The Obama Tax Hike Machete

In his deficit reduction “vision” speech on Wednesday, President Obama tried to distinguish his plan from that of House Budget Committee Chairman Paul Ryan by using a rather crude analogy. The president said, “We have to use a scalpel and not a machete to reduce the deficit.”

But when it comes to tax hikes — to extend the analogy — the Obama administration’s 2012 budget is charging at business partnerships of all sizes with what could be described as a Texas-size guillotine.

The blunt instrument in Obama’s proposed fiscal year budget unveiledlast February — a budget that he referenced on Wednesday as the blueprint for his deficit plan — is a proposal to tax much of the capital gains of a partnership as ordinary income as well as subject them to hefty payroll taxes for Medicare and Social Security. This would more than triple taxes in many cases from the current top capital gains rate of 15 percent to the top personal income tax rate of 35 percent. Or actually 39.6 percent, since Obama would let the Bush tax rates expire too.

The contrast in Obama’s approaches to spending and taxes could not be clearer. Obama insisted Wednesday that he would not pursue spending cuts that “sacrifice the core investments we need to grow and create jobs.” Whether the spending he wants to preserve actually does “grow or create jobs” — and most of it does not — is one thing.

But Obama shows no such care or precision when it comes to making sure his tax policies do not “sacrifice the core investments” of the private sector. The carried interest tax is a direct attack on the structure of partnerships that are used by innovative businesses — from small firms to venture capital and “angel investor” groups — that take risks and make an outsized contribution to economic growth and job creation.

Proponents of the “carried interest” want you to believe that this will only hit big hedge funds. Not that there is anything wrong with hedge funds per se, even though George Soros runs one. As I   have written, they are one of the best forces to hold public company CEOs accountable to all shareholders.

But the tax, as put forward in the Obama budget and by legislation last year from the Democrat-controlled Congress, would actually have a much broader reach to virtually all partnerships. There is no asset or income threshold, so firms from venture capital houses to doctors’ offices to family farms, all of which are often structured as partnerships, could be negatively affected. According to a new   studyby the accounting firm Ernst & Young, “flow-through businesses” such as partnerships and limited liability companies “employ more than one-half of the private sector workforce in every state except for Delaware and Hawaii.”

And a   report by the accounting firm KPMG on the Democrats’ “American Jobs and Closing Tax Loopholes Act of 2010,” which passed the House last year and came three votes short of the 60 needed to clear the Senate, found that the bill “could apply to partnerships in virtually any kind of business and could fundamentally change how partnerships are taxed.”

In a partnership — from hedge funds to venture capital to small business — the partners are taxed on a business’s earnings at individual tax rates, instead of the business itself being taxed at corporate rates and then doubly taxed on any dividends it pays out. In many partnerships, some partners get bigger stakes in the company because of the services they perform, in addition to the capital they have contributed. This is called the “carried interest.”

The individual with the “carried interest” is taxed at the rates of ordinary income for his or her everyday salary and for much of the business’s activities. But these partners pay the individual capital gains rate when the other partners receive capital gains for sales of such assets as stock and real estate. The president’s budget would drastically change this, taxing these gains as ordinary income and subjecting them to payroll taxes. This would more than triple the rate of taxation in many cases.

Even if there were an asset threshold for partnerships, this tax hike should still be rejected because of its devastating effects on the job creators. Although their investment strategies differ, large venture capital partnerships are organizationally structured in the same manner as hedge funds. According to the National Venture Capital Association, “By more than doubling the taxes paid by venture capitalists on carried interest, Congress would be upending the risk/reward balance and creating serious economic consequences for very little revenue.”

Ironically, by stifling venture capital and innovative partnerships, Obama’s carried interest tax hike would also be cutting the lifeline of some of the very types of businesses he champions, such as “green energy.” Folks peddling windmills and biofuels are getting tons of funding from venture capital and angel investors, as well as arguably more deserving entrepreneurs.

In short, Obama’s tax hikes on innovation and entrepreneurship are a recipe for, to borrow his phrasing, losing the future.