Now that the New York State Attorney General has started an investigation into the practice by some private equity firms, including Mitt Romney's old firm Bain Capital, of funneling management fees (which are taxed as ordinary income at 35%) back into their funds so that they could come out at the other end as capital gains (which are taxed at the lower rate of 15%), the debate about whether such tax dodges should be allowed is sure to get plenty of attention.
But the other issue that also needs to be addressed is whether capital gains themselves should receive the preferential tax treatment that they currently do. I first raised this issue months ago in my piece entitled Tax for Thought: Paying Less is not More.
Capital gains are a form of passive income that arise not from working but from realizing profits from investments. While there is nothing wrong with making money passively, there is no defensible reason to tax that type of income any differently than the wages of say, a policeman or a cashier at a fast food restaurant. After all, those people contribute to our economy as well, so why should they be treated differently?
The common argument goes that a lower tax rate on capital gains encourages Americans to invest more money and help grow the economy, which in turn leads to higher tax receipts for the IRS. That may be true up to a point but it is worth remembering that tax revenues from increased investment activity are also offset by revenues lost due to lower rates on capital gains. According to the Congressional Research Service, the capital gains tax break amounts to $71 billion per year, an amount that could put a handsome dent in our deficit.
The other argument for keeping the capital gains tax rate low has to do with double taxation, since businesses already pay taxes on their income, which is then effectively taxed again when passed on to investors. That is a valid point but it fails to take into consideration the fact that many companies, especially the biggest ones, rarely pay full taxes on their income due to the vast variety of tax loopholes and credits available to them. As a result, the problem of double taxation is often overblown and more a convenient myth than a reality.
And finally, there is the issue of fairness. While investment activity may not be limited exclusively to the wealthy anymore, it is still a much bigger source of revenue for the rich than for the middle class, which leads to an imbalance in the tax treatment. Most Americans live on paychecks and are therefore stuck with paying 35% or more on the bulk of their earnings. In that way, the preferential tax rate on capital gains becomes a form of "entitlement" for the wealthy, and penalizes everyone else. The actions of companies like Bain Capital that move money around to enjoy lower tax rates further amplifies this inequality, since ordinary citizens and even small businesses simply do not have the means to reduce their taxes via these mechanisms.
President Obama wants to raise the capital gains tax rate to 20%, which I think is a good way to restore some equality while preserving the impetus for investment. His challenger, on the other hand, does not want to raise the rate at all, which is not surprising given that Romney himself made a lot of money on the back of a preferential capital gains tax rate - first through his involvement with Bain and then via his private investments; and that renders his view disturbingly self-serving.
In any case, for the sake of sheer pragmatism, it is high time that the capital gains tax rate was raised. It will be good for our deficit, good for equality, and good for our economy.
Sanjay Sanghoee has worked at leading investment banks and hedge funds and is also the author of a financial thriller, MERGER. Please visit www.sanghoee.com for more details and to sign up for updates.
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