Freddy Ferrer, New Yorks 2005 Democratic mayoral nominee, may be politically finished, but his economy-killing tax philosophy lives onin Washington, thanks to Senator Hillary Clinton and Congressman Charles Rangel. The former Bronx borough president ran for mayor on a platform of restoring the transfer tax on New York Stock Exchange and other local securities-market trades. New York had wisely repealed this tax back in 1981, but Ferrer argued that restoring it would generate $1.25 billion for the city annually, money that could be used on the school system.
Most everyone agreed that Ferrer demonstrated a shocking ignorance of how the financial worldthat is, New Yorks economyworked. Ferrers tax would have made jobs disappear, losing income-tax revenue for the city, and slowed down both commercial and residential real-estate markets, losing property-tax revenuein all, possibly costing the city more than that $1.25 billion annually.
Ferrer was defeated. But some of the Democrats who now control Washington, supported by Clinton and at least one other major presidential candidate, John Edwards, want to push through a Ferrer-style plan, only on a vastly greater scale. While the bill might not go anywhere soon, particularly since Democratic support is far from unanimous, its a key indicator of how some of the partys most prominent members of Congress would shape domestic policy if they ever got their way.
Last Wednesday, the Senates finance committee set its sights on a relatively new crop of wealth creatorshedge funds and private-equity firmsas the next potential big source of federal tax revenue. The committee is considering the merits of a House proposal, sponsored by Michigan representative Sander Levin, to more than double the tax rate on private-equity and hedge-fund managers. Some House Democrats, including Manhattans Rangel, the Ways and Means chairman, would like to treat the money that these managers earn from their funds profitsusually 20 percent of the gains made for investorsas ordinary income, taxed at 35 percent, instead of as capital gains, taxed at 15 percent for investments held longer than one year. Hedge-fund managers, these House members argue, arent actually risking their own capital to gain this money. Instead, those profits are a share of the money that outside investors put into the fund. Further, the disparity means that, as Clinton and Edwards argue, a middle-class secretary at a hedge fund likely pays a higher tax rate than her boss doesand that doesnt seem fair.
But things prove more complicated. Consider: if youre a private-equity manager, and you know that youve got a pretty good payday coming whether your fund returns 10 percent or 20 percent this quarter, why take a bigger risk to earn the higher figure? After all, if you risk too much, you might actually suffer a loss in the fund, and thus wind up with no share of quarterly profits at all; 20 percent of nothing is nothing.
The lower tax rate encourages the manager to take the greater risk in pursuit of a higher return, because he knows he gets to keep more of that money. Conversely, a higher tax rate on these gains will discourage risk-taking: nobody wants to risk too much if hell just have to give it away to Uncle Sam come April.
But what would a higher tax rate on risk-taking mean for the economy? For an answer to that question, just follow the Democratic senators who, thankfully, seem most reluctant to act. New York senator Charles Schumer, unlike Clinton, remains agnostic, saying that the tax code should provide incentives for risk-taking and entrepreneurship, because new ideas and new businesses create good jobs. He adds that hes worried that higher taxes on capital could hurt New Yorks economy and the nations.
Schumer is right to worry. New York City, Westchester, and Long Island are home to thousands of hedge-fund and private-equity fund managers and their employees, and to tens of thousands of people who work indirectly for such industries. New Yorks major investment houses, PR firms, and law firms process trades, give advice, handle marketing and customer service, and do other work for hedge funds and private-equity funds.
Massachusetts senator John Kerry has also voiced concern (although his colleague in the House, Barney Frank, is a cosponsor of the bill). A higher tax on investment-fund profits could have a destructive effect on venture-capital firms, whose managers risk their investors money (and their own share of that money) for start-up companies in Bay State cities like Cambridge, Boston, and Worcester. Californias Silicon Valley should be concerned as well; its own start-ups still depend on venture capital and other private-equity investment to get off the ground. Since 1970, according to a Global Insight study, venture-capital firms investments have helped create more than 10 million American jobs; companies like Google and Intel got their starts with private-equity money.
If wealth creators think that Americas tax rates on capital are too high, they can easily take their wealth elsewhereand some of the start-up companies in which they invest will follow. Indeed, in the same week that the Senate held its hearing, investment banking powerhouse Goldman Sachs announced that in the first half of 2007, for the first time in history, it had generated less than half of its global revenues from business in the Americas (mostly the United States). As recently as 2001, the bank had been earning nearly two-thirds of its revenues at home.
While such news is perhaps inevitable in an economy where national borders matter less to global capital every day, it should serve as a warning to Washington: when taxes on wealth creation are too high, the creators of wealth can take their business somewhere else.