Tax Loopholes for the Rich Weaken the Middle Class

Most “regular” Americans—those making under $100,000 per year—pay about 35% of their taxable income to the IRS. Those who earn more than a $1 million per year pay less than 30%, and the wealthiest 400 Americans pay about 18%, on average. This makes the US tax code regressive: the less you earn, the more you pay.

Progressive v. regressive tax codes

Our tax code was originally intended to be progressive so that people with higher incomes would contribute more of their income. One major reason for our progressive tax code was to protect the middle class. A progressive tax code preserves the middle class by making sure middle-class families can keep enough of what they earn to buy a home, invest for retirement, and spend money on things like cars, college, and home improvement. A few people with a ton of disposable income can’t keep the economy going. It takes a lot of people, each with a little bit of disposable income.

A regressive tax code, on the other hand creates a one-way flow of wealth from the middle class to the wealthy, which will eventually destroy the middle class. That’s a huge part of why half of Americans are now living at or near the poverty line. And why a non-partisan task force assembled by the Pew Charitable Trusts recently found that “The view that America is ‘the land of opportunity’ doesn’t entirely square with the facts.”

The “carried income” tax loophole

The main reason the rich pay so much less in taxes is not the tax income brackets, however. It is because much of wealthy Americans’ earnings are subject to the 15% capital gains tax rate instead of the 40% tax bracket that would otherwise apply. In Tax Gift to the Rich, John Farrell of iWatch News explains that “hedge fund operators, venture capitalists and other private equity managers to treat their pay, for tax purposes, as a return on an investment instead of as a salary.”

Unlike with pure investment income, where there are some good arguments for lowering the tax rate to encourage investment, there is no logical reason for treating investment managers’ salaries—carried income—as capital gains. Farrell explains how this came to be: “The treatment of carried interest is a legacy of 20th century partnership law, crafted with small businesses in mind in the years before the financial services industry became a behemoth.” Democratic Senator Carl Levin weighed in on this issue in the Senate last June:

If you are a hedge fund manager, your job is to manage a hedge fund. The income you receive for that job is no different than the income a waitress receives for waiting tables, or a janitor receives for scrubbing floors. The idea that the income of millionaire fund managers should be taxed at a lower rate than that of their staff or other workers is an absurdity.

Lobbying keeps the carried income tax loophole on the books

Why is the law still on the books? Well, a 20%+ difference in tax rate adds up to a couple billion dollars a year in savings for the rich, so it’s worth a few billion over a couple of decades to make sure the carried interest loophole stays open. The lion’s share of this money has gone to Republican leadership in the House, which has aggressively protected the carried interest loophole.

The bottom line? Closing tax loopholes like this is a critical part of rebuilding the middle class, which is a critical part of rebuilding the US economy.