IF POLITICAL rhetoric alone killed tax rules, a favor to the rich known as the carried-interest loophole would have been dead and buried long ago. In a nutshell, this particular break enables hedge-fund managers and similarly situated wealthy investment professionals to pay only the 23.8 percent federal capital gains rate on much of their annual earnings, instead of the 39.6 percent ordinary income rate. Everyone in politics — from Sen. Elizabeth Warren (D-Mass.) on the populist left to President Trump on the populist right — has denounced this giveaway, which costs the treasury roughly $2 billion per year.
Yet somehow it survives. President Barack Obama opposed it but balked at repealing it via executive order, though some legal experts think that’s possible; meanwhile, Congress has not enacted repeal, pending a broader tax-reform bill that would supposedly sweep out unjustifiable loopholes.
Of course, it is also possible to abolish carried interest in the process of making the tax code considerably less fair overall. That is the apparent approach of Mr. Trump’s recently floated proposal for a tax overhaul, albeit by implication. Mr. Trump would abolish the carried-interest loophole — then instantly render that irrelevant: His plan lowers the top tax rate on all businesses — those incorporated as shareholder-owned enterprises, which currently face a top rate of 35 percent, and so-called pass-through entities, whose profits are taxed at their owners’ ordinary income rate — to 15 percent. Obviously, hedge funds could simply reorganize as pass-through entities to pay the 15 percent rate, an even sweeter deal than the 23.8 percent they pay on carried interest now.
Steven Mnuchin, Mr. Trump’s treasury secretary, promised unspecified “rules” to prevent excessive tax avoidance, but they’d have to be strong rules indeed to overcome these incentives. House Republican tax plans would not cut the top business rate to 15 percent, but they could give rise to some pass-through mischief of their own. The GOP proposal unveiled last year would have cut the top individual rate on ordinary income to 33 percent, while capping the rate on pass-through businesses at 25 percent. In other words, it would create a new incentive — to the tune of an eight-percentage-point-lower tax rate — for taxpayers to recharacterize their earnings as business profits. If you think that won’t happen very often, think again: When Kansas created a similar differential in its state income taxes five years ago, nearly 400,000 filers took advantage of it, according to the nonpartisan Tax Policy Center. The resulting loss of hundreds of millions of dollars in revenue helped create the chronic fiscal crisis that has roiled that state in recent years.
In short, tax reform can be a good cause or a license for mischief — something to keep in mind the next time you hear the president trumpeting his opposition to carried interest.
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