Outrageous Wealth: Carried Interest, Philanthropy, and Political Consequences

We have allowed wealth to grow to dangerous levels that pose a threat to the workings of a democratic nation.  Here we will discuss some of the ways we have allowed wealth and its associated power to accumulate without bound, and some of the consequences of that accumulation.

The term “carried interest” is usually thought of as a tax loophole that allows those running hedge funds to earn ordinary income and pay taxes at the much lower capital gains rate.  The situation with respect to carried interest is actually quite a bit more complicated.  Alec MacGillis who covers politics for ProPublica provided background on this little understood topic in The Billionaires’ Loophole, an article that appeared in The New Yorker.

MacGillis tells us that the concept of carried interest originated in the twelfth century when ship captains bargained with the owners of products to deliver their wares.  Think of each voyage as a shared investment in a business venture.  The owner of the product contributed the freight to be delivered while the ship’s captain contributed the transportation.  In principle, the captain was merely providing a service and might have been compensated with a set fee, but the riskiness of sailing in those days made the venture more of a partnership.  Captains received a 20% share of the profits as might be expected from a partnership.

Macgillis says the modern version of this sort of arrangement arose in the oil industry in the 1920s.

“When a group of partners drilled for oil, a few would put up the money and others would invest only their labor, or ‘sweat equity’—finding land and investors, buying equipment, and so on. If the partners sold out, the I.R.S. would tax the profits of all the partners at the lower rate for capital gains rather than as ordinary income.”

This taxing of partnerships was firmly established in the tax code in 1954.  Eventually, it was recognized that other industries, such as real estate and venture capitalization encountered similar types of partnerships and could take advantage of the same tax break.

The tax break didn’t become a tax loophole until the emergence of huge hedge funds and private-equity funds.  In those cases the individuals running the funds were mostly dealing with other peoples’ money and were of a mind to claim a “partnership” without having much of an investment of their own involved. 

Interestingly, the 20 % profit level has endured since the twelfth century.  Both hedge and private-equity funds tend to adhere to a “2 and 20” policy.  Investors in the funds pay an annual fee of 2% of the value of their investment to cover management expenses.  They also agree to pay up to 20% of any profits to the fund managers, who wish to continue to claim these profits as capital gains rather than earned income.  In the private-equity case, a threshold rate of profitability is defined, and the fund will get 20% of the profits in excess of that threshold profit.

The major beneficiaries of this loophole are the private-equity funds.  Their investments are generally greater than a year in duration and investors’ profits meet the long-term requirement for capital gains.  Hedge funds transactions often happen at a higher rate and are less able, in general, to take advantage of the loophole.

Private equity is where fund managers earn the most profit and have the least justification for claiming capital gains on those earnings.

“Private-equity firms stretched the model to its breaking point. Their work is essentially a combination of investment banking and management consulting: they are compensated not for building new ventures from scratch, with the risk that entails, but for managing the investments of wealthy individuals and pension funds and other institutional clients. These funds are pooled, along with borrowed money, to acquire private companies or to take public companies private—before making improvements or cutting costs and selling at a big profit.”

If the fund performs well, the managers can become fabulously wealthy.  If the fund performs poorly, the managers have still been paid a princely sum.  Apparently, some even claim the 2% fee as carried interest and take the lower tax rate.

“Even if no profits are realized, private-equity firms get paid: under the “2 and 20” compensation structure, they receive a two-per-cent fee annually on assets under management, in addition to a twenty-per-cent cut of profits beyond a given benchmark. The I.R.S. characterizes the managers’ cut of the profits as carried interest, taxing it as though it were capital gains made through the sale of a person’s own investment.”

The amount of money lost to the treasury is in the billions of dollars per year, with estimates varying from a few billion to many.  There is an argument to be made about the fundamental fairness of taxation policy that the credibility of the tax system is at risk if such loopholes are not closed.

The more critical issue is that hedge funds and private-equity funds with their fee schedules and their tax breaks are vehicles for producing a few outrageously wealthy individuals—and with wealth comes power.

“Since the end of the recession, private equity has reported record profits, and at least eighteen private-equity executives are estimated to be worth two billion dollars or more each.”

Some of the outrageously wealthy use their power to accomplish noteworthy things.  Others use their power to further personal agendas, both economic and political.

Jane Mayer examines the dark side of outrageous wealth in frightening detail in her book Dark Money: The Hidden History of the Billionaires Behind the Rise of the Radical Right.  She reports this bit of analysis:

“The Economic Policy Institute, a progressive think tank, estimated that the hedge fund loophole cost the government over $6 billion a year….Of that total, it said, almost $2 billion a year from the tax break went to just twenty-five individuals.”

