June 29 (Bloomberg) -- If laws are someday passed changing the taxation of income for private-equity managers, analysts might look to June 12, 2007, as a turning point.

That was when the idea that these Wall Street pros were under-taxed got a big boost from someone with the highest market credentials: Robert Rubin, the former Treasury Secretary and Goldman Sachs Group Inc. chief who now is chairman of Citigroup Inc.'s executive committee.

Speaking before two think tanks, the Hamilton Project, which Rubin co-founded, and the Center for American Progress, Rubin joined those who questioned whether the share of the profits private-equity managers earned for investing their partners' money should be taxed as capital gains, at a 15 percent rate, or as ordinary income, which is 35 percent for high earners.

``It seems to me what is happening is people are performing a service, managing peoples' money in a private-equity form, and fees for that service would ordinarily be thought of as ordinary income,'' Rubin told the Hamilton Project.

Ten days later, 12 leading House Democrats introduced a bill that would tax performance-based compensation in any partnership -- from hedge funds to real estate investment trusts to venture capital -- as ordinary income.

Those opposing such legislative changes start by arguing that the high risk-reward structure of these managers' compensation makes their earnings more like investments than typical salaries. After all, while most private-equity partners get an automatic fee of 2 percent of assets under management, their 20 percent share of the profits is tied to the investment success of the fund.

Not Automatic

While performance-based compensation may carry more risk, and may also be a smart way to align employee and employer interests, it doesn't automatically turn earned income into capital gains from a tax perspective.

Some professional athletes take lower salaries in exchange for performance bonuses. Silicon Valley executives gamble on stock options, and lawyers accept contingency fees knowing they might walk away without a cent. Except for a small slice of stock options, all of these earnings are taxed as ordinary income.

The next line of defense for the status quo comes from those like Pat Toomey, president of the Club for Growth, who argue that ``private-equity firms play an important and positive role in our economic growth.''

Few observers doubt that private equity has made scores of companies more efficient and viable. But arguing for a lower tax rate based on an industry's economic prowess is oddly the type of approach that conservatives normally scorn as a government effort to pick winners.

`In the Game'

Furthermore, raising taxes on private-equity managers' profits has no direct effect on those providing the capital in these funds.

A third line of defense holds that private-equity general partners have ``skin in the game'' because they often put in 1 percent to 5 percent of the total capital. Yet, the size of these investments only highlight that most of their income is coming from managing other people's money. If they wanted to take 20 percent of the profits, the cleanest way is to invest 20 percent of the capital.

The strongest argument for capital-gains treatment for managers who don't invest their own capital is the desire to provide a risk-subsidy for the sweat-equity entrepreneur. When someone with a great idea is willing to work full-time starting a small business, but needs a partner with capital, allowing the entrepreneur to share in the capital gains may be justified.

Interchangeable Income

But this rationale for a risk-subsidy for small business entrepreneurs hardly applies to the cadre of private-equity managers who are today sought out by swaths of institutional investors because of their ability to run diverse portfolios.

News reports that private-equity managers have discussed a willingness to swap their 2 percent management fees for a bigger share of the profits or ``special distribution'' payments confirms what's obvious: The ordinary income and the capital gains they receive are interchangeable, and the distinction is used mainly to justify the lowest tax rate.

Ending this unjustified rate preference still requires policy makers to consider how narrow or broad any solution should be, and to guard against unintended consequences. Moreover, even if the House proposal passes, my guess is that private-equity and venture-capital professionals will find new ways to ensure 15 percent capital gains or dividend tax rates on most of their day-to-day income.

Larger Questions

This raises larger questions. Spurring growth should be a major rationale for our tax system. We may even wish to provide some risk subsidy for capital investment. Few deny that many of those raking in huge incomes are making significant contributions to jobs and productivity. That doesn't mean there is a justification for allowing the wealthiest Americans to pay a 15 percent tax rate on unlimited capital gains each year.

There is just something too offensive to our values about having a tax code that allows the very top earners in the U.S. to structure their incomes so that they pay lower marginal tax rates than the people who care for their children, serve them food at restaurants and save their lives if they have a fire.

(Gene Sperling, author of ``The Pro-Growth Progressive,'' was President Bill Clinton's top economic adviser. He is a senior fellow at the Center for American Progress. The opinions expressed are his own.)

To contact the writer of this column: Gene Sperling in Washington at gsperling@cfr.org.

Last Updated: June 29, 2007 00:04 EDT