Yes, Tax the Rich

It’s only a blog, so allow me to expound on a subject at the intersection of two fields I know nothing about: tax law, and presidential campaign politics. There’s been a lot of screeching about growing inequality and unfair tax loopholes for “the rich”; about Warren Buffett’s secretary, Mitt Romney’s tax returns (and dodges), etc etc.  While most of this is populist demagogy, some tax practices that benefit (almost exclusively) very wealthy taxpayers lend it more credence than it deserves. I think.

Partners of hedge funds and private equity firms typically earn something like 2 percent of the fund’s assets in management fees. That’s distributed to them and taxed as income (35%). But it’s not where the real money is: the partners collectively usually take around 20 percent of the fund’s gains. Most (not all) of that “carried interest” is taxed at the capital gains tax rate of 15%. The income (or gain, or whatever) can be very substantial, even for partners who have left their firms. In 2010 Mr. Romney declared $7.4 million carried interest from his time at Bain Capital; his 2011 return shows another $5.5 million. The fact that the carried interest was taxed at the capital gains rather than the income tax rate produced something like $2.5 million in tax savings.

Call me naïve but to me, carried interest looks, quacks, and operates like a performance bonus; and every such bonus I’ve ever received or heard of has been and is taxed as ordinary income. It’s not obvious to me why the hedge fund guys should be different.

Here’s another thing earned mostly by “the rich” that’s taxed at 15%: corporate dividends. The argument for this practice, as I understand it, is, that dividends are taxed twice, first as corporate income (at a 35% rate) and then at the individual level. Here, the sensible solution (it seems to me) is my colleague Alex Pollock’s: tax the stuff as ordinary individual income at the applicable rate, and not at all at the corporate level.  (Alex argues that this would have the additional virtue of removing corporations’ artificial incentive to build up leverage.)

Taxing carried interest and dividends as ordinary income strikes me as perfectly consistent with the general thrust of Romney-Ryan tax philosophy: lower the rates, and mow down the exemptions. A confident public embrace of those proposals would have the additional, considerable advantage of refuting Mr. Obama’s shrill warnings of the coming plutocracy. So far, alas, Mr. Romney and advisers have been blowing hot and cold on carried interest: IRS tax experts should “carefully study” the issue. Thank you, Mr. President.

The irresolute stance, I think, is a mistake not only for tactical reasons but also for a more general and deadly serious reason. I understand that one can make an argument for the preferred treatment of carried interest (and dividends), but that’s beside the point. The coming administration and Congress will have to take a lot of things away from people who think they’ve earned them and for which experts and K-Street artists can think up an argument: farm subsidies, exotic energy grants, ethanol mandates, Social Security increases, disability benefits, food stamps, mortgage subsidies and guarantees, and so on ad nauseam et infinitum. That will be the test of any halfway serious administration: “We hear you, and we feel for you, but it’s not good enough. You can’t have it.” But that’s a hard thing to say and do. One has to doubt any incoming administration’s commitment to the enterprise and its ability to carry it through—and the public’s willingness to hold still for it. Confidence on those counts would be greatly enhanced by a campaign’s declaration to the effect that “Everyone will have to give up something—and let the rich go first.”

Michael S. Greve

Michael S. Greve is a professor at George Mason University School of Law. From 2000 to August, 2012, Professor Greve was the John G. Searle Scholar at the American Enterprise Institute, where he remains a visiting scholar. His most recent book is The Upside-Down Constitution (Harvard University Press, 2012).

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  1. says

    Michael, I agree with your reasoning, but you’ve just barely scratched the surface. When the true nature of income taxes are understood, we’ll eventually discover that most companies should be paying 3 different kinds of income taxes, with individual employees having an option to claim that their wages are personal property under the Direct Tax Clauses, not income under less restrictive the Indirect Tax Clause.

