Edward J. McCaffery and Darryll K. Jones offer an engaging explanation for the lack of progress in closing the carried interest loophole in The Curiouser and Curiouser Case of Carried Interests. This well-known loophole—which has been analyzed extensively in the literature—allows top hedge fund and private equity managers to pay tax on service income at the lower rate afforded long-term capital gains. The article draws on earlier scholarship by each of the co-authors and provides an updated account of the decades-long lack of progress in closing the loophole.
In 2006, McCaffery and Linda Cohen published Shakedown at Gucci Gulch: The New Logic of Collective Action, 84 N.C. L. Rev. 1159 (2006). That 2006 article drew on Mancur Olson’s 1965 book, The Logic of Collective Action, which theorized the conditions required for special interest lobbyists to overcome collective action problems and wield outsized legislative influence. McCaffery and Cohen posited that Olson’s framework did not adequately explain the shenanigans surrounding estate tax repeal. Instead of legislators being the dupes of special interest groups, legislators were engaging in extortionate brinkmanship to increase campaign contributions from the special interests with the most to gain (or to lose) from estate tax legislation. As McCaffery and Jones summarize in their article, the game is “reverse” Mancur Olson because “legislators come first, special interests second.”
In 2008, Jones published The Taxation of Profit Interests and Reverse Mancur Olson Phenomenon, 36 Cap. U.L. Rev. 853 (2008), and applied the McCaffery and Cohen’s reverse Mancur Olson framing to the carried interest loophole. McCaffery and Jones explain that Jones’s 2008 article “was rather more sanguine” about the likelihood that the carried interest loophole would be closed soon than McCaffery and Cohen had been about estate tax reform.
But, as McCaffery and Jones observe, “Flash forward 15 years, and here we all are: still talking, and still not doing much, about carried interest.” The co-authors use the details of those subsequent years of “carried interest capers” to make a compelling case that congressional failure to close the carried interest loophole flows from legislators’ desire to reap campaign contributions.
The article deliberately refrains from making the normative case for removing the loophole. It suggests, however, that such efforts by others (noting in particular the influential work of Victor Fleischer and his key article, Two and Twenty: Taxing Partnership Profits in Private Equity Funds, 83 N.Y.U. L. Rev 1 (2008)) helped set the stage for legislators, at times aided and abetted by the executive branch, to be able to use plausible threats of closing the loophole as a tool for fundraising.
Internal Revenue Code § 1061 provides one curious example in the history of carried interest (in)action. This Code provision was enacted in 2017’s Tax Cuts and Jobs Act under the first Trump administration. Section 1061 applies only to private equity and hedge fund managers. It does not, however, get into the “maze of subchapter K” partnership tax rules to prevent managers from using longstanding IRS guidance to convert service income into preferential capital gains. Instead, § 1061 operates, in essence, to increase the holding period required for the preferential tax rate from more than one year to more than three years. As McCaffery and Jones explain, however, by 2010—seven years before § 1061 was enacted—the average holding period of such interests was 3.8 years and rose to 5.4 years by 2020.
In presenting the history of § 1061 as a case study of the reverse-Mancur Olson phenomenon, the article highlights three essential ingredients. First, there must “be one or more small groups with high stakes” and money to spend. Private equity and hedge fund managers clearly fit this bill. As the authors notes, the top 25 fund managers in 2022 together raked in $21.5 billion, and a “13.2% tax break (from 37% to 23.8%) is worth $132 million annually” per $1 billion dollars.
Second, “there must be plausible legislative action, for who would pay without threat of pain or promise of benefit?” And third, the issue must have “‘two or more sides’ to prevent all lawmakers from gathering on the one side where the money is and—heaven forbid—actually doing something.” The second and third conditions operate hand-in-glove in the carried interest situation because the two sides needed to string things along come not from distinct special interest groups (as occurred in the estate tax case) but rather from “closely divided government.”
As McCaffery and Jones highlight, “[h]istorically, private equity has supported Democrats.” And, because of their overall approach on taxes, Democrats have been able to mount the more credible opposition to the loophole. Presidential candidate Hillary Clinton campaigned on the issue, even vowing “to use her regulatory authority” to do something. This prompted “an opportunity to Trump to play the principled hero” on the issue, “tweaking Clinton.” McCaffery and Jones document how then-candidate Trump campaigned on the issue but, once in office, left the negotiations with “Wall Street players who would be predictably sympathetic to the break.”
President Trump was, however, able to create a plausible threat of action by Republican legislators, leading to a large, new infusion of private equity contributions for Republicans, most notably for Senator Collins. The authors recount how Senator Collins made a day-long threat to increase the holding period to more than 8-years as part of the 2017 legislative process, which because it might have done something, “set off a flurry of concerned communications.” She backed off, and ProPublica reporters later uncovered that she received more campaign contributions from private equity than any other senator.
Enactment of § 1061 in turn allowed Democratic legislators in 2022 to plausibly propose increasing the holding period to more than five years, with Senators Manchin and Sinema (with an assist from Senator Schumer) reaping the most in contributions from private equity in the lead up to not actually changing § 1061.
The article concludes that in recent years, these legislative shakedowns “play[] out from simple assumptions about rational behavior”: legislators “need money”; “Congress has monopolistic control over the power to tax”; and at times a particular “politician (Collins, Manchin, Sinema) may have monopolistic power over Congress’s monopolistic power to tax.” Each party has been able to use the carried interest issue to take a turn at shaking down private equity.
The public is, for all practical purposes, not a party to the game because it is “a very long longshot indeed” that a citizen’s vote would turn on the carried interest issue. As a result, reverse-Mancur Olson gamesmanship plays out “in plain sight.” Because it is a manifestation of rational behavior by all the players, McCaffery and Jones conclude that there are not “magic answers” to the carried interest problem (or to other manifestations of the phenomenon for that matter).
The article notes, “If we are going to get money out of our politics, we must get the reasons that money is in politics out of our politics. As long as a complex set of tax laws allows opportunities for lawmakers to use their taxing power to fundraise, the games will go on…” While the overall arc and tone of the article is fairly bleak—albeit in a witty and entertaining way—the authors’ case study persuasively emphasizes the necessity of “better watch[ing] the watch dogs” through calling out the process by which lawmakers are leveraging the tax system to fundraise.
