Carrying Their Own Tax Weight?: High Finance and Carried Interest

June 14, 2010

Money

The US Senate is combing through the American Jobs and Closing Tax Loopholes Act of 2010 this week. Included in that bill is a provision to close the loophole on what's called "carried interest," which is where most of the income of hedge fund and private equity firm managers comes from.

About the loophole: mega-rich financiers' incomes are a percentage of their funds' annual profits. Our friends at Citizens for Tax Justice explain that managers of various investment partnerships are generally compensated with a "two and twenty" system–that is, they receive a 2% management fee and 20% of all profits of the investment, even if they didn't contribute any funds up front. They claim that income to be capital gains, distinct from earned income, which is therefore subject to the much lower capital gains tax rate of 15% (vs. the top income tax rate of 35 percent).

Ergo, billions of dollars are lost each year to insufficient and unfair taxation on the incomes of these investment banking leaders. Closing this loophole could generate an estimated $25 billion in federal revenue over 10 years.

Len Burman, fellow at the Brookings Institute, had this to say on NPR's Morning Edition:

"It's a huge windfall to some of the best-off people in society, [...] High-income people are supposed to be taxed at the highest rates, 35 percent, [...] But people who are lucky enough to be in the private equity or hedge fund business get their income taxed at a 15 percent rate."

Despite popular anti-Wall Street sentiments and broad, multi-class support for increased taxes on America's wealthy, closing the carried interest loophole is not guaranteed. Alan Sloan gives a personalized take in the Washington Post:

The legislation, introduced by Rep. Sander M. Levin (D-Mich.), calls for private-equity firms, venture-capital firms and real estate investment partnerships to have half their carried interest income treated as capital gains in 2011 and 2012, and 25 to 45 percent of it to be treated as capital gains from 2013 on. [...]

Next year, with tax rates on regular income and capital gains set to increase, the carried interest types' 50-50 split would give them an effective tax rate of 31 percent, rather than the 20 percent capital gains rate. Now, take me, someone who makes a (low-) six-digit income but is stuck in the phaseout bracket of the alternative minimum tax. If my income were split 50-50 next year, my rate would be 32 to 33 percent. I'm well-off, but far from rich by any definition except the Obama administration's. So my sympathy for private-equity types paying higher taxes on their carried interest income is, shall we say, extremely limited."

Some feel that this proposed tax change would stifle industries other than high finance. In the Morning Edition story we cited above, John DeBoer, president of the Real Estate Roundtable, argues that nearly half of US investment partnerships are in real estate, and that increased taxes on developers would prevent a rebuilding of the struggling sector. This and every other anti-tax argument in the context of the carried interest debate don't come as a surprise.

This particular move to even the tax playing field has and will continue to draw criticism from many different directions–including those dreaded and well-funded industry lobbyists. But, we can rest a little easier, as Linda Beale has provided a sensible analysis to help us through most of it. Here's a quick synopsis:

1) Any economic justification for privileged treatment of fund managers is absurd. (They'll still make boatloads of money, even if they have to pay taxes like average Americans.) And, this won't be catastrophic to investment partnerships. (Most of these folks aren't going to quit doing their jobs simply because they're taxed like ordinary people.)

2) Any provision that splits the rate structure (like Rep. Levin's) is arbitrary, creates undue complexity, seems to ask for folks to game the system, and would, according to Beale, only serve as a pacifier for certain high-wealth campaign contributors.

3) Any half-baked measure that continues to favor fund managers is only a sign that "the House and Senate are willing to sell out ordinary taxpayers and continue to favor the wealthy and that fairness loses when the House or Senate is thinking about campaign contributions."

4) Compromises on carried interest "makes a mockery of the basic fairness concept in taxation." Beale posits that both chambers of Congress understand that carried interest provides preferential treatment for a very small number of people, and that there is no way to justify such treatment. A failure to pass strong legislation to close the carried interest loophole is further evidence of shady dealings between special interests and our lawmakers.

The carried interest debate is but one of many, many tax debates in the pipe for the year. As with any rule or practice that's been deeply ingrained in our government or society, change becomes a battle of inches. Twenty-five billion dollars over 10 years may not be enough to leap all of our country's many economic hurdles, but it could certainly make life a little less of a struggle for millions of Americans, instead of more lavish for a few.

Photo credit: Shirley Two Feathers

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