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This tax loophole allows hedge funds to pay a lower rate than middle-income Americans

AYESHA RASCOE, HOST:

The Inflation Reduction Act that Joe Manchin agreed to would also narrow but not completely close a tax loophole that benefits private equity and hedge funds. It's called carried interest, and both Democrats and Republicans have promised to do away with it for years. Now, I know what you're thinking. What in the world is carried interest? That's why we called Steve Rosenthal. He's a senior fellow at the Urban Institute's Tax Policy Center, and he joins us to explain how this loophole works. Welcome.

STEVE ROSENTHAL: Well, thank you. I'm happy to be here.

RASCOE: So, OK, let's start with the obvious. What is carried interest?

ROSENTHAL: Well, carried interest is compensation to a fund's managers for managing the fund. Some are hedge funds - most commonly private equity funds. The fund's managers do a whole bunch of things - taking in money, finding investments for the money, managing the assets that the fund purchases and then eventually distributing the money. And a carried interest, also known as a profits interest, allows the fund's managers a share of the profits of the fund. And that's very valuable from a tax standpoint in terms of compensation because a carried interest, a profits interest, is taxed at a top rate of, say, 20% compared to top rates of 37% for ordinary income.

RASCOE: OK. And that's what the loophole is?

ROSENTHAL: Yes. Profits, or capital gains, often are taxed at lower capital gains rates, which are 20%. And a carried interest, which entitles the private equity manager to share in those profits - those are reported at 20% top rates.

RASCOE: So 20% versus 37%. So that's a big difference. That's a lot of money, especially with millions of dollars. That's a lot of money.

ROSENTHAL: Oh, there's a lot of money at stake. Some of the richest Americans have made their fortunes by earning carried interest, especially through private equity funds.

RASCOE: Let's say they do close it. How much more money would this actually mean for the U.S. government?

ROSENTHAL: It's hard to estimate precisely because there's a lot of opaqueness to private equity. But Congress' experts project that over the next 10 years, Congress could raise, say, $14 billion, at least for the carried interest proposal that's now being debated on Capitol Hill.

RASCOE: Fourteen billion dollars. I mean, that's nothing to sneeze at. The federal government probably, you know, has that under some couch cushions. But it's nothing to sneeze at. And, you know, it's American tax dollars, right?

ROSENTHAL: Right. But there's also the principle at play. Why should the wealthiest Americans who manage private equity funds structure their compensation to pay a tax rate lower than nurses and teachers and police officers? And that unfairness, that principle at stake, has captured the American public. I'm surprised how many of the public now understands there's a carried interest loophole out there.

RASCOE: Are there arguments against closing this loophole?

ROSENTHAL: That the risk-takers, the entrepreneurs - they are entitled to pay fewer taxes because they're making the world and our economy better for all of us. I don't buy it. These private equity managers make phenomenal amounts of money. If you look to the Forbes 400 list, you find it populated by many private equity and hedge fund managers. And so I'm not really concerned that taxing them at regular rates will somehow dampen their economic fortunes or their enthusiasm. That strikes me as a stretch.

RASCOE: If lawmakers have been looking at doing something about this carried interest loophole for a long time, why hasn't it been done yet?

ROSENTHAL: Well, that's the problem of our current political system. It's very hard to take on special interest. And the private equity managers spend tens of millions of dollars every year lobbying against closing the carried interest loophole. Every presidential campaign since 2008 has had on the platforms closing carried interest loophole, yet it persists. In 2017, Congress actually did something. It narrowed the carried interest loophole, making it a little harder for the managers to avail themselves of the lower tax rate. But Congress left a lot of loopholes, and it wasn't nearly good enough. The pending provision is much better, and it closes many of the loopholes that exist under present law with the carried interest provisions in the tax code. Still more I'd like to see done, but we're moving in the right direction.

RASCOE: Steve Rosenthal of Urban Institute's Tax Policy Center, thank you for being with us and breaking down this complex subject, which I now understand.

ROSENTHAL: Yeah. Thanks for tackling tax.

(SOUNDBITE OF SAMMY BURDSON'S "NEWS BACKGROUND A") Transcript provided by NPR, Copyright NPR.