Trump’s Tax Plan Isn’t Tough on Wall Street or Carried Interest After All

June 22, 2016

Donald Trump has received considerable positive attention for his plan to raise taxes on investment firms by ending the much-maligned “carried interest” loophole. It’s one of the clearest things Trump himself has said about his tax plan, with statements like “I want to do something with the Wall Street guys because some of these guys are making so much money. I want to get rid of carried interest.” And it’s gotten him favorable headlines such as “Trump Lands a Blow Against Carried Interest Tax Loopholes.” All of this has distracted from the very regressive nature of his overall tax plan.

So how much money does Trump’s carried interest proposal raise? When Tax Policy Center ran the numbers, it found that this approach actually lowered tax revenue slightly, giving a tax cut to those who currently claim carried interest. While Trump would remove the carried interest loophole in name, he would replace it with an even more generous policy. Instead of taxing carried interest at the top capital gains rate of 23.8 percent, or his new top marginal income rate of 25 percent, Trump’s plan would ultimately tax carried interest at just 15 percent.

Hillary Clinton noted this in her speech on Trump’s economic agenda yesterday, saying that his tax plan “actually makes the current loophole even worse. It gives hedge-fund managers a special tax rate that’s lower than what many middle-class families pay. And I did have to look twice because I didn’t believe it. Under Donald Trump’s plan, these Wall Street millionaires will pay a lower tax rate than many working people.” Let’s discuss why.

The carried interest loophole is an interpretation of the tax code that allows managers of private equity firms and some hedge funds to characterize their earnings as capital gains rather than labor income. These individuals are thus able to avoid the 39.6 percent top marginal income tax rate faced by most top earners and instead pay the capital gains rate of 23.8 percent.

Initial reactions to Trump’s plan were premised on the mistaken notion that carried interest would face the full top marginal rate, but getting rid of carried interest matters a lot less if you also slash the top marginal tax rate on labor income. Since Trump’s plan also drops that rate from 39.6 to 25 percent, his increase on carried interest would be just a small 1.2 percentage points.

This by itself would be enough to take the air out of the idea that Trump will be tough on wealthy investment firms, but his tax plan is actually even more generous than this first-level analysis suggests. By cutting the tax rate for business income from 35 to 15 percent, Trump offers an easy way for financiers to avoid even the modest 1.2 percent tax increase.

By simply recategorizing carried interest as business income, investment managers will be able to pay the new 15 percent rate. This reduction is one of the most significant changes in the plan, as it reduces the top rate on passthroughs (a type of business that pays taxes at the individual level rather than the entity level) by nearly two-thirds, from 39.6 to 15 percent.

This would have a significant impact on inequality. A landmark 2015 study revealed that in 2011 the top 1 percent received nearly 70 percent of S-corp and partnership income. Cutting taxes for these entities will only enlarge the share of their revenue going to the country’s wealthiest individuals, especially if they continue to grow rapidly; since 1980, passthroughs have tripled in number and more than doubled as a share of U.S. business income, now totalling more than 50 percent of all business receipts.

The picture gets slightly more complex when we consider effective tax rates—the rates actually paid after various deductions and allowances are factored in—rather than the statutory rate, but the results are no different. Trump’s promised tax hike disappears and, importantly, preferential rates are cemented.

Due to a number of tax avoidance strategies outlined in the Roosevelt Institute’s new report Untamed: How to Check Corporate, Financial, and Monopoly Power, partnerships such as hedge funds and private equity firms currently pay an estimated effective tax rate much lower than the top income rate of 39.6 percent, or even the 23.8 percent capital gains rate, with some estimates as low as 15.9 percent. The Tax Policy Center estimates that under Trump’s regime, the passthrough rate would come in around 16.9 percent (Trump cuts some deductions, pushing the effective rate up).

Whether Trump’s policy ends up being a substantial tax cut or a small increase on investment managers depends on numerous uncertainties surrounding what the actual effective rates are, but one thing is for certain: The promised tax on investors is nowhere to be found.  Regardless of rate changes,, but the long-term policy change is serious: Under current law, categorizing carried interest as capital gains is permitted but not codified, so the IRS could challenge it at any time. Trump’s plan would make this low rate a permanent feature of the tax code, unassailable except by legislation.

If I were in private equity, I would probably welcome the Trump tax plan. It manages to not even do the one thing to push back against inequality and finance that it promised to do.