Politics Manchin and Sinema are on a collision course over closing a tax loophole for rich Americans. It could upend Biden's $790 billion deal.

© Jacquelyn Martin/AP Photo Sen. Joe Manchin speaks with Sen. Kyrsten Sinema Jacquelyn Martin/AP Photo

• Manchin and Sinema are about to collide on a tax loophole affecting wealthy investors.
• Manchin wants to close carried interest, but Sinema may knock the change out of the bill.
• It's possible Democrats will wait days, if not weeks, before Sinema breaks her silence.

Senate Democrats are relearning an old Argentine dance lesson: It takes two to tango.

Sen. Joe Manchin of West Virginia stunned many by striking an agreement for a $790 billion climate, healthcare, and tax package. The legislation is much bigger than most Democrats thought possible only two weeks ago when Manchin appeared to take climate programs and tax hikes off the table, citing growing fears about fueling inflation.

How Manchin struck a miracle of a deal with Schumer, Pelosi and Biden

A months-long standoff between Senate Majority Leader Chuck Schumer (D-N.Y.) and Sen. Joe Manchin (D-W.Va.) ended Wednesday when they reached a historic deal on deficit reduction, an Affordable Care Act extension, drug price reductions, climate and clean-energy investments to provide energy security, and expedited full-spectrum energy-permitting reform. Washington, the Democratic Party, and perhaps the world…Washington, the Democratic Party, and perhaps the world can breathe more easily again because — by some miracle of twisted turns and backflips — Schumer, Manchin, President Biden and House Speaker Nancy Pelosi (D-Calif.

But the most carefully negotiated deals can still be upended in an environment where no margin of error exists. Manchin is on a collision course with Sen. Kyrsten Sinema of Arizona over a small part of the bill. The pair disagree on carried interest, a loophole in the tax code that mostly benefits wealthy investors and hedge fund managers.

Eliminating carried interest is a goal that's eluded both Republican and Democratic administrations for a decade. It's the percentage of profits that hedge-fund managers receive from lucrative investments. But that compensation is taxed at a lower capital gains rate that tops out at 23.8% and doesn't face a higher income tax rate like most Americans pay on their wages. Critics argue it amounts to a huge gap in the tax code.

Democrats' proposed tax hikes probably won't affect you — in fact, they'll help you buy an electric vehicle and put solar panels on your house

The surprise spending deal Democrats announced Wednesday aims to tax wealthy investors and corporations to pay for electric vehicle and solar rebates.The Inflation Reduction Act of 2022 is, as the name suggests, aimed at bringing down inflation. It would put billions towards climate spending and slash prescription drug prices. Rather than hiking taxes on individuals, or imposing a broad surtax on the ultra-wealthy — both previously proposed to cover spending — the package is narrowly targeting ultra-wealthy investors and corporations, while also stepping up IRS enforcement.

Sinema was cut out of private negotiations between Manchin and Senate Majority Leader Chuck Schumer. It reportedly prompted her to ask fellow senators "What's going on?" when news broke of the deal on the Senate floor.

"It's the latest perplexing move by Senate leadership and doesn't seem like a strategy designed to maximize chances of success," John LaBombard, an ex-aide to Sinema, told Insider. He said the Arizona Democrat has long held "particular interest" on the tax proposals in the mix. "It strikes me as a very strange strategy to let the rest of the caucus learn about the agreement from a press release."

For his part, Manchin has expressed strong support for the measure and doesn't seem inclined to drop it. Last year, he joined two Senate Democrats in sponsoring a bill eliminating carried interest. "The only thing I was adamant about was the carried interest," he told reporters on Thursday.

Sinema is known to harbor objections to narrowing carried interest, per a Democratic aide familiar. But Democrats are hoping it's not thrown out since it represents the only tax increase on rich individuals within the bill. Sen. Elizabeth Warren of Massachusetts said Democrats are doing "exactly the right thing" by including it.

Others caution the party is in for a bumpy ride. But the finish line is in sight after a year of tense negotiations that still rest on Manchin and Sinema. "Until you get it done, there's twists and turns," Sen. Tim Kaine of Virginia told Insider. "Senator Sinema is going to do her own due diligence, which she does."

Sinema's office said in a statement that she is still reviewing the 725-page legislation and awaiting rulings from the Senate parliamentarian, who governs what qualifies under reconciliation, the legislative maneuver Democrats are using to avoid a Republican filibuster and pass the bill along party lines in the evenly split Senate. It's possible Democrats will wait days, if not weeks before Sinema breaks her silence on the package.

Schumer declined to comment on Thursday whether he'd kept Sinema in the loop. "Members are reviewing the text, and we'll all be talking shortly," he said at a press conference. He aims to put the bill on the floor sometime next week.

A tax loophole that Democrats and Republicans alike can't seem to close

© Bill Clark/CQ Roll Call From left to right: Sen. Kyrsten Sinema (D-Ariz.), Senate Majority Leader Chuck Schumer (D-N.Y.). Bill Clark/CQ Roll Call

Both Presidents Donald Trump and Barack Obama sought to scrap carried interest but failed to do so. What's on the table now doesn't get rid of it either; the changes that Democrats are pursuing only make it harder for rich investors to get the preferential tax rate on swaths of their income.

"This doesn't completely close the loophole," Kimberly Clausing, a former Treasury Department tax official for the Biden administration, told Insider. "It only partially does by lengthening the amount of time that you have to hold the investment for it to qualify as a capital gain."

Closing the carried interest loophole would only affect a slice of the financial sector. But it's a tax that hits a powerful group of rich Americans who have managed to escape tax increases so far under the Biden administration.

The American Investment Council, a lobbying group that represents private equity firms like Blackstone, immediately pummeled the carried interest initiative as a burden on small businesses benefiting from their investments.

"This is like a small universe of a few hedge funds that maybe hold long-term investments, a lot of private equity or venture capital firms," Ben Koltun, the research director at Beacon Policy Advisors, said in an interview. "It's a very select few people, but also a very powerful few people as well."

It is possible to revamp the proposal so it secures the support of Sinema without losing Manchin's thumbs up.

"There are ways of adjusting it," David Kamin, the former deputy director of the White House National Economic Council under Biden, told Insider. "But this is one that already represents a compromise even as it raises $14 billion from changing the treatment of a small group of people who are able to convert their their labor income to capital gains."

"If this just dropped out, the amount of money would not sink these other really important things that the bill is doing," Clausing said.

However, Sinema has wielded enormous influence over the process. That isn't likely to change.

"I certainly hope that by this point, it's abundantly clear to Senator Schumer and other party leaders that political pressure does not work on Senator Sinema," LaBombard, now a senior vice president at public affairs firm ROKK Solutions, said. "After a year of repeatedly trying and failing to pressure her into taking positions contrary to her long-held views, this should not surprise anyone."

Investors and money managers hoping to knock carried interest out of the bill may have an ally in Sinema. Individuals and organizations in the securities and investment industry donated $2.2 million to the Arizona Democrat since 2017, per data from nonpartisan campaign finance tracker OpenSecrets.

"You know, one will say 'I object to this' and the other one will say, 'I object to that' and we can't have this or that,'" Steve Rosenthal, a senior fellow at the Tax Policy Center, told Insider. "It's almost like performance theater at this moment."