The Daily - The Tax Loophole That Won’t Die

Episode Date: August 15, 2022

Carried interest is a loophole in the United States tax code that has stood out for its egregious unfairness and stunning longevity. Typically, the richest of the rich pay 40 percent tax on their income. The very narrow, select group that benefits from carried interest pays only 20 percent. Earlier versions of the Inflation Reduction Act targeted carried interest. But the loophole has survived. Senator Kyrsten Sinema, Democrat of Arizona, demanded her party get rid of efforts to eliminate it in exchange for her support. How has the carried interest loophole lasted so long despite its obvious unfairness? Guest: Andrew Ross Sorkin, a columnist for The New York Times and the founder and editor-at-large of DealBook.Background reading: What is the carried interest loophole and why hasn’t it been closed by now?Ms. Sinema’s puzzling defense of the loophole.For more information on today’s episode, visit nytimes.com/thedaily. Transcripts of each episode will be made available by the next workday. 

From The New York Times, I'm Michael Barbaro. This is The Daily. For decades, a single loophole in the U.S. tax code has stood out for both its egregious unfairness and its stunning longevity. egregious unfairness, and its stunning longevity. Today, my colleague Andrew Ross Sorkin on how that loophole survived its latest brush with death. It's Monday, August 15th. Andrew, right after the Senate passed this landmark climate and prescription drug bill about a week ago,

we spoke with one of our colleagues in Washington, Emily Cochran, about this long, dramatic journey required by Senator Joe Manchin of West Virginia to get behind it. But there was another Democratic senator who was the other real holdout during this process, and that's Kyrsten Sinema of Arizona. And I want to talk to you about the very specific thing that she did at the last minute that threatened to derail this historic legislation. Can you tell us that story? Well, Senator Sinema basically said, I'm holding up this entire bill over one provision in it.

Arizona Senator Kyrsten Sinema wants some changes to that major Democratic spending bill in exchange for her vote. She didn't want to include a plan that would have practically gotten rid of a big tax loophole. This is specifically for the richest business people in private equity, the people who make hundreds of millions of dollars a year. That benefits some of the wealthiest folks in the entire country. She has for a while been skeptical of the measure that's in here that would aim to close or tighten the carried interest loophole. And for her, getting rid of that loophole was effectively the hill that she was going to die on. Seeing as she could single-handedly block this bill, well, Democrats may not have much of a choice. Right. And if she was going to die on that Hill, she was going to kill the entire bill

because, of course, the Democrats need every single senator. Right. Over on Capitol Hill this morning, Democrats appear to have reached a breakthrough on their show. And the Democrats ultimately buckle to her demands. In a statement, Sinema said, we have agreed to remove the carried interest tax provision, protect advanced management... And they get rid of any effort to eliminate this tax loophole. And Andrew, what are you thinking when Democrats cave to Senator Sinema and they say, fine, fine, fine,

we won't touch this tax loophole? What am I thinking? I'm thinking, here we go again. This tax loophole, which I've been writing about since 2007, just won't die. It is never going away. It is the cockroach of tax breaks. And for reasons that remain inexplicable, we are still talking about it today. So, Andrew, tell us about this tax loophole. What is it? So, first of all, it's called carried interest. And what it really means is that a very narrow,

select group of people on Wall Street, at the highest of high ends, have found a way to effectively pay half of what just about everybody else in the world pays on their income at the end of the year. So the richest of the rich today pay about 40% of their income, typically. Right. This group effectively pays half of that, about 20%.

Wow. And the truth of the matter is, it is one of the great inequalities of our tax code. This small group of people have managed to create a loophole that is allowing them to collect billions of dollars a year. And uniquely, it is a gaping hole that is obvious to just about anybody that looks at it. So, Andrew, where does this inequity in the tax code come from? Why does it exist?

Okay, so the best way to understand this is actually a little bit of a history lesson, which is back in 1913, we as a country decided to have two types of taxes on money. One was an income tax on labor. It's what most people pay today on whatever their wages are for the year. Right, the income tax on our salary. The income tax on our salary. But we also created another type of tax called a capital gains tax. And that is a tax on money that people invest.

