It’s the time of year when a young man’s fancy lightly turns to thoughts of deductions and write-offs. One select group of Americans, though, has a more pressing tax-season task on its mind: preserving a lucrative loophole in the I.R.S. code. The provision allows money managers at privately held partnerships—like hedge and private-equity funds—to treat most of the money they make as capital gains rather than as ordinary income. That means that their income is often taxed at fifteen per cent, a much lower rate than it otherwise would be. In December, the House of Representatives passed a bill closing this loophole, the third time it has done so in three years. But it’s an open question whether the Senate will even take up the bill, let alone pass it.
In a typical private-equity fund, the managers get paid two per cent of assets as a regular fee, plus twenty per cent of the fund’s profits. They pay regular income tax on the two per cent. But on their share of the profits, which is called “carried interest,” they usually pay only long-term capital gains—even though they put up hardly any of the fund’s actual capital, most of which comes from outside investors. The difference in tax rates saves private-equity managers billions of dollars a year, and means that they pay taxes at a much lower rate than, say, your average lawyer. It also means that their taxes are lower than those of people who do the same kind of work, or get the same kind of pay, as they do. A general principle of good taxation is that similar jobs, and similar kinds of compensation, should be taxed the same way: otherwise, the government is effectively subsidizing some jobs over others. But the carried-interest tax break upends this rule. If you manage money for a mutual fund or a public company, you pay regular income taxes; do it for a private fund, and you pay capital gains. Similarly, when a corporate executive gets stock or stock options as a bonus for a job well done, it’s generally subject to income taxes; carried interest, which is also performance-related, isn’t. Like the rest of us, fund managers are being paid for their labor, but, unlike the rest of us, they get to pay taxes as if they were capital.
Opponents of reform have suggested that it will have a “chilling effect” on investment at a time when the economy needs all the help it can get. But doing away with the tax break for fund managers won’t change the incentives for the investors who actually put up the money for these partnerships, because their capital will still be taxed at the capital-gains rate. And while there have been worries that changing the rules could hurt other businesses that are set up as partnerships, like law firms or even mom-and-pop stores, it won’t: the reform proposals currently out there are restricted specifically to the investment business.
As a matter of policy and equity, then, doing away with the tax break makes sense, and the idea has been endorsed by many figures on Wall Street and by both conservative and liberal economists. At a congressional hearing on the subject, Warren Buffett said, “If you believe in taxing people who earn income on their occupation, I think you should tax people on carried interest.” And, more crassly, as a matter of politics in a time of populist fervor the idea seems like a winner. Yet carried interest endures. And its persistence is most important not for what it says about Wall Street but for what it says about Washington.
If we were starting from scratch, after all, it seems unlikely that the Senate would choose this particular moment to pass a bill subsidizing money managers to the tune of billions of dollars a year. But, because the tax break already exists, it exerts a kind of gravitational pull that makes it hard to get rid of. In part, that’s simple economics—those who benefit from the tax break have more money to lobby for it to be kept in place. Furthermore, while the cost of subsidies is spread out among all taxpayers, the benefits are highly concentrated, so, naturally, opposition is generally diluted and diffuse while support is intense. If you work in private equity, it’s possible that nothing the government does matters more than keeping this tax break intact. And this pattern is true not just of subsidies but of government programs in general: every government action creates a constituency with an interest in keeping that action going.
The tendency toward legislative inertia would be harmless if the outside world moved as slowly as Congress does. But, when the world changes and the rules don’t, opportunities to game the system are created, leaving us with results that no one intended. Carried interest is a quintessential example of this: when the law governing partnerships was passed, back in 1954, the goal was to make it easier for people to run what one law professor has termed “simple ventures.” No one imagined that the law would end up covering an industry that manages trillions of dollars in assets, and would cost the government billions in tax revenue. You can see the same problem at work in the case of farm subsidies, which have morphed from a way to keep small farmers afloat during the Great Depression into a multibillion-dollar handout to huge agribusiness companies. And something similar happened during the financial crisis, when outmoded regulations left the government ill equipped to deal with the collapse of huge financial institutions like A.I.G. and Lehman Brothers. (Remarkably, those regulations are still in place.) Too often, we’re using horse-and-buggy laws to deal with a Formula One world. We shouldn’t be too surprised when we get run over. ♦
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