West Virginian Senator Joe Manchin, a Democrat, speaks with reporters about a compromise package that could significantly change a tax provision known as the “carried interest loophole.”
Getty Images/Anna Moneymaker Democrats have been working for years to abolish the carried interest tax loophole, which they claim only benefits a small number of the wealthiest Americans, and it is now being tucked away inside the voluminous Senate compromise measure on climate change and health care.
The legislative agreement, negotiated last week by West Virginia Democrat Joe Manchin and Senate Majority Leader Chuck Schumer, may be the greatest federal clean energy investment in American history.
Democrats claim that a change to the way the United States taxes what is known as “carried interest,” a significant source of income for many fund managers and private equity investors, would provide the $14 billion needed to support those initiatives.
But this form of income is currently taxed at a significantly lower rate than the salary the majority of Americans make from regular work, which has long caused controversy.
The long-standing clause has withstood numerous attempts and pledges to do rid of it from both Democrats and Republicans.
“There is a large sum of money at risk. Carry interest has helped some of the wealthiest Americans build their fortunes, particularly through private equity funds “said Steve Rosenthal, a fellow at the Tax Policy Center of the Urban Institute, in an NPR interview.
WHAT HAS BEEN PROPOSED BY DEMOCRATS AND HOW DOES THE LOOPHOLE WORK? According to David Wessel, an economics fellow at the Brookings Institution, “Partners in private equity firms and hedge funds who generally manage other people’s money get a share of the profits from any deal they do, often about a 20 percent share, even if they have invested any of their own money in it.”
The problem is that, although being effectively their compensation, the portion of earnings that hedge fund managers keep is taxed at a lower rate than regular income. As long as it is held for at least three years, carried interest is taxed at the capital gains rate, which is normally 20 percent for those high-income earners, as opposed to the standard individual income tax rate of 37 percent for the top earning group.
The discrepancy can be worth billions of dollars. (Precise estimations can be challenging because “private equity is really opaque,” according to Rosenthal.)
According to Senate Democrats, their plan would raise $14 billion over ten years. The amount corresponds to an estimate issued by the Congressional Budget Office for a 2019 proposal to classify carried interest as ordinary income. (In 2020, the Congressional Research Service noted reported that the amount of money under this type of management had increased significantly in recent years, reaching $14.3 trillion.)
Instead of a higher short-term rate, these types of investors must currently keep their returns for three years to be eligible for the 20 percent capital gains tax. The holding period would increase from three years to five years under the Democratic proposal. In a nod to Biden’s earlier pledge that he wouldn’t raise taxes on any Americans earning less than $400,000 per year, the longer holding period requirement would only be applicable to those earning more than that amount. Other technical changes would make an effort to stop hedge fund managers from varying the way they structure their revenue.
Wessel added that while it wouldn’t totally seal the gap, it would greatly restrict it.
WHAT WAS THE ORIGIN OF THE IDEA AND WHY HAS IT NOT BEEN ACCEPTED EARLIER? Closing the loophole has long been a proposed solution.
When carried interest first made national headlines in 2007, after a law professor wrote a journal article about the loophole it contributed to the beginning of a discussion on Capitol Hill over whether or not to close it. The Occupy Wall Street protests brought the topic back to the forefront in 2010 and again in 2011. Discussions regarding the taxes Mitt Romney, the then-nominated Republican for president, paid while running a private equity investment business in 2012 brought up the topic of carried interest. While President Trump’s tax package from 2017 fell well short of closing the loophole, it was a pledge made by all three presidential contenders in 2016: Jeb Bush, Donald Trump, and Hillary Clinton.
However, no prior attempt to narrow the loophole has been successful, in part because of tenacious campaigning to maintain it.
Many private equity and hedge fund partners are significant campaign donors, especially to Democrats, and they are very concerned about this, according to Wessel. All the other members of Congress, he continued, “don’t even know what it is.”
The disparity in tax rates, according to the loophole’s proponents, serves as an incentive to invest in the economy rather than being a loophole at all. Additionally, they claim to pay taxes in various ways.
Hedge fund managers might just find alternative ways to organize their income to avoid the higher tax rate, according to a different, probably more realistic, viewpoint.
PERPETUATE IT THIS TIME? MAYBE. Democrats would likely need the support of all 50 members of their own caucus to pass their proposal, including Arizona Sen. Kyrsten Sinema, whose resistance to any sort of increased taxes for companies or affluent Americans last year contributed to the failure of Democratic legislation.
Manchin refuted the claim that the measure, particularly its carried interest clause, would result in tax increases in In a Sunday interview on Fox News .
“There was no tax increase. We’ve blocked off the gaps. Only that was done. I took steps to ensure that there were no tax rises in any way, “Manchin remarked.
The bill might be taken up by the Senate as soon as this week. If it is approved, the carried interest provision adjustments and the imposition of a corporate minimum tax rate of 15% will benefit climate change-affected areas, fund the construction of renewable energy projects, and encourage Americans to purchase electric vehicles.