So once you've made your money, you go invest that money and you pay a lower rate on the profits that you make from money that's invested. And that's called capital gains. And why did the U.S. decide to do that? Why create this second tier of income separate from the kind of universal concept that you're taxed on what you earn as your pay? Well, the concept was that by having a lower rate for investment, it would spur additional investment in the economy. for investment, it would spur additional investment in the economy. Instead of taking your money and buying frivolous things with it, you would put it back into the economy by investing

in businesses and that that would create more growth in the economy. So the second tier, the capital gains tax rate, which is lower, is an invitation from the government to please put your money into the economy. Right. And in theory, right, it's available to any individual who decides to invest. The rich, the kind of rich, the not so rich at all. So long as you invest. Anybody who has some extra money, which means you have to have wealth of some sort, Anybody who has some extra money, which means you have to have wealth of some sort, who can take that money and invest, will be able to capture the lower capital gains rate on their profits.

So what happens after the birth of this capital saw a explosion of investment, both in the stock market and privately. Individuals taking their own money, in some cases bandying together to buy businesses and to buy stocks. And they were beneficiaries of this lower incentivized capital gains rate when they made money. And over time, a lot of these kinds of investments become professionalized in the context of something called private equity. Companies are born to effectively create funds that collect money from different investors, put that money together, and then go buy businesses with them. And this industry, really in the 70s, 80s, starts to balloon. It gets bigger and bigger and bigger. And firms like KKR and Bain Capital and Blackstone and the Carlyle Group emerge during this period and start buying bigger and bigger companies, big name companies that we all know, Neiman Marcus, Hilton Hotels, Toys R Us, J.Crew and others. And what happens once a private equity company buys one of these companies? Well, typically, a private equity firm is trying to buy a company, oftentimes that's distressed, with debt. They hope to fix it up, in some cases, slash cost, which oftentimes means eliminating labor, firing people, and then turning around and trying to sell it at a higher price.

And Andrew, what is all of this, the rise of the professionalized private equity firm and all of the big brands that these private equity firms are buying, what does that have to do with the lower tax tier of capital gains that you have been telling us about? Well, the reason it's so important is because the private equity firms did something very clever, which is the way they structured themselves and they structured their own compensation. They collect 20% of the profits

that they make investing other people's money. Remember, this is other people's money. And yet, they effectively have managed to say that the profits that they get should be taxed at this lower rate, at the capital gains rate that has typically been reserved for people who are investing their own money, not their labor. for people who are investing their own money, not their labor. And the private equity firms are saying, look, this money is at risk. It is just like an investment. And so it should be considered an investment. And therefore, we should collect this lower rate. Having said that, there are a lot of people who have jobs that have a performance element to them. A real estate broker could spend

five years of their life wooing a family, trying to sell a home. It takes them five years to actually sell the home. They finally get a commission. They pay ordinary income tax on that commission. Private equity, after five years, claims that that money should be taxed at this lower rate. Right. You told us that capital gains was reserved for the money that you yourself invest. And now you're saying these private equity managers are using this lower tax rate to pay less taxes on really their income,

which derives from the investment of other people's money rather than their own. So this is just not at all how this was supposed to work. Right. And the government, for years and years and years, has let them do this. Andrew, given that the private equity industry seems to be abusing this entire tax tier of capital gains, are people outraged about this from the very start of the industry?

Well, the truth is, in the beginning, nobody knew it. Nobody understood what was really happening, given how complicated the world of finance often is and how the industry was so, so opaque. Right. It was a secret to most people. But then as the industry grew so large, the secret got out.

We'll be right back. So, Andrew, what happens that finally awakens the world to this tax loophole and to the fact that the private equity world has been exploiting it. Well, at least as I remember it, it was sometime back in 2007, and I was talking to some folks in the private equity industry about taxes. And it was explained to me for the first time that this was how these folks were treating their compensation. That instead of paying the normal rate that everybody else was paying, they were paying 20% lower. And I thought this was something I'd never heard before. And I thought to some degree, the public would be outraged. And so I wrote about it in a column. Now, at about the same time, there was a professor named Victor Fleischer, who had actually written an academic paper on it that started to get passed around Washington and

