New York Legislators Enter Dangerous Territory With Investment Tax Bill A 19% tax on carried interest would throttle investment partnerships

This article originally appeared on MarketWatch.

Some New York state legislators want to take over federal taxation of carried interest. This is an important development to watch.

Rather than Congress and the president determining federal tax law, New York, home to many investment partnerships, now wants to increase state taxes on capital gains and keep the revenue for itself. New York already taxes capital gains and ordinary income equally, but apparently that’s not good enough.

Carried interest on real estate, private equity, venture capital and all other investments in capital assets has been taxed as capital gains since the birth of the tax code in 1913. The top rate on carried interest is 24% (the top capital gains rate) rather than 43% (the top rate on ordinary income). Carried interest is a capital gain because it represents the profit realized from the sale of a capital asset.

If the bill became law, New York would likely see part of its financial sector leave for other states.

The New York legislators want to raise the taxes on carried interest to federal ordinary income tax rates, not just for New York residents, but for everyone all over the world who get returns from partnerships with a business connection to the Empire State.

Bills in the New York State Assembly and Senate would increase taxes on profits earned by venture capital, private equity and other investment partnerships by imposing a 19% additional tax — the difference between the tax on capital gains and the tax on ordinary income — on those capital gains.

If the bill became law, New York would likely see part of its financial sector leave for other states, because many investors nationwide would become subject to taxes that were 19 percentage points higher. The sponsors of the legislation appear to acknowledge that by delaying the implementation of the provisions until Connecticut, New Jersey and Massachusetts enact “legislation having an identical effect.”

But even if four states were to raise taxes simultaneously on carried interest, investments would still migrate to the other 46 states. Pension funds and other large investors would prefer investments based in San Francisco, Dallas or Chicago, where taxes would be far lower. No one is going to pick an investment that is taxed at 43% when they could choose one that is taxed at 24%. The value of investments in New York, Connecticut, Massachusetts and New Jersey would decline.

Investment taxation under the bills would be uneven, an invitation to distortion. Two investment partnerships, one of which had carried interest income and the other which did not, would face unequal treatment upon the sale of their capital assets. Even within carried interest, the bills would arbitrarily discriminate by not raising taxes on carried interest in real estate, such as partnerships that own auto dealerships, ice cream shops or family farms.

University of San Diego professor (and critic of carried interest) Victor Fleischer estimates that the bill would raise $3.7 billion a year, which proponents are saying could be spent on “schools, roads, state parks, and infrastructure.” (Who could be against those?) But Fleischer assumes that investments will just stay in New York and be taxed, when they could get a higher return elsewhere.

For comparison, the Joint Committee on Taxation calculates in a recent 2016 revenue estimate that the amount of revenue raised by a change in the federal law for the entire United States would be about $1.96 billion a year. It defies common sense to say that New York state would get almost double the total U.S. revenue forecast by the Joint Committee on Taxation when capital would flee the taxed area.

The debate over carried interest matters not only because some New York legislators are trying to hijack federal taxation, but because the long-standing capital gains treatment of carried interest encourages firms to provide private investment for businesses that need it. If taxes on carried interest were to rise, this form of private investment would shrink, and many businesses would lose access to capital and expertise. This is a major reason why calls for similar legislation are consistently shut down at the federal level. Start-ups already face shortages of capital, and raising taxes on carried interest would further reduce investment options for private companies, innovators and small firms getting off the ground.

According to Preqin, private equity assets under management now total $4.2 trillion, of which $2.8 trillion is invested capital and $1.3 trillion is callable capital reserves.

Partnerships often encourage innovation because they enable those with capital and management experience to team with entrepreneurs, supporting businesses of all sizes that create many of America’s jobs. The high-tech sectors in which the United States has a global competitive advantage have benefited from private equity investment.

Shrinking private equity in America would be unhelpful at any time, but particularly when Federal Reserve officials are warning of the effects of a global slowdown. Other countries satisfied with slow economic growth may choose to tax carried interest at higher rates. America is not, or at least should not be, satisfied with the resulting slow economic growth.

Lower taxes on capital gains encourage private equity and venture capitalists to supply the financial capital and business expertise that are essential for investments that spur innovation, improve productivity and expand capacity.

In addition to overturning existing tax law and making the playing field grossly uneven, raising taxes on investment partnerships would have negative unintended consequences. More than half of invested capital belongs to pension funds, foundations and endowments.

Increasing taxes on carried interest would mean less efficient capital markets and, therefore, smaller pensions for millions of retired Americans and fewer foundation grants for charity and research. Populists can talk about taxing the rich, but in the end the average investors pay the price.

Diana Furchtgott-Roth is a senior fellow and director of Economics21 at the Manhattan Institute. Follow her on Twitter here.

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