The Russians, like all other human beings do not like paying taxes, especially those old enough to have lived through the “Soviet” era. When capitalism started once again in Russia everything was done to hide or ‘shelter’ was we call it all taxable income. Russians easily became drunk with so much disposable income and that begat some very irrational decision making. As a Russian friend of mine said, “Everyone wants to drive a BMW tomorrow!” Pyramid schemes grew like mushrooms in Russian forests. Another (younger) friend of mine invested his life savings, $3,800, in such a scheme despite my lengthy conversation with him against this ‘surefire investment’. He wanted to drive a BMW tomorrow also. The “oligarchs”, former Communist apparachiks who ‘bought’ industries and natural resources on less that mills to the dollar of the actual value, smuggled or transferred the billions upon billions the made out of Russia knowing full well that the day would come when they would be held accountable. The most egregious perpetrators now live abroad (outside) of Russia and usually sport an Israeli passport to insure that they won’t be kidnapped by the FSB and brought back to Russia for trial. Today Russians still do all they can to avoid paying taxes. If you ever want to become a partner in a Russian business ask to see the books. If they really need your money the most likely answer will be, “Which set?” Russia’s state tax system is an abysmal failure, that is why some of the oligarch’s ill gotten assets were seized. The Russian state is funded by still state owned natural resources, oil, natural gas, minerals, etc. Whatever taxes are paid into the state coffers isn’t the frosting on the cake, it couldn’t even qualify as the cherry. Don’t look to Russia for a solution to any tax quandrary, real or perceived.

So yes, from an outside perspective, his observations are totally banal. But within the heat of arguing about the one and only true and living way to tax an investment manager’s receipt of carried interest, it served (or at least, tried to serve) to deflate the truth rhetoric and remind everyone that the tax treatment is what the legislature wants it to be, not what it is economically destined to be.

If you’re interested, his column is here.

Umm, isn’t this totally banal? I mean, doesn’t everyone agree with this, basically? The debate focuses on this very issue: Whether or not to change the tax code. Is anyone actually arguing anything other than this?

Aaron B

On your second point, the failure of the tax code to take into account inflation is an imperfection of the system. Given the low rate of inflation and the relatively decent appreciation of most capital assets, nobody in the last ten or twenty years has been paying tax while losing real dollars, but part of the capital gains tax is on inflation. I don’t know how I feel about that currently: while it seems unfair to pay taxes on gain that aren’t economic gain, I’m not sure if it’s worth the complexity that would be added to the system to figure out how to remove the portion of cap gains attributable to inflation (although I recognize that other portions of the Code—not counting, of course, the AMT—are indexed for inflation). (Of course, you could argue that part of the reason cap gains are taxed at a lower rate is as a crude fix for the inflation problem. Really crude, I admit, but I’m not sure if a surgical fix would be economically viable.)

I can see that the long run incidence question is complicated. The problem is that a comparable analysis applies to the ordinary income tax obligation of salaried professionals as well. So to make a fair comparison we would need to reduce both sides of the ledger.

One thing that hasn’t been mentioned yet is that capital gains is currently a tax on nominal, not real gains, i.e. it is not inflation adjusted. You can be losing money in real terms, and still be required to pay a tax on your “gain”.

Aaron,
There are a couple primary arguments that I’m familiar with. A favorite is that taxing investment managers at ordinary rates will prevent US funds from being competitive with offshore managers, and so will drive the PR and hedge fund practices offshore. (Along with that argument is the argument that it will raise costs, which will ultimately be passed to investors, reducing the return on investment funds.)

I’ve also heard the argument that the investment managers’ return is a legitimate risk-based return (usually, for those who don’t know, investment managers for hedge and private equity funds get paid 20% annually of the gainst that the fund makes, with certain adjustments) and, for the same reason other risk-based returns are taxed at a lower rate than wage income, their return should be taxed at the advantageous rates.

I’m sure there are other arguments out there, but these two seem to be the biggest ones. Whether you find these argument convincing or not is, of course, an entirely seperate question. Ben Stein had a great editorial in the New York Times three or four months ago in which he says, basically, so what if the tax code currently treats carried interest at the 15% rate? The tax code wasn’t written in stone by the finger of God, so change it if you don’t like it. Ultimately, that’s where I come down: currently, what they’re doing is perfectly legal. If we evaluate Vic Fleischer’s argument against the investment managers’ argument and decide Vic’s right, then we change the tax code, and that is that.

When private companies began to flourish in Russia, they had no experience with paying taxes. Furthermore, the state had no experience collecting taxes from companies it did not own. The idea was to create a simple tax systen to make it easy for companies to comply with and for the state to enforce. Had things proceeded apace, I would have expected more complexity to enter the tax system as both taxpayers and collectors became more sophisticated.

As it happened, companies that were generating huge tax liabilities (and allegedly not paying them) were simply confiscated by the state. So the Russian experience is not exactly a fair test.