(Think Congress should do something about it?)

by Rebecca Wilkins and Joan Entmacher

Tomorrow, the Senate Finance Committee is holding a hearing with the unbelievably boring title of “Carried Interest, Part I.” But before you yawn and ignore this hearing (or this post), consider this:  CEO Stephen Schwarzman reportedly will receive as much as $677 million from the “carried interest” he receives for managing The Blackstone Group, which went public last month. That’s an impressive amount of money—but the real kicker is that he’ll only pay 15% federal income tax on that income. That’s the same tax bracket that a single worker is in if she earns between $16,575 and $40,600 (assuming she claims the personal exemption and standard deduction).  A single worker earning between $40,600 and $85,850 is in a 25% bracket.

And Schwarzman’s not alone in earning unimaginable sums of money—and paying taxes on those earnings at a lower rate than millions of middle-class workers. Top hedge fund managers, some earning over $1 billion a year, also manage to pay tax on most of their income at just 15%.

How is this possible?  Two words:  capital gains. 

Currently, the highest tax rate on capital gains income is 15%, while the highest tax rate on “ordinary earned income” is 35%.  This 20 percentage point difference creates a lot of incentive to try to turn ordinary income from earnings into capital gain.  And super-wealthy private equity managers have learned to be creative.  The typical fee arrangement pays the managers an annual fee of about 2% of fund assets (taxed as ordinary income) and a 20% share of fund profits—the carried interest.  The payments of income from the “carried interest” are taxed as capital gains, rather than as ordinary income—so managers pay only 15% federal income tax instead of 35% on the larger part of their compensation.

What does the “carried interest” tax loophole mean to Mr. Schwarzman?  It means he will pay $101,550,000 in federal income tax instead of $236,950,000 in tax on the $677 million he is expected to make—a savings to him of $135,400,000. That would help him throw an even bigger bash for his next birthday. What else could $135.4 million in tax revenues buy?  Head Start services for nearly 19,000 additional low-income children, or health insurance coverage for an additional 90,000 children, or family planning services for as many as 1 million additional families.

Some members of Congress are starting to go after the private equity tax loopholes.  Rep. Sander Levin (D-MI), along with Ways and Means Committee Chair Charles Rangel (D-NY) and House Financial Services Committee Chair Barney Frank (D-MA), introduced a bill (HR 2834) to treat income from carried interests as compensation and tax it as ordinary income. Senate Finance Committee Chair Max Baucus (D-MT) and ranking member Charles Grassley (R-IA) introduced a bill (S. 1624) that would tax as corporations publicly traded partnerships that derive their income from investment advising or management services, such as the newly public Blackstone Group.  Most publicly traded partnerships are already taxed as corporations.

Predictably, the private equity industry has lined up well-connected lobbyists to fight the bills, and the White House has already announced that it opposes both measures.  We hope that Congress takes a stand for tax fairness.  But they need to come up with a better title for their next hearing:  “The Billionaires’ Tax Loophole, Part II” perhaps? Or, "Should ‘Masters of the Universe’ Pay Taxes Like the Rest of Us?"