elsewhere, where he really sort of walked through the dynamics of what was happening. And this idea that carried interest was perverting the tax system and that some of the richest people in the country were benefiting in ways that most of us didn't even realize. And once his paper started to circulate and we started to write about it in the newspapers, Congress woke up and said, oh my. Carried interest deductions, they should be paying their fair share of taxes like all Americans. And the fight over carried interest has been taking place practically ever since. I think it's odd that people making that much money off of essentially labor income should be paying lower rates than the average, than their secretaries, to put it boldly. How about increasing taxes on a person that made $3.6 billion in a year

and pays 15% income taxes? How about if you pay the same kind of taxes everybody else in this country pays? And it wasn't just Congress. It was a raft of Wall Street executives who actually had every incentive in the world to stay quiet actually came out publicly against it to say this is crazy. And this makes absolutely no sense. You had people like Warren Buffett come out against it. Believe me, it's just it's it's an occupation. And if you believe in taxing people as earned income on their occupation, I think you should tax people of carried interest. This is an abuse of the tax system.

Right. So suddenly, Andrew, this loophole is very clearly under attack. There's legislation that means it might go away. So what is the response from the world of private equity? I assume it's not happy. Well, while the rest of the world is lambasting carried interest, the industry itself goes into high gear to defend it. They create a trade group in Washington. They start lobbying. They make massive donations to candidates in both parties,

not just to candidates in their own states, but to candidates all across the country to try to protect this loophole for themselves. And Andrew, what is their argument? As they're making these donations, setting up this trade group, what is their case for defending the carried interest loophole in the face of this onslaught?

Well, initially, in truth, they just tried to confuse the situation by conflating the profits that they were making for themselves with the profits that they were making for their investors and saying they're basically the same thing and therefore they should be taxed at the same rate. But they moved from that argument to a very different one. What is private equity? Private equity makes an enormous contribution to the U.S. economy. Which was to really change the face of what private equity is to the public.

Think of the innovative software company downtown. It has a bright future. Which is to say that they are on the side of the little guy. Think of the local factory that has been shedding jobs for years. That they are on the side of small businesses because they are investing in small businesses. How does the innovative software company grow or the struggling factory turn around? By partnering with private equity. And they're investing money on behalf of the little guy. They're investing pension money for firefighters and for teachers. The end result is a dynamic growing company, new jobs, better products, and economic benefits that ripple throughout the U.S. economy. And they're saying, look, if you take away this tax incentive, it's going to hurt all of that.

That's private equity at work. with their ability to keep people employed at the companies they own or get good returns for the firefighters awaiting their pensions in New York City or any other city? Not at all. Completely disingenuous. Because the truth is the tax treatment for the private equity executive doesn't change the returns that a pension fund or somebody who invests with a private equity firm is going to be receiving. It's only going to impact how much money the private equity executive gets themselves at the end of the year.

In other words, private equity firms are not going to suddenly have less incentive to turn a profit just because they get taxed on their salary like everybody else. And we're talking about such large quantities of money that private equity managers are still going to be paid extremely well. They would be taxed more on those huge payments, but their pay is still stratospherically high compared with everybody else. Got it. So what happens next in this saga? So the campaign by the private equity industry gets put to the test. And this happens in 2010. Under Obama, Democrats put forth a plan to try to close the carried interest loophole. Okay. And it actually passes the House. And it actually seems at that point that it's going to go away. It seemed almost like such a gaping hole to so

many people that it was going to be gone. Democrats, they're going to get rid of the carried interest loophole. But as you would imagine, private equity goes into high gear and starts donating money left and right to senators and candidates across the country. And Democrats just can't get enough votes. They can't get 60 votes to get rid of this loophole. And it's not like all of a sudden there are senators defending the loophole. It's just that everybody goes quiet. So carried interest survives. It survives and actually survives a very long time before it becomes a political issue all over again and becomes a political issue from the most unlikely place.

Mr. Trump, you have two minutes. Donald Trump. Well, one thing I do is get rid of carried interest. One of the greatest provisions for people like me, to be honest with you. During his 2016 campaign, he actually campaigns against the loophole. I would change it.

They're paying nothing, and it's ridiculous. The hedge fund guys are getting away with murder. They're making a tremendous amount of money. They have to pay taxes. He says it's unfair. He says he doesn't like it. He says it makes no sense. And he says that he is going to get rid of it

if he gets in office. That's very interesting because, of course, Donald Trump, very famously, does not like to pay taxes. That's why I said it was from a very unlikely place. It will be simple. It will be easy. It will be fair. Some of the very unfair deductions that certain people have been given who make a lot of money will not be available any longer. And, of course, he gets elected into office. And of course, he gets elected into office.

