Reported by Gretchen Morgenson in the NYTimes
It’s only natural that Barack Obama, entering the homestretch of his presidency, would be concerned about his legacy. Judging from a recent interview in The New York Times Magazine, getting credit for the actions he has taken on economic issues seems to be of special interest to him.
Mr. Obama expressed frustration that many middle-class Americans feel they’ve been left behind during his time in office. The wealthiest Americans, meanwhile, have become richer during the Obama years.
There is a lot about this problem of income inequality — and about the economy over all — that Mr. Obama cannot control. Still, there is something he could do right now to help narrow the widening gulf between rich and poor.
In one deft move, Mr. Obama could instruct officials at his Treasury Department to close the so-called carried interest tax loophole that allows managers of private equity and hedge funds to pay a substantially lower federal tax rate on much of their income.
Forcing these managers to pay ordinary income taxes on the gains they reap in their funds would accomplish two things. It would take away an enormous benefit enjoyed almost exclusively by some of the country’s wealthiest people. And, tax experts say, it would generate billions in revenue to the government each year, though there are wide differences over exactly how much.
But doesn’t changing the carried interest loophole require an act of Congress? Not according to an array of tax experts. Just as Mr. Obama’s Treasury Department recently changed the rules to curb corporate inversions, in which companies shift their official headquarters to another country to lower their tax bills, the Treasury secretary, Jacob J. Lew, and his colleagues could jettison the carried interest loophole.
Alan J. Wilensky is among those urging such a change. He was a deputy assistant Treasury secretary in charge of tax policy in the early 1990s when the carried interest loophole came about.
“This is something President Obama can do and should do,” Mr. Wilensky said in an interview. “This is not an impossible thing to get done.”
Now a lawyer in Minneapolis, Mr. Wilensky recently wrote an article on this topic for Tax Notes, the definitive publication on national and global tax issues.
Victor Fleischer, a law professor at the University of San Diego, is another who has recommended that the Treasury get rid of the unjust tax treatment on carried interest. Mr. Fleischer, a contributor to The New York Times, has also estimated how much money such a change would bring to the Treasury.
“It’s something that Obama could accomplish and, to be honest, I’m not entirely sure why the Treasury hasn’t taken an interest in it,” Mr. Fleischer said in an interview. “In fact, there is quite a bit of revenue at stake. And doing this on carried interest would cement Obama’s legacy in substance as well as symbolically.”
Rachel McCleery, a Treasury spokeswoman, said in a statement that closing the carried interest loophole has been a priority for the Obama administration from the outset and that the department is continuing to explore its existing authority for ways to address the loophole.
But the department cannot eliminate the carried interest tax benefit by itself, she contended.
“The president’s first budget in 2009 — and every one since — has included a proposal to close this unfair loophole and we’ve been pushing Congress to get it done,” she added. “No one should be able to play by a different set of rules, so it’s time for Congress to act to close the carried interest loophole once and for all.”
The provision has come under repeated political attack. During the current presidential campaign, all three remaining candidates — Bernie Sanders, Hillary Clinton and Donald Trump — have called for eliminating it. A number of lawmakers tried to get rid of the carried interest tax benefit beginning in 2007; by 2010, it looked as if the special treatment would go by the boards.
But a lobbying campaign by the financial industry, supported by a number of influential Republican lawmakers who argued that carried interest should be ended only as part of a broader tax overhaul, put a stop to the effort.
The Treasury’s recent action on corporate inversions is encouraging, Mr. Wilensky said. But he acknowledged that it was easier to get rid of a tax rule that benefits faceless corporations than it was to abolish a regulation that enriches a small group of extremely powerful and vocal people.
“Hedge fund and private equity managers are really the one-tenth of the 1 percent, and the carried interest rule hits their pocketbooks directly,” Mr. Wilensky said. “It’s much easier to implement regulations that have an adverse effect on anonymous shareholders and institutions.”
Managers of hedge funds and private equity funds receive two types of payments. One, paid annually, represents a percentage of assets under management, usually around 2 percent. Those earnings are taxed as ordinary income.
But these managers also receive 20 percent of gains that their funds generate over time, known as carried interest. These profits are taxed at the lower capital gains rate, thanks to a 1993 ruling by the Treasury and the Internal Revenue Service.
Closing the loophole, tax experts say, would involve characterizing both the 20 percent and the 2 percent as income from services rendered.
In a 2008 paper, “Two and Twenty: Taxing Partnership Profits in Private Equity Funds,” and in a follow-up paper published last year, Mr. Fleischer described the current carried interest tax treatment as a conversion of labor income into capital gain, an “anomaly that was contrary to some generally accepted principles of tax policy.”
It is odd, he argued, to treat such partnership profits more favorably than “other economically similar methods of compensation, such as partnership capital interests, restricted stock or at-the-money nonqualified stock options (the corporate equivalent of a partnership profits interest).”
Mr. Fleischer’s solution would be to tax carried interest at ordinary income rates “if the amount of capital contributed to a partnership by tax-exempt entities exceeds the amount of capital contributed by the service provider,” or manager. Tax-exempt entities, such as public pension plans and college endowments, are big investors in private equity and hedge funds.
In last year’s paper, Mr. Fleischer noted that a close reading of legislative history from 1984 “shows that Congress expected that the managers of an arrangement like a modern private equity fund would be taxed at ordinary rates.” In addition, Congress allowed the Treasury Department broad discretion on such matters and directed it to write regulations, Mr. Fleischer said.
Financial officials in Britain have already started to trim beneficial treatment for carried interest. They have cut back on what qualifies for the lower, long-term tax rate.
Beyond fairness, there’s another compelling reason for Mr. Obama to act on this inequity: It could generate $150 billion in revenue over 10 years, by Mr. Fleischer’s estimate. Two-thirds of that would come from the financial industry; the rest would be generated by real estate, oil and gas partnerships and mining companies, he said.
(Mr. Fleischer’s prediction, though, is far larger than the Congressional Budget Office’s official estimate, which is close to $18 billion over 10 years.)
Whatever the correct amount, the best reason to eliminate this tax break for the wealthy is that it would help narrow the gap between rich and poor in America. The carried interest loophole contributes substantially to the increase in top-end inequality in the United States, Mr. Fleischer has concluded.
If these experts are right, Mr. Obama can direct the Treasury to end what is an enormous subsidy for the wealthiest Americans. The Treasury disagrees. But punting this task to Congress means nothing is likely to be done. And that’s too bad.
Really too bad!