NOTE: This article was originally written for Studio’s production of Kings in the 2018-2019 season.
The carried interest tax loophole, despite its name, has nothing to do with carrying interest over from year to year. The name comes from sixteenth-century Italy, when ship captains “carried” physical goods and took a 20% cut from that cargo. In practice today, carried interest is the percentage of investment gains that venture capital partners, hedge fund managers, or private equity executives take as compensation (usually above their management fee). This class of investors get “two and twenty”—2% of the total assets and 20% of the fund’s profits, which can amount to tens or hundreds of millions of dollars. This 20%, however, is taxed at 23.8%: 20% from capital gains, and 3.8% on the increase due to investment.
This rate is significantly lower than the IRS’s 37% tax rate on incomes. The argument supporters make is that investors should be treated as entrepreneurs, reaping the benefits of selling something that they “built” from a “vision.” The “benefits”—the “carry” is tied to their performance, so it should be treated like an investment, even though managers profit regardless of whose money is at risk (and rarely theirs.) However, many even within the industry believe this money should be taxed as income, raising the taxes to 37%. In practice, investors for private equity funds make, on average, $2.4 million a year, and are taxed at a significantly lower rate than an American making, say, $40,000 a year.
Closing the loophole has bipartisan support. Republicans, in general, have favored the loophole, but have indicated a willingness to discuss closing the loophole if Democrats were willing to negotiate other reforms to the tax code. Hillary Clinton, Donald Trump, Jill Stein, and Bernie Sanders all believe this loophole should be closed. In fact, closing this loophole was part of Trump’s campaign promise, as well as some hedge fund managers themselves. So, if everyone seems to be on board with this, why hasn’t the loophole been closed?
The most likely reason seems to be congressional leaders. Senate Majority Leader Mitch McConnell and Speaker of the House Paul Ryan both have major donors who have benefited from the loophole. (It doesn’t take many major donors to give remarkable amounts of money—the top 25 hedge fund managers earned a combined $11.62 billion in 2015). In other words, if these hedge fund managers make less money, they will have less money to donate to their political campaigns. This reason may explain why the current Republican president has little interest in maintaining the loophole: not only is the loophole universally disliked by the public, he was able to privately fund his election, while the Republican members of congress have worked hard to protect the loophole despite the desires of their constituencies.
While a Speaker and Majority Leader can corral votes and lay out terms for negotiation, they do not a law pass. So where are the rest of the votes coming from? This is where lobbyists, such as those in Kings, come in. While there are hedge fund managers who want to get rid of the loophole, there are plenty who want to keep it: carried interest does benefit them, after all. According to the Senate Office of Public Records, lobbyists for the securities and investment interests (which include hedge funds) raised $97.3 billion in 2017 for congressional races, presumably in exchange for support of a continued break on tax rates for carried interest. The revised tax code pushed through by the Republican Congress in 2017 preserves the carried interest provision—provided that hedge funds hold the interest for three years, instead of the current one year.