The Problems with Raising Taxes on Carried Interest, Part II

by Avik Roy

On Friday, I discussed why raising taxes on carried interest (the equity compensation common to alternative investment funds such as hedge funds, venture capital funds, private equity funds, and the like) would constitute active discrimination against certain forms of long-term investing. Today, I will talk about some of the factual misunderstandings of how carried interest is taxed today, and the unintended consequences that might flow from raising those tax rates.

One such misperception is that hedge fund managers are rewarded when they make money, but bailed out when they lose money. This is true of investment banks (see TARP), but not true of hedge funds. Yes, hedge fund managers get paid well when they succeed, but they usually go out of business if they lose money in a given calendar year (underperforming funds are lucky if they’re even allowed to survive the year). Every 1% decrease in mean monthly returns is associated with a 10% increased risk of the fund’s death. It’s true that managers don’t often have to pay investors back for their losses—without this caveat, no one would enter the business—but the industry is ruthless in weeding out those who lose investors’ money. (If only the same could be said of Washington.)

Our view of investment managers is colored by selection bias. We read in the paper about billionaire hedge-fund titans like Steve Cohen. We don’t read about the thousands of managers who fail to get off the ground. Rest assured it’s not easy to get people to entrust their money to you, let alone to beat the market if they give you the chance. (If you don’t believe me, ask your friends if they’d let you manage their money.)

Another common misperception among journalists and policy types is that carried interest is taxed at 15 percent. This is incorrect. Carried interest; i.e., income derived from an investment partnership, is taxed at a “pass-through” rate derived from the investment gains of the partnership. The reason why most carried interest is taxed at 15 percent is because most investment income subject to carried interest derives from long-term capital gains, which are taxed at 15 percent.

I’ve put together a chart comparing the composition of investment gains for finance and insurance partnerships, real estate partnerships, and all partnerships, from an analysis by former CBO director Douglas Holtz-Eakin using 2007 (pre-crash) data from the Internal Revenue Service. As you will see, about 10 percent of investment gains distributed to partners in investment partnerships come from short-term capital gains, compared to 11 percent from dividend income, 29 percent from interest income (i.e., bonds) and 58 percent from long-term investments:

Of course, there is a wide diversity in the investment styles of these partnerships. A quantitative, trading-oriented hedge fund, which may hold its individual positions for less than a day, will book nearly all of its investment gains (and losses) as short-term capital gains. In turn, carried interest in that fund will be taxed at the short-term capital gains rate; i.e., that of ordinary income (the same as your personal income tax rate).

Conversely, a venture capital fund, which holds its investments for an average of ten years, will book nearly all of its investment gains (and losses) as long-term capital gains. As shares of those gains are parceled out to the partners, those gains are taxed at the long-term capital gains rate of 15%.

Problem 1. Hedge funds are less sensitive to higher tax rates on carried interest

Therefore, insofar as the goal of taxing carried interest at the ordinary income rate is to target hedge-fund managers who are perceived as making unfair amounts of money, the results will be underwhelming. Hedge funds, relative to other types of investment partnerships, tend to hold their investments for a shorter period, and will therefore have their taxes increased by the lowest amount, under such a regime, relative to other types of investment funds.

Problem 2. Higher tax rates on carried interest will hammer the venture capital industry

There are two reasons why long-term investments are taxed at a lower rate than short-term investments: (1) as a matter of policy, Congress wishes to reward longer-term investors; (2) long-term investments are costlier due to the time value of money. Think about it this way: if you invest $100 today in “risk-free” investments such as U.S. Treasuries, you’ll make about 3% a year. Over a ten-year period, through the power of compound interest, you’d make 34%. Hence, the way investors think about it, if you make 50% on a ten-year investment, in real terms, you only made 16% (50 minus 34).

If these investments are suddenly taxed at 35%, instead of 15%, many VC fund managers will find that the risks of investing in startup companies to outweigh the rewards, and leave the venture sector for greener, shorter-term pastures. This will, by extension, reduce the amount of capital available for entrepreneurs in venture-backed companies.

Problem 3. Higher tax rates on carried interest will encourage short-term investing and discourage long-term investing

If hedge-fund managers face equal tax treatment for short-term and long-term investments, they are certain to shift their focus to the short-term, given the time value of money problem I discussed above. This means fewer investments in smaller companies (which are less easy to trade in and out of); fewer investments in corporate and government bonds (making it harder for companies and governments to borrow money); and pressure on publicly-traded companies to cater to near-term financial performance instead of long-term business growth (e.g., firing people to “make numbers” instead of hiring people who will cost money up-front, but bring economic rewards down the line).

There are tens of trillions of dollars invested via partnerships in America. The populist appeal of taxing carried interest is unsurprising: but you don’t change the tax treatment of that amount of money without unleashing significant unintended consequences throughout the economy. Look before you leap.

The Agenda

NRO’s domestic-policy blog, by Reihan Salam.