Discrimination in the Top Tax Bracket

Those hedge funders are right--it is unfair

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There’s racism. There’s sexism. There’s anti-Semitism. There’s discrimination against Latinos and gays and people with disabilities. Our society has attempted to address all of these, to one degree or another. But if there’s one form of discrimination that doesn’t get the attention it deserves, it is discrimination against one group of rich people compared with another group of rich people.

Just ask Douglas Lowenstein, president of the Private Equity Council. “It’s discriminatory and inequitable,” Mr. Lowenstein groused last week. He is referring to a bill already passed by the House that would require private equity firms and hedge fund managers to pay ordinary income tax rates (35 percent if you’re in the top bracket—and for heaven’s sake, why be a hedge fund manager if you’re not?) on 75 percent of their income. The rest would be taxed at the capital gains rate of no more than 15 percent. Right now their entire job income is taxed at 15 percent. Fifteen percent is slightly less than the rate that minimum wage workers pay into Social Security and Medicare, even if they don’t make enough money to pay any income tax. This so-called “payroll tax” is mostly phased out at incomes far below that of the typical Private Equity manager.

It seems to me that if anyone has a gripe, it is those financial operators who chose equally arcane specialties and probably have done equal damage to the country and yet never got this special 20 percent off deal on their taxes in the first place. Oh yes, them and every other taxpayer whose share of the national debt is just that much higher because hedge funds and private equity got this absurd break.

What really gets the goat of the private equity and hedge fund persons is a related provision in the House bill that would tax profits from the sale of an investment management business itself at ordinary income tax rates rather than as capital gains. Once again, that would be 35 percent instead of 15 percent. “This would make investment partnerships the only businesses in America whose owners would be ineligible for long-term capital gains treatment.”

And Mr. Lowenstein is right: it is absurd and unfair to tax the sales of different kinds of businesses at such dramatically different rates. But it is equally absurd and unfair to tax capital gains and ordinary income at such dramatically different rates. Mr. Lowenstein should pay his taxes at the same rate as any other business executive, and they both ought to pay at a higher rate than their cleaning ladies.

The special tax treatment of capital gains is a subject that quickly gets arcane and theological. I’ve been fighting this battle for years. When I started, the top marginal tax rate for capital gains was 35 percent—but the top rate for ordinary income was 70 percent. Now, after years of struggle, ordinary income is down to 35 percent, but capital gains are at a ludicrous 15 percent. A “capital gain” is a profit on the sale of an asset. This is considered to be profoundly different than income from, say, working 9-5. The incomes of hedge fund managers has enjoyed capital gains treatment rate because it took the form of profits on the sale of securities. But many businesses make their money by selling goods at a profit, and there are sensible rules that if what you’re selling is “inventory” of a going business (a candy store, for example), then your profit is ordinary income.

Special treatment of capital gains, based on the theory that they are different somehow from ordinary income, is one of many areas of tax law that have become a cat-and-mouse game. Clever lawyers pry open a loophole, the IRS or Congress closes it, then the lawyers find another one, and so on.

This is not merely costly and inefficient. It suggests that the differences between capital gains and ordinary income are less important than the similarities. It’s an untenable distinction. If only to stop hedge fund managers from turning to violence in protest over the unfairness of it all, the distinction ought to be eliminated.

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This article is from the archive of our partner The Wire.