You had to see it coming. The moment Mitt Romney released his tax returns the left and media focused immediately like a laser on the fact that, on more than $20 million of earnings in 2011, his effective tax rate was not much more than 15.4%. So, after being subdued by three failed attempts in 2011 to inject the carried interest debate into the American consciousness, the Obama administration has found renewed enthusiasm among aneven broader cross-section of voters who might not have even given it a second thought before the release of Romney’s returns. Unlike the more perfunctory and short-lived debates that accompanied the several attempts to close the carried interest loophole last year, this time around it is likely to gain steam as the election comes to a head in November.
Now, a whole new punditry has emerged, dedicated to educating the public on the myths and realities of carried interest taxation. Each side is presenting their case as to why carried interest should or should not be treated differently than ordinary income, and the stronger case, or the one more easily understood by the public is likely to influence policy going into 2013. Even though 70% of Romney’s income came from investment income, such as capital gains and dividends (both taxed currently at 15%) other than carried interest, the current debate centers on the legitimacy of carried interest as a capital gain or ordinary (earned) income. And, although increasing the tax rate on carried interest would produce nothing more than a few drops in the $1.5 trillion deficit bucket, it is being trumpeted as part of the Obama administration’s call for “fairness.”
At issue is whether carried interest, currently taxed at a rate of 15%, is actually income that has been earned – in other words the managers of VC firms, private equity and hedge funds worked for it – or whether it is capital gains which is income generated from your money at work. If it is earned income, then, of course, it isn’t fair to the rest of us working stiffs who are taxed at ordinary income tax rates (never mind that the average tax payer paid less than a 15% tax rate last year). Warren Buffet, who has become Obama’s “tax the rich” spokesperson, only pays taxes at a 17% rate because most of his income comes in the form of capital gains and dividends.
Defenders of carried interest have attempted to make a counter-fairness argument by pointing out that the income received by fund managers has already been taxed at the corporate level which puts the effective tax rate at closer to 45%. Unfortunately it is probably the weaker of the two arguments because few people will understand it and fewer people probably care.
While nothing is expected to happen with regards to carried interest in an election year, it is likely to become the main attraction in a political football game in which there will be no winners. It will be the cornerstone of Obama’s “fairness” agenda and Republicans will stand fast on any tax hike proposal. The real losers are the American people in being distracted by phony issues. Raising the tax rate on carried interest will do little reduce the deficit and it doesn’t get to the heart of the problem which is a drastically flawed tax system which allows politicians to pick winners and losers. The only real solution is to move to a flat tax rate in which all income is taxed the same and all loopholes are eliminated.
