An invitation to tax reform

Friday, December 10, 2010; 9:04 PM

LONG AGO, in 1986, Congress passed, and President Ronald Reagan signed, a tax reform package that subjected ordinary income and capital gains to the same top rate: 28 percent. The idea was to end the market-distorting game of relabeling earnings as capital gains for tax purposes. Since then, Congress and Mr. Reagan's successors, of both parties, have gradually reopened the differential, cutting the capital gains rate and raising the top income rate for various short-term reasons ranging from deficit reduction to investment promotion.

The Bush administration tax cuts pushed long-term capital gains rates down to 15 percent; the top ordinary income rate is 35 percent. And, under the tax deal between President Obama and Senate Republicans, this gap of 20 percentage points will remain for at least another two years.

On balance, we support the compromise. But we do so despite the fact that, because of the lingering gap between ordinary income and capital gains, the compromise perpetuates the indefensible favorable treatment of "carried interest," as the winnings of private equity and hedge fund managers are known. Managers usually collect1 or 2 percent of assets as an annual fee taxed as ordinary income. But their really big bucks - sometimes millions of dollars a year - come as "carried interest": the general partner's share, often about 20 percent, of profits above a certain "hurdle rate." Current law considers this a capital gain, taxable at 15 percent. But since general partners don't risk their own capital, it's more realistic to think of their take as ordinary income - compensation for services rendered, basically - and to tax it at 35 percent. The tax code would be fairer, and billions of dollars could be applied to deficit reduction.

Rep. Sander M. Levin (D-Mich.) and Sen. Max Baucus (D-Mont.), chairmen of the House Ways and Means and Senate Finance committees, respectively, spent months attempting to rectify this anomaly, with Obama administration support. Their approach was to use fairer taxation of carried interest to pay for the extension of other tax breaks. The politics was always difficult. Beneficiaries of the breaks that reform would pay for backed the bill, but Wall Street resisted, backed by far more numerous real estate partnerships - which said they would be hurt by a provision designed to prevent private equity from dodging the new tax. Now, since the various other tax breaks can be extended via the $850 billion compromise package - which both sides have agreed not to pay for - the fight is over. With Republicans taking control of the House in January, the chances of resurrecting an increase in taxes on the investment industry by itself are practically nil.

If there's a silver lining here, it is that Congress and the country have received an education in the distortions and inequities that have accumulated in the tax code since the last time it was overhauled a quarter-century ago. The best way to deal with "carried interest," and all the other credits and loopholes, is to return to the basic principles of tax reform: flatter rates levied on a broader base. Then there won't be anything to fight over.

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