Hedge Fund Bonus Gold Mine-Or Fool's Gold for Dems Who Don't Get It?

Signs of debt crisis strain are everywhere these days. Despite over $14 trillion in US debt, the Left is calling Republicans extreme for wanting major cuts. On the other hand, Obama has no written plan but is acting like a born-again deficit hawk going after corporate jets. Even better, some are touting the bonuses of hedge fund managers as a tax gold mine. The latter sentiment is yet more proof that politicians on the Left just don’t get economics – at all – and also highlights one of America’s worst problems.

For those that have been following, it turns out that certain bonus income of money managers is taxed at a 15% rate (like dividends) instead of potentially 35% (like ordinary income). The tax laws allow for that lower rate if they hold onto the bonuses for a certain period of time. Non-Real World politicians and economists are crying foul – asserting it is unfair they get that break – and claiming that as much as $20.7 billion could be collected if that loophole is done away with.

Such is the state of “good enough for government” thinking.

You see, Non-Real World politicians and economists see the world like a calculator: change a tax rate and collections rise. In the Real World, human behavior adjusts to laws that change – sometimes dramatically so when it involves taxes. Just ask American Founder and Supreme Court Justice John Marshall who stated that “the power to tax involves the power to destroy.”

Take the 1920’s for instance. The Democrats had increased the top marginal tax rate to over 70%. That increase greatly diminished or nearly “destroyed” incentives for individuals. Indeed, Secretary of the Treasury Andrew W. Mellon noticed that rather than taking risks with their capital, capitalists were parking their money in tax-free government bonds.

Mellon argued that it was silly for government to pay capitalists tax-free interest on money that should be working. According to Mellon: “The history of taxation shows that taxes which are inherently excessive are not paid. The high rates inevitably put pressure upon the taxpayer to withdraw his capital from productive business.”

Mellon advocated lowering the top tax rate to 25% so that capitalists would put their money at risk, make money and pay taxes instead of the government paying risk-free and tax-free interest to capitalists. History knows that those tax cuts worked, and despite lowering rates from over 70% to 25%, revenues jumped over 60% in the low-inflation Roaring 20’s.

Turning back to the money managers, if they woke up tomorrow to news that the law changed and those bonuses would be treated as ordinary income, those very smart people who are making that money would not just sit pat and hand over the money to the Feds. Instead, they would change the manner in which they conduct business to avoid the higher tax. They would do so by creating numerous corporations or LLCs, granting ownership interests, and distributing the income as dividends instead of bonuses. By doing so, they would be changing their behavior to avoid paying taxes – easy as pie.

As a business start-up attorney who has worked with countless accountants over 24 years, I can tell you that business people are consumed with making decisions based on tax implications, not business reasons. Indeed, I often tell them that once we learn from the accountant the tax consequences of their proposed transaction, i.e. the best way to pay the least taxes, I will provide them the legal framework for that transaction. That happens every day across this country countless times.

It is a maxim of history that the more complicated the laws, the more it benefits the rich and powerful because they can afford to hire someone to figure it out. The non-rich don’t have that luxury. Rather than encourage that, and to discourage decisions based on taxes instead of sound business reasons, the tax code should be dramatically reduced, deductions eliminated en masse and low flat rates enacted for individuals and corporations.

When Communist China has lower tax rates that the US (and higher growth rates), the real world should start to creep into our policymaking. Searching for fool’s gold in the form of taxing bonuses won’t cut it and demonstrates just how out-of-touch with reality our government is.