Why Journalists and Commentators Must Define Their Terms....

There’s a huge argument over income and taxation that’s been going on for a very long time.

The problem is, as we ALL know (yes, even journalists and commentators know this), income is NOT the same as compensation, nor should they be.

While ALL income is compensation, NOT all compensation is income.

Chris Matthews repeated a long-standing lie the other night and in his case, I’ll admit that I can’t be sure if Matthews knows the difference between compensation and income. I’ve met Mr. Matthews and he does not tend to strike one as a deep thinker, to say the least.

Still, he claimed, as Mr. Buffett had many months ago, that “Many CEO’s pay a lower tax rate than their secretaries.”

That’s clearly and demonstrably untrue.

Few, if any CEOs earn less than Costco’s Jim Sinegal ($400,000/year) and few, if any secretaries earn over $50,000/year. The tax rates on those incomes is vastly different AND the tax rate for the CEO is substantially HIGHER.

Of course, most major executives are NOT primarily compensated with income. They get stock options, and are often even able to buy additional shares at a very low “insider’s price.”

A CEO who was given 100,000 shares of stock as a compensatory “stock option, now valued at $50/share, has been given an additional $5 MILLION in compensation. If he keeps that for two years (and he WILL), he’ll pay the prevailing Capital Gains tax on that stock – 15%, which IS lower than the secretaries income tax rate.

And it SHOULD BE! NO ONE has ever argued that ALL compensation should be taxed equally. Not one such argument has ever been made.

What’s pathetic is seeing the likes of Warren Buffett, a member of the group that lobbies for LOWER Capital gains taxes on investments, making such ridiculous claims that confuse common income with legitimate Capital Gains based compensation.

There are also other, more nebulous ways that certain positions get around the income tax. Private equity funds, venture capital funds and hedge funds all use a “points system,” by which managers don’t take stocks and hold them, but convert their commissions into “points” and then hold them, claiming those as Capital Gains!

My wife has worked on some Hedge Fund clients and seen mangers with portfolios of over $100,000,000 in “points,” that will be taxed as Capital Gains.

Now THAT practice of converting commissions from managed investments into “points” that the IRS (the government set that loophole up, NOT any fund managers) devised CAN BE changed with the stroke of a pen.

Jeffrey Carter of the CME Board defends the points system this way; “Let’s say you set your fund up and it’s a 2.5%/20 fund. This means that you will collect a salary of 2.5% of the value of the fund, the money raised, and you will collect 20% of the growth of the fund if it’s successful. If it’s unsuccessful you get nothing. Assume a ten million dollar fund just for fun. As you know, sometimes these funds are in the billions. The manager of a ten million dollar fund will make the magical amount of $250,000/yr. That money ought to be taxed at the highest rate because they is guaranteed that salary. There isn’t any risk once the money is raised."

“An aside, it’s not easy to raise money. Not just every Tom, Dick, or Harriet can raise a fund.

“On the 20% gains any manager ought to pay only 15%, or whatever the capital gains rate is. Why? Because the fund manager is using his talent to take a measured risk. Not all these deals work out, not every trade a hedge fund makes works out. Hyde Park Angels, my angel group in Chicago, did some research and found out some of the best funds make all their money on two deals. The rest of the deals they invest in go broke.

“Wall Street and Greenwich are littered with the remains of busted hedge funds, and fund of funds. Silicon Valley and Boston have had plenty of Venture Capitalists go belly up. Leverage buyout and Private Equity firms go out of business too.

“If America wants venture capital, and other risk loving funds out there, then they can’t overtax them. They provide much needed growth capital to really big businesses. The backbone of the internet you are reading this blog on was financed by some risk loving venture capitalists. So was most of the software you use. Tax risk capital at a high rate, you will have less of it. It means less growth, lower GDP, higher unemployment.

In other words, Carter argues that those who guide those investments are also creating a legitimate Capital Gain and that their skill-sets and the commissions derived from those SHOULD BE taxed at the Capital gains rate.

However, Berkshire Hathaway Vice Chairman, Charles Munger vehemently disagrees with Carter over "points" (commissions)  being allowed to be taxed as Capital gains. "I think the idea that the hedge fund manager gets lower taxes than the taxi driver or the physics professor is insane. The legislators who leave that policy in place are derelict in their duties to be rational and fair. There are plenty of them in both political parties. It's totally outrageous.

"Hedge funds treat the money that's really paid to him for management [as a deferred capital gain.] It's the equivalent of doing your work [points to journalist]. You pay ordinary income taxes, and they pay 15%. Or even less than 15%, which is not quite understood! There's a lot of untaxed appreciation that accretes to them with no taxes at all.

"The situation is crazy. Yet these people make political contributions and they wrap themselves in the flag of enterprise, and we end up with hedge fund managers who have what you and I would call ordinary income taxed way lower than the income of a taxi driver. It's totally outrageous.

The ONE area hopefully everyone CAN agree on is that should higher tax rates lead to LESS investment in critical areas, then government in ANY form must be barred from filling that void.

Otherwise that might serve to undermine the Capitalist system’s foundation (independent investment and the private ownership of property) while supporting the foundation of the failed Command system (government direction of both investment and industry). The world’s already been littered with the carcasses of such failed experiments (Bulgaria, Albania, the former USSR, etc.).