You have to hand it to the US Congress for recognizing a tax loophole when it sees one, even one of its own making.
What has our elected representatives up in arms right now is a provision—an exception, really—in a 1987 tax law that gives special tax treatment to certain publicly traded partnerships. Private-equity firms Blackstone Group LP and Fortress Investment Group LLC. capitalized on this largesse when they sold shares to the public in recent months, organizing as partnerships to qualify for the more favourable capital gains tax rate (15% maximum) rather than the corporate rate of 35%. Why was there such a big loophole? And what’s to say that buttoning up one won’t expose another? (The rich are different from you and me: They have better tax lawyers.) The tax code is the problem, not the solution.
The current debate concerns the historical treatment of limited partnerships.
“Partnerships have always been treated as ‘flow-through’ entities,” says Victor Fleischer, law professor at the University of Illinois. “The partnership doesn’t pay taxes; the income flows through to the partners.” With more and more businesses going public in the 1980s and retaining the partnership structure, Congress passed a law requiring those entities to pay tax as if they were a corporation, regardless of how they were registered with the state.
Congress included an exception to the rule for publicly traded partnerships with 90% or more in “passive income”—profits from dividends, capital gains, interest and rents—as opposed to income from running an active business. Blackstone complied with the letter of the law, according to the Internal Revenue Service. Congress is saying compliance with the law’s spirit was lacking.
The Senate finance committee is considering legislation that would close this loophole. At the same time, House committees are looking at a related matter, the tax treatment of hedge funds’ “carried interest.” Hedge funds generally earn a 2% management fee and 20% of the profits. At issue is the tax treatment of the 20%: Is it a capital gain or a fee for service, in which it would be taxed as ordinary income at a maximum rate of 35%?
While this is sure to be a signature issue for all anti-tax groups, the reality of any reclassification of hedge funds’ claim on investor profits is apt to be small, according to Fleischer. Most funds won’t be affected because the bulk of their gains are short-term. Short-term capital gains are taxed as ordinary income.
Beyond that, the generic tax issue relates to the provision of labour services, according to Robert Hall, a professor of economics at Stanford University, who along with Alvin Rabushka developed a proposal for the flat tax. “The general partner, or administrator, is providing labour services—fancy labour services, I’ll grant you—that are akin to a stock option.” Executive stock-option grants are “part of compensation for labour services and taxed as ordinary income,” he says. Carried interest should be treated the same.
While tax experts debate whether carried interest is capital income (it’s the investors’ capital, not the general partners’, that’s at risk) or ordinary income, congressional tax writers want to secure a potential source of revenue to pay for domestic spending initiatives. If a bunch of rich white guys pays higher taxes in the future, so be it.
Yet in finding another fall guy and closing another loophole, Congress is missing both the point and the opportunity to do something meaningful with the tax code, such as scrap it and start all over with something simpler and flatter.
There will always be someone smarter waiting to exploit another “exception” in the tax code. If Congress effectively raises the taxes on hedge funds, “I guarantee they will find another way to reduce taxes to the absolute minimum,” says Tom Wright, director of investor relations for Emory Capital Management, a hedge fund in Clearwater, Florida, and a long-time spokesman for FairTax.org, a grass-roots organization advocating replacing the income tax with a national retail sales tax. “It is their fiduciary responsibility to do so.”
Ken Griffin, chief executive of Citadel Investment Group Inc., a $14 billion hedge fund in Chicago, told The New York Times that trying to alter the income distribution via a more progressive income tax would result in more people moving “from one tax area to another.”
I’ve never understood why Congress—Democrats as well as Republicans—isn’t more interested in simplifying the tax code. (OK, I understand it—members derive power from passing out favours, especially tax breaks—but I don’t get it.) It would level the playing field by taking away the incentive—for the rich, mostly—to avoid taxes.
A side effect of shifting to a flat tax, with no deductions, or a sales tax—both of which tax consumption, either directly or indirectly, provide rebates or exemptions to the poor, and reward saving—would be death to lobbyists. Spending for federal lobbying totalled $1.36 billion in the second half of 2006, according to Politicalmoneyline.com. The $1 billion mark has been breached in every half-year reporting period since the second half of 2003. With a simple, flat-tax system, there would be increased incentive to work, invest and save, all of which are deemed “good” for society. There would be no—or less—incentive to lobby for favours, an activity considered “bad” by most folks. Is there any doubt Congress prefers bad over good apples?