March 18, 2002; General Partner Tax Not Indexed For Inflation

Practically all of the eloquent arguments critical of excessive government taxation apply, in our opinion, to the taxation by the general partner in KMP, KMR and EPN.  Even “taxation without representation” applies to a degree because limited partner often means limited rights in a governance sense.  The objection we focus on this week is the naked exposure of limited partners to inflation. 

Though limited partners tend to be individual investors, there are institutional investors in KMR and KMI.  While KMI is actually on the other side of the general partner tax, we are concerned that if stock market values erode for KMP, the bullish case for KMI also erodes.

Fortunately inflation is currently running at a low rate.  Yet it is not negligible and even at a low rate the cumulative effect is meaningful.  The short term trend is not favorable as inflation expectations as measured in the Treasury debt market widened further in the past week to almost 2.0% per year up from a low of 1.3% only four months ago. 

Moreover one can always be surprised. President Johnson thought that inflation could be kept at low levels despite his policy of “guns and butter”.  Instead simultaneous spending on the Viet Nam War and the Great Society helped turn modest inflation into rampant inflation.  Now President Bush is engaged in a military buildup at the same time government spending is high for other purposes.  We further note rumblings that a little inflation might be good for corporate profits that are needed to keep economic growth humming.

Recall how the general partner tax works.  Any increase in the distribution of income or principal to unit holders is taxed 50% by the general partner of KMP, KMR and EPN.  The unit holders further pay income taxes that are mostly deferred in the early years, but bite hard in the later years when inflation also bites.  Thus if the assets of the partnership generate an extra dollar of distributable cash purely because of inflation, the general partner gets $0.50 as an "incentive".  The government would get $0.15 at a 30% tax rate and the limited partners would keep just $0.35 of the dollar of inflation.

The unfairness of government taxation of inflation has been widely argued.  In partial deference to fairness, some income levels at which higher taxes apply are indexed to inflation.  Thus in some cases, at least, the tax rate does not go higher because of inflation, but taxation of inflation still takes place.

There is no indexing for inflation of the trigger levels for higher general partner tax.  As in government taxation, indexing would not eliminate taxation of inflation, but it would make a dent, more so as time goes on.

The lack of indexing of general partner tax for inflation is just another indication of the one-sided investment proposition.  The tax rate, 50%, is higher than the maximum government tax rate.  And we repeat that the tax also applies to depreciation, which is technically a return of principal and not usually taxed by government. 

The socialist governments around the world with high tax rates inevitably lagged behind economically.  The same prospects are in store, in our opinion, for KMI, KMP, KMR and EPN.   The stocks are highest on the Greed Gauge that measures general partner taxation and are also the most over valued stocks on the McDep Ratio.