A tax break that needs to be broken

By DAVID IGNATIUS Washington Post Writers Group
Published July 20, 2007

WASHINGTON - For mysterious reasons, people can suddenly become indignant about government policies they have accepted for years as a matter of course. That sudden seismic shift seems to be happening now in public attitudes toward taxation of America's superrich financiers.

The three leading Democratic candidates - Hillary Clinton, Barack Obama and John Edwards - all announced recently that they support higher taxes on what's known as "carried interest," the form of compensation received by financial moguls that has created some of the biggest new fortunes on Wall Street.

We may be seeing a political bubble bursting: For decades, the capitalists who ran private equity, venture and hedge funds managed to convince Congress that the 20 percent carried interest profit share they took on deals wasn't ordinary income taxed at up to 35 percent but a capital gain (taxed at 15 percent), even though they typically were risking almost none of their own capital. This gross inequity was taken as a financial fact of nature. But no more.

Even the wealthy - at least those with a social conscience - seem to share the new concern about restoring fairness to the tax system. The most prominent critic is mega-billionaire Warren Buffett, the chief executive of Berkshire Hathaway and a director of the Washington Post Co. He admonished his fellow moguls a month ago that they were paying a lower tax rate than the people who cleaned their offices - and offered them $1-million if they could prove otherwise.

Buffett is hardly alone. Some of the people who know Wall Street best understand how unfair the current tax system is. A good example is Robert Rubin, a former treasury secretary and, more to the point, a former head of Goldman Sachs. He recently joined those arguing that carried interest amounted to a fee paid to the money managers, and should thus be taxed as ordinary income.

A billionaire who runs one of the leading hedge funds wrote me in an e-mail last week: "Amusing what is going on in the tax charades of the money managers. How in the world anyone can uphold those egregious amounts of money paying low or no taxes is really becoming laughable."

Another financier who heads a private equity fund with more than $5-billion in investments offers a similar scorching indictment of the current system. The argument that the 20 percent he automatically takes away from profitable deals should be taxed as a capital gain is "completely ridiculous," he says. Most firms put only a tiny amount of their own capital at risk - often as little as two-tenths of 1 percent, or $2-million on a $1-billion deal.

The giant private equity funds are nervous enough about the pressure building for tax changes that a few months ago they created their own Washington trade group, the Private Equity Council, which is already producing studies to justify the existing tax breaks. Their Web site explains that although fund managers may be putting up little of their capital, they deserve special tax breaks because they are contributing "sweat equity." Try telling that to the guy on the shop floor who's actually sweating - and paying taxes at a far higher rate.

A measure of just how rich the new financiers are is a list compiled annually by Alpha magazine of the top 25 hedge fund managers. The average earnings for these financial titans last year were $570-million, an increase of 57 percent over the 2005 average. "In total, the top 25 earners raked in more than $14-billion, equivalent to the GDP of Jordan or Uruguay," writes Alpha. It's a wonder there isn't a revolution against a global financial system that produces such disparities.

Is Alpha's readership of tycoons embarrassed by these numbers? Apparently not. A June 2007 editorial urges greater political activism by the superrich to save their tax breaks. If current trends continue, the article warns, "we may wake up one day to find fundamental changes affecting our business." What a happy thought.

David Ignatius' e-mail address is david ignatius@washpost.com

Washington Post Writers Group

[Last modified July 19, 2007, 22:23:33]