Tax Reform and the Current Fiscal Crisis

Tax Reform and the Current Fiscal Crisis

Insanity: doing the same thing over and over again and expecting different results - Albert Einstein

In his recent State of the Union address, President Obama singled out eliminating the carried interest tax break as one method to reform the tax code, increase revenue, and close the Federal deficit.  The carried interest tax break is one of hundreds of loopholes that exist in the Federal Tax code, and their existence may be the symptom of a greater problem, which is the inequality between capital and income tax rates (20 vs. 39.5 percent.)  In order to achieve the goals laid out in his State of the Union address, President Obama and Congress should focus on eliminating this inequality in order to restore the tax parity enjoyed under President Reagan’s 1986 Tax Reform Act. 

What is the Carried Interest Tax?

…An obscure, complex loophole designed to help private equity managers avoid income tax

The carried interest tax break is not one that I was familiar with prior to hearing Obama’s State of the Union address, so I wanted to learn more about it and how its elimination can help solve the current fiscal crisis.  The Brookings Institute defines carried interest as a “right that entitles the general partner of a private investment fund to a share of the find’s profits,” which is depicted below.

The purpose of a Private Equity Fund is to invest in a company for a limited period of time to then sell for a profit. For example, Private Equity Fund X invests in Widget Company Y over a period of 5 years, and then sells it to Widget Company Z for a profit.  In this structure, each investor from the Private Equity Fund receives a rate of return on any profit generated from the sale.  The General Partner acts as the manager of this fund, and receives an annual management fee of 2 percent of the fund’s assets plus a “carried interest.” The carried interest consists of 20 percent of the fund’s profits that are above the standard rate of return that the other Fund investors receive.  Out of the total profits from the sale of Widget Company Y, 80 percent is divided among all investors, and the remaining 20 percent goes to the Manager.  These profits are taxed as capital gains (20 percent), and the management fee is taxed as income (39.6 percent rate).  Some tax analysts believe that the difference in taxes paid between the management fee and carried interest equates to a tax break. 

Would closing it matter?

…according to Congress, it’s complicated.

Recently, Senator Levin from Michigan introduced a bill to tax carried interest as income rather than capital gains. This bill on its face appears straightforward, but the Congressional Budget Office has some reservations.  The Office completed an analysis of whether carried interest made by the General Manager is a wage or a capital gain, and then compared four alternative methods for closing the loophole.  The challenge they encountered is the complex nature of the loophole, as it is unclear whether or not the General Manager should be classified as an employee of the Private Equity Fund.  The Office suggested implementing a strategy entitled “Tax Imputed Interest on the Implied Loan,” which is about as obscure and complicated as the loophole itself.  Their argument for this alternative is that it will prevent General Managers from classifying themselves as something other than a person subject to income tax, but the “complexities involved make it difficult to implement in practice.” Further, The National Review states that closing the loophole “amounts to nothing,” as the Congressional Joint Committee on Taxation concluded that closing it will save $2 Billion a year, a small fraction of the total $16 Trillion Federal deficit.

Why focus on it, then?

…it’s what made Romney rich!

Private Equity Funds have been increasing in value since the 1980’s, and the Economist graph below illustrates their rapid growth over a relatively short period of time.  As someone with multiple investments in Private Equity Funds, Mitt Romney paid an effective tax rate of 14.1 percent on $13.7 million in income according to his 2011 tax return.  Democrats in Congress have used this fact to highlight the importance of closing the carried interest loophole.  However, the complex nature of implementing such reform and its relatively insignificant impact on the Federal deficit makes it hard to justify this method alone as a sound method of tax reform.  Instead, the focus seems drawn along partisan lines and sidesteps a conversation about implementing a truly broad-based approach to tax reform. 

What should Congress do instead?

…end the insanity by doing something different, which is non-partisan tax reform.

The 1986 Tax Reform Act gave parity to capital and income tax rates, but the Tax Code has been amended several times to include hundreds of pages of loopholes and deductions, which have lead us to the current state of affairs.  The Center for Tax Justice makes the argument for its reinstatement with two reasons. First, a lower tax rate on capital gains than income creates opportunities for tax avoidance by classifying income as capital gains.  Second, the inequality creates incentives for tax shelters and complicates the tax system. In order to eliminate this incentive, the Congressional tax debate needs to move from circular arguments that go tit-for-tat over loopholes and deductions to a productive conversation that restores the level of equality written into the 1986 Tax Code.