THERE'S TALK IN

Washington right now about raising taxes on hedge-fund managers. Some people think it's a great idea. After all, those guys are rich so they can afford it!

But I think it's a terrible idea. We need more people to do more investing. And whenever you raise the taxes on something, you get less of it.

Why do you think all the antismoking advocates want to raise taxes on cigarettes? Why do you think all the antipollution people want to raise taxes on carbon emissions? Because they want less of those things.

Believe me, if we raise taxes on hedge-fund managers we'll get fewer hedge-fund managers. Today, with lots of hedge-fund managers trading all the time and keeping markets efficient, stocks are at record highs around the globe and markets are deeper, more liquid and less volatile. With fewer hedge-fund managers, markets would shrink, become more volatile and more costly, and tumble from their present highs.

Investors need to keep their eyes on this debate about taxes. It could determine which way the stock market goes later in the year and in the years to come. Because in the end, it's not just about the way hedge-fund managers are taxed; it's about the way you're taxed, too.

Right now hedge-fund managers are taxed just the way you are, assuming you're an ordinary individual investor. Hedge-fund managers get most of their income from performance fees, usually 20% of the gains in their funds. If those gains are ordinary income, they pay at the ordinary income rate, just the same as you. If those gains are capital gains, they pay at the lower capital gains rate, again just the same as you.

The talk now in Washington is to make it so that hedge-fund managers have to treat all their income as ordinary income, rather than capital gains. That's going to more than double their federal tax rate from the capital gains rate of 15% to the ordinary income rate of 35%.

But there's no difference between what you do as an individual investor and what hedge-fund managers do. Why should you get the lower capital gains tax rate, but not them?

The hedge-fund manager spends all his time thinking about investing, while you probably have a full-time job doing something else entirely and do your investing in stolen moments. But other than that, you and the biggest, most sophisticated hedge-fund manager are basically doing exactly the same thing.

You both win sometimes, you both lose sometimes. You may think all the hedge-fund managers are big winners, but that's not true. Only the ones still in business are. For every one of them, there are 20 former hedge-fund managers who are now driving cabs.

You're investing your own money, but there are probably other people in your family who depend on that money. The hedge-fund manager may be investing other people's money, but his performance fees give him a direct stake in the outcome, just like you.

And you both, whether you know it or not, are fulfilling an important economic mission. By trading and investing, you both set the prices of the world's securities and make the world's markets efficient and liquid. You make possible the indispensable function of allocating capital to the businesses that need it to innovate and grow.

So why should you and a hedge-fund manager be taxed any differently?

But wait, this is a matter of politics. You have to be very careful when you ask questions like that. Politicians are likely to use them against you.

In this case, the revenue-hungry politician might come back at me and say, "Fine, the individual investor and the hedge-fund manager are the same. So let's raise taxes on both of them!"

The argument there would be that capital gains are no different than any other form of income, so why should they be taxed any differently?

The reply is that capital gains are very different, and therefore they ought to be taxed differently.

For one thing, capital gains are money you earn by investing money that you've already paid taxes on. Why should you have to pay taxes on the same money, over and over again?

For another, capital gains is a tax that actually costs the U.S. Treasury money. The government would collect far more in revenues if it eliminated the capital gains tax altogether.

How can that be? Simple. If there were no capital gains tax, people would be willing to invest a lot more money in new inventions, new businesses, new factories and new jobs. All that would lead to vastly more income taxes and corporate taxes than the relative pittance earned on capital gains.

Take Bill Gates as an example. He's made many tens of billions in capital gains, and if there were no capital gains tax, the government would be deprived of some revenue every time he sells a share of Microsoft. But because he created Microsoft in the first place, he's been responsible for generating trillions of dollars in income, year after year, all around the world, thanks to the growth and productivity that has been unleashed by the use of Microsoft's products.

If a lower capital gains tax can inspire some Bill Gates of the future to create the next Microsoft, it would be worth it many times over.

And to bring it all closer to home, lower capital gains taxes make stock prices higher and that's better for everyone. Why should that be? Because when you lower the tax on the returns to investing capital, you make capital more valuable.

Think about how the market soared the last two times the capital gains tax was cut, in 1997 and again in 2003. Throughout history, it's always worked that way and it always will.

So now there's talk about eliminating favorable capital gains tax rates for the biggest investors in the marketplace. That's very bad for stocks.

And the current low rates on capital gains expire for everyone not just hedge-fund managers and revert to somewhat higher than pre-2003 levels after 2010. That's right. It'll take an act of Congress between now and then to keep rates where they are. If that doesn't happen, it'll be even worse for stocks than raising the rate on hedge-fund managers.

So, as you enjoy the stock market making new all-time highs almost every day, remember that it won't last much longer if the politicians you've elected to look out for you decide to ruin it.

Donald Luskin is chief investment officer of Trend Macrolytics, an economics consulting firm serving institutional investors. You may contact him at don@trendmacro.com.