Blog of the Century

Graph: How Closing the Carried Interest Loophole Would Save Billions

Blog Post by: Benjamin Landy, on February 8, 2013

Every few months, it seems, Washington grinds to a halt over some new manufactured crisis: the 2011 debt ceiling debacle and the failure of the super committee; the expiration of the Bush tax cuts and the year-end fiscal cliff; the debt ceiling debate redux (now postponed until late August, when it will need to be raised again); and the return of the sequester, now scheduled for March 1, promising drastic cuts to domestic spending and defense.

Part of the reason these budget disputes have become so intractable—and so apocalyptic—is that liberals and conservatives hold increasingly divergent views on the significance of the national debt. Establishment Republicans decry government profligacy as crowding out private investment and undermining business confidence, despite all market signals to the contrary, while Democrats tend to take the more nuanced view that economic growth and job growth, not deficits, are the real problem in the short term. Both parties agree that we need to reduce the deficit and stabilize the debt-to-GDP ratio in the medium-to-long term, but are fundamentally at odds when it comes to determining the proper ratio of spending cuts to new revenues that will be needed.

One way to move beyond this ideological impasse is for policymakers to instead focus on tax breaks, whose $1.3 trillion cost can be understood as either government spending or foregone revenue. For Republicans, special tax exemptions for industries and interest groups represent spending through the tax code, and the worst of crony capitalism. Cleaning up the tax code would strengthen the free market and broaden the tax base. For Democrats, closing loopholes for corporations and deductions for the wealthy represents an opportunity to raise effective rates and recapture lost revenue. In theory, both sides get to declare a victory; which is as close to a deus ex machina as you're liable to find in Washington these days.

Democrats are signaling that they are interested in beginning this process of tax reform by closing the carried interest loophole—a particularly egregious tax break that conservatives have defended in the past, but perhaps now presents an opportunity for reform-minded Republicans to prove theirs is no longer "the party that simply protects the rich so they get to keep their toys.”

Here's how the loophole works: Currently, investment managers at private equity firms, hedge funds, and venture capital groups take their salary in the form of a share of their company's investment returns, including the fees charged to clients. Because these managers ostensibly take on increased risk in the way their compensation is structured, this "carried interest" is taxed as a capital gain. That means their income is taxed at the preferential 20 percent rate, rather than the maximum 39.6 percent rate applied to ordinary wage income. (This is how former presidential candidate Mitt Romney, for example, paid a 14.1 percent tax rate on his $13.7 million income in 2011.) 

Taxing carried interest as ordinary income, which most Democrats argue it is, would raise more than $2 billion a year, according to the nonpartisan U.S. Congress Joint Committee on Taxation. Over the next decade, closing the carried interest loophole would raise an estimated $21.4 billion—not enough on its own to make a serious dent in the trillion-dollar budget deficit, but a good place to start for politicians interested in tackling the nation's most inequitable tax breaks.

Tags: tax reform, tax breaks, economics & inequality, carried interest