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What is the carried interest loophole, and why doesn’t Romney want to close it?

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In an interview in Fortune Tuesday, Mitt Romney ducked a question about whether he'd close the "carried interest loophole," which allows hedge fund managers and other executives at investment firms – such as Bain Capital executive Mitt Romney – to pay lower capital gains tax rates on their wages, rather than the regular income tax rates.

"What I've said in the past is that if something is a capital gain it should be treated as a capital gain," Romney responded. "If something is ordinary income it should be treated as ordinary income."

But that's exactly the issue -- are the earnings of hedge fund and private equity executives ordinary income, or are they capital gains? In the past, the Romney campaign has signaled that Romney wants to repeal the deduction, indicating he thinks the executives' earnings are ordinary income, not capital gains. But the question isn't clear-cut.

Typically, if you draw a wage — you work at a company, get a paycheck, etc. — that's counted as ordinary income, whereas if you buy an asset like a stock or house and then sell it for more than what you paid, that's a capital gain, taxed at a lower rate. Currently, the top capital gains rate is 15 percent, set to increase to 18 percent if the Bush tax cuts aren't extended. Compare that to the 35 percent current top income tax rate, or the 39.6 tax rates if the tax cuts expire.

The lower tax rates on capital gains are meant to encourage investment. While some, like Joel Slemrod of Michigan (pdf) and Jared Bernstein at the Center for Budget and Policy Priorities, have cast doubt over whether lower capital gains taxes actually spur investment, others, such as Alan Viard of the American Enterprise Institute and Martin Feldstein of Harvard (pdf), have made the case that it's economically useful. But if you're a hedge fund manager or the head of a private equity firm, investment is your job. Your firm's profits and losses are solely a function of how good the investments you make are. Thus many such executives choose to be paid a proportion of that investment income rather than a standard wage, so that they can benefit from the much-lower top rates on capital gains.

Senate Democrats have tried and failed to force these executives to pay normal income tax rates in recent years, a change that would bring in about $17.7 billion in new revenue over 10 years. The argument for the change is that this income is effectively a salary and should be taxed as such. What's more, if you doubt that lower capital gains rates spur investment, it's unclear that there's a big economic downside to boosting rates on hedge fund managers. It raises a bit of revenue and corrects a system that looks unfair on its face. But some, like Viard, argue that the tax preference is justified for the same reason lower capital gains rates in general are. Jim Manzi of the Manhattan Institute has argued the change would be easily evaded by hedge funds and other affected firms reorganizing as different kinds of companies for tax reasons.