This week the New Yorker's financial columnist James Surowiecki explained how money managers at hedge funds and private equity firms sneak around the tax code by treating most of their income as long-term capital gains, which is taxed at 15 percent, instead of earned income, which is taxed at a much higher rate. What he doesn't mention is that a new Republican tax reform plan from Paul Ryan would make those capital gains -- which account for between 20 and 50% of hedge fund profits -- completely tax free.
The left-leaning Citizens for Tax Justice blasted Ryan's plan for losing "$2 trillion over a decade even while requiring 90 percent of taxpayers to pay more." But the most politically unpalatable part of the plan might be how it would dramatically cut taxes for Wall Street investors by making up to half their earnings entirely tax free.
I spoke to the Tax Policy Center's Joe Rosenberg about what eliminating the capital gains and dividends tax could mean for American businesses. He said the problem of income reclassification could extend beyond private equity. For example, if you've got a law firm structured as a partnership, the partners could conceivably pay themselves a small wage and declare that anything above that wage would be declared a tax free dividend. Similarly, a business owner could pay himself a smaller wage and then distribute other profits to himself as a dividend, and escape those taxes.
The Tax Policy Center concluded that lower tax rates on income and the capital gains tax elimination might offset. But there is the distinct possibility that cutting capital gains taxes from 15 percent to zero could -- without watchful enforcement from the IRS and Treasury -- introduce a rash of income reclassification across industries that could cost the federal government even more tax revenue.