As Talking Points Memo reported this afternoon, Oklahoma Rep. Tom Cole, a conservative Republican who is close to Speaker John Boehner, made some promising news in an interview Bloomberg’s Al Hunt:
He expressed openness to revenue-raising tax reforms on repatriation of stranded profits overseas and ratcheting back the carried interest loophole, which allows private equity firms to avoid paying some taxes by having their income taxed as capital gains. “I think that’s certainly — this is my personal view, it’s not speaking for anybody else — that ought to be something on the table,” he said. “So those kinds of things are reasonable.”
The Tax Policy Center has an excellent explainer on carried interest, but to put it simply, carried interest is basically a share of the profits generated by a business that a private equity or hedge fund has invested in that are allocated to the General Partner (management) of the fund, once said business has earned enough profits to clear a pre-set hurdle rate of return, usually something like 20 percent. This is considered investment income and taxed at the capital gains rate of 20 percent (for the highest income bracket, where hedge fund managers operate).
This seems straightforward enough, but the General Partner only puts up a tiny, single-digit percentage of capital held by the fund. The other 95 to 99 percent is contributed by outside investors, or as they are called in this model, Limited Partners. These investors pay the General Partner a management fee (usually around two percent, which is not bad considering many funds routinely hit nine and ten figures), which is correctly taxed as ordinary income, considering the General Partner is getting paid for providing the service of managing its Limited Partners’ money.
The second source of income for the General Partner is carried interest. The General Partner invests a pool of money that is overwhelmingly not its own and receives the post-hurdle profits as a reward for a successful venture. Investing other people’s money for them in exchange for payment seems a lot more like providing a paid service than a return on an personal equity investment. This is ordinary income, and should be taxed as such.
The fact that the General Partner chipped in a token sum does not mean the entire proceeds should be considered investment income. At most, the capital gains rate should only apply to the share of the profits equal to the share of the capital investment made by the General Partner.
This matters because the Forbes 500 list is chock full of hedge fund managers and private equity types. There’s a lot of potential tax revenue lost to the carried interest loophole. Getting rid of it is a much better way to raise revenue than jacking up marginal income tax rates, which have much more of an effect on the larger economy. Most rich people don’t pay anything close to ordinary income rates anyway, because most of their cash flow comes from personal investments taxed at the capital gains rate, which is perfectly legitimate because it’s their own money.
Raising awareness of the unfair carried interest loophole to the point where it’s legitimately on the chopping block may be the best consequence of Mitt Romney’s failed presidential campaign. Fund managers still have a fantastic income model. It ought to be taxed like one.