While state lawmakers don’t have the power to rewrite the federal tax code, a bill now advancing in the New Jersey Legislature is seeking to change state tax policy to make up for what many consider to be a federal loophole that delivers a huge break to Wall Street fund managers.
The legislation would apply a hefty state tax on the performance fees earned by the managers of hedge funds and private-equity funds because, right now, those fees are taxed at the federal level as capital gains instead of as individual income. The savings for the fund managers comes from the higher tax rates that the federal government levies on personal income vs. capital gains.
But New Jersey could generate $100 million or more in new revenue according to some estimates by establishing a state tax on the performance fees, which are commonly referred to as “carried interest.” The legislation, however, would also need to be passed in several other neighboring states to go into effect in New Jersey.
The push to tax carried interest in New Jersey in the same manner as a teacher’s or plumber’s income is taxed is being led by liberal groups like New Jersey Policy Perspective, a think tank that’s based in Trenton. But those groups have picked up an unlikely ally in President-elect Donald Trump, a Republican who’s made reforming carried interest at the federal level a key component of the tax plan he’s expected to bring before Congress once he takes office in January 2017.
“Closing the carried interest tax loophole — which gives some of the wealthiest Americans a lower tax rate than teachers or firefighters — would be a big step towards a fairer federal tax code,” said Jon Whiten, deputy director of NJPP.
But since the issue has been discussed for years without progress in Washington, D.C., sponsors of the New Jersey legislation are not waiting around for a breakthrough at the federal level. Under the bill, New Jersey would establish a 19 percent “carried interest fairness fee” to bridge the gap between the federal capital gains rate, which is 20 percent, and the top-end marginal income-tax rate, which is 39.6 percent.
And to discourage fund managers from simply relocating to other states to escape the proposed state surcharge, the new fee would not go into effect in New Jersey until Connecticut, Massachusetts and New York adopted the same change. None have done so thus far.
The nonpartisan New Jersey Office of Legislative Services didn’t specify in a recent fiscal note exactly how much additional revenue the state could collect from taxing carried interest as income, except to say that the windfall could be “significant.” But other estimates suggest the state could generate between $80 million and $113 million by enacting the surcharge.
In addition to the tax-fairness issue, carried interest has also been a controversial topic in recent years for the New Jersey State Investment Council, which sets policy for the state’s $73 billion public-employee pension system. Public-worker unions have criticized the pension system’s reliance on alternative investments like hedge funds and private equity to protect against wild swings in the stock market because those investments require the state to pay the private fund managers general management fees in addition to performance fees, which are paid out to the managers when the fund exceeds certain investment goals.
Earlier this year, state officials revealed the state paid more than $700 million (to alternative-investment managers during the 2015 fiscal year, counting both the management fees and the carried interest. That’s a cost union officials criticized as way too high for a pension system supported primarily by taxpayers and public workers. And after initially failing to reach an agreement on just how much to invest in hedge funds during the 2017 fiscal year, which began on July 1, the investment council voted in August to cut such stakes in half, from 12.5 percent to 6 percent.
Taxing hedge-fund and private-equity management fees as income instead of capital gains was a central component of the populist economic message that set Trump apart from most other Republican candidates as he clinched the GOP nomination during the party primaries held earlier this year. He kept the position in his platform as he went on to win more electoral votes than Democrat Hillary Clinton in the presidential election held earlier this month.
“The hedge fund guys are getting away with murder. They're making a tremendous amount of money,” Trump said during a CBS “Face the Nation” interview that was held before he won the GOP nomination. “They have to pay taxes.”
It’s unclear whether Trump will be able to convince Republicans who control both the U.S. Senate and House of Representatives that carried interest should be taxed as income and not as a capital gain. Trump has generally agreed with Republicans like House Speaker Paul Ryan that corporate tax rates should be reduced, but Ryan so far has not prioritized carried interest in his own proposal of tax reforms.
But what happens next at the federal level is important because the New Jersey carried-interest legislation includes a provision that would stop the proposed state-level surcharge if the federal government eventually enacts a measure that fully addresses the tax-fairness issue.
The state Assembly Appropriations Committee voted last month along party lines in favor of the new surcharge. Eight Democrats voted for the bill, while three Republicans voted against it.
Assemblywoman Holly Schepisi (R-Bergen) cited her own experience as an investor in a partnership as the reason why she was one of the “no” votes. The partnership’s profits yielded a large tax liability for her under New Jersey laws, but no liability was assessed on the same profits for the partners who are based in Texas under that state’s laws, she said. She suggested under different circumstances she would have considered moving to escape New Jersey’s more aggressive tax policy.
“My concern in implementing something like this, we’re just incentivizing people once again to not do stuff within the state of New Jersey,” Schepisi said. “For that reason, I have to say no.”
But Whiten, the liberal think-tank official, points to the package of tax cuts that Gov. Chris Christie and lawmakers just enacted in October along with a gas-tax increase as a reason to back the surcharge on investment fees. Those tax cuts included a phase out of New Jersey’s estate tax, which will primarily benefit the very wealthy.
“At a time when the state's budget will soon be hampered once again by tax cuts that will most benefit the well off, this would be a small but helpful step to help balance the scales," he said.