Back in the fall, President Barack Obama wanted to partially pay for his American Jobs Act with one of the most wrong-headed tax hike ideas you’ll ever hear about. See, when an entrepreneur sells his business or takes it public, any profit on the transaction is traditionally taxed as a capital gain, currently subject to a 15 percent rate. This has been true whether the business is a private equity manager, an oil partnership, or a comic book store.
But Obama wanted to change the rules of the game by targeting an unpopular sector of the economy: Wall Street. Specifically, Obama sought to tax profits from the sale of investment management partnerships—such as private equity, venture capital, or hedge fund firms—at the top ordinary income rate of 35 percent. (Soon to be 40 percent if the Bush tax cuts are not extended for 2013 and beyond.)
In other words, a special tax just for financial entrepreneurs. (An earlier version was somewhat broader.) The Private Equity Growth Capital Council had a solid point when it said that such a tax hike “violates basic tax fairness policy and seems to single out the private equity, venture capital, and real estate industries in a punitive fashion.” But for the White House, those are features not bugs. It hoped the move would both boost the chances of getting Congress to pass a tax hike as well as embarrass those Republicans who opposed. (The Occupy movement was cresting right around this time.)
Indeed, the tax provision is so bizarre that some Washington tax mavens thought it a bizarre clerical error when they first noticed it. Penalizing the “sweat equity” of entrepreneurs—and people who start and build financial firms are entrepreneurs just like those who start technology companies—would be a radical change in tax policy.
Even worse, the administration tried to hide what it was doing by intentionally conflating the issue with that of carried interest, the performance fee fund managers earn as part of their compensation. Carried interest is also currently taxed at the lower capital gains tax rate. Team Obama and other Democrats—and Warren Buffett—have argued that wealthy fund managers shouldn’t pay a lower tax rate than their secretaries.
The “enterprise value” tax, however, is something completely different. But, like many carried interest proposals, it is intended to smack investment funds. Combining an EVT with an effort to raise taxes on carried interest creates the misperception that both tax measures are ending unfair loopholes. Now, that might be true with carried interest. It is undeniably untrue when it comes to the EVT. Indeed, of the $21 billion in new revenue that might come from the two tax hikes—assuming no negative economic impact—two-thirds would come from the EVT.
But this is about more than just raising a bit of revenue for Uncle Sam. The EVT, likely to arise again as a way to pay for a full-year extension of the payroll tax cut, gives Obama another cudgel to pound the financial industry as part of his neo-populist presidential campaign. And imagine if his Republican opponent is Mitt Romney, a veteran of both private equity and venture capital when he ran Bain Capital. Obama would surely use Romney’s likely opposition to an EVT as more evidence that Romney and his fellow Republican only serve the needs of the wealthy.
The EVT may make for good politics, but it is simply horrible policy when Washington should want to a) encourage venture capital to finance the companies and industries of the future and b) encourage private equity to make existing companies more productive.