There has been talk in recent days that the congressional effort to raise taxes on the earnings of private equity managers has been killed. Don’t believe it.

The Washington Post’s Jeff Birnbaum reported on Oct. 9 that Senate Majority Leader Harry Reid (D-Nev.) has decided to deep-six the bill following a multi-million dollar lobbying campaign by the financial partnerships. But House Ways & Means Committee Chairman Charles Rangel (D-N.Y.) remains committed to using money raised by a tax hike on private equity managers to help pay for alternative minimum tax relief. And don’t bet against Rangel when both issues are thrown into a last minute, end-of-session omnibus money bill sometime in December.

To the amazement of tax policy experts all over Washington, the exquisitely complex dispute over how to tax "the carry" has become the issue de jour. Depending on who you talk to, carried interest is either the compensation that the general partners in private equity and hedge funds earn for doing their deals, or it is a return on their investment. Thus, it should either be taxed as ordinary income at 35 percent or as capital gains at 15 percent. There are big bucks involved here, but there are also some very important tax principles at stake. The Tax Policy Center's Gene Steuerle did a nice job of putting this mess in perspective in his testimony before the House Ways & Means Committee on Sept. 6.

To help understand what the debate is about, imagine a large financial services firm: At one desk sits a 26-year-old Harvard MBA who is beavering away as an investment banker. Across the hall, his classmate is doing private equity deals. Their work is indistinguishable. Yet the income generated by the banker is taxed at 35 percent while income produced by private equity deals is taxed at 15 percent. It is hard to work up much sympathy for investment bankers these days, but this seems to be a textbook case of what has gone wrong with the tax code.

Since the protagonists can't agree on what the carry is, it should be no surprise that they can't agree on how to tax it. Those who believe it is compensation argue that it should be taxed as ordinary income, just as it is for the bankers. University of Illinois law professor Victor Fleischer laid all this out at the Ways & Means Committee.

By contrast, Bruce Rosenblum, Managing Director of The Carlyle Group, and Chairman of the Board of the Private Equity Council, told the Ways & Means Committee that private equity firms are no different than the entrepreneurs who create companies. True, the buy-out specialists are making an underperforming asset profitable instead of starting a business from scratch. But they are creating value where there was none before and, thus, the returns to both their capital and their sweat equity should be taxed as capital gains.

To sort through this, it helps to understand how the managers of private equity firms get paid: They get a base fee of 2 percent, plus 20 percent of any profits after investors earn an agreed-upon return. Taxes on the 20 percent (at least) are both deferred and subject to the sweet 15 percent capital gains rate.

The problem is the law never contemplated these kinds of arrangements. So, we end up with tax policy as simile. Fleischer got to the heart of the dispute during a Sept. 7 TPC forum: Are these investors acting like bankers who are taxed in full, or do they function like entrepreneurs who enjoy the capital gains preference?

And, whatever they are, does their work deserve a special tax break? Supporters of low rates argue that the tax code should encourage risk taking. But, the after-tax rewards to these transactions are very generous, even if they are taxed at a 35 percent rate. The industry itself claims that the top 25 percent of private equity firms returned more than 39 percent per year to investors from 1980 to 2005. University of California at Berkeley professor Alan J. Auerbach estimates the extra tax would trim those returns by just 10-20 basis points (0.1 percent to 0.2 percent). That’s not likely to be a deal breaker. And if it is, maybe the deal isn’t worth doing.

Backers of the low cap gains rate have a tough sell. On Capitol Hill, they’ll have to overcome the fairness argument--it just doesn’t seem right to many politicians that rich guys who earn 20 percent or more by sitting in Greenwich, Conn. and investing other people’s money should get a tax break too. But there is more than just populist politics going on here. Good tax policy says if you do the same work, you should be taxed the same way. And whatever private equity managers call themselves, they are investment bankers and should be taxed as such. If it walks like a duck....