Common Sense: Questioning the Dogma of Tax Rates

Warren Buffett pays a lower tax rate than his secretary and the 19 other people who work in his office. He pays a much lower rate than I do, and, I suspect, lower than nearly everyone reading this column. So, no doubt, do a long list of American billionaires, including Stephen Schwarzman of Blackstone and the hedge fund king John Paulson.

Is this fair?

The issue of tax loopholes for the rich has been simmering for months, but boiled up again this week after Mr. Buffett, the famed investor and Berkshire Hathaway chief executive, called for higher taxes for the wealthy in an Op-Ed column in The New York Times. “My friends and I have been coddled long enough by a billionaire-friendly Congress,” he wrote.

President Obama has been making a similar argument, and has made the “carried interest” exemption from ordinary income rates, which benefits hedge fund and private equity managers, the centerpiece of his tax campaign. “How can we ask a student to pay more for college before we ask hedge fund managers to stop paying taxes at a lower rate than their secretaries? It’s not fair. It’s not right,” the president said a few weeks ago.

By now it’s gospel that the carried interest exemption is a tax loophole, which suggests that those benefiting from it are somehow evading a legal obligation imposed on others in similar circumstances. For most hedge fund and private equity partnership managers, carried interest is compensation in the form of a percentage (usually 20 percent) of any gains they generate for investors. If a hedge fund manager generated $1 billion for investors by betting against mortgage-backed securities before the real estate market collapsed, the hedge fund manager is entitled to keep $200 million as compensation. The tax code treats that as a capital gain, taxed at a lower 15 percent rate. (The top rate on ordinary income is 35 percent.) The argument that this should be ordinary income rests on the notion that hedge fund managers earn these fees from their labor, just like other workers get a salary for theirs and are taxed at ordinary income rates.

This seems sensible, and the people who are laying out $45 million for Manhattan apartments and Hamptons estates and throwing themselves multimillion-dollar birthday parties make appealing targets. But like so much about the United States tax code, nothing is that simple. Carried interest is indistinguishable from nearly all other forms of compensation that are treated like capital gains, such as stock options, deferred stock grants for corporate executives and many forms of incentive compensation, which is widespread across many industries. Like all capital investments, carried interest entails risk, since there’s no way of knowing what it will be worth until long after the labor is performed, often years later.

Some argue that favorable treatment for carried interest also confers a social benefit. It aligns a manager’s financial interest with that of investors, most of whom are pension funds, endowments and other nonprofit institutions like hospitals, museums and universities.

Hedge funds and private equity managers don’t even make up the bulk of people who are compensated through carried interest. The fiercest lobbying against raising the tax on carried interest has come not from Wall Street but from the battered real estate industry, which often uses carried interest as compensation. “Why take down the entire real estate industry with the ship when the objective was to tax a different industry?” James V. Camp, chairman of legislative affairs in California for a real estate trade group, told me this week. “The real estate industry will be decimated if the carried interest taxation concept becomes law.”

This is largely why legislative efforts to eliminate the carried interest exemption have gone nowhere, not because of any special fondness in Congress for hedge fund managers. Unless Congress is willing to say baldly that hedge fund and private equity managers are a special class who deserve to pay higher taxes — a potentially dangerous effort to use the tax code to punish a group of people who are in disfavor largely because they make a lot of money — policy makers are going to have to confront a much broader and potentially far more explosive question: why are all capital gains, not just carried interest, treated more favorably than ordinary income?

The notion that low capital gains tax rates are a good thing because they promote investment, lead to job creation, encourage people to sell assets without fear of tax consequences and actually raise total tax revenue is so entrenched in both parties that the idea of equalizing capital gains and ordinary income rates is barely mentioned or, when it is, is quickly denounced. It’s become a third rail of tax policy and electoral politics. “It’s now so woven into standard thinking that it’s become a cultural norm,” a prominent hedge fund official told me this week.

Article source: http://feeds.nytimes.com/click.phdo?i=a67b1de155195b11fca4bbc68941df2a