Recently it has come to light that certain money managers are enjoying unduly favorable tax treatment enabling them to pocket more than $6 billion a year in tax breaks.  Remarkably, an Economic Policy Institute analysis shows that the top 25 private equity (aka hedge) fund managers walk away with nearly $2 billion of those tax breaks (http://www.epi.org/content.cfm/pm120).   On the other hand, poor people get about a dollar a meal in food stamps, and the improvement in benefits just passed by the House was more modest than originally proposed because they could not come up with another $1.6 billion over 5 years for more adequate nutrition help.  Further, this loophole allows highly paid managers a marginal tax rate significantly lower than that of an unmarried receptionist in the same firm earning $42,000 a year.  The glaring unfairness has received a flurry of press attention and led some members of Congress to seek changes in the tax code.
Representative Sander Levin (D-MI) has introduced H.R. 2834, which treats as ordinary income the compensation for investment management services that do not entail financial risk on the part of the manager.  Now, the private equity fund managers classify large amounts of their income as capital gains.  Capital gains are taxed at a much lower rate than regular earnings, but because it is generally agreed that the fund managers are not risking their own money in investments, Representative Levin’s bill would clarify that their compensation should not be taxed at the lower rate.

Proponents of maintaining the loophole contend that ending this practice will hurt those whose pension money is in private equity funds like teachers, police officers, firefighters and other public employees.  H.R. 2834 has no bearing on the pension funds or the returns on those funds, and it has been endorsed by unions who represent the workers whose retirement savings are in those pension funds.  Other bill opponents contend that the bill would create a disincentive for fund managers to do a good job of managing the investments.  However, fund managers would still be well compensated – those top 25 managers average $570 million each in earnings, according to the Economic Policy Institute.

While experts agree that it is wrong to treat this kind of income as capital gains, it does raise the  larger issue of the very low capital gains tax rate (a maximum of 15 percent), compared with the top rate of 35 percent on income from labor.  Historically investment income from capital gains has been taxed at a much higher rate than it is now.  In 1976, the maximum capital gains tax rate was 49 percent.  In 1986 it was lowered to 28 percent and subsequently cut to 20 percent in 1997.  In 2003 the Bush tax cut included cutting the maximum tax rate on capital gains to 15 percent, the lowest level since World War II, and that change contributed heavily to an overall windfall to millionaires averaging $118,477 each in 2006.  The cut to 15 percent is scheduled to expire after 2010, which for many analysts would be a move towards a fairer tax code. But without waiting for these larger issues to be addressed,  H.R. 2834 takes on an egregious abuse that is costing taxpayers billions.

For a more details see the Citizens for Tax Justice paper: “Myths and Facts about Private Equity Fund Managers – and the Tax Loophole They Enjoy”.

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