Got it. So we're in a familiar place on the cusp of Congress getting rid of the carried interest tax loophole. Right. And it's like deja vu all over again. Now, the private equity industry goes into overdrive, really super drive this time, to try to keep that tax loophole. They fight, they fight, they lobby and lobby, and eventually they win. There was a small tweak that was made to it, but really just a watered-down tweak, but it essentially survives intact. And this was a big disappointment to politicians and a lot of Americans on both sides of the aisle who thought that this was the moment that this Leupold would finally die. So another bullet dodged,

which I think, Andrew, brings us to today and what happened with Senator Sinema. She single-handedly kills the latest effort to close this tax loophole. And what is her argument for doing that when she does it last week? She basically adopts the talking points of the private equity industry. She says that eliminating carried interest would hurt the small businesses that she represents

in Arizona. She thinks it's going to hurt job growth. She praises the private equity industry for its investments in her state. But of course, Andrew, as you've already told us, how private equity companies are taxed really has nothing to do with how the companies they own are performed or how much money they're going to be investing in a place like Arizona. Correct. Okay, so I have to ask, how much money has Senator Sinema gotten from private equity firms and trade groups?

A lot. So the industry is some of her biggest donors. And by the way, there are not a lot of private equity firms that are based in Arizona. Right. So these are private equity executives that are in New York that are paying her money. And in fact, the Associated Press just put out a report showing that she received $983,000, almost a million dollars, just since last summer from the private equity industry. That's a tremendous amount of money. Yeah. So if they are in her biggest donor,

they are very, very close. And for them, clearly she was the linchpin. Right. And she delivered. Yes, she did. So Andrew, for the foreseeable future, this loophole looks like it's safe. It's the tax break with nine lives. It's spared under Obama. It's spared under Trump, now spared under Biden. And so private equity managers will go on making millions of dollars a year, in some cases tens or hundreds of millions of dollars a year, that are taxed at this much lower rate in a way that almost everybody agrees is not fair. So I'm curious what you think will be the long-term consequence of that and of this loophole being unkillable. and of this loophole being unkillable? Well, look, there's the practical cost, which is that it's estimated that closing the loophole would bring in $14 billion over 10 years

that could otherwise be used for social programs, education, you name it. In many ways, though, there's an even bigger, almost philosophical implication, and that's about the damage that a loophole like this does to the basic sense of fairness in our country for many Americans. If you think of it as a demonstration of what a meritocracy is supposed to look like, of our democracy really, the idea that this loophole exists and is as big and gaping and galling as it is, just creates even more distrust in the system. You know, the way the tax code's supposed to work,

the wealthiest are supposed to pay the highest percentage of their income. Right. So when the wealthiest are paying less than most of us in taxes, it just creates an even greater sense that the system is rigged. Well, Andrew, thank you very much. It's great to be here, Michael. Thank you. We'll be right back. Here's what else you need to know today.

The Times reports that a lawyer for former President Trump signed a written statement in June claiming that all classified material held at Trump's home in Florida had been returned to the government, a claim that turned out to be false. FBI agents found multiple sets of classified documents at Mar-a-Lago when they searched it last week, including some marked top secret. The fact that Trump and his lawyers claimed they had returned those documents when in fact they hadn't, may explain why the FBI warrant used to conduct the search cited a criminal statute related to unlawful obstruction.

And police say that Friday's attack on the author Salman Rushdie, who was repeatedly stabbed on stage during an event in New York, was premeditated and targeted. Rushdie was severely injured but is expected to survive. The author has been living under the threat of assassination since 1989 when he published the novel The Satanic Verses, which some Muslims consider blasphemous because of its depictions of the Prophet Muhammad. Today's episode was produced by Ricky Nowetzki, Luke

Vanderplug, and Diana Wynn. It was edited by Liz O'Balin, contains original music by Marian Lozano, Dan Powell, and Rochelle Banja, and was engineered by Chris Wood. Our theme music is by Jim Brunberg and Ben Landferg of Wonderly. That's it for The Daily.

I'm Michael Barbaro. See you tomorrow.