The carried-interest loophole was little noted until a few years into the current century.  Mayer suggests that what raised consciousness to a high level was reporting of the earnings of Stephen Schwartzman the chairman and CEO of the private-equity firm the Blackstone Group.  Schwartzman had to make public his earnings as part of taking his group public.

“In 2006, when he decided to transform Blackstone from a private partnership into a public company, he had been required to disclose his earnings for the first time.  The numbers stunned both Wall Street and Washington.  He made $398.3 million in 2006, which was nine times more than the CEO of Goldman Sachs.  On top of this, his shares in Blackstone were valued at more than $7 billion.”

Mayer provides this quote from a friend of Schwartzman.

“You have no idea what impression this made on Wall Street.  You have all these guys who have spent their entire lives working just as hard to make twenty million.  Sure that’s a lot of money, but then Schwartzman turns around and, seemingly overnight, has eight billion.”

The House in Congress had been trying to pass bills that would address this loophole since 2007, but the motions always died in the Senate.  Few Republicans would support such legislation, but it was really a few Democrats particularly beholden to financial interests who blocked passage (MacGillis calls out Schumer, Bayh, Warner, and Hagan explicitly on the early attempts).

Under Obama, another bill addressing the loophole passed the House but would again die in the Senate.  The fact that Obama would dare such a brazen assault on the wealth and privilege of hedge fund and private-equity managers outraged them.

“Stephen Schwartzman….would call the administration’s efforts to close the loophole ‘a war,’ claiming it was ‘like when Hitler invaded Poland in 1939’.”

“….Schwartzman and a number of other financiers regarded this as a new level of affront and flocked to the June Koch summit with their check books in hand, determined to prevent his reelection.”

The Koch brothers, Charles and David, have for many years been holding what Mayer refers to as “summits” where wealthy individuals with similar political beliefs would gather and discuss ways in which to replace our current form of government with one more to their liking.  They seem to believe that the only necessary function of government is the protection of private property, theirs in particular.  All other actions of government are to be eliminated, and all rules and regulations terminated.  When David Koch ran for vice-president on the Libertarian Party ticket in 1980, William F. Buckley Jr. derided their views as “Anarcho-Totalitarianism.”  In 1978, Charles Koch wrote:

“Our movement must destroy the prevalent statist paradigm.”

The Koch’s methods have evolved over the years, but there is no evidence that their ultimate objectives have changed.

“Organizers were waiting for Schwartzman and others at the June Koch summit, the theme of which was ‘Understanding and Addressing Threats to American Free Enterprise and Prosperity.’  The financiers represented a different strain of the Republican Party from the Kochs.  Few were fanatically ideological.  Most were simply concerned with protecting their continued accumulation of wealth.  But when their resources were combined with the idea machinery built by the conservative movement’s early funders, along with the ideological zealotry of the Kochs and other antigovernment radicals, the result was a raging river of cash capable of carrying the whole Republican Party to the right.”

“The concentration of wealth at the Koch summit by this point was extraordinary.  Of the two hundred or so participants meeting secretly with the Kochs in Aspen that June, at least eleven were on Forbes’s list of the four hundred wealthiest Americans.  The combined assets of this group alone, assessed in accordance with the magazine’s estimates of their wealth at the time, amounted to $129.1 billion”

Mayer details how that cash was used to create a new Republican Party.  That will have to be a tale for another day.  Better yet, read her book!

There are two messages to take away from this slightly rambling tale.  The first is that our tax code is a mess.  The carried interest loophole is only one issue.  Consider the fact that the Kochs and their allies can finance all their dirty tricks and attack adds with charitable contributions subsidized by the rest of us taxpayers.  One can organize an entity supposedly dedicated to the public good—which is considered a charitable activity for tax purposes—and spend up to 49% of its funds on a strictly political agenda.  One can then transfer the remainder of the funds to organizations that are also dedicated to political activities and it is all legal.  Anyone with a little money and some smarts can take advantage of this scam and create such an entity.  A billionaire can create hundreds of them and coordinate their activities to make it appear that some vast popular movement has arisen.

The second message is that outrageously wealthy people can be dangerous people.  Philanthropy has a dark side.  What the Kochs are up to is using the mechanism of philanthropy to wage war on our society’s values.  Even when the wealthy use their assets in beneficial ways, we are giving up our own prerogatives, to be reached via elections and decisions by office holders beholden to voters, to be replaced by those of wealthy individuals.  Why?  Depending on philanthropy for public decision making is madness.