The capital gains tax loophole must go

Last week I wrote about the Additional Child Tax Credit and highlighted its detrimental effects on our economy as illegal immigrants, abusing the system, cheat the American taxpayer out of approximately $4.2 billion per year.

I suggested that if we closed this loophole, we could help students get more reasonable student loan rates or get $4.2 billion closer to closing the federal budget deficit.

Well, here’s another way to cut the federal deficit. I might even get in trouble for bringing this one to your attention, but it’s costing hard-pressed taxpayers as much as $4 billion per year. Hedge fund managers use tax loopholes that allow the carried interest they receive from handling clients’ funds to be taxed as capital gains and not as ordinary income.

What’s the difference between a capital gain and ordinary income? Basically, the income you’re paid for your work is classified as ordinary income. On the other hand, a capital gain is when you buy an asset and sell it for a higher price at a later time. The profit you make from holding on to it is defined as a capital gain. Capital gains are taxed at lower rates in an effort to encourage people to invest capital for longer periods of time.

The debate about the taxation of carried interest has lagged in Congress for years with little to no action, a true testament to the power the financial industry has in Washington. Private-equity managers and hedge fund operators continue to pay 15 percent capital gains taxes, while you and I pay ordinary income rates as high as 32 to 35 percent. Why? Money managers argue that they are paid based on the performance of their funds and take risks to earn their money.

They argue that if the tax rate were raised, it would discourage more risky investments, thus impacting the entire industry.

I would argue that they’re being paid for services rendered, which is investing money, meaning the interest they make should be classified as ordinary income.