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Regulations Raise Fairness Question

What do a waitress earning tips, a real estate agent earning a commission, and a private equity executive managing other people’s money have in common?

They all receive risky, performance-based compensation for their services.

What separates them?

The private-equity-fund manager pays the 15 percent capital gains rate on his or her compensation, while the others pay ordinary income tax rates of up to 35 percent, plus payroll taxes.

When I was in law school, a tax professor taught me that if you are going to tax some things differently than others, you need to do so on the basis of rational distinctions. For Congress, that means we all need to be able to go home and look our constituents in the eye and tell them that our tax code is fair and makes sense. Otherwise, we risk undermining people’s confidence that our system works for them.

Private-equity-fund managers typically take part of their compensation as a “carried interest.” In exchange for managing their investors’ assets, they receive a portion of the fund’s profits, usually 20 percent. The distinction we need to draw is whether this is investment income or compensation for services.

One private-equity manager who testified at a recent Ways and Means hearing, Leo Hindery, was quite blunt: “It really isn’t all that hard to decide how to properly tax carried interest. Is [it] income which a money manager earns on his or her personal investments, or, instead, is it the performance fee earned for managing other people’s investments? If carried interest is personal investment income, then it is properly entitled to capital gains treatment — however, if it is a performance fee, as my 20 years of firsthand experience clearly tells me it is, then it should be taxed as ordinary income.”

Even The Blackstone Group wrote in its initial public offering filing with the Securities and Exchange Commission: “We believe that we are engaged primarily in the business of providing asset management and financial advisory services and not in the business of investing, reinvesting or trading in securities. … We also believe that the primary source of income from each of our businesses is properly characterized as income earned in exchange for the provision of services.”

How we tax the carried interest that a private-equity or hedge-fund manager receives is a basic question of fairness. Why should a private-equity-fund manager receive capital gains treatment of their income when an executive who exercises a stock option pays ordinary rates? Why should someone who manages a fund organized as a partnership pay the capital gains rate when a professional at the Goldman Sachs Group doing exactly the same job pays the ordinary rate?

I have introduced legislation that would correct this inequity by making individuals who manage investment partnerships pay ordinary income tax rates on their carried interest. It would continue to treat returns on a manager’s personal investment in the fund as a capital gain.

Some defenders of the status quo have argued that the risk or sweat equity involved justifies the capital gains tax treatment for their services, and they even tried to compare fund managers to a mom and pop grocery store or to Bill Gates.

The reality is that there are many forms of risky compensation, from an executive’s stock options to a real estate agent’s commissions, all of which are taxed as ordinary income. And the fundamental difference between a fund manager and the examples above is that “mom and pop” and Bill Gates own the grocery store and Microsoft, while the fund manager is managing assets owned by his or her investors.

Former Treasury Secretary Robert Rubin had it right when he said, “basically I think what they’re doing is getting paid a fee for running other people’s money, and if that is essentially what’s happening, while you can certainly create all kinds of analogies that are complicated and if I were arguing against this I think I would try to develop a lot of complicated analogies and use that as my way of trying to prevent something from happening.”

Other defenders of the status quo have argued that taxing equally the income of all investment managers will harm economic growth or impede capital formation. Yet a number of conservative economists, from the chairman of the Cato Institute to a group of individuals who served in senior economic advisory positions for the past three Republican presidents, have agreed that carried interest is compensation for managing other people’s money and should be taxed as such. We can have both growth and equity.

Still others have argued that our nation’s pension funds would be harmed by correcting the tax treatment of carried interest. The chairman of the New Jersey State Investment Council, Orin Kramer, has called this “ludicrous,” and a number of experts testified at our hearing that managers’ ability to increase their fees as a result of the change would be severely limited by market forces.

Finally, some have argued that extending this more equitable tax treatment to real estate partnerships would lower property values or hinder development in poor and underserved communities. However, this proposal would have no effect on anyone who makes a capital investment in real estate. This will not determine property values, and if we want to encourage development in underserved areas, which I believe we do, we would be better off expanding programs like the Low-Income Housing Tax Credit or the New Markets Tax Credit.

The Ways and Means Committee has a responsibility to review and improve our nation’s tax system. Overall, our goals are a tax code that is a simple as possible, promotes economic growth and treats all taxpayers who are providing services equitably. This is a big job, but correcting the treatment of carried interest is a step in the right direction.

Rep. Sander Levin (D-Mich.) is a member of the Ways and Means and Joint Taxation committees.

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