This tax loophole made hedge managers rich. Closing it may help fund the climate bill

Tucked inside the sprawling Senate compromise bill for climate change and health care is an effort, years in the making, to close what Democrats say is a loophole that benefits a handful of the richest Americans: the carried interest tax.

The legislative compromise, reached last week by Senate Majority Leader Chuck Schumer and West Virginia Democrat Joe Manchin, could represent the single largest federal clean energy investment in U.S. history.

About $14 billion meant to fund those efforts would come, Democrats say, from a change to the way the U.S. taxes what is called "carried interest," a major way that many fund managers and private equity investors earn their compensation.

But it has long been controversial because this kind of income is currently taxed at a much lower rate than the salary most Americans earn from ordinary jobs.

The long-standing provision has survived repeated attempts and promises to eliminate it, from Democrats and Republicans alike.

"There's a lot of money at stake. Some of the richest Americans have made their fortunes by earning carried interest, especially through private equity funds," said Steve Rosenthal, a fellow at the Urban Institute's Tax Policy Center, in an interview with NPR.

How does the loophole work, and what have Democrats proposed?

"Partners in private equity firms and hedge funds who generally manage other people's money get a share of the profits from any deal they do — often about a 20% share, even if they have invested any of their own money in it," said David Wessel, an economics fellow at the Brookings Institution, in an interview with NPR.

Here's the rub: While that slice of profit pocketed by hedge fund managers is essentially their salary, it is taxed at a lower rate than ordinary income. Rather than be subject to the normal individual income tax rate — 37% for the highest bracket of earners — carried interest, so long as it is held for at least three years, is taxed at the capital gains rate, which is typically 20% for those high-income earners.

The difference could represent billions of dollars. (Precise estimates can be difficult because "there's a lot of opaqueness to private equity," Rosenthal noted.)

Senate Democrats say their proposal would raise $14 billion over a period of 10 years. That number is equal to an estimate issued by the Congressional Budget Office for a 2019 proposal to treat carried interest as ordinary income. (In 2020, the Congressional Research Service noted that the amount of money under this kind of management had reached $14.3 trillion, a dramatic increase in recent years.)

Currently, these kinds of investors must hold their earnings for three years to qualify for the 20% capital gains rate, rather than a higher short-term rate. The Democratic proposal would change the holding period from three years to five. (The longer holding period requirement would apply only to people earning more than $400,000 annually, a nod to Biden's previous promise that he would not raise taxes on any Americans making less than that amount.) Other technical changes would attempt to prevent hedge fund managers from structuring their income in different ways.

"It wouldn't completely close the loophole, but it would substantially restrict it," Wessel said.

Where did the idea come from, and why hasn't it passed before?

The idea of closing the loophole has been around for a long time.

Carried interest first surfaced in national headlines in 2007, after a law professor wrote a journal article about the loophole and helped launch a debate on Capitol Hill over whether to close it. The issue found itself on the table again in 2010, then again in 2011 amid the Occupy Wall Street protests. In 2012, carried interest came up in discussions about taxes paid by Mitt Romney, then the Republican nominee for president, during his years running a private equity investment firm. In 2016, presidential candidates Jeb Bush, Donald Trump and Hillary Clinton all promised to close the loophole (though President Trump's tax bill in 2017 fell far short of eliminating it).

But no previous proposal to close the loophole has stuck — in part because of aggressive lobbying to keep it.

"There are a lot of private equity and hedge fund partners who are big campaign contributors, including to Democrats, and they care about this a lot," Wessel said. Meanwhile, he added, "all the other constituents of Congress don't even know what it is."

Supporters of the loophole say it's not a loophole at all — rather, the difference in tax rates represents an incentive to invest in the economy. They also say they pay taxes in other ways.

Another argument, perhaps more pragmatic, is that hedge fund managers would simply find other ways to structure their income to avoid the higher tax rate.

Will it pass this time? Maybe.

To pass their proposal, Democrats will likely have to secure all 50 votes from their own caucus — including that of Arizona Sen. Kyrsten Sinema, who last year helped to torpedo Democratic legislation over her opposition to any form of higher taxes for corporations or wealthy Americans.

In a Sunday interview on Fox News, Manchin disputed the characterization that the proposal, including its carried interest provision, would raise taxes.

"We did not raise taxes. We've closed loopholes. That's all we did. I made sure there were no tax increases in this whatsoever," Manchin said.

The Senate could take up the bill as early as this week. If it passes, the changes to the carried interest provision, along with the establishment of a corporate minimum tax rate of 15%, would help fund the development of renewable energy projects, encourage Americans to buy electric vehicles and support communities affected by climate change. [Copyright 2022 NPR]