Wow, there's so much to talk about when the conversation turns, as it does periodically, to taxing the "carried interest" that fund managers collect on the upside. It's back in the news again, however briefly, because the House earlier this month passed a bill that will simultaneously suspend the Alternative Minimum Tax for a year and raise the tax on carried interest from the capital gains rate to the ordinary income rate. President Bush has promised to veto the bill because of the harm it would do to the economy -- a matter we'll return to later. But it's not likely to ever reach his desk, since the notion has some prominent -- and surprising -- opponents in the Senate -- to which we'll also return later.

For now, let's consider something more basic: whether taxing the carry as capital gains is even fair. It isn't. But first, a little background: Fund managers, whether they're running real estate investments, hedge funds, or private equity, typically earn compensation two ways. First there's management fee on the assets regardless of how they perform, typically two percent a year. Fund managers pay ordinary income tax on this. But the fee is usually just fraction of the manager's total earnings -- the windfall comes as an outsized share of the fund's profits, usually 20 percent, but sometimes as high as 30 percent. That profit-taking is known as carried interest, or simply "carry." (Many private equity firms earn the carry only after a benchmark rate of return has been met; if a fund returns 20 percent and this threshold is eight percent, the managers are entitled to the carry on the 12 percent difference.) The carry is considered capital gains rather than income, and the distinction can be extraordinarily lucrative -- the difference between a tax rate of 15 percent and 35 percent -- particularly when individual managers are earning a billion dollars or more.

The advantageous capital gains tax rate is designed to spur investment by rewarding financial risk. Many economists have called that calculus into question, but either way, fund managers seldom risk their own capital (which by now is considerable: in 2006, the top 25 hedge fund managers earned $14 billion, according to this article). Instead they provide expertise, vision, even. Like a lawyer might, or an accountant -- both of whom would pay income tax on their compensation. Ah, but a fund manager's fees are based on performance, you say. It doesn't matter. As the non-partisan Congressional Budget Office's Peter R. Orszag noted at a hearing before the Senate Finance Committee last summer, "a wide range of performance-based compensation, including arrangements in which service providers accept the entirety of the risk or the success or failure of the enterprise, is effectively labor income and taxed as ordinary income for services."

In fact, James Surowiecki, writing earlier this month in the New Yorker, noted that fund managers keep the carry they earn in good years, even if the fund later plummets -- they can profit even when their investors lose money. That, it seems to me, would be the opposite of risk. Meanwhile, "nothing prevents a hedge-fund manager from simply shutting down after a bad year and walking away with the fees he's already accrued." Surowiecki suggests that the risks hedge fund managers take on behalf of the fund seem to vary inversely with their personal risk. "Because fund managers reap large rewards on the upside without a correspondingly punitive downside," he says, "they have a much greater incentive to take big risks than ordinary investors do." (Like, for example, big bets in subprime mortgages.)

That some fund managers apparently have lowered their management fees only to raise their take of the profits suggests that the compensation is basically fungible, and structured to avoid taxes. As the CBO's Orszag told the assembled senators, "Most legal and economic analysis suggests that carried interest represents, at least in part, a form of performance-based compensation for services undertaken by the general partner." In other words, from an economic point of view, fund managers are getting an undeserved break. No doubt they're laughing at the rest of us even as you read this.