Should Billionaires Pay Lower Taxes Than Everyone Else?

The latest list of richest people published by Forbes magazine includes 27 American billionaires who made their fortunes by managing private equity investments, which means they buy distressed companies, fix them up and sell them at a tidy profit.

Is it fair that they pay tax on their extravagant incomes at only a 15% rate when everyone else in the country has to pay up to 35%?

Many Democrats in Congress don't think that situation is equitable and they have included in the bill to extend unemployment benefits a provision that would increase the tax rate on so-called "carried interest" -- the profits earned by investment partnerships -- to the same level as that imposed on ordinary income.

Capital gains are taxed at 15%, while regular income is taxed on a sliding scale up to 35%.

Trying Again to Close Tax Loopholes

The bill, dubbed the American Jobs and Closing Tax Loopholes Act, was passed by the House of Representatives on Friday, but won't be considered by the Senate until June 7 when it returns from vacation. The House has passed a similar carried interest tax bill three times in the past, but the Senate has always rejected it.

The proposed law affects mainly private equity funds, real estate investment partnerships, venture capital funds -- which invest in startup companies -- and hedge funds. While hedge funds have gotten most of the press in the current debate, most hedge funds trade on a daily or short-term basis and don't qualify for capital gains treatment. It's private equity, venture capital and real estate investors that are going to be hit the hardest.

In most private equity deals, the investment manager, known as the general partner, and investors, who are called limited partners, form a partnership to buy companies. The general partner gets a 20% ownership of the partnership in exchange for his expertise in selecting buyout targets, fixing up the firms and then selling them at a higher price. The limited partners are entitled to pay tax on their returns at the capital gains rate because it is a return on their financial investment, but the general partner often has no money of his own invested but takes 20% of the profits.

As currently written, the law will increase the tax from 15% to 35% on half of the profits of investment fund managers in 2011 and 2012. Beginning in 2013, they will have to pay the higher tax rate on 75% of their income. The remaining profits will be taxed at the lower capital gains rates.

Slow the Flow of Capital?

According to the Congressional Budget Office, the measure is expected to increase revenues by $19 billion over the 10 years ending in 2020. The money will be used to help finance the extension of unemployment benefits, among other things.

"I think this will significantly affect behavior," says Robert W. Stewart, vice president for public affairs at the Private Equity Council, a Washington, D.C.-based lobbying group. "The industry's view is this will slow the flow or stop the flow of capital to businesses that need it. It will probably slow it the most to businesses that need it the most."

Mark Heesen, president of the National Venture Capital Association, says venture capital firms will probably decide to divert their money away from the most risky investments such as cutting-edge technologies like biotech and clean tech. "We see later-stage investing and more conservative investing going on at the expense of innovative young companies getting funded," he says.

You Helped Break It, You Help Fix It

Supporters of the bill say this reasoning is nonsense. "We think private equity managers and hedge fund managers need to pay their fair share, and it's unacceptable that their income is taxed at a lower rate than ordinary workers or workers at Goldman Sachs" (GS), says Brandon Rees, deputy director of the AFL-CIO's office of investment. "Wall Street helped create the financial crisis, and they should help pay to fix it."

Howard Gleckman, a research fellow at the non-partisan Tax Policy Center in Washington, D.C., says that taxing the income of investment managers at a low capital gains rate fails to address the way the money is earned.

"Any reasonable person would look at this and say this compensation is a bonus and it ought to be taxed like any other ordinary income," Gleckman says. "Just because some smart lawyer was able to carefully maneuver his way around the law to tax this at capital gains, I don't see any reason why Congress shouldn't shut it down and make them pay taxes just like anybody else."

Capital Gains, or Ordinary Income

Gleckman was disturbed that Congress was proposing to tax only 50% or 75% of the income at the ordinary levels. "That's silly, it's either capital gains or it's ordinary income, and you should tax it that way," he says. "If these guys aren't investing their own money, if they are investing their clients' money, I don't understand how it can be a return on invested capital."

Stewart of the Private Equity Council says that raising the tax could force investment firms to reconsider which companies they buy.

"If you have to make a significantly higher return as a general partner to make it worth your while, you are going to change the types of companies in which you invest," he says. "What that means is some companies that might look like an attractive opportunity at one yield, would not look like an attractive opportunity at another, and the difference between that is a 157% tax increase."