Socialism for the Rich: Battle to keep tax breaks for hedge funds and private equity partners

An important battle for financial stability and tax justice is being fought out in Washington, but don't get your hopes up: while the Obama administration in the White House has committed itself in its 2009 budget to taking action, vested interests in the Senate will almost certainly win.

The issue at stake revolves around a rule in the U.S. tax code that allows private equity and hedge fund partners to classify profits as 'carried interest'. This means that while ordinary people and small business owners are liable to pay federal income tax up to a maximum rate of 35 per cent, plus social security and Medicare payroll taxes, a chosen few are given a special tax treatment which treats trading profits as capital gains, liable for a maximum tax rate of 15 per cent and exempt from payroll taxes.

This astonishing twist in the tax code is at least partly responsible for the proliferation of complex financial instruments over the past 20 years. The IMF has warned about this, but the likelihood of change in Washington - or London - is slim since the political power of the financial lobbies far outweighs any counter-balancing from civil society. According to Gary Weiss, writing in the current issue of Portfolio.Com, past efforts to eliminate the distortion have been stymied, time and again, by Republican Party senators:

"Elimination of carried interest has passed in the House of Representatives three times in recent years, most recently last December, but went nowhere in the Senate. The obstacle to removing this open sore from the tax code is the usual one—partisan politics. When carried interest came up for a vote last December, it was approved on a party-line vote, with nearly every Republican voting against it."

The defenders of socialism for the rich include the U.S. Private Equity Council, an industry lobby, which defends the principle of 'carried interest' on the grounds that private equity partners earn their profits through buying capital assets, increasing their value, and selling the asset at a higher price. Of course, this is often achieved through short-term measures like laying-off staff, or adopting aggressive tax positions, rather then through genuine innovation or quality improvement. Furthermore, in many cases the private equity investors and hedge fund managers are using borrowed money to achieve their goals, taking hefty management fees (up to 20 per cent of profits) which are taxed as capital gains.

In economic terms this is a nonsense. In its report on how tax policy has contributed to the financial crisis, the IMF warned: "Tax distortions are likely to have encouraged excessive leveraging and other financial market problems evident in the crisis. These effects have been little explored, but are potentially macro-relevant." That ugly term, macro-relevant, is IMF-speak for likely to impact the economy as a whole.

The problem is that no-one seems to be picking up on this warning. Research is urgently needed, but meantime measures are required to stop further damage arising from these distortions. For starters, capital gains should be taxed at the same rate as income, to avoid temptations to dress one up as the other. And the special treatment of private equity and hedge fund 'carried interest' (undoubtedly a market distortion) should be abolished.

This mess should be sorted out without delay.