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Tucked inside the sprawling senate compromise invoice for Climate Change and Health Care is a years-long effort to close what Democrats see as a loophole that benefits a handful of the wealthiest Americans: the deferred interest tax.
The legislative compromise, reached last week by Senate Majority Leader Chuck Schumer and West Virginia Democrat Joe Manchin, could represent largest federal clean energy investment in U.S. history.
About $14 billion to fund those efforts would come, Democrats say, from a change in how the U.S. taxes what are known as “carried interest” a major way for many fund managers and private equity investors to earn their compensation.
But this has long been controversial because this type of income is currently taxed at a rate far lower than the wages most Americans earn through regular jobs.
The longstanding provision has survived repeated attempts and promises to eliminate it, from Democrats and Republicans alike.
“There’s a lot of money at stake. Some of the wealthiest Americans have made their fortunes earning carried interest, particularly through private equity funds,” said Steve Rosenthal, a fellow at the Tax Policy Center at the Tax Policy Center. ‘Urban Institute, in an interview with NPR.
How does the loophole work and what have the Democrats offered?
“Partners in private equity firms and hedge funds that typically manage other people’s money get a share of the profits from any deal they do – often around a 20% share, even if they’ve invested in it. some of their own money,” David said. Wessel, an economics researcher at the Brookings Institution, in an interview with NPR.
Here’s the catch: While this slice of profit pocketed by hedge fund managers is essentially their salary, it’s taxed at a lower rate than ordinary income. Rather than being subject to the normal personal income tax rate – 37% for the highest income bracket – deferred interest, as long as it is held for at least three years, is taxed at the rate of capital gains, which is usually 20% for those high earners.
The difference could be billions of dollars. (Precise estimates can be difficult because “there’s a lot of opacity in private equity,” Rosenthal noted.)
Senate Democrats say their proposal would raise $14 billion over 10 years. This number is equal to an estimate issued by the Congressional Budget Office for a 2019 proposal to treat deferred interest as ordinary income. (In 2020, the Congressional Research Service noted that the amount of money under this type of management had reached $14.3 trillion, a dramatic increase in recent years.)
Currently, these types of investors must retain their income for three years to qualify for the 20% capital gains rate, rather than a higher short-term rate. The Democratic proposal would increase the detention period from three to five years. (The longer holding period requirement would only apply to people earning more than $400,000 per year, a nod to Biden’s previous pledge that he would not raise taxes on Americans earning less than that amount.) Other technical changes would attempt to prevent hedge fund managers from structuring their income in different ways.
“It wouldn’t completely close the rift, but it would significantly limit it,” Wessel said.
Where did the idea come from, and why didn’t it come before?
The idea of closing the loophole has been around for a long time.
The focus first appeared in national headlines in 2007, after a law professor wrote a newspaper article about the loophole and helped start a debate on Capitol Hill about whether to shut it down. The problem was found again on the table in 2010, then again in 2011 amid Occupy Wall Street protests. In 2012, the interest carried increased in discussions on the taxes paid by Mitt Romney, then a Republican presidential candidate, during his years running a private equity firm. In 2016, presidential candidates Jeb Bush, Donald Trump and Hillary Clinton all promised to close the loophole (though President Trump’s 2017 tax bill came a long way from eliminating it).
But no previous proposal to close the loophole has been successful – in part because of aggressive lobbying to keep it.
“There are a lot of private equity and hedge fund partners who are big campaign contributors, including to Democrats, and they care a lot,” Wessel said. Meanwhile, he added, “all the other voters in Congress don’t even know what it is.”
Proponents of the loophole say it is not a loophole at all — rather, the difference in tax rates represents an incentive to invest in the economy. They also say they pay their taxes in other ways.
Another, perhaps more pragmatic, argument is that hedge fund managers would simply find other ways to structure their income to avoid the higher tax rate.
Will it pass this time? Maybe.
To pass their proposal, Democrats will likely need to secure all 50 votes from their own caucus, including that of Arizona Sen. Kyrsten Sinema, who last year helped torpedo Democratic legislation. on his opposition to any form of tax increase for corporate or wealthy Americans.
In a Sunday interview on Fox NewsManchin took issue with the characterization that the proposal, including its deferred interest provision, would raise taxes.
“We didn’t raise taxes. We closed the loopholes. That’s all we did. I made sure there were no tax raises in this area,” Manchin said. .
The Senate could take up the bill this week. If passed, changes to the deferred interest provision, along with the establishment of a minimum corporate tax rate of 15%, would help fund the development of renewable energy projects, encourage Americans to buy electric vehicles and support communities affected by climate change.