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2017-11-09 19:22:03
Common Sense: A Tax Loophole for the Rich That Just Won’t Die

After the billionaire investor Warren Buffett exposed the unfairness of a federal tax code that assessed his secretary at a higher rate than him, it was hard to imagine a tax reform plan that would be even less fair.

House Republicans have come up with one.

That’s not because the plan indiscriminately favors the rich. It’s because to a degree unprecedented in American tax history, it favors the investor class, Mr. Buffett prominent among them, at the expense of people who work for a living, like his secretary.

It favors Donald Trump and his fellow real estate developers and investors, who already benefit from numerous loopholes in the tax code.

“I wouldn’t call this tax reform,” said Steven M. Rosenthal, a senior fellow at the nonpartisan Tax Policy Center.

There is no more glaring example of the House Republicans’ indifference to the inequities embedded in the tax code than the treatment of so-called carried interest. For decades, the carried interest provision has enabled wealthy private equity managers, hedge fund managers and real estate investors to pay the lower capital gains rate (20 percent, not counting the Obama health care surcharge of 3.8 percent) on their income rather than the rate on ordinary income (a maximum of 39.6 percent).

The former Republican presidential candidate Mitt Romney was excoriated for taking advantage of the loophole in 2012, and as a candidate Mr. Trump repeatedly promised to close it.

“The hedge fund guys didn’t build this country,” Mr. Trump said in 2015. “These are guys that shift paper around, and they get lucky.”

“They are energetic,” he added. “They are very smart. But a lot of them — it’s like, they are paper pushers. They make a fortune. They pay no tax. It’s ridiculous, O.K.?”

Yet in the plan unveiled last week, the carried interest loophole emerged unscathed. It was unclear how the loophole will be treated in the Senate version, which was scheduled to be released sometime Thursday.

The proposed legislation “is a home run for private equity investors,” said Victor Fleischer, a law professor at the University of San Diego who has spent years arguing (persuasively, in my view) that the loophole should be closed. “If you were designing something that perfectly avoids hitting private equity, venture capital and real estate, this would be it.” (Mr. Fleischer is also a contributor to The New York Times.)

This week, the House Ways and Means Committee chairman, Representative Kevin Brady of Texas, said he would address concerns about the loophole by seeking to extend the holding period for assets that qualified for the tax break from one year to three years. That’s better than doing nothing, and might affect some hedge funds. But they could easily qualify simply by holding the assets for more than three years.

Mr. Brady’s tweak would have no impact at all on most private equity managers, who typically buy companies, restructure and refinance them, and then sell them, usually after seven to 10 years. Most real estate partnerships have similar holding periods. And Mr. Brady said explicitly that the revision would preserve the carried interest provision for real estate interests.

“The amendment will encourage and reward long-term investment while also applying equally to all sources of growth capital — no matter if that investment is provided by hedge funds, private equity, venture capital or otherwise,” Shane McDonald, a spokesman for Mr. Brady, told me. “By providing a three-year holding period on certain assets, this amendment strikes the right balance for economic growth and fairness without stifling investment in American entrepreneurship.”

But the primary argument against the carried interest loophole isn’t that those who benefit from it don’t hold their assets long enough. It’s that the “carry” — the percentage of an investment’s gains that the manager takes as compensation — should be treated as a payment for services and taxed like regular income, and not be viewed as a return on invested capital, in which the manager has put assets at risk.

“The real issue is that carried interest is compensation for services performed for the investment fund,” Mr. Fleischer said. “The theory behind the Republican plan is that somehow, holding something for a longer period of time makes it more like a financial investment. But why would that be the case?

“If you write a book, and it takes three or four years before you earn a royalty, that doesn’t make the income a capital gain,” he continued. “If a movie takes three years to generate a return, that doesn’t make it a capital gain. There’s no reason why financial services should be any different.”

Proponents of the loophole, most of whom benefit from it one way or another, have long argued that the lower tax rate encourages risk taking and hence economic growth, an argument that Republican lawmakers appear to have embraced.

But there’s little empirical support for the position.

Mr. Fleischer argues that the proposed tax bill — by slashing the corporate and pass-through tax rates and preserving the lower rate for capital gains — already heavily favors risk taking and investment.

“We don’t need to further subsidize people who go to work in this sector by giving them a lower tax rate,” he said. “There’s no shortage of people who want to go into private equity and earn millions or billions of dollars.”

The rationale, he said, “is absurd.”

That the carried interest provision survived, despite Mr. Trump’s campaign statements and populist hostility to it, appears to be a testament to the enduring influence that Wall Street and wealthy investors exert over both the White House and Congress.

Some of Mr. Trump’s most prominent backers and donors come from the world of private equity, hedge funds and real estate partnerships, among them Stephen A. Schwarzman, chief executive of the powerhouse firm Blackstone; Wilbur Ross, the former private equity executive who is now secretary of commerce; Thomas J. Barrack, Jr., executive chairman of Colony Northstar, a real estate investment trust, and chairman of the president’s inauguration committee; Betsy DeVos, a co-founder of the Windquest Group and now secretary of education; and Stephen A. Feinberg, a co-founder of Cerberus Capital Management and a Trump donor and adviser. And Treasury Secretary Steven Mnuchin and Mr. Trump’s top economic adviser, Gary Cohn, are prominent alumni of Goldman Sachs, which has a range of hedge fund and private equity clients.

More broadly, preserving the break for carried interest fits into the overarching theme of the Republican tax plan: that what is good for investors is good for economic growth, which in turn is good for everyone, including the working poor. That’s why the proposed code is tilted so heavily toward investors rather than people who earn salaries or compensation for services rendered.

That’s also why it’s imprecise to say the proposed code benefits the “rich.” While most rich people are also investors, and thus will benefit disproportionately, not all rich people will benefit. People with high incomes generated primarily by their own labor or services may actually see their federal tax increase, especially if they lose their deductions for state and local taxes. The proposed code specifically names lawyers, doctors, athletes and performers — all of whom work for a living — as ineligible for the lower pass-through rate.

The plan “is a tax increase on the working upper middle class and the rich in states like California, New York and New Jersey in order to benefit the people who own pass-through entities and are shareholders,” Mr. Fleischer said.

Tax reform advocates generally agree that a fair code shouldn’t single out certain groups for favorable treatment at the expense of others. There is already widespread resentment that ultra-rich investment managers pay such low rates — nowhere near the top 39.6 percent rate.

Closing the loophole may promote fairness, but it wouldn’t do much to help the overall budget deficit. The Congressional Budget Office has estimated that eliminating it would generate $17 billion over 10 years, a drop in the bucket given that Republicans have been trying to close a budget gap in the trillions. Mr. Fleischer contends that the figure is much higher, more like $180 billion over 10 years. Even that is a modest down payment on the larger cuts the tax plan calls for.

But as a symbol, the carried interest loophole looms large, calling into question the fairness of the entire proposed tax code. That’s a shame, since large elements of the proposal have widespread bipartisan support. (Even former President Barack Obama agreed that the corporate tax rate needed to be lowered for the United States to be competitive.)

There’s still a chance that lawmakers will eliminate the loophole as the bill moves through Congress.

Mr. Rosenthal said he wasn’t holding his breath. Republicans seem to be gambling that most Americans won’t care about a few rich private equity managers if their own taxes go down, their stock portfolio goes up and economic growth accelerates. “I don’t think most Republicans really care about carried interest,” he said.