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In Defense of Logical Tax Policy

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Influential progressive blogger Matt Yglesias, whom I read on a regular basis despite innumerable differences of opinion on policy matters, posted earlier today about an issue that has attracted some attention recently: the taxation of investment earnings of hedge fund managers. Matt's post echoes claims from other commentators that billionaire Pete Peterson, who has poured millions of dollars of his considerable personal wealth into a public education campaign on the dangers of debt through his Peterson Foundation, is hypocritical for supporting higher taxes on wealthy individuals while opposing higher taxes on earnings of hedge fund managers, also known as "carried interest." My aim isn't to defend Mr. Peterson of that charge necessarily, but instead to take issue with the notion that the framework within which we tax these investment earnings is a "loophole" that needs closing.

This is a complicated issue, to be sure. The basic story is this: Private equity managers are compensated using what's called a "2-and-20" method. That means they get a salary worth 2 percent of the fund's assets and receive 20 percent of any capital gains the fund earns (the carried interest). If the fund suffers a loss, its manager receives nothing from the "20" portion and is compensated solely by the 2 percent salary portion. That 2 percent is taxed at ordinary income tax rates, which currently max out at 35 percent (and will rise to 39.6 percent if Congress fails to extend the tax cuts by the end of the year). The 20 percent share is taxed at capital gains rates, which currently max out at 15 percent.

So, how is that not a loophole, you say? After all, these fat cat hedge fund managers get to have significant portions of their earnings taxed at less than half the income tax rate. Shouldn't they pay at least as much as the proverbial fire fighter or school principal? Well, no, not really. And it has nothing to do with the fact that they're very wealthy private equity guys, and everything to do with sound tax policy.

Historically speaking, the "20" portion has been treated as a capital gain and NOT as ordinary income because it represents the return on, or loss from, an investment. It is subject to the same risk factors as any other investment, and thus receives capital gains treatment. When individuals invest dollars, they do so after having already paid income taxes on them. The reason Congress established lower capital gains and dividends tax rates in the first place was to relieve that double-taxation and the market distortions that high rates impose.

It's also worth pointing out that it's only now that the capital gains rate is a relatively low 15 percent that attacks have been leveled at the fairness of this system. This suggests that the true complaint may rest with the lower tax rate, not the supposedly improper treatment of the compensation. That's why I'd be interested to hear Matt's thoughts on some other issues in capital gains tax fairness that, in my opinion, are largely ignored by the progressive community.

For example, current law does not allow a taxpayer to adjust the value of an asset for inflation when declaring a capital gain. Stated more simply, if you purchased an asset for $100 in 1980 and sold it for $150 in 2010, you would pay the capital gains tax rate on your "gain" of $50. But if you account for the effects of inflation, selling that asset for $150 actually represents a significant loss, since you'd have to sell that asset for more than $250 today just to keep pace.

Furthermore, there is a fundamental fairness issue in the differing treatment of gains and losses. Government subjects the full computed value of a capital gain to taxation, while only $3,000 of a capital loss (on ajointly filed return) is deductible for income tax purposes in a given year. Because these limits aren't even inflation-adjusted, any "carryover" loss amounts for future years are being taken against a deduction that's losing value.

Unfortunately, Congress (under both Republican and Democratic leadership) hasn't seen fit to deal with any of these important issues. Given the posturing on both sides, I rather doubt that is going to change any time soon.