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A millionaire managing a hedge fund might pay a lower tax rate on income greater than $1 million than a working man pays on income over $55,000.
President Obama and the top Republican tax writer, Rep. Dave Camp of Michigan, agree this inequity should end. Obama in his latest budget, and Camp in his recent tax-reform proposal, would close the “carried interest loophole,” as it’s known. But that proposal is weightier in symbolism than substance.
The debate over carried interest highlights the limits of populism in the complex worlds of U.S. finance and taxes.
There is no “carried interest loophole” in the tax code. The “loophole” results from two factors: First, long-term capital gains are taxed at a lower rate (20 percent for wealthy people) than ordinary income (39.6 percent for the wealthy). Second: Partnership rules allow hedge funds to pay managers an ownership interest in the fund, or “carried interest.”
From one perspective, the setup is blatantly unfair: When a hedge fund billionaire successfully manages other people’s money, he’s working — much like a Merrill Lynch financial adviser. Shouldn’t Steven A. Cohen’s compensation be treated the same as yours — or your financial adviser’s?
Sure, Cohen gets paid for performance, so there’s some risk, but performance bonuses are typically taxed as ordinary income.
Fund managers have underlings who do the same sort of work as the manager, and those employees are paid salary, which is taxed as ordinary income.
So, yes, there’s something deeply unfair about rich investment moguls having lower tax rates than their secretaries.
Here’s one place, however, where populism often goes astray. An inequity rigs the game in favor of the well-off, and the populist assaults it head-on. In this case, the populist rallying cry — with which I sympathize — is “close the carried-interest loophole!”
But it’s not so easy. Sometimes the inequities have roots so deep in the system that you can’t just tear them out.
Consider the second tax policy involved in the carried interest question: The Internal Revenue Service allows partnerships to allocate gains to various partners however the partners choose.
This freedom to distribute gains among partners is no loophole for fund managers. It’s a key to American capitalism, and even the American dream.
A couple of years ago, I met Osiris Hoil, a Mexican immigrant who lost his construction job during the 2008-2009 downturn. While out of work, a wealthy neighbor in Virginia suggested Hoil open a taco cart — the neighbor would front the cash, and Hoil would provide the expertise and the labor.
That taco cart business has grown into District Taco, a local chain with storefronts in Arlington, downtown Washington and Capitol Hill. Should Hoil and his neighbor have been barred from splitting the ownership stake in the company 50-50? If they sell, should Hoil’s stake be taxed as ordinary income, while the neighbor’s stake is taxed at lower capital gains rates?
Would it really be populist to treat the providers of capital better than the providers of labor? Do we really want to smash the notion of “sweat equity”?
Camp’s answer: The IRS would single out investment partnerships such as hedge funds and tax their capital gains differently from the gains of, say, taco partnerships. Obama has similar plans in his budget.
So to fix an inequity, Camp and Obama would complicate the tax code and single out a particular class. Worse: It might not work.
For one thing, if the fund’s investors are mostly wealthy individuals, the manager could just change his cut of the gains from 20 percent to 26.5 percent, and call it a fee and a bonus instead of “carried interest.” After taxes, both the investor (again, only if it’s an individual, not if it’s an institution) and the manager could come out the same as under the current system of carried interest.
There are plenty of other games hedge funds could play to get around Camp’s or Obama’s rules — creative structuring of loans or payment in the form of equity. Whatever fixes the IRS invents to curb these games, count on crafty financiers to find new “loopholes.”
Tweaking partnership rules may be futile. To fix the problem, it may be necessary to treat capital gains the same as ordinary income. Politicians won’t like that solution: Cutting income tax rates could reduce federal revenue, but hiking capital gains rates could also reduce revenue.
When the whole system is rigged, there’s often no good way to unrig just one part.
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