SOMEBODY WHO earns hundreds of millions of dollars a year can afford to pay income taxes at standard rates, which top out at 35 percent. Yet partners in hedge funds and private-equity firms are getting off easy, because much of their earnings are taxed at the 15-percent rate for capital gains. This break is unwarranted. Congress should pass a bill by US Representative Sander Levin of Michigan that would abolish it.
Partners in certain investment vehicles -- including the scantily regulated hedge funds and the private-equity firms that buy and sell businesses, primarily with borrowed money -- enjoy a privileged income status. They are compensated not just with a fixed management fee, but also with a share of the profits from the assets that they manage. The management fee is taxed as income, but the other part, known as "carried interest," is not.
The Private Equity Council, a trade group, maintains that, while one might object to the difference between the tax rates for regular income and capital gains, there are no grounds to single out the private-equity industry. Hedge-fund managers could similarly claim there's no reason to treat their carried interest differently from other capital gains.
Oh, but there is. The rationale for the lower capital-gains rate goes like this: People who invest hard-earned savings from their post-tax dollars shouldn't be taxed, at least not at the same rate, on the money their investments generate. But what hedge-fund managers and private-equity partners do is fundamentally different; both manage large pools of money -- largely other people's money - in ways that generate more money.
The Private Equity Council argues that the payment structure isn't something that the industry dreamed up as a tax dodge. But as Congressional Budget Office director Peter Orszag noted before the Senate Finance Committee this summer, some partners are taking less and less of their income as management fees and more and more as carried interest. This suggests that the two types of income are fungible, and that hedge-fund and private-equity barons are funging as fast as they can.
Orszag identified other forms of performance-based compensation that are taxed as regular income -- from certain types of stock options to the cut that A-list Hollywood stars receive from a movie's box-office proceeds. If this money can be taxed as income, carried interest deserves the same treatment.
This wouldn't hurt the economy or impose an unfair burden upon hedge-fund honchos. The chief danger of treating carried interest as income is that the compensation structure would mutate to take advantage of some other, as-yet-unmined quirk within the tax code.
That's a problem for another day. The least Congress can do now is tax the ample fruit of these wealthy people's labor at the same rates as everyone else's.