Obama’s Half-Assed Tax Hike Populism

Eight years after launching his campaign, and six years after being inaugurated, President Obama is finally living up to the greatest fears of his detractors in a significant way. Tonight, he’s expected to propose a plan to tax the rich and banks more, and distribute the proceeds to those on the lower rungs of the income ladder through tax credits. But he still won’t do much to address a glaring tax loophole that exists only to help the rich get richer.

Obama’s faith in progressive taxation—hyped to a large degree by critics over the years—has of course always been apparent. Obamacare included extra Medicare taxes on the wealthy, the proceeds of which are being used to subsidize health care for the poor and middle-class.

Additionally, the denouement of the fiscal cliff at the end of 2012 wound up partially reversing the Bush-era tax cuts, taking the top rate on income from 35 percent to 39.2 percent, and the top rate on long-term capital gains from 15 to 20 percent. (Since Obamacare adds an additional 3.4 percent tax on capital gains for highest earners, the top rate for long-term capital gains is now 23.4 percent.)

But considering the rampant income inequality and the vast distortions in the tax code enacted in favor of the wealthy in the aughts—and the fact that mere inaction would have eliminated all of them—those fixes were remarkably mild.

The same might be said about the proposal released over the weekend, which Obama will likely formally introduce in his State of the Union tonight. A year after the American publication of Thomas Piketty’s Capital, the runaway bestseller about the ways in which the world’s wealthy have become ever more wealthy over the decades, the leader of the party of FDR and Lyndon Johnson has finally picked up a pitchfork. But its tines still aren’t very sharp.

One component of the proposal is specifically aimed at one of the ways Mitt Romney made his fortune. President Obama is proposing to cap at $3.4 million the amount of wealth that can be shielded on a tax-advantaged basis in Individual Retirement Accounts. By dint of some excellent tax advice and the willingness to drive a truck through a loophole, Romney was able to stash more than $100 million in his.

But capping IRA amounts does little to address the way Romney really made his money—and that represents one of the most egregious, income-inequality-inducing wrinkles in our tax code. It’s the factor that has really allowed hedge-fund titans and private-equity barons to routinely mint Rockefeller-size fortunes.

It’s called the carried interest rule, and Obama doesn’t look like he’s ready to do away with it yet.

People in the private-equity and hedge-fund world get paid to manage the money of other people and institutions—typically a flat fee (about 2 percent) on the amount of money they manage and place at risk, plus a chunk of the profits those investments return (typically about 20 percent.)

Take $100 million from investors, invest it in stocks, apply some leverage, and rack up a 30 percent return in a good year, or $30 million in total profits. Return $24 million to investors, and keep $6 million for yourself as payment for managing the money.

But here’s the wrinkle. The IRS doesn’t regard those payments as wage income—as, say, a mutual-fund manager might charge for managing money, or as a lawyer or accountant might charge for providing advice. Rather, it regards it as capital gains—even though the hedge-fund and private-equity managers aren’t investing their own money.

That makes all the difference in the world. Under the current system, ordinary income can be taxed at rate as high as 39.6 percent. By contrast, long-term capital gains are taxed at 23.4 percent. That’s a 40 percent difference. Thanks to the carried interest rule, a private-equity manager pays taxes of only $2.34 million on a $10 million performance fee; were it taxed as ordinary income, he’d pay $3.96 million in taxes on that same sum.

There’s no serious defense of this special treatment. Capital gains tend to be taxed more lightly than ordinary income because the government wants to provide incentives for people to put investment capital at risk. They could, after all, lose everything.

But private-equity and hedge-fund managers aren’t putting their own money at risk; they’re largely putting other people’s money at risk. Because a sharp gap opened in the Bush years between the tax rates on capital gains and on ordinary income, this difference became hugely lucrative.

In classifying carried interest as capital gains, the tax code, which already privileges income earned by capital over income earned by labor, privileges the type of labor conducted by a very small fraction of the wealthiest over the labor of the rest of us.

Now, Obama’s proposal would help narrow that divide—a little bit: He’s proposing to raise the top tax on capital gains from 23.4 percent to 28 percent. But doing so without touching the carried interest rule still leaves a gaping hole between the top capital gains rate and the top income tax rate.

This isn’t entirely surprising. Over the years, Obama has made occasional gestures toward eliminating the preference. But there isn’t that much of an appetite among congressional Democrats for such a move. Even in 2009, when the Democratic Party, flush from victory and sitting on solid majorities in both houses of Congress, didn’t attempt to eliminate the loophole.

The likely reason? Democrats—especially the core group of senators from coastal states like New Jersey, Connecticut, New York, California, and Massachusetts—tend to represent remarkably wealthy constituencies. Also, hedge fund, private equity, and venture capital honchos have been among the most prolific donors to the party apparatus, and to independent expenditure campaigns (see under: Soros, George; and Steyer, Tom).

So if this is class warfare, the wealthy are extremely lucky that it’s being waged by President Obama and his Democrats.