  2. libertarian jerry says

    Michael…..a few points. 1st. The question to ask is NOT who pays the taxes or the method of calculating taxes owed or the methods of collecting taxes. The question to ask is WHY do we need Income Taxes in the first place? 2nd. Most Libertarians and fiscal Conservatives say that its not a tax problem but a spending problem. That as long as the Federal Government involves itself in large budgets to finance the Welfare State or the Warfare State Empire,with all its inherit waste and corruption,then fighting over who pays the bills is moot. Its the Federal Establishment that has to rein in it’s spending. This is partially true. 3rd. What the real problem is,is the money system. Is it any wonder when the Income Tax was enacted in 1913 that,at the same time, the Federal Reserve Fiat Money system was created. The idea was that the Federal Government could have all the necessary revenue, at any time, to finance its expenditures. That by creating sovereign debt backed fiat currency created out of thin air, and therefor putting the American people into perpetual debt, government could be financed without the need to raise politically unpopular taxes. 4th. All of this fiat debt and credit,created out of thin air, is extremely inflationary. Basically there are 3 ways for a central bank and by extension a central government to control inflation. (A) limit the amount of money in circulation, (B) raise interest rates on debt instruments(as Paul Volker did in the early 1980s). (C) Enact and Income Tax to tax back and therefor “soak up” extra capital in circulation and therefor limit the amount of money and credit to be spent on products and services and therefor maintaining or limiting the bidding up of those same prices. 4th. In essence the Income Tax,which is the 2nd Plank of the Communist Manifesto, is used by the Federal government to control inflation. That basically the IRS is nothing but a collection agency for the collection of the interest on the National Debt. Almost all of the money collected lands up with the Federal Reserve Bankers in the attempt of maintaining the value of its currency. As an aside only about 35% of the Federal Budget is made up of Income Taxes. The revenue for running the government comes mainly from other taxes(payroll,Social Security,excise,tariffs,corporate,value added,fees) plus hundreds of others. When America went off the Constitutional Rails by creating the private Federal Reserve System to control the issuing of our currency and ,at the same time,enacted an Income Tax the die was cast for the destruction of the American Economy and for the turning of American into a nation of serfs. What happened,in the early part of the 20th Century, was that all the rich and powerful gathered their wealth and sheltered that wealth in tax free endowments,trusts and foundations. At the same time they created an interest baring paper money system that has destroyed the American Economy through inflation and high taxes. AS Lenin once said,”let us grind the Middle Class between taxes and inflation.” Ron Paul was right. Now is the time to abolish the Federal Reserve and at the same time dismantle it’s collection agency the IRS.

  3. Daniel Artz says

    While I am normally one who has great disdain for the Left’s “tax the rich” mantra, I too see something amiss with taxing carried interest returns at capital gains rates when the interest holder has no invested capital, and his or her share of capital gains distributions is, in reality, compensation for personal services. This would seem to be a relatively easy fix in the tax code — limit capital gains treatment to distributions of capital gains only to the extent that such distributions are directly proportional to the investment in the asset giving rise to the gains; any distribution made without regard to investment, or in compensation for personal services, shall not be entitled to treatment as a capital gain. I’m good with that.

  4. libertarian jerry says

    I wrote a comment here on 8/15/12 explaining why we have an Income Tax. The comments were factual and well researched and took me 2 hours to compose.That comment was taken down. So much for free speech and the 1st Amendment.

  5. Brett Bellmore says

    “farm subsidies, exotic energy grants, ethanol mandates, Social Security increases, disability benefits, food stamps, mortgage subsidies and guarantees, and so on ad nauseam et infinitum. ”

    Strictly speaking, these are not instances of “taking away”. They are instances of ceasing to give. Now, taxing? That’s genuine taking away.

    I like to keep these things clear; You can’t reason clearly if you start from false premises.

  6. Yackums says

    Hello, I’m a first time reader and commenter. This essay certainly makes some good points, and I don’t know anything more about tax law than the author, but if I’m relying on his description at the beginning of the essay, it’s perfectly clear why carried interest is treated as capital gains. The author himself states the key words. This is a payment that is distributed to partners (the author’s word – i.e. people with an ownership stake in the firm), on the basis of the fund’s gains (the author’s word – i.e. the appreciation in the value of the firm’s assets). I do know something – not a lot, but I have a basic business-school education – about finance, and that seems like the textbook definition of capital gains to me.

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