In a recent interview, President Barack Obama indicated he will target the carried-interest loophole in the tax code. A sense of fairness and logic supports the president's proposal. It is time to fix what borders on an egregious tax break for a few high earners.
As a quick review, we are talking about taxation on the earnings of managers of some alternative investment vehicles, including private equity funds and hedge funds. These people manage investments for others — usually wealthy individuals and institutions — and charge two fees for the service. One is an annual management fee based on committed funds, typically 2 percent. They pay ordinary tax rates on income earned from the management fee.
So far, so good. A second fee is a charge assessed against profits earned on investments; it is typically 20 percent. This is where the rub comes in. These gains flow through to the fund managers as "carried interest" and they are then taxed at capital gain rates rather than the higher earned income rates.
Proponents of this tax rate argue that the 20 percent is really a capital gain and, so, is taxed appropriately, just the same as it would be for any other investor. But, there are some good reasons why this favorable tax treatment should be addressed and the loophole closed.
First, the United States has a long history of progressive tax rates — people who earn more pay more, not only in amount but also in rate. Those who manage funds with the carried interest tax treatment often make a lot of money, maybe in the tens of millions of dollars per year and, yet, they pay a much lower tax rate than middle class wage earners who make a mere fraction of that amount.
There is nothing wrong with earning a lot of money; that's a good thing. Most people strive for that. But isn't there a question of fairness to other taxpayers if a small fraction of people making extraordinary incomes should also be taxed at lower rates?
Second, in most cases the fund managers invest little, or no, money of their own in the fund. When most of us make an investment, we have skin in the game. If the investment loses, we lose real money. If the investment is profitable, we win and pay capital gain taxes on the profit. We all want to buy low and sell high but few of us have the opportunity to invest virtually nothing and yet receive gains on the sale of an asset that are then taxed at low rates. Is there really a capital gain when little or no capital is invested?
Third is the question of whether these investment managers are actually being compensated for their labor. Many believe that at least a part, if not all, of this profit is earned income and that the complex argument for carried interest is little more than a tax-avoidance scheme. If the 20 percent of profits accruing to the managers is really a payment for labor, then these earnings should be taxed as ordinary income using the same rate schedule you and I do.
As long as there is a differential in the taxation of earned income and capital gains, writing effective legal remedies may not be so easy. Private investment funds have access to the best tax lawyers and accountants who are, no doubt, already crafting strategies to work around changes in the law.
So the solution is straightforward: All dividends and capital gains should be taxed as ordinary income. Then people earning a lot of money, whether from labor, capital or carried interest, will all pay at the upper tax rates. This is not without precedent. At various times in U.S. history, the rates on capital income have been the same as those on earned income.
But wouldn't all Americans be affected by this solution? Probably not.
Many, if not most, taxpayers have the majority of their financial investments in retirement plans that will be taxed at ordinary rates. They would be left relatively untouched while the greater burden of the change would fall on those with high incomes and wealth and those benefitting from the carried-interest loophole. Equal taxation for labor and capital would return greater progressivity and greater fairness to our tax system.
Richard Meyer is a professor emeritus in the College of Business at the University of South Florida. He wrote this exclusively for the Tampa Bay Times.