Obama Could End the Hedge Fund Tax Loophole By Himself ... If He Wanted To

One proposal for Obama's Legacy Library, a building that won't build itself (view 1, discussed here).

by Gaius Publius

Turns out that the president, currently Obama, acting alone, could personally end the egregious "hedge fund tax loophole," the one only a certain class of wealthy person qualifies for. Most people think it would take an act of Congress. Not according to an excellent piece by the excellent Gretchen Morgenson, writing in the New York Times:

Ending Tax Break for Ultrawealthy May Not Take Act of Congress

By GRETCHEN MORGENSON MAY 6, 2016

... There is a lot about [the] problem of income inequality — and about the economy over all — that Mr. Obama cannot control. Still, there is something he could do right now to help narrow the widening gulf between rich and poor.

In one deft move, Mr. Obama could instruct officials at his Treasury Department to close the so-called carried interest tax loophole that allows managers of private equity and hedge funds to pay a substantially lower federal tax rate on much of their income.

And that's all you need to know. With an order, Barack Obama could end the carried interest loophole that allows private equity and hedge fund managers to cap the nominal tax paid on earnings at 15%, before deductions and any other avoidance is applied.

What Is the "Carried Interest Loophole"?

A brief explanation from the piece, so you have an idea how this income is treated by the IRS and ultimately, by the Treasury Department. Morgensen again:

Managers of hedge funds and private equity funds receive two types of payments. One, paid annually, represents a percentage of assets under management, usually around 2 percent. Those earnings are taxed as ordinary income.

But these managers also receive 20 percent of gains that their funds generate over time, known as carried interest. These profits are taxed at the lower capital gains rate, thanks to a 1993 ruling by the Treasury and the Internal Revenue Service.

Closing the loophole, tax experts say, would involve characterizing both the 20 percent and the 2 percent as income from services rendered.

In a 2008 paper, “Two and Twenty: Taxing Partnership Profits in Private Equity Funds,” and in a follow-up paper published last year, Mr. Fleischer described the current carried interest tax treatment as a conversion of labor income into capital gain, an “anomaly that was contrary to some generally accepted principles of tax policy.”

Converting labor into salary gain is what most of us do when we work, but we don't earn  the billions it takes to buy an exception. And yes, we are looking a billion-dollar incomes here. (Before we move on, keep this in mind, that this generosity is "thanks to a 1993 ruling by the Treasury and the Internal Revenue Service" and not thanks to some law that Congress would need to unwind. Wonder who was president in 1993...)

Billion-Dollar Salaries

Two items to note. First, "private equity" firms used to be called "leveraged buyout" firms until the name "leveraged buyout" became too toxic. (It still should be toxic.) LBO firms rebranded themselves so that they'd be grouped with the much more likeable "venture capital" firms.

Second, we're talking about real money in this world, seriously real money. Here's an estimate of the salaries of the top five hedge fund managers, according to Barry Ritholtz:

1. David Tepper, Appaloosa Management — $4 billion 
2. George Soros, Soros Fund Management — $3.3 billion 
3. James Simons, Renaissance Technologies — 2.5 billion 
4. John Paulson, Paulson & Company — $2.3 billion 
5. Steve Cohen, SAC Capital Advisors — $1.4 billion 

I hope you're seeing the "b" as in "billion" next to the numbers. These are "salaries" according to Ritholtz, and yet they are treated as "carried interest" by current tax regulation — again, not law, regulation — and taxed at no higher than 15%. This is what Warren Buffet means when he says that his secretary pays a higher tax rate than he does.

Can you imagine earning $4 billion dollars in a year, personally earning it? (Here's what that looks like in numbers — $4,000,000,000 per year.) Now can you see them twisting the arms of the Executive Branch whose presidents they put in office for the express purpose of keeping their taxes lower than their secretary's, all in the hunt for even more money than the $1 to $4 billion they just earned? Seems a little ... monomaniacal, a little pathological ... to me. ("Pathological" is Jeffrey Sachs' term.)

Which brings me to the next point.

If Obama Could Do This On His Own, Why Doesn't He?

Morgensen, a first-rate reporter, has surveyed a number of experts, most of whom are certain that since this is a "regulation" and not a law, it can be rewritten within the Executive Branch:

But doesn’t changing the carried interest loophole require an act of Congress? Not according to an array of tax experts. Just as Mr. Obama’s Treasury Department recently changed the rules to curb corporate inversions, in which companies shift their official headquarters to another country to lower their tax bills, the Treasury secretary, Jacob J. Lew, and his colleagues could jettison the carried interest loophole.

Alan J. Wilensky is among those urging such a change. He was a deputy assistant Treasury secretary in charge of tax policy in the early 1990s when the carried interest loophole came about.

“This is something President Obama can do and should do,” Mr. Wilensky said in an interview. “This is not an impossible thing to get done.”

Now a lawyer in Minneapolis, Mr. Wilensky recently wrote an article on this topic for Tax Notes, the definitive publication on national and global tax issues.

Victor Fleischer, a law professor at the University of San Diego, is another who has recommended that the Treasury get rid of the unjust tax treatment on carried interest. Mr. Fleischer, a contributor to The New York Times, has also estimated how much money such a change would bring to the Treasury.

“It’s something that Obama could accomplish and, to be honest, I’m not entirely sure why the Treasury hasn’t taken an interest in it,” Mr. Fleischer said in an interview. “In fact, there is quite a bit of revenue at stake. And doing this on carried interest would cement Obama’s legacy in substance as well as symbolically.”

There's a lot of opinion that this 1993 IRS ruling could be reversed by Obama alone. Yet he keeps trying to go to Congress to get it changed, instead of just changing it himself. Morgensen quotes Treasury Dept. spokesperson Rachel McCleery:

“The president’s first budget in 2009 — and every one since — has included a proposal to close this unfair loophole and we’ve been pushing Congress to get it done,” she added. “No one should be able to play by a different set of rules, so it’s time for Congress to act to close the carried interest loophole once and for all.”

The only piece of disingenuity in the entire article is around this point. In her introduction (not quoted here), Morgensen attributes to Obama genuine concern about income inequality. Reversing income inequality require wealth redistribution, and that involves the tax system. There's no way around it.

So why would Obama ask Congress to change what he could change himself? Perhaps because Congress is a great place to send things you never want to happen. Congress is where bills that make the one-percent of the One Percent unhappy ... go to die.

And why might Obama want the proposal to die? Because, as Morgensen correctly says, he really does have his eye on his legacy and his post-presidential future. Part of that future is pictured above, and legacy libraries don't come cheap. I suspect you'll see an Obama Legacy Foundation at some point, and foundation donations don't come from people with no money to donate. I'll leave you to suss out the rest.

What Would Sanders Do?
 

A thought:  That the danger represented by Bernie Sanders — to DC Democrats and Republicans alike, the bipartisan consensus — is not what he couldn't do, but what he could do. Just as a President Sanders not only could break up the big banks, but would do it — a President Sanders would direct his Treasury Secretary to end this loophole immediately, or whatever "immediately" means in regulation-speak.
As Morgensen points out:

During the current presidential campaign, all three remaining candidates — Bernie Sanders, Hillary Clinton and Donald Trump — have called for eliminating [this loophole].

When one of these people is elected, we'll find out if that new president is sincere in eliminating this loophole, or just blowing campaign smoke.

GP