One of the Most Hated Tax Breaks in America Just Won't Die
(Bloomberg) -- One of private-equity and hedge-fund managers’ most prized tax breaks is again in politicians’ cross hairs, but Democrats would need to sweep the 2020 election if they want to pull the trigger to end the option.
President Donald Trump said in May that he wanted to increase taxes on carried interest, a major form of compensation for hedge-fund and private-equity managers. Several leading Democratic presidential candidates -- including former Vice President Joe Biden, and senators Bernie Sanders and Elizabeth Warren -- also have said they want to end the break.
Yet there are a couple of reasons the carried-interest tax break, despite bipartisan opposition, isn’t dead yet. Most Republicans, and even some Democrats, oppose killing a tax option that investment firms have successfully argued creates jobs. And eliminating the break wouldn’t actually raise all that much money.
Partnerships such as private-equity, venture capital and hedge funds typically get compensated in two ways. They charge an annual management fee, as well as a performance fee, which can be about 20% of gains, depending on the fund. For tax purposes, the performance fee is treated as a capital gain, meaning that it gets hit by a top rate of 23.8%, rather than ordinary income, where rates can reach as high as 37%.
Various proposals to tax carried interest as ordinary income have been estimated to raise between $3 billion and $16 billion over a decade, depending on the particulars of each plan. That’s a drop in the bucket for federal spending, meaning that it has limited value as a money-raiser.
“As a political scalp, it’s still something very hot for Democrats, but no Republicans are going to vote for a tax increase,” said Stephen Myrow, managing partner of Beacon Policy Advisors in Washington. “It’s an uphill battle unless Democrats control everything.”
The preferred tax treatment is a frequent target on the campaign trail as a way to pay for other priorities. Democratic candidate Amy Klobuchar, a Minnesota senator, said in a CNBC interview in May that eliminating the loophole could help pay for infrastructure. Kamala Harris, a California senator, in March similarly cited carried interest when asked in an NPR interview about her proposed tax rebate to lower-income households.
And the current crop of candidates isn’t the first to put the break in their sights.
Former Democratic Representative Sander Levin of Michigan first introduced the “Carried Interest Fairness Act of 2012” that would have largely ended the option’s favorable tax treatment. It was never approved by the Republican-led Ways and Means Committee. The Carried Interest Fairness Act of 2015 didn’t fare any better, nor did the Carried Interest Fairness Act of 2017.
The Carried Interest Fairness Act of 2019, now sponsored by New Jersey Democrat Bill Pascrell, has 28 cosponsors, fewer than Levin had four years ago.
“Mr. Trump campaigned on giving regular Americans a fair shake. His repeated support for closing this egregious loophole combined with Americans desiring real reform gives me genuine hope for passage this Congress,” Pascrell said in a statement issued through a spokesman.
Historically, performance fees received the more-favorable tax treatment as long as a fund held the investment for at least a year, but the 2017 tax law increased the minimum holding period to three years. That hit some faster-trading hedge funds hard, but was less painful for private-equity and venture-capital funds, which tend to have longer holding periods.
Protected by Billionaires
Private-equity magnates such as Blackstone’s Stephen Schwarzman, who is also a Trump adviser, have become protective of a break that helped make them billionaires. When President Barack Obama tried to close the loophole, Schwarzman reportedly likened it to Hitler invading Poland. He later apologized for the comparison.
For investment firms, it could have been worse. As the 2017 tax law was being written, Gary Cohn, then the White House national economic adviser, said the break should be eliminated. Ultimately, Treasury Secretary Steven Mnuchin and some congressional Republicans fought for a compromise: Instead of taxing all carried interest as ordinary income, the threshold for taxing it as a capital gain would rise to three years from one year.
In a Fox News interview in May, Trump said he’d still like to end the benefit and claimed that he traded keeping the loophole open in the 2017 legislation in exchange for a lower corporate tax rate. But in fact, raising the tax rate for carried interest would have raised more revenue in the tax bill, making it easier to lower corporate rates.
Analysts note that the tax treatment of carried interest doesn’t have a large effect on the federal budget either way, making the change a strong political talking point without a real fiscal impact.
“It certainly seems to be a likely target given the current environment. That being said, it is clearly not going to be much of a revenue-raiser,” said Don Snyder, a tax lobbyist for Federal Policy Group in Washington.
Changing the treatment of carried interest also carries significant policy hurdles, Snyder said. For one, taxing all partnership gains the same way would encourage short-term trading, since hedge funds would no longer have a tax incentive to hold an investment for the long term, he said.
Trade associations that support keeping the break say that eliminating it could reduce investments in companies and kill jobs. The American Investment Council, a trade association for private-equity firms, releases an annual study calculating private-equity investment by congressional district.
“Raising taxes on carried interest capital gains will destroy jobs, decrease investment, and discourage entrepreneurship across America,” the group’s president, Drew Maloney said in a statement.
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