Tax code asymmetries

The US tax code distinguishes between "ordinary income" (wages, salaries, freelance, interest, short-term capital gains) and "preferential income" (long-term capital gains, qualified dividends, carried interest). The latter is taxed at much lower rates. The defenders of this distinction argue it encourages investment. The critics note that the labor of a teacher or nurse is taxed at higher rates than the passive ownership of stock — and this is, in itself, a moral statement about what society values.

Compare scenarios below. Same gross dollar amount. Different sources. Different fates.

The most egregious gaps

Carried interest: hedge fund and private equity general partners get 20% of fund profits. This is, economically, their compensation for managing money — labor income. But it's taxed as long-term capital gains at 20% instead of ordinary income at 37%. Estimated cost: $1-2 billion/year, benefiting roughly 5,000 people. Both Trump and Obama campaigned on closing this. Neither did.

1031 exchanges: sell an investment property, roll the proceeds into a new one, defer the capital gains tax indefinitely. Stack these moves over a lifetime, then die with stepped-up basis (see Lesson 8) and never pay tax at all. Estimated cost: $5+ billion/year.

Pass-through deduction (199A): the 2017 TCJA created a 20% deduction for qualified business income from pass-through entities (LLCs, S-corps, sole proprietorships). Originally pitched as small-business support; in practice, much of the benefit goes to high-income owners of professional services firms. Estimated cost: $50+ billion/year.

Donor-advised funds (DAFs): contribute to a DAF, take the full charitable deduction immediately, but face no required payout schedule (unlike private foundations which must distribute 5%/year). DAF assets have grown from $30B in 2010 to over $250B today. Used to park appreciated assets, get the deduction, and trickle distributions out for decades.

Backdoor Roth: high earners are technically locked out of Roth IRA contributions, but a "backdoor" workaround (contribute to traditional, immediately convert) makes the limit fictional for anyone with a financial advisor.

These are called "tax expenditures" and are basically spending programs run through the tax code. The total annual cost approaches $1.5 trillion — roughly the discretionary federal budget. None of them require annual congressional reauthorization. Most have well-organized lobbying support and almost no political opposition strong enough to remove them.