Initial Public Offerings”

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