The Senate is considering a bill this week aimed at creating jobs and extending some business and family tax breaks. Lawmakers have decided to pay for those provisions by partially closing a controversial tax loophole that has allowed managers of investment partnerships, from hedge funds to real estate developers, to pay less than half the regular tax rate on much of their income.
Closing this loophole would more than double the tax paid on something called carried interest income.
Here's how it works at a hedge fund: An investment manager launches a fund and gets a lot of rich people or institutions to put up most of the money. The manager is paid, in large measure, by getting something like 20 percent of all the profits the fund makes. If it earns $100 million, the investors pay the manager $20 million. But instead of paying the top income tax rate of 35 percent on that amount, the manager pays just 15 percent. That's normally the tax rate reserved for capital gains income like the profits made on the sale of stocks or real estate.
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"It's a huge windfall to some of the best-off people in society," said Len Burman, a fellow at the Brookings Institution and a professor at Syracuse University.
In addition to largely benefiting wealthy Americans, the provision is a huge hit to government revenues. It is estimated that closing the loophole completely would bring almost $25 billion over the next 10 years into the U.S. Treasury. The tax fairness issue is important, Burman says, because the U.S. is supposed to have a progressive income tax system.
"High-income people are supposed to be taxed at the highest rates, 35 percent," he said. "But people who are lucky enough to be in the private equity or hedge fund business get their income taxed at a 15 percent rate."
Representatives of the hedge fund industry say that's not totally true. They say hedge fund managers actually pay the higher rate on most of their income because they trade constantly and hold most of the assets in their funds for less than one year. To qualify for the 15 percent capital gains rate, assets must be held for more than one year.
Opposition From Real Estate Industry
Jeffrey DeBoer, president of the Real Estate Roundtable, says the commercial real estate industry would actually be hardest hit by the tax increase. He says those proposing the tax change are focusing on hedge fund managers largely because they are an easy target right now.
"There's a lot of red herrings, a lot of smoke over this issue," DeBoer said. "And what we're trying to do is make people understand this is very much a Main Street tax increase, not a Wall Street tax increase."
DeBoer says nearly half of the investment partnerships in the United States are real estate investment partnerships. He argues that with more than 1 in 4 construction workers unemployed and the commercial real estate sector struggling, now is not the time to raise the tax rates paid by real estate developers.
"Those people hire construction workers. They hire all kinds of other people around the projects," he said. "And this proposal, again, discourages that kind of activity."
But Burman argues that favoring one kind of activity or business over others by giving it a lower tax rate can distort investment decisions and make the economy less efficient.
"I think actually, aside from the equity issues and the fact that the government might need the money, it would be worth taxing these guys the same as others just so that you don't have this artificial incentive for people to choose this kind of investment instead of others, or this kind of line of work," Burman said.
DeBoer insists that investors who take risks should be treated differently.
"These are risks that people take in order to build value," he said. "And the American system has always rewarded risk-taking."
The Senate will likely vote this week on the bill. If the measure passes, it would shrink the loophole on carried interest income but not close it completely. The House has already passed a similar provision.