In recent days Senate Minority Leader Mitch McConnell (R-KY) and House Speaker John Boehner (R-OH) have both suggested that they might be willing to allow some tax cuts for high-income individuals to expire. But Sen. McConnell—and evidently Rep. Boehner, as well—are reportedly still insisting that the Bush tax cuts on investment income be extended.
The Republican leaders’ willingness to discuss top tax rates is a welcome step forward. But until policymakers address the gap between tax rates on ordinary income (income from wages, salaries, and so on) and the tax rates on investment income (capital gains and dividends), they will not have fully addressed the fundamental unfairness in the tax code.
No tax policy better illustrates this unfairness than the tax treatment of “carried interest”—a loophole that some of the wealthiest people in the country use to take advantage of the special low tax rates on capital gains. Closing the carried interest loophole should be a part of any significant deficit-reduction or tax-reform effort.
In anticipation of this next front in the fiscal policy fight, here’s a quick primer on the carried interest loophole.
What is the carried interest loophole?
The carried interest loophole allows people who manage investment funds—such as private equity funds and hedge funds—to convert their income into lower-taxed capital gains.
Here’s how it works: The partners in businesses that manage pools of money on behalf of investors are paid in two ways. One part of their income is a “management fee” for managing the investments. This fee is generally taxed as ordinary income, according to progressive tax rates that currently top out at 35 percent. The other part of the fund managers’ income is their cut of the fund’s profits. The fund managers treat their part of the fund’s earnings as a capital gain, subject only to a top rate of 15 percent.
Investment managers, who include some of the world’s richest people, typically take a management fee equal to just 2 percent of the assets they manage—plus a 20 percent cut of their investors’ profits. In doing so, they are able to shield the bulk of their income from ordinary tax rates.
Why is the carried interest loophole unfair?
Our tax code treats labor income and investment income differently. If you are paid for performing a service (such as managing a company), your compensation is subject to ordinary income tax rates. If you make an investment (such as buying the stock of a company), any profits you earn when selling that stock are subject to the lower capital gains tax rates. The differential treatment of labor and investment income is problematic in and of itself, but the carried interest loophole is particularly unfair because it treats fund managers’ compensation as if it were investment income, when it is actually derived from the labor and skill involved in managing other people’s investments.
The main justification given for the low rates on capital gains is that it is needed to incentivize investors to put their capital at risk. But fund managers’ so-called carried interests do not represent a return on capital. The capital is put up by the investors, who are simply compensating the managers for their services by sharing a percentage of the profits. The fund managers do incur some level of risk and uncertainty by agreeing to be compensated in this manner, but that is no different from other compensation arrangements—such as sales commissions, tips, or performance bonuses—that are not fixed in advance and entail differing degrees of risk. All of those forms of compensation income are taxed as ordinary income.
What should Congress do?
Congress should close the carried interest loophole by taxing all fund manager compensation—including incentive compensation—as ordinary income. Eliminating this loophole would raise $21 billion in revenue over 10 years, according to the Congressional Budget Office.
The carried interest loophole is just one of many ways the U.S. tax code offers preferential treatment to some of the wealthiest Americans. Our recently released tax reform and deficit-reduction plan addresses this and other loopholes while raising revenue, simplifying the tax system, and making it more progressive.
Seth Hanlon is Director of Fiscal Reform and Gadi Dechter is Managing Director of Economic Policy at the Center for American Progress.
 Some fund managers, however, have entered into agreements to “waive” the management fee in exchange for an additional carried interest, thus converting ordinary income from the management fee into lower-taxed capital gains. Such fee conversions are legally dubious. See Nicholas Confessore, Julie Creswell, and David Kocieniewski, “Inquiry on Tax Strategy Adds to Scrutiny of Finance Firms,” The New York Times, September 1, 2012, available at http://www.nytimes.com/2012/09/02/business/inquiry-on-tax-strategy-adds-to-scrutiny-of-finance-firms.html?pagewanted=all&_r=0.