Wednesday, January 25, 2012

I am confused about carried interest

Does anybody have a good reason for the carried interest tax exemption?  It seems to entirely benefit a group that already has very large incomes and doesn't really seem to be in the same class as investment capital that was risked in the marketplace.  Paul Krugman notes how much benefit a retired investment adviser can reap from this exemption:
 First, $13 million of the total was carried interest, which gets taxed like capital gains but is really just commissions that receive special treatment for no good reason. No profits taxes were paid on that income; right there, a minimally defensible tax code would have levied $2.6 million more in taxes on Romney.

I am completely agnostic as to the identity of the person in question -- it would be just as concerning if Barack Obama had millions in carried interest in his tax forms.  The real question is how this exemption (which is commissions) can stimulate economic growth.  I understand the argument for preferential treatment of capital gains.  I even understand how capital gains can end up making moving between houses expensive for no really good reason.  So I comprehend how this can be a matter of academic debate.

But can anyone explain why commissions should get preferential tax treatment?


  1. I'm not aware of the commissions being carried forward as capital gains. It sounds like a tax loophole.

    However, going back to capital gains. There are compelling reasons for not giving special tax status to capital gains.

    1) As Warren Buffet said:
    "I have worked with investors for 60 years and I have yet to see anyone -- not even when capital gains rates were 39.9 percent in 1976-77 -- shy away from a sensible investment because of the tax rate on the potential gain," Buffett wrote in his column. "People invest to make money, and potential taxes have never scared them off. And to those who argue that higher rates hurt job creation, I would note that a net of nearly 40 million jobs were added between 1980 and 2000. You know what's happened since then: lower tax rates and far lower job creation."


    In other words, the soundness of the investment is what drives investment. I'm not going to say that tax considerations don't matter, but they are secondary to the attractiveness of the investment.

    There are some goofy things in tax code related to corporate losses, but that's a separate matter.

    2) Even if capital gains were treated as income, they still would be tax-advantaged. There still would be tax-deferment. You only pay taxes when you sell unlike a divident or interest bearing investment. Also, payroll taxes (FICA) are not levied against capital gains.

    3) The capital gains rate being lower than income also leads to wacky things on Wall Street. It's more important to pump up the stock price than it is drive the money-making prospects of a business. I would like to see dividends and capital gains on equal footing.

  2. For carried interest. McArdle had a lengthy, moralizing post on this here:
    A lot of this is a bit tiresome, but I think this at least helps understand why the exemption is there:

    "At least as I know understand it, carried interest taxation is a longstanding feature of partnership taxation. And it exists not so that hedge fund managers can afford to buy genuine gold tile to line the floors of their extravagant mansions, but so that partners who come in with less capital can build "sweat equity".
    There are arguments for an against. The arguments for the carried interest are fairly compelling: without it, the partners who contributed ideas and talent end up being taxed much more heavily on their earnings than partners who contributed financial assets. This is not only sort of unfair, and impedes the ability of talented people with few financial resources to move into the moneyed class, but also might have implications for economic growth: if your gains are going to be taxed at ordinary income rates, why quit that safe job and risk all on an untried venture? "

  3. I am familiar with the McArdle post. My view is that we tax earned income (when not partnered with capital) at ordinary income tax rates and this prohibits entry into the moneyed classes.

    I can kind of see a flat tax argument (I don't agree with it, but I can understand it). But the partner putting up capital is taking risk that the partner putting up expertise is not. Fair or unfair is hard to judge in these contexts as no approach can treat either group completely equally.