Carried Interest: Obama Takes Aim at Wall Street's Second Favorite Tax Loophole

On Sunday, President Obama took aim at what many believe to be a long overdue target: the carried interest tax rate. Suggesting that "smart spending cuts" could reduce the deficit and make it possible to increase education funding, he proposed a closing more tax loopholes, cutting more government waste, and reforming some too-costly health programs. The centerpiece of his proposal, however, was an end to certain key tax loopholes, notably carried interest -- a tax break that almost exclusively benefits high-income investors and money managers.

Carried interest has been in and out of the headlines for months, thanks in large measure to GOP presidential nominee Mitt Romney, who had made good use of it for many years.

For all the confusion surrounding carried interest, the lucrative tax loophole is actually fairly simple: Instead of taking a straight salary, many hedge fund managers and other investment advisers receive a percentage of the money that their funds generate. Because their lavish compensation comes from investments, it's not treated the way your salary is: It's taxed at the capital gains rate -- previously 15 percent, now 20 percent -- rather than at the significantly higher income top tax rate: 35 percent until last year, 39.6 percent as of 2013.

This amounts to a huge tax break; For example, it was largely responsible lowering Mitt Romney's real tax rate in 2010 to a fiscally rewarding (but politically devastating) 13.9 percent. Overall, the ability to use the carried interest tax rate saved up to 20 percent of his considerable income from the IRS.

It's important to separate the carried interest tax rate from the capital gains rate. In the latter case, there's a clear case to be made as to why the lower rate exists: By offering investors a tax break on the money they make in the market, the tax code encourages investment. This should, in theory at least, translate into more money being poured into the American financial system and, eventually, into American businesses.

Fans of the capital gains and dividend tax rates also point out that, often, the money being invested in the market has already been taxed once at the higher income tax rate. After all, if someone invests his or her nest egg in the market, the money was probably taxed when he or she earned it. For that matter, investments often fail, so -- they claim -- investors should be offered an additional enticement to put their money at risk.

There are certainly arguments to be made against these ideas, but for the purposes of discussing the carried interest tax break, let's assume for a moment that, with regards to the capital gains and dividend tax rates, they're completely legitimate. Even if one wants to argue that the value of providing liquidity to a risky market justifies a hefty tax break for big-ticket investors, the carried interest tax break still makes little sense.

Unlike investors, the hedge fund managers who get the carried interest break aren't investing their own money. They haven't paid income tax on it, and they don't stand to lose their hard-earned cash if their hedge funds fail. In short, they are being taxed as if they are taking a risk, when they aren't risking anything.

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Not surprisingly, for Obama -- and, indeed, for anyone looking to reform the tax code -- carried interest is a very easy target. Congress' Joint Committee on Taxation estimates that abolishing carried interest would generate $16.8 billion over ten years.

And what of investors? In 2011, Warren Buffett railed against the carried interest and capital gains tax rates. "I have worked with investors for 60 years and I have yet to see anyone -- not even when capital gains rates were 39.9 percent in 1976-77 -- shy away from a sensible investment because of the tax rate on the potential gain," he said. He then went on to note that the comparatively high taxes of the 1980s and 1990s produced "40 million jobs," while the post-2000 tax breaks ultimately resulted in "far lower job creation."

Following so quickly on the heels of January's tax increase, it seems unlikely that the carried interest rate will go up without a huge fight. That having been said, it's hard to explain why millionaire hedge fund managers should pay a lower tax rate on their wages than waitresses. And for a Republican party that is trying hard to reach out to moderate voters, carried interest seems like an unwise place to draw a line in the sand.

Bruce Watson is a senior features writer for DailyFinance. You can reach him by e-mail at bruce.watson@teamaol.com, or follow him on Twitter at @bruce1971.