A lucky few Wall Street types have been abusing a loophole in the U.S. tax code so aggressively that they now have a lower effective tax rate than most middle-class Americans.   These millionaires and billionaires cost taxpayers billions every year by avoiding paying their fair share to Uncle Sam.

Many of the cheaters are modern day robber barons making hundreds of millions of dollars a year, with the top earner last year earning $1.7 billion.  They are employed by some of the world’s wealthiest financial institutions to manage investment portfolios, known as private equity funds.  The portion of their income that qualifies for the loophole is known as “carried interest,” or “the carry.”

The loophole allows these fund managers to treat part of their income as capital gains for tax purposes.  As a result, they pay the capital gains rate of 15% on a portion of their income, instead of the highest income tax rate of 35%. 

The details of carried interest controversy are actually quite a bit more complicated than that, however.  The term “carried interest” actually refers to the 20% bonus paid to firms for managing investments, which is generally passed along to the firm’s fund mangers.  But the key point is that if your return – the bonus – is never at risk, it is income plain and simple, and should be taxed at the relevant income tax rate.

The beneficiaries of this generous loophole argue they should be rewarded because they are putting large amounts of money at risk to generate returns on investments.  And by taxing those returns at a lower rate, they help stimulate investment in the economy. 

Proponents of closing the loophole, including Representative Sander Levin (D-MI), billionaire financier Warren Buffet, and others, make variations of fairness or equity arguments.  Gregory Mankiw, President Bush’s former Chair of the Council of Economic Advisors, created quite a stir recently by supporting the treatment of carried interest as income for tax purposes.  With so many critical of what one observer calls a “sweet tax status,” it’s hard to see why the issue continues to go unaddressed.  Those skeptical of closing the loophole, including Sen. Charles Schumer (D-NY), Rep. Eric Cantor (R-VA), and some business groups, argue that increasing the tax rate would harm the economy. 

Both the U.S. House of Representatives and Senate recently held hearings on the issue.  Senate Finance Committee Ranking Member Charles Grassley (R-IA), said it best, “We can’t allow the carried interest tail to wag the capital gains dog.”  Some industry insiders agree, calling arguments to maintain the current regime “poppycock.” You can’t reinterpret the rules for a small group of folks simply because you are concerned about the economic effects. You have to follow the rules or change the rules in public, so that all are treated fairly and equally.

One reason change may not come swiftly is that a pirates booty of campaign cash flows from Wall Street to Washington, DC.  Some members who originally supported closing the loophole may be reconsidering the affects that carried interest tax legislation might have on their campaign coffers.

At the end of the day, you can forget all the tax mumbo jumbo and look at the issue in more simple terms.  People are paid a bonus – a cut of the profits – to manage a fund.  It’s really no different than the yearly bonus you get for laying pavement, answering the phone, or exceeding your sales goals, yet these are treated as income and taxed as such.  Why should one type of bonus payment be treated differently?