NEW YORK (CNNMoney.com) -- Some of the highest-earning Americans are paying a lower percentage of tax on some of their income than everyone else. Whether or not that's justified was the subject of a Senate Finance Committee hearing on Tuesday.
Specifically, lawmakers considered whether to raise taxes on the portion of private equity and hedge fund managers' compensation known as "carried interest," which is their share of the fund's profits. Typically, that share is 20 percent. That's on top of a 1 percent to 2 percent management fee, which is taxed as ordinary income.
Managers, who make all the decisions about the fund's investments, are not required to invest any of their own money. Indeed, less than 5 percent of assets managed by private equity and hedge funds is estimated to have come from managers.
But under the law, managers' share of the profits, like those of the investors who do put in cash, are treated as capital gains and taxed at 15 percent. Investment income is taxed more lightly than ordinary income to provide incentive to invest capital and to compensate investors for the effect of inflation on the sales price of long-held assets.
Key Democratic lawmakers in the House have introduced legislation that could double the tax on the manager's carried interest by treating it as ordinary income, thereby subjecting it to rates as high as 35 percent.
Their reasoning: it's really a fee for service.
That position garnered support from four of the seven witnesses testifying at Tuesday's hearing, including three academics and a longtime venture capitalist.
Like a CEO bonus, which is taxed as ordinary income, "(carried interest) is additional compensation for services," said Joseph Bankman, a professor of law and business at Stanford.
Venture capitalist William Stanfill, founding partner of Trailhead Partners LP in Denver, said that he pays a lower rate on his carried interest than his son's teacher pays on his salary. "We get ample compensation, financial and psychic, for the work that we do - from managing others' money - in the form of a share of the profits," Stanfill said. "I don't think it's fair that teachers and firefighters subsidize special tax breaks for me."
Three other witnesses from a variety of investment partnerships contended that a lower tax rate on carried interest for fund managers is justified both because of the risk they take and their input in creating or revitalizing an entity. Those efforts, they argue, can create jobs and high returns for the fund's investors, which include pension funds and university endowments.
Likening general partners to founders of companies who contribute sweat equity and ask investors for money to build a business, Bruce Rosenblum, managing director of the Carlyle Group and chairman of the Private Equity Council, a newly formed lobbying group, told lawmakers, "We're co-owners with our limited partners, not their employees."
Investments in inner city and rural areas, and investments in dilapidated properties, which often have a harder time attracting capital, may be curtailed if the tax bite for doing so is increased, said shopping-center developer Adam Ifshin, president of DLC Management Corp. in Tarrytown, N.Y. "The tax treatment allows us to take risks we otherwise wouldn't take."
He also noted that real estate general partners do take financial risk for their investments because they may personally guarantee construction loans and redevelopment loans.
Those who object to raising the tax rate on managers' carried interest contend there will be a chilling economic effect, including a move of capital offshore, less willingness to invest, and lower effective returns for investors, which include pension funds and university endowments.
"It's simple economic common sense," Rosenblum said, noting that tax changes typically have ripple effects.
He said while he couldn't say with certainty what the knock-on effects would be, he said ultimately ventures may restructure so they're not subject to a higher tax.
Rosenblum and other witnesses expressed doubt that managers themselves would move off-shore. But some at the hearing expressed concern that capital will, including Rosenblum and Senator John Ensign (R-Nevada).
"Capital flows to places of least resistance. ... The law of unintended consequences is the worst kind of law we pass around here," Ensign said during his questioning of witnesses.
Senator Charles Schumer (D-NY) said he wouldn't want to see financial services and investment partnerships taxed any differently than oil and gas, biotech or other types of partnerships that also tax managers' carried interest as capital gains.
"It's not fair to target one industry when other partnerships around the country use the same tax structure to pay lower taxes," Schumer said.
Each of the seven witnesses concurred that partnerships of all kinds should be taxed identically.
The debate is being conducted as lawmakers seek to raise revenue to shore up various projected shortfalls due to entitlement obligations, alternative minimum tax reform and the cost of the war in Iraq among other things. There are no firm estimates yet on how many managers would be affected if carried interest is taxed as ordinary income or how much tax revenue would be gained - or lost - as a result. 
