Hedge-Fund Tax Really Attacks Capital Gains

"I have come here not to bury the capital-gains-tax rate, but to save it," was the de facto message delivered by Sen. Chuck Grassley at the U.S. Senate committee hearing I attended today on the wisdom of forcing hedge-, venture-capital-, and private-equity-fund managers to pay a higher tax rate—ordinary income rather than the cap-gains rate—on their 20 percent "carried interest" in the profits of their funds.

The Iowa Republican said he wanted to make it clear that the possibility of changing the tax law was not about raising taxes or "attacking the investor class." People making those charges should "cool it," he said.

Instead, the idea was all about removing a quirk in the tax code that was "undermining" support for keeping the long-term-capital-gains rate of 15 percent, below the rate for ordinary income. Plus, Grassley added, the carried interest preference made keeping the lower cap-gains rate past 2010 —when it and all the other Bush tax cuts are due to expire—more expensive.

Yet listening to many of the Democrats on the committee, it sure seems as though they believe higher capital-gains-tax-rates would be a good thing and that the "hedge-fund tax" would be only the beginning. Sen. Ron Wyden of Oregon made it clear he wants to remove the tax preference given to capital gains as way of making the tax code simpler and reducing economic distortions. Sen. Chuck Schumer of New York, while repeating his past support for lower investment taxes, admitted that the government does need to raise revenue to pay for education and infrastructure spending.

And what would be the harm in raising capital-gains-tax rates? Peter Orszag, head of the Congressional Budget Office, testified before the panel that the capital-gains-tax rate has little economic impact and, besides, there is plenty of capital out there right now.

Of course, that sort of "static analysis" tends to ignore the behavioral impact of taxes, such as the one highlighted by venture capitalist Kate Mitchell, head of Scale Venture Partners. Mitchell said higher taxes would reduce the incentive for people like her to be in such a high-risk business, forsaking much comfier and safer jobs on Wall Street or with technology companies.

See, while there may be "infinite capital" available for investing, "intellectual capital" is a bit more limited. And incentives matter. One person who did not "cool it" was Sen. John Ensign, a Nevada Republican. Ensign called changing the tax code an "absolutely dangerous idea."