Hillary Clinton rather casually mentioned in an interview with USA Today, published yesterday, something that's a really big deal — if elected president, she will direct the Treasury Department to close the so-called "carried interest" loophole that allows some financial managers to pay a lower tax rate than normal workers.
The Congressional Budget Office says this move would raise about $18 billion over 10 years, though some independent analysts like Victor Fleischer have come up with much higher numbers.
But it would also address what looks to most people like a question of basic fairness — one so elementary that politicians like Donald Trump and Jeb Bush have frequently made a big deal about on the campaign trail. They usually talk about closing the loophole in the context of overall plans to drastically lower taxes on high-income households. Meanwhile, Clinton’s proposal comes in the opposite context of an overall plan to modestly increase the taxes paid by the wealthiest Americans.
The notion that the Treasury Department can make this change unilaterally is a longtime contention of Alan Wilensky, who was a deputy assistant secretary at Treasury in the 1990s when fund managers began to exploit the opportunity to pay lower rates. President Obama’s Treasury Department has generally seemed to deny that it has such authority, but obviously a new administration could at least try to leave the courts to sort it out.
Carried interest, explained
A standard private equity or hedge fund has a compensation structure governed by the principle of 2 and 20. You earn a management fee of 2 percent of the total value of the fund, and you also earn 20 percent of the investment profits. That management fee is taxed like regular income (at a current top rate of 39.6 percent), but the profit share is taxed at the capital gains rate (at a current top rate of 23 percent).
Back in the 16th century, the profits of trading ventures to Asia were split between investors who earned a "capital interest" in the voyage and the captain and his key officers, who earned a "carry interest" for doing the work. Through a little linguistic drift, the 20 percent profit share for fund managers has come to be known as carried interest based on analogy to the ship captains of yore.
But this carried interest isn't just a fun a piece of nautical history; it's also a valuable loophole because it's taxed at the lower rate used for investment income rather than the higher rate earned for labor income.
The policy rationale for taxing investment income at a preferential rate is to encourage people to save a larger share of their income, thus boosting investment activity throughout the economy. But clearly taxing hedge fund managers at a preferential rate doesn't encourage any kind of savings. That's why there's fairly widespread policy agreement that it would be desirable to close this loophole, though of course there is interest group lobbying to keep it place and a lot of room for disagreement about what to do with the money that could be raised.
The case for unilateral action
Whether or not Treasury has the authority to do this unilaterally hinges on your reading of 26 US Code § 707, which is supposed to govern the situation in which a partner in an enterprise provides services to the partnership "other than in his capacity as a member of such partnership," in which case "the transaction shall, except as otherwise provided in this section, be considered as occurring between the partnership and one who is not a partner."
The idea of this rule is that if you are an investor in a partnership but you also earn income by selling services to the partnership, then this latter stream of income needs to be classified as wages rather than as part of your partnership income.
And according to the statute, the Treasury secretary is supposed to promulgate rules that help sort out what does and doesn't qualify.
The main proposal for unilateral action says the Treasury Department should interpret the statute as saying that investment management services qualify as services provided "other than in his capacity as a member of such partnership."
The case against this comes from the legislative history. A mid-'80s Senate Finance Committee report from the time when the law was written indicates that its drafters thought the certainty of income would be a key factor in determining whether income counts as partnership income or service provider income, and since carried interest is based on performance, it doesn't fit the bill.
The counterargument, per Fleischer, is that "there is no legal requirement that the regulations follow the legislative history, so long as the regulations are a reasonable interpretation of the statute."
Whether or not the courts will ultimately buy that argument is a separate question, but Clinton is committed to at least trying to see if it works.
