Congress must open its eyes to carried interest

When the 114th Congress convenes on Jan. 15 with a Republican majority in both houses,
comprehensive tax reform will be high on their to-do list. Among the first things they should address is ending the practice of treating so-called carried interest as ordinary income.

For those of you who did not grow up passing around copies of the tax code, there are few subjects more esoteric than America’s byzantine tax code. The federal tax code consists of nearly 74,000 pages and about four million words, twice the length of the King James Bible and the entire works of Shakespeare combined.

This voluminous magnum opus validates the average American’s suspicions that Washington is a stage of prancing marionettes tweaked by Wall Street (aka Crime Central) and other moneyed interests.

Rewriting the tax code is a difficult undertaking given the multitude of well-capitalized special interest groups from every comer of American business and society that have skin in the game when it comes to tax policy. Closing tax loopholes that favor particular groups instigates knock-down drag-out political fights. This is why the last serious tax reform came in 1986, also known as light years ago, under President Reagan.

One place to start comprehensive tax reform is to bring an end to the carried interest loophole, which allows super wealthy investment managers, including those in the private equity, hedge fund and venture capital business, to define their compensation as capital gains and pay income tax at a far lower rate. This forces ordinary people to pay more by transferring the burden to those who cannot afford tax attorneys.

Investment managers take a considerable portion of their pay as carried interest, which means being compensated for managing funds’ investments as a share of fund profits, without putting their own capital at risk. Under current tax law, carried interest is treated as a capital gain, subject to the top 20 percent capital gain rate plus a 3.8 percent surcharge on unearned income to help pay for the Affordable Care Act, rather than as ordinary income subject to the top marginal tax rate of 39.6 percent.

As former Treasury Secretary Robert E. Rubin noted several years ago, “I think what they’re doing is getting paid a fee for running other people’s money.” Put differently, carried interest is performance¬≠ based compensation for investment management services rather than a return on financial capital invested by managers.

The one-percenters, who tend to be big political donors, are the principal beneficiaries of carried interest. Quite apart from basic fairness, treating all taxpayers who provide a service the same, the Obama administration has estimated that ending this tax loophole would generate an additional $15 billion in revenue over 10 years.

For a long time, this loophole has unfairly enabled some of the highest paid individuals in the country to sharply reduce their tax bills and it is time to close it once and for all. Legislation is needed to fix the carried interest dodge and ensure that income earned managing other people’s money is taxed at the same rates as that earned by teachers, factory workers, attorneys and millions of other Americans for the services they provide.

Because of the financial sector’s outsized influence, you can expect to hear how closing the carried interest loophole will destroy capitalism as we know it and undermine the economy. Experience teaches us that the financial sector’s lobbying clout, combined with the fact that doing the right thing is a dangerous luxury for politicians, Main Street standing on the sidelines is not a recipe for success on this issue.

The American public has to actively engage and abandon the assumption that so many things are now taken for granted that it’s as if the public literally no longer sees them.

originally published: December 27, 2014

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