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Wall Street needs to give up its bargain tax rates

February 8, 2012: 5:00 AM ET

Investment managers have held on to it for years, but 'carried interest' carries an odious loophole that needs to go.

FORTUNE -- Politics has moments when it's actually useful. Case in point is the uproar over Mitt Romney's tax returns, which may help rid us of a small but noxious and symbolic loophole worth several billion dollars a year to managers of investment partnerships.

I'm talking about "carried interest" -- finance-speak for investment managers' piece of their investors' profits. Much of Romney's income derives from that source. Even though he left Bain Capital in 1999, Romney still collects a chunk of Bain's piece of the profits realized by investors in the firm's buyout funds. Because tax law treats carried interest as a piece of a partnership rather than as a (fully taxable) fee, Romney's carry gets the same tax treatment that the funds' investors get: as long-term capital gains, taxed at 15%.

The outrage generated by Romney's returns has produced real pressure to eliminate the loophole, which is so offensive to common sense and public morality that even Pete Peterson, retired co-founder of the Blackstone buyout firm (BX) and current deficit hawk, wants it closed. (Peterson isn't offering to return the zillions the loophole saved him, but, hey, we can't have everything.)

The carried-interest crowd has managed to fend off reform for years with a behind-the-scenes narrative that goes like this: If we make carried interest fully taxable, some investment managers will retire or turn to other pursuits (croupiers? toll collectors?), and the economy will suffer from reduced investment. The second argument is that closing the loophole is futile, because managers will offset their higher taxes by charging their investors more.

Pardon me for snickering, but both those arguments are nonsensical. Kohlberg Kravis Roberts (KKR), the first major buyout firm, began operation in 1976, when the capital gains rate was 35% and the top rate on regular income was 70%. Its principals were ready to pay 35%, today's top personal rate, on their carry. Texas Pacific Group set up shop in 1992, when the top personal rate was 31% and the cap gains rate was 28%, barely a difference at all.

So the idea that managers will find another profession if they have to pay more than 15% on their carry is silly. Ditto for the idea that the deep-pockets types who invest in buyout funds will meekly accept lower profits in order to allow fund managers to maintain their lifestyles.

Finally, there's no indication that carried interest rates vary with tax rates. The tax on cap gains has been 15% since 2003, down from 20% in 1997 and 35% in 1976. Did managers reduce their carry when their tax rates dropped? Somehow I doubt it.

There's one additional benefit managers get from treating carried interest as capital gains: They can offset it with capital losses, as Romney clearly did in 2009. His 2010 return shows he had a net capital loss in 2009, which means that any carry income he got was totally offset by losses. By contrast, you can offset only $3,000 a year of regular income with capital losses. (Romney's campaign declined comment.)

Please don't think I'm picking on the buyout barons. I think all carried interest -- hedge funds, venture capital, real estate, energy, anything else -- should be treated as what it is: a fully taxable fee, not investment income.

It's not clear how much money we're talking about. Congress's Joint Committee on Taxation puts the carried-interest loophole at $1 billion to $2 billion a year. That seems low -- but even if it's $5 billion, it's barely a rounding error in our budget deficit. However, it's a huge deal for the affected managers -- and closing a loophole for the ultra-rich is important symbolically.

In an ideal world closing the carried-interest loophole would be only the first step in a total tax reform. And we would close the loophole properly. Some reform efforts that stalled would not only have closed the loophole, but would have also done something I think unfair: treated any profit on sale of any stake in investment management partnerships as ordinary income rather than capital gains.

But in this less than ideal world, I'll settle for carried interest being carried out feet first. And be happy that a political campaign has done something useful.

--Reporter associate: Doris Burke

This article is from the February 27, 2012 issue of Fortune.

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About This Author
Allan Sloan
Allan Sloan
Senior Editor at Large, Fortune

Allan Sloan, who has been writing about business for more than 40 years, joined Fortune in July of 2007. Before that, he was the Wall Street editor for Newsweek for 12 years. His work also appears in The Washington Post. Allan is a seven-time winner of the Loeb Award, business journalism's highest honor, receiving awards in four different categories for five different employers. He is a graduate of Brooklyn College and has a master's degree in journalism from Columbia University. He and his wife live in New Jersey. They have three grown children.

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