Hedge Hogs

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This column was written by the editors of The New Republic.

Imagine for a moment you were a car salesman and that you drew most of your income from commissions — sell a few more minivans, get a bigger paycheck, and so on. Now imagine the IRS said you didn't have to pay full income taxes on those commissions — that you would be taxed at half the normal rate. It'd be a pretty sweet deal for you. But everybody else would complain. And rightly so: Why do car dealers deserve special treatment? Well, swap "hedge-fund managers" for "car dealers," and you've just become acquainted with the latest skirmish in what the right calls "class warfare" but the rest of us call restoring sanity to the federal tax code.

For many years now, the managers of hedge funds — large investment funds run exclusively for wealthy individuals — have taken their compensation in so-called two-and-twenty arrangements. The two refers to 2 percent of fund value, which the managers get as an annual management fee; the twenty refers to 20 percent of returns, which they take home annually as sort of a commission. These funds are enormous, and the good ones do quite well. So you might not be surprised to hear that the fund managers make some extraordinary incomes, sometimes in excess of $1 billion (yes, billion) a year.

And, hey, that's fine. This is America, and there's nothing wrong with getting rich. But we do expect all Americans, even those with the most money, to pay income tax like everybody else. And here's the surprise: These fund managers don't. Under current law, that 20 percent is considered a form of capital gains. So, even though fund managers can take the bulk of their earnings this way, they will pay taxes on it at the reduced rate for capital gains — which is 15 percent, or less than half what they would pay for other forms of income. Among those taken aback by this arrangement is Senator Max Baucus, the chairman of the Finance Committee, who has convened meetings on the subject with an eye toward closing the loophole.

The investment community has responded, predictably, by dispatching lobbyists. The Wall Street Journal editorial page has responded, just as predictably, by throwing a tantrum. "There's no good rationale for this," say the high priests of conservative economics, "beyond the fact that Congress wants money and private equity funds have lots of it" — which, in more sensible circles, is known as trying to finance the essential operations of government in the fairest way possible. The Journal also argues that reform will hamper the economy, since the current tax break "aligns" the interests of managers and investors — as if a fund manager making only three-quarters of a billion dollars might be tempted to screw his investors, while a fund manager making the full billion wouldn't.

Of course, the best argument for repealing this break is that it distorts the economy — in this case, by encouraging people to become fund managers rather than, say, entrepreneurs. But this is just a reminder of a larger problem: the fact that we favor capital gains in the first place. It's the wealthy who earn most of their money from investments; why should they get a tax break when people who make money by hauling concrete, answering phones, or performing surgery don't? And, quite apart from distributional justice, the break on capital gains interferes with the free market by encouraging investments that people might not otherwise undertake. Indeed, there is a whole business devoted to reclassifying normal income as capital gains to take advantage of the reduced tax rate — more proof of the artificial distinction between investment income and labor income.

You would think that conservatives, who fancy themselves guardians of the free market, might see this logic. And, while Republicans notoriously overlook this, the tax favor for hedge-fund managers is so egregious that it irks even some of their stalwarts. Senator Charles Grassley, of the Finance Committee, was actually the first to raise this issue. That's an important signal: It may actually be possible to do something about this small, though significant, flaw in the tax code, even if the much larger fight over capital gains must wait for another day.

By the editors of The New Republic
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