Mitt Romney’s release of his tax returns has pushed the arcane issue of “carried interest” — the share of an investment fund’s profits given to its managers as payment for their services – back into the headlines. Critics have renewed their calls to tax the carried interest as ordinary income. Unfortunately, the populist rhetoric used by some critics can obscure the facts about how carried interest is actually taxed.
Some critics assert that all carried interest is taxed at the lower 15 percent that applies to capital gains and dividends. They complain that these funds are able to “turn” ordinary income into capital gains and dividends by paying managers in carried interest rather than salary, and that the funds are exploiting a special loophole not available to other firms. Looking at how carried interest works reveals that none of these things are true.
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A private-equity, venture-capital, or hedge fund may earn various types of income — interest, short-term and long-term capital gains, dividends, and profits from non-corporate business holdings. These funds are organized as partnerships, with both the managers and the investors as partners. As a partnership, the fund is not directly taxed on its income. Instead, each partner is taxed on his share of the fund’s income — whether or not he removes it from the firm.
The managers pay the same tax rate on income from the fund as they would pay if they had earned the same income on their own — channeling the income through the partnership doesn’t change the tax rate. Managers pay 15 percent tax on any carried interest that reflects long-term capital gains or dividends earned by the fund, as they would on any long-term gains or dividends they might earn on their own. But managers pay ordinary income-tax rates on any carried interest that reflects short-term gains, interest, or non-corporate profits earned by the fund. The tax rate depends on the kind of income the fund earns — not all carried interest gets the 15 percent rate.
But, should any of it get that rate? Critics point out that, if the fund had paid its managers a straight salary, the salary would have been taxed as ordinary income. They argue that the fund should not be allowed to “turn” ordinary income into capital gains or dividends simply by paying the managers carried interest rather than salary.
But that’s not what’s going on. The way the fund pays its managers can’t change the total amount of capital gains and dividends or the total amount of ordinary income the fund has earned. Paying carried interest rather than salary simply reallocates the two types of income among the two types of partners — it gives managers more of the gains and dividends and less of the ordinary income while giving the investors less of the gains and dividends and more of the ordinary income. Nothing gets turned into anything else.
To be sure, this reshuffling of income usually produces net tax savings. The managers pay less tax because they get more of the lightly taxed gains and dividends. And the investors are often pension funds that don’t have to pay tax no matter how much ordinary income they’re given.
Critics don’t explain, though, why these tax savings are improper. The funds and managers aren’t exploiting a special loophole — they’re following the same tax rules that apply to everyone else. Because all partnerships may choose how to allocate their income among their partners, any partnership is free to allocate gains and dividends to partners who work rather than those who invest. The funds certainly have good business reasons to pay carried interest rather than salary — that arrangement gives managers the most powerful incentives to maximize performance. And managers who receive carried interest face the same risks as the investors.
These complicated issues could be avoided under a consumption tax or a better-designed income tax. Starting from today’s system, it’s hard to identify a single “right” rule for how partnerships should be allowed to allocate income. But critics have failed to make a good case for imposing special restrictions that would prevent private-equity, venture-capital, and hedge funds from using the tax rules that apply to other industries. Any tax changes that are adopted should apply throughout the economy and should be based on facts rather than populist rhetoric.
— Alan D. Viard is a resident scholar at the American Enterprise Institute for Public Policy Research.
National Review's provision of a platform for the tireless apologists for the carried interest loop hole has finally changed my mind. I now have come to see that taxing capital gains at a lower rate than other income is a stupid idea.
Thanks, National Review. You've convinced a committed conservative that taxes rates should go up.
You're right, there should be no difference in tax rates due to the source of the income. But the solution isn't to raise the capital gains rate but to lower ordinary rates.
I'd venture to say that NR has either just done a terrible job explaining it to you, you weren't listening, or you weren't ever a committed conservative. The entire point of all this is that tax rates on the wealthy, or corporate partnerships, are not the cause of the problems we have in our society. And NR has simply been trying to point out why these exist, and why the unfounded attacks on certain industries (i.e. Wall Street) who get this treatment aren't any different that the ones that people aren't attacking. And which people have no problem with if you were to ask them without disclosing that. These people invest their money, for which the profits from the company they invest it in are taxed at the corporate rate and then again when the receive their cut. Having it taxed at carried interest provides them with the incentive to maximize productivity (and therefore profits), otherwise they might find something else to do. These people do create jobs, and there is something to the idea of creative destruction, