Fiscal Cliff Negotiations Leave Hedge Fund Tax Loophole Unscathed

Common ground is hard to come by in Washington these days, but everyone, it seems, hates tax “loopholes.” Democrats claim they rob the government of revenue and benefit the rich. Republicans say tax loopholes distort free markets by letting the government pick winners and losers, thereby potentially introducing artificial and undesirable incentives.

Indeed, during the 2012 presidential race, Republican vice presidential nominee Paul Ryan attacked tax loopholes for the rich, declaring that he and Gov. Mitt Romney wanted to “get rid of special interest loopholes and deductions that are uniquely enjoyed by the wealthy." 

So what about the so-called “carried interest tax loophole”? That’s the provision that allows hedge fund managers and investment firm executives to have the profits from the sale of a company taxed at the capital gains rate (soon likely to rise to 20%) instead of the traditional income tax rate (soon likely to jump to 39.6% for top earners).   

Private equity businesses say this is fair, because these investment managers receive deferred profits gained through risk-taking investments. Others, however, claim that these “risks” are being made with investors’ capital, not necessarily their own, and therefore compensation for managing the investments should be taxed as regular income. As one U.S. Tax Court judge pointed out, "stockbrokers, financial planners, investment bankers, business promoters and dealers" all pay ordinary compensation taxes, so why not fund managers?

The battle over the carried interest loophole took center stage in the presidential election when it was revealed that a sizable portion of Mr. Romney’s Bain Capital pension income was taxed at the lower 15% capital gains rate than the 35% top income tax rate. What Mr. Romney did was entirely legal, but should it be?

Mr. Romney’s own economic adviser Harvard University economics professor Greg Mankiw has said he’s for closing the carried interest loophole. Likewise, Sen. Tom Coburn (R-OK) has said he's open to reforming it. And no less an ardent capitalist than billionaire media mogul and News Corp. Chairman Rupert Murdoch has gone on record against the carried interest provision: "Romney tax uses long-term legal loophole. 'Carried interest' makes all fund managers rich. Time both parties stopped selling out to Wall S," Mr. Murdoch tweeted last year. He then blasted carried interest a second time, aiming his comments at President Barack Obama: "Carried interest tax racket. Billions over many years. Why and where has Obama been?"

It’s a good question. In 2008, Mr. Obama received nearly twice as much in political donations from private equity and hedge funds as Sen. John McCain. And while Mr. Obama has included provisions to end carried interest in past budgets—and certainly used the issue as a political bludgeon against his GOP challenger—the current fiscal cliff negotiations at this hour appear to have left carried interest unscathed. 

According to the Congressional Budget Office (CBO), taxing carried interest as ordinary income would yield $21 billion in revenue over ten years. 


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