It’s no secret that neither Congress nor the leaders of the two major parties can agree on much these days. This is perhaps even more true on tax policy than any other issue. So, when there is bipartisan agreement on sensible tax reform, we should not only take notice, but seize the moment to get something done. Such bipartisan agreement is on full display in the recent case of Hillary Clinton and Donald Trump coming out on the same side of a popular tax controversy. In an interview with USA Today, Hillary Clinton mentioned that she would authorize the Treasury Department to close what’s known as the “carried interest” or “hedge fund” loophole. Donald Trump made similar remarks on CBS’s “Face the Nation.” While this issue is more likely to vex policy wonks than plaster headlines, it’s an important departure from the norm in that it provides ample room for both parties to send a strong bipartisan message to Wall Street.
The Hedge Fund Loophole
The hedge fund loophole has been a way for the super-rich to dodge tax liabilities for decades. Here’s how it works — when managers of hedge funds and private equity firms produce a profit for their investors, they receive compensation in two forms. First, they receive 2% of the total value of the fund as a management fee, but they also receive a 20% cut of the interest accrued by the assets they manage, which can often amount to quite a bit of money. While the management fee is taxed like income, the 20% yield from investments, or the “carried interest,” is taxed like a capital gain. Why does this matter? Well, the top tax rate for capital gains is only about half as much as the top tax rate for labor income, and since hedge fund managers make most of their money through carried interest, their effective tax rate can be, as in the case of former presidential candidate and Bain Capital executive Mitt Romney, as low as 14%. The effect of this loophole is that super-rich managers of investment funds can pay a lower tax rate on their compensation than their own secretaries, chefs, and chauffeurs. The unfairness of this loophole is also apparent if you consider how other high-earners are taxed. After all, why should hedge fund managers pay half the tax rate of other top earners like bankers, lawyers, accountants, and other service providers? Should NBA players like Stephen Curry really owe twice as much as hedge fund managers?
Something We Can Agree On
People from across the political spectrum have announced their support for closing the loophole. According to John Chapoton, a tax policy official in the Reagan administration, the loophole was a “policy mistake.” It was never supposed to function the way it does. Democrats like President Obama and Republicans like Sen. Chuck Grassley (R-Iowa) agree that this loophole is a misinterpretation of the law. Financial industry leaders like Warren Buffet and Marc Lasry also echo that point. Even 2016 Republican presidential candidate and former Florida Governor Jeb Bush opposed the loophole. When all of these folks can agree on an issue, Congress should be able to as well.
A Way Forward
In spite of the broad political consensus, Congress has yet to act. So, there is discussion of alternate ways to close the loophole. Some suggest that a presidential administration could close the loophole by instructing Treasury to invoke an obscure statute suggesting that individuals engaged in a partnership, who conduct affairs other than as a partner would, will not be treated as partners. In other words, if you are partner managing people’s investments, you are selling them a service, and so the money you earn is a wage, not a capital gain. However, unilateral action from Treasury may draw criticism from Republicans who could have been allies on this issue. Furthermore, according the Matthew Yglesias, Treasury could be in conflict with a previous Senate Finance Committee report that left the determination ambiguous. The best solution is for congress to throw bipartisan support behind the Carried Interest Fairness Act (S. 1686, HR 2889.) This act would close the hedge fund loophole, and make sure hedge fund managers and private equity managers pay a fair tax on their income, just like the rest of us.