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.”