Why Obama’s Budget Eliminates The Carried Interest Tax Loophole

The budget President Obama released this week is aimed at fostering a long-term fiscal compromise with congressional Republicans, but it still includes some of the president’s priorities, including new revenues to help bring more balance to the overall deficit reduction efforts he and Congress have already made. The budget seeks $580 billion in revenues generated by closing tax loopholes and ending tax breaks that largely benefit the wealthy.

One of those tax breaks is the carried interest loophole, which benefits wealthy hedge fund managers and private equity investors. The loophole played a prominent role in the 2012 presidential election (it was, as Mother Jones termed it, “Mitt Romney’s favorite tax break”), because it was among the reasons Romney was able to pay such a low tax rate on his exorbitant income.

The carried interest loophole applies to barely anyone, but it gives the few who use it a major tax break by allowing them to treat income gained from the profits of their investors as investment income subject to the capital gains tax rate, which maxes at 20 percent, rather than the ordinary income tax rate that tops out at 39.6 percent. To take advantage of it, hedge fund and private equity managers take cuts from their investors’ profits instead of charging traditional management fees, thus reducing the amount they need to pay in taxes without reducing their income.

Carried interest income, as Seth Hanlon and Gadi Dechter have explained, is “derived from the labor and skill involved in managing other people’s investments” and should be taxed as ordinary income, not under preferential capital gains rates. The loophole costs the U.S. a substantial amount of money — Obama’s budget raises $16 billion over the next decade by closing it.


More importantly, though, closing the loophole would help achieve one of Obama’s major tax reform goals: making the tax code fundamentally more fair. And fairness isn’t the goal simply for the sake of fairness. American income inequality has burgeoned over the last three decades, in large part because the tax code has become less progressive and failed to offset differences in wage gains at different ends of the income ladder. The preferential capital gains rate, according to studies, is “by far the largest contributor” to the increase in inequality, and if raising the capital gains rate back to its Reagan-era levels isn’t on the table, closing the carried interest loophole will at least end a tax break that benefits a small number of super-wealthy financial managers at the expense of everyone else.