How to Think About Taxing Carried Interest
Economic theory provides strong support for the view that consumption, rather than income, is the best tax base. Under a consumption tax, all investment income would face a zero effective tax rate on the margin. By increasing overall taxes on investment income, the tax bill recently passed by the House of Representatives moves the tax system further away from the consumption-tax ideal. Of course, given that the United States has an income tax rather than a consumption tax, there is a legitimate interest in adopting income tax rules that allocate capital efficiently. In some cases, tax changes that raise the overall tax burden on investment and thereby tend to shrink the capital stock can be justified if they promote a more efficient allocation of the (smaller) capital stock. But such changes should be accepted only when there is a compelling case that they will produce a significantly more efficient allocation. That case has not been made for the provision to tax carried interest.