The Larger Question of “Carried Interest”

The Larger Question of “Carried Interest”

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At this writing, investment fund managers and their friends on Capitol Hill are working to weaken a legislative proposal to partly close an egregious tax loophole that lets them pay tax on their income at the 15 percent capital gains rate rather than at regular income tax rates that range all the way to 35 percent.

That proposal, crafted by key House and Senate members to help finance the pending jobs bill, is already a watered-down version of what the Housed passed in late May – and that, in turn, was a watered-down version of a proposal, which the House passed in December, to eliminate the loophole altogether.

The income in question for these investment fund managers goes by the fancy name “carried interest,” but make no mistake: It’s ordinary income, not capital gains, and those who earn it should pay income tax on their income like everyone else.

So, for those interested in a fair tax code and concerned by the undue influence of moneyed interests in Washington, policymakers are moving in the wrong direction. But the wrangling over this proposal begs a larger question: why does the tax code offer a lower tax rate on capital gains to begin with?

To raise the question is almost to commit an act of blasphemy in Washington, where the preferential tax treatment of capital gains is widely accepted on both sides of the political aisle as a key tool to incentive investment.

But lower capital gains rates suffer from two problems. First, despite its broad appeal, common sense suggests that it’s less important than its proponents claim. Second, the costs of providing a lower rate far outweigh the benefits in terms of lost federal revenue and huge incentives to make the tax code less fair.

First, let’s talk common sense.  As I understand the argument, policymakers need to provide an incentive for people, especially people with lots of money, to invest – or else they may not want to take the risk.

Really? Americans pay income taxes at rates of 10, 15, 25, 28, 33, and 35 percent. So, at worst, they keep two-thirds of every dollar they earn. Let’s say the tax code did not provide a lower rate for capital gains.

Would they stop investing in mutual funds and stocks because, at these tax rates – which, by the way, are much lower than before Congress reformed the tax code in 1986 – they fear the tax man? Would they park all their savings in money market accounts with low rates of return, no matter how well the stock market was doing? Would you? I don’t recall an investment crisis after that 1986 act, which dramatically lowered income tax rates and eliminated the preferential treatment of capital gains.

Lawrence Haas
is former senior White House official and award-winning journalist, writes widely on foreign and domestic affairs. His articles have appeared in The New York Times, USA Today, Los Angeles Times, Baltimore Sun, Miami Herald, San Diego Union-Tribune