Structure of a private equity fund (c) Tax Policy Center
The Obama administration has been trying for some time now to do something about the big carried interest loophole. During the 2008 presidential election, Barack Obama was one of the few candidates who bothered to have a position on the seemingly obscure matter. But as the financial crisis and recession have unfolded, stories about how private equity and hedge fund bankers have been using the loophole to avoid taxation have become more known to the public. Although increased public awareness of how the carried interest loophole allows wealthy bankers to avoid paying taxes, there still is confusion over what it is and why it matters. Bankers have used this confusion, as well as their lobbying leverage, to defeat opponents of the loophole in Congress.
Perhaps the proverbial poster child for the carried interest loophole is John Paulson. Paulson''s position as a hedge fund manager notably "earned" him $9 billion over the past two years. Tax bill? Zero. Paulson didn't get taxed at the capital gains rate for managing these investments because as long as he didn't cash in the investment, the profits are "carried" until he does cash out:
What the news media missed is that hedge-fund managers don’t even pay 15 percent. At least, not currently. So long as they leave their money, known as “carried interest,” in the hedge fund, their taxes are deferred. They only pay taxes when they cash out, which could be decades from now for younger managers. How do these hedge-fund managers get money in the meantime? By borrowing against the carried interest, often at absurdly low rates—currently about 2 percent.
Since borrowed money is not income, that's $9 billion straight to his pocket, tax-deferred as long as he pleases. That's why Paul Ryan's budget eliminates the capital gains tax. Paulson could cash out, pay back the loan in full and walk away with $9 Billion. Tax free. Ryan and the Republicans are looking out for their masters.
There was legislation pending to at least tax these monies as ordinary income rather than capital gains. Last year, there was a bill that contained a provision that did just that, but it was killed by Chuck Schumer in the Senate. President Obama has called for the provision again in his 2012 budget proposal.
This is a point of negotiation. On one side the president is making the reasonable request that these earnings shall be taxed as ordinary income. For a high earner, the old Clinton rates would apply under the president's proposal. People like Paulson could still borrow against their earnings and defer the tax so long as the profits remain in the hedge fund. On the other side, the Republican budget eliminates the tax altogether. What would a compromise look like? Congress could split it right down the middle and create a special capital gains tax provision for investment advisers requiring a 19.5% capital gains rate on these types of profits rather than the current 15%. That is still a huge, huge tax break for the rich. But it would be better than what we have now. Congress could also add a provision that requires these sorts of gains to be realized in two or three years, or else face the ordinary income rates. That would prevent these hedge fund managers from deferring taxes forever.
On the politics, this seems like a no-brainier. With the public seething in anger at the arrogance and greed of Wall Street, it is a winning political issue to assertively state that Wall Street should pay taxes just like everyone else. I see no political downside to demanding that Wall Street pay their fair share. Except, of course, that bankers and fund managers are significant political contributors to both parties. As Sen. Dick Durbin once famously said, they " own the place." Fundraising on Wall Street in both parties is probably the biggest obstacle to closing this Mack truck sized loophole for the rich.
The way hedge funds and some private equity funds are structured, the manager of the funds typically take their compensation, or fee, from the profits of the fund. It doesn't matter if they invested absolutely no money at all. A fund manger could organize a hedge fund, make $10 billion in profits, and collect a fee of $2 billion. Why should that $2 billion be treated different than the $500 you get in your paycheck? On the simple question of basic fairness, giving hedge fund managers a break because they manage hedge funds rather than operating a lathe is horribly unfair. Work is work. Earnings are earnings. Both should be taxed progressively. It is only fair. This is a fundamental issue of fairness. That is why it matters.
It is unclear how far to the mat the House GOP is willing to go for Wall Street, but if the past is prologue, it is probably pretty damn far. There will be Democrats to join them too. Together they will fight like hell for a carried interest tax rate of zero. The question is how far Democrats in Congress and the White House will go to see to it that Wall Street pays just like the rest of us. Hopefully, Congress will get the president's carried interest changes enacted. But it is going to be a tough fight.