Too Clever by Half

September 10, 2007

Lobbyists for America’s rich love to wink. At legislative hearings on tax reform – or any other issue that might inconvenience their clients – you can see them winking all the time.

The pattern usually plays out like this: High-priced lobbyists set themselves down behind the witness table and proceed to predict the end of western civilization, or some comparable catastrophe, should the reforms their clients oppose ever become law.

This outrageously dire scenario on the record, the lobbyists then cheerfully grin at their lawmaker pals across the witness table, secure in the knowledge that simple legislative gridlock, if nothing else, will keep in place the rich people-friendly status quo they’re so ardently defending.

But last week, at a day-long House Ways and Means Committee hearing on a “Fair and Equitable Tax Policy for America’s Working Families,” Capitol Hill’s lobbyist legions weren’t winking. They were worrying. No back-slapping power-suit bonhomie filled the high-ceilinged congressional hearing room. Only nervous laughter.

This past spring, America’s premier private equity firm -- the Blackstone Group --  filed the public disclosures necessary to have its stock sold on Wall Street, a move that suddenly revealed how incredibly huge private equity manager earnings have become. Blackstone’s top five executives together personally pocketed $771.5 million in 2006.

In short order, headlines would also reveal that private equity fund kingpins, on their hundreds of millions in income, are paying taxes at rates lower “than the people who clean their offices and answer their phones,” as a labor-public interest reform coalition noted last week.

These reformers are backing legislation, introduced by Michigan Rep. Sandy Levin, that would up the tax rate on the mega millions that go to investment fund managers from 15 to 35 percent, and, last week, this legislation took center stage at a House Ways and Means hearing.

Opponents of the Levin legislation, predictably, brought out the heavy artillery. A small army of business trade associations showed up to make the case that raising tax rates on investment fund honchos would, as the U.S. Chamber of Commerce put it, “risk undermining America’s preeminent position in the world as a leader in invention, innovation, entrepreneurial activities, and growth.”

But these business groups face a dilemma. To stop reform legislation, business lobbyists normally simply work behind the scenes to gum up the congressional works. Their goal: congressional inaction. If Congress doesn’t act, the status quo holds, loopholes stay open. The rich win.

This tried-and-true formula, here in 2007, no longer applies. America’s most affluent today desperately need congressional action on taxes, not inaction. The reason? If they don’t get action – and soon – they’ll lose all the tax cuts the George W. Bush years have so generously bestowed upon them.

The Bush tax cuts started flowing in 2001 with the passage of sweeping legislation that slashed tax rates on America’s highest incomes and estates. But that passage didn’t come easily. To maneuver the cuts through Congress, GOP leaders had to play games with the legislative process. They had to include in the final tax legislation an expiration date.

Under the legislation, as signed into law, the Bush tax cuts will go fully into effect in 2010 and then expire. In 2011, under current law, the tax code will revert to the pre-George W. status quo. 

GOP leaders in Congress and the White House, back in 2001, saw this expiration date as no big deal. They figured they would have plenty of time, before 2011, to make their tax cuts permanent.

But the political tables have turned. George W. Bush has become amazingly unpopular, and his legislative allies no longer control Congress. The private equity fund manager revelations have, in the meantime, dramatically raised the public profile of the tax code’s incredible unfairness.

To make matters worse — for the deep-pocket set — some powers in Congress are now talking about plugging the private equity tax loophole and using the resulting proceeds to provide tax relief for middle class families caught up in the “alternative minimum tax,” or AMT.

Congress created the AMT in 1969 to crack down on wealthy tax cheats. But the AMT has since evolved into a tax regimen that subjects merely modestly affluent households to higher-than-normal tax rates. To lift this burden, House Ways and Means Chair Charlie Rangel from New York said last week, Congress must now “look at the entire tax code.”

Inaction on taxes, in short, no longer remains an option. Rangel and other top congressional leaders want action to avert a fiscal AMT train wreck. The rich, for their part, need congressional action to preserve the status quo set to expire in 2011. And the rich need this action quickly, while George W. Bush still sits in the White House.

But if the rich and their hired guns push for action on taxes, amid the current furor over private equity tax windfalls, they risk losing the battle over what that action will be.

The loss could be huge. The nation’s investment fund managers could lose their preferential tax treatment. The wealthy, overall as a class, could even lose their single biggest loophole of all: the current preferential tax treatment for “capital gains” income from the sale of stocks and other property.

The current storm over private equity taxation has, if nothing else, begun to refocus the legislative spotligh — for the first time in years — on the privileged status capital gains income now enjoys.

A taxpayer who reports $1 million in capital gains income currently pay taxes on that income at a 15 percent rate. By contrast, a Major League centerfielder who earns $1 million will pay taxes on the bulk of that at 35 percent, the highest tax rate now on the books for “ordinary” income.

This rate differential, not surprisingly, gives rich people an enormous incentive to do whatever they can to turn ordinary income into capital gains. That’s exactly what the managers of private investment funds have been able to do.

Private investment partnerships, be they private equity firms, hedge funds, or real estate funds, all raise vast pools of investment capital from both wealthy individuals and institutional investors.

The managers of these funds – the “general partners” – charge these investors a management fee, usually 2 percent of the funds invested. This fee gets taxed at ordinary income tax rates. Fund managers also charge what amounts to a performance fee. They typically demand from investors 20 percent of the profits the investments eventually generate.

Under current law, these 20 percent fees — known as the “carry” — rate as capital gains income. But the manipulation doesn’t stop there. Many investment fund managers have also figured out how to have their 2 percent management fees counted as capital gains, too.

How much does all this manipulation cost the federal Treasury? As much as $12 billion a year, say some analysts.

Other experts at last week’s House Ways and Means tax hearing warned that taxing the carry will not end the game-playing to convert ordinary into capital gains income. Only ending the privileged status of capital gains, they emphasized, can do that.

“A lower tax rate on capital gains and dividends than on other forms of income,” as  Congressional Budget Office director Peter Orszag testified, “creates opportunities for tax avoidance and complicates the tax system.”

Back in 1986, Congress did abolish the distinction between tax rates on capital gains and ordinary income. But as part of the compromise that allowed that action to pass, Congress also dropped the top tax rate on America’s highest income dollars from the 50 percent that had been in effect since 1981 to 28 percent.

Just about a decade later, in 1997, Congress restored preferential tax treatment to capital gains, but left the top marginal tax rate on ordinary income far below the 91 percent top rate in effect throughout the 1950s and the 70 percent rate in place in the 1960s and 1970s. The top rate currently stands at just 35 percent.

In other words, America’s wealthy today enjoy the best of all tax worlds. They get preferential tax treatment for the capital gains income that makes up a major portion of their incomes and a top marginal rate on ordinary income that stands at just half the norm in place during the Eisenhower years.

Tax reformers now have an opportunity to start changing all that. The current debate over taxing private equity earnings makes for a welcome first skirmish.

— Sam Pizzigati

Sam Pizzigati edits Too Much, the weekly online newsletter on excess and inequality. For updates on inequality stats, trends, and books — and everything else about inequality — check here for a free weekly subscription.