June 28, 2010
By Sam Goldfarb — sgoldfar@tax.org
As the Senate has steadily weakened a tax increase on carried interest income over the last couple of weeks, some policy observers have become steadily more frustrated.
For decades, some managers of investment businesses that are structured as partnerships have been able to claim a portion of their firm's profits as capital gains instead of ordinary income. Those earnings -- commonly referred to as carried interests and associated with hedge fund and private equity managers -- have drawn the ire of some progressives, who consider them to be among the most blatant examples of unfairness in the tax code.
Since Democrats took control of the House in 2006, Congress has been taking a close look at carried interests, and the House has voted twice to change their tax treatment entirely from capital gains to ordinary income. Although that legislation has repeatedly stalled in the Senate, things were looking different in 2010 -- at least until recently.
On May 20 the chairs of the House and Senate taxwriting committees announced that they had reached agreement on a tax extenders bill containing extensions of tax breaks and safety-net spending programs that were about to expire or had already expired at the end of 2009. One of the offsets for the American Jobs and Closing Tax Loopholes Act of 2010 (H.R. 4213) was a proposal to treat carried interests as a combination of capital gains and ordinary income. The provision would be phased in over time, but by 2013, 75 percent of carried interests would be taxed as ordinary income and 25 percent would be taxed as capital gains. (For the legislation, see Doc 2010-11323 or 2010 TNT 98-32 2010 TNT 98-32: Proposed Legislation. For prior coverage, see Tax Notes, May 24, 2010, p. 846.)
For House Democrats like acting Ways and Means Committee Chair Sander M. Levin, D-Mich., the proposal was a compromise, but its full endorsement from Senate Finance Committee Chair Max Baucus, D-Mont., seemed to bode well for its prospects.
Since then, however, the carried interest provision has been consistently diminished. Before passing H.R. 4213 on May 28, the House delayed the provision's enactment date from the start of 2010 to 2011. Shortly thereafter, Baucus introduced a substitute amendment to H.R. 4213 that would treat carried interests differently depending on how they were earned. Income derived from assets held for a longer period would be taxed at a lower rate than income tied to assets held for a shorter period. That approach was pushed further in a second substitute amendment in which carried interest income tied to assets held for at least five years would be taxed as 50 percent capital gains and 50 percent ordinary income, while income associated with assets held for less than that amount would be taxed at the originally proposed 75/25 split. (For the first Baucus substitute, see Doc 2010-12595 or 2010 TNT 110-35 2010 TNT 110-35: Proposed Legislation. For the second Baucus substitute, see Doc 2010- 13400 or 2010 TNT 116-23 2010 TNT 116-23: Proposed Legislation. For prior coverage, see Tax Notes, June 21, 2010, p. 1307.)
A third Baucus substitute amendment, introduced last week, made so-called technical corrections and clarifications to the carried interest provision. Like the other substitute amendments introduced before it, the latest substitute failed to overcome a procedural vote in the Senate, and the bill remained stalled on the Senate floor. (For related coverage, see p. 1416. News Stories For the latest Baucus substitute, see Doc 2010-14037 or 2010 TNT 122-19 2010 TNT 122-19: Proposed Legislation. For a Finance Committee summary, see Doc 2010-14029 or 2010 TNT 122-21 2010 TNT 122-21: Congressional News Releases.)
According to the Finance Committee, the carried interest provision in the newest Baucus substitute would raise $13.6 billion over 10 years. That compares with an estimated $18.7 billion that would be raised by the proposal put forward on May 20 and $28.6 billion that would be raised by the proposal in President Obama's fiscal 2011 budget, which would tax carried interests as 100 percent ordinary income. (For the Joint Committee on Taxation's revenue estimate of Obama's budget proposal, see Doc 2010-5625 or 2010 TNT 50-13 2010 TNT 50-13: Congressional Joint Committee Prints.)
Economic Effects Questioned
For some, the development of the carried interest provision has been dispiriting, if not altogether unexpected. It is "just the clearest example that the people with money can make their voices heard most clearly," said Steve Wamhoff, legislative director at Citizens for Tax Justice.
Although industry groups such as the Private Equity Council have been arguing that a tax increase on carried interests would lead to less investment and fewer jobs, those claims are "completely ridiculous," Wamhoff said. He noted that the capital gains tax has been reduced twice in the past 15 years without any noticeable increase in the number of private equity managers, who could take advantage of the tax benefit.
Even some conservatives have suggested that the incentive provided by the tax treatment of carried interests may be minimal. In a recent paper, Kevin Hassett and Alan Viard of the American Enterprise Institute wrote that the carried interest form of compensation would "likely be used even if it offered no tax savings" because managers of investment funds would still have plenty to gain by linking their earnings with the success of their funds. (For the paper, see Doc 2010-12491 or 2010 TNT 109-33 2010 TNT 109-33: Washington Roundup.)
In the opinion of Hassett and Viard, changing the tax treatment of carried interests would still be misguided. The "managers to whom the gains and dividends are allocated helped generate the gains and dividends," they wrote. If Congress believes in providing a special tax break for capital gains, the managers of investment funds deserve to benefit from it and can even help contribute to its effectiveness, they added.
For the most part, lawmakers who have been concerned about increasing taxes on carried interests have not been making technical arguments about tax policy. Rather, they have publicly worried about the economic impact of the tax increase, particularly on venture capitalists, who they have characterized as important job creators.
Fear is a driving force behind maintaining the tax-favored treatment of carried interests, said Sima J. Gandhi, a senior policy analyst at the Center for American Progress. Senators are afraid that changing the law would have the effect that lobbyists say it would have, even though the arguments that lobbyists are making are "very tenuous," she said.