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US Tax: Taxing Patience

The game of pingpong being played on Capitol Hill over how to tax the income of private equity managers is as clear a sign as any that Congress is way too deep in the muck over taxes — and can't find an easy way out.

The specific issue here is how much of what is paid to those who look after deep-pocket investments in American companies should be taxed at the favorable low rate accorded to capital gains and how much should be treated as wages earned for providing a service.

Beyond the merits of that narrow issue, fundamental questions of fairness, progressivity, and the disparate taxation of labor and capital are all at the center of this fight — but they aren't really being addressed. Instead, lawmakers are counting votes and simply trying to find what outcome might win a majority.

Currently, fund managers, including those who manage real estate investments, can treat their income as capital gains, which to some Democrats in Congress seems absurd since they generally didn't put up their own money as an investment in the fund. That means they have no capital at risk and therefore could have no capital gains.

Even the job title — fund managers — suggests that these individuals are just very highly compensated worker bees. The notion is that they are paid for their labor, the same as a plumber or a bank teller, even if they are responsible for the success or failure of huge investments made by others. And they should be taxed as such.

 So, lawmakers at both ends of the Capitol are trying to forge a compromise that would tax at least a portion of fund managers' income at the conventional rates most workers pay. The problem lies in the proposed solution. It isn't settled — and opposition in the Senate may yet be sufficient to kill it — but what's being called a hybrid tax system for this obscurely named form of income called "carried interest" is taking shape. Under this hybrid, an arbitrary share would be deemed capital gains and the rest wages. If the underlying investments had been owned for a while, the capital gains share would grow and the tax owed would shrink.

As compromises go, this one could hardly be dubbed "elegant." The hybrid plan is based on no underlying logic, only on political expediency. Moreover, the proposed change is primarily intended to generate a little revenue to pay for the short-term extension of tax breaks that benefit others. And a little revenue it would be — perhaps not much more than $1 billion or so a year. If the hybrid proposal gets enacted, no one will be satisfied.

Keeping It Simple

At its core, this debate represents how a relatively small issue can have widespread implications. What seems possible, or even likely, is that whatever lawmakers do will make an already convoluted and impossible to understand tax code — and one that delivers conflicting economic signals — even more complicated and obtuse.

Wishful thinkers persist in saying that legislative developments such as this present an opportunity for Congress to step back and look at the principles that are supposed to undergird tax policy and then to follow them in the way the law is rewritten.

In this case, regardless of ideology, lawmakers have a chance to address two shortcomings in the tax code that are widely disparaged. First, the law is far too complicated, which results in mistakes and, possibly even worse, taxpayer decisions based on the amount they would owe, not economic value. Second, despite a host of provisions intended to induce saving and investment, the law still rewards consumption and in the minds of many economists does far too little to boost investment.

One idea is to layer on a value-added tax or some other levy designed to remove the reward for consumption, but some economists — mostly academic types — offer instead what they say is a simpler and more effective change. They want to keep the income tax base, but adjust it so that it touches only "consumed income."

In effect, every dime saved or invested would be subtracted from all earnings, whether wages, pensions, capital gains or dividends. All remaining income would be taxed at the same rate, unlike today, when the top rate on wages is 35 percent and the top rate on capital gains and dividends is 15 percent. If taxpayers reinvest dividends, or if wage-earners sock away some of their paychecks in savings or investment accounts, that money wouldn't be subject to tax.

Other changes would be required to make this work: Tax rates would have to be adjusted to net the desired amount of revenue. And interest payments could no longer be deductible, because that would favor borrowing rather than investment of current income.

On the other hand, many provisions designed to promote saving or limit gamesmanship could be stripped away because they would be unnecessary. And for the first time labor and capital would be taxed the same, which means the tax code would be more likely to reward economic enterprise rather than mere wealth.

Such a radical proposal isn't likely to be adopted any time soon. But, then again, thinking about new ideas for overhauling the tax code is a pleasant distraction from watching yet another uninspired debate over the taxation of private equity fund managers.

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