Democrats Have Set Up A Showdown Over A Notorious Tax Loophole

Democrats’ big inflation reduction proposal tightens a notorious tax loophole benefiting hedge fund managers and other wealthy investors that Sen. Kyrsten Sinema (D-Ariz.) has previously insisted be left untouched.

The loophole is one of the most infamous in American politics. It’s what billionaire investor Warren Buffett refers to when he discusses how he pays a lower tax rate than his secretary. It has also been protected over the years by ferocious lobbying efforts from Wall Street. Though its fate isn’t necessarily linked to the success of the entire $740 billion package, whether it survives could show how willing Democrats are to stand up to a tiny but powerful and wealthy group of Americans.

Sen. Joe Manchin (D-W.Va.), who negotiated the proposal with Senate Majority Leader Chuck Schumer (D-N.Y.), told reporters on Thursday he demanded the closure of the carried-interest loophole, which allows hedge fund managers, venture capitalists and private equity partners to have their earnings taxed at the 15% capital gains rate instead of at much higher rates for normal income.

“The only thing I was adamant about was the carried interest,” Manchin said.

However, Democrats’ other business-friendly holdout, Sinema, asked party leaders not to touch the loophole during negotiations over President Joe Biden’s “Build Back Better” proposal last fall. And she has declined to comment so far on the Manchin-Schumer proposal, dubbed the “Inflation Reduction Act,” saying she wants to review the text of the legislation first.

The loophole is now most closely associated with the private equity industry, where it refers to the 20% of a fund’s investment profits that its managers take in on top of a fixed fee. If Democrats close the loophole, managers will instead pay the top marginal income tax rate of 37%.

Democrats are not closing the loophole entirely, instead just making it more difficult to use. A proposal from Sens. Ron Wyden (D-Ore.) and Sheldon Whitehouse (D-R.I.) to completely seal it would have raised $63 billion over the next decade, while the version agreed to by Manchin and Schumer raises just $14 billion. It will require managers to hold the investments for five years instead of three to get the favorable rate, and it creates stricter requirements for those investments.

The relatively small amount of revenue the legislation would raise ― just under 2% of the package’s total cost ― means Democrats could shunt it aside without having to perform emergency surgery on the rest of the proposal, which would spend $300 billion on deficit reduction and $369 billion on climate change and energy security, with the rest going to health care costs. Notably, Biden did not mention carried interest during his 12-minute speech on the legislation on Thursday afternoon.

But Manchin, at least, seems to want a fight with Wall Street.

“On the carried interest — for the wealthiest one-tenth of 1% of Americans to take advantage of a tax break for them, that they have no risk at all and they get to take the lowest tax rate?” Manchin said on West Virginia MetroNews radio on Tuesday morning. “So we got rid of that.”

The American Investment Council, which represents the private equity industry, has long defended the loophole as a fair way to encourage investment and risk-taking, arguing most of the money private equity invests goes to help small businesses.

The American Investment Council has donated $10,000 to Sinema in the past, the maximum possible donation but a small part of Sinema’s campaign war chest, which stands at $7.4 million. They’ve also spent $1.6 million on lobbying through the first two quarters of this year, according to federal records.

Politicians of every ideological stripe have attacked the loophole, but it has always managed to survive. Former President Barack Obama promised to end it, and he slammed his 2012 GOP opponent, now-Sen. Mitt Romney, for benefiting from it. During the 2016 presidential campaign, Republican Donald Trump and Democratic Party candidates Hillary Clinton and Bernie Sanders all wanted to close it.

The GOP’s 2017 tax law, which delivered most of its benefits to the wealthy, did begin the process of tightening it, instituting the existing three-year waiting period.

“They’re paying nothing and it’s ridiculous,” Trump told Time magazine in 2016. “The hedge fund guys didn’t build this country. These are guys that shift paper around and they get lucky.”