Despite our 2012 presidential debates devolving into mud-slinging over the intricacies of each candidate’s tax plan, the conversation stemming from the election did little to advance tax policy in the United States. Namely, for all of the discussion of closing tax loopholes, both candidates failed to significantly address the source of one of our most significant tax inefficiencies: the flawed definition of what constitutes capital gains.
A capital gains tax is a special tax paid on, unsurprisingly, gains from capital investment. The problem, however, stems from the fact that under the current tax code, people who make their money through the management of capital, instead of through its investment, are also taxed at the flat capital gains tax rate of 15%, rather than through the progressive income tax. While this may seem like semantic quibbling more suited for an accountant’s office than the Oval, this policy leads to significant losses in government revenue.
The problem arises from the difficulty in defining the income of capital managers. Hedge fund and private equity managers, including venture capitalists, are compensated based partly on a management fee (usually between two percent and three percent of fund size) as well as a performance-based fee (usually around 20 percent of the gains from investment.) The argument in favor of the existing policy goes as follows: since fund managers are paid based at least partly on the performance of their funds, their earnings represent capital gains and should be taxed as such. The logic behind the capital gains tax being lower than all but two of the marginal income tax rates (historically 15 percent, though raised to 20 percent in the January 2013 fiscal cliff compromise) is that the money invested was initially taxed as someone’s income, and it would be unfair to tax that income twice at the same rate. While this argument holds water for wage-earning Americans who choose to invest the fruits of their labor, it does not for those fund managers whose primary income is from capital gains. While fund managers’ income may be performance-based (and in that no different from salesmen who work on commission), it is no more capital gains than any other form of income. Working to maximize others’ capital gains is not capital gains itself.
In the context of our current political budget mania, it is strange that such an obvious loophole should exist, let alone go largely unacknowledged. A quick look at the campaign contributions made to various members of congressional leadership, however, quickly makes the reason plain. Key leaders in Congress on both sides of the aisle are major recipients of hedge fund money. Both House Speaker John Boehner (R-Ohio) and House Majority Leader Eric Cantor (R-Va.) count Paulson & Co, one of the most successful funds in the United States, among their top five largest donors. Paulson & Co is also the single largest donor to Senator Charles Schumer (D-N.Y.), chairman of the Senate Democratic Policy Committee. Securities and investment firms number among the top donors by industry for every single member of the 112th Congress’ leadership.
While it probably comes as no surprise that politicians have a vested financial stake in policies that favor the titans of finance, this breach of fiscal logic has gone unaddressed for far too long. Even in the most recent presidential election, so dominated by debates over the relative tax policies of the two candidates, neither seriously mentioned reforming the government’s definition of capital gains.
This shortcoming in Congress’ examination of the capital gains prevents lawmakers from utilizing a significant tool for deficit reduction. Even if only the 25 most successful hedge fund managers were taxed according to the system of progressive income tax, the government could raise millions of dollars of lost tax revenue from the so-called “one percent.” As the congressional battle over budget austerity rages on, the time has come for Americans to push leading politicians to address this tax oversight, even if in doing so they must bite the hand that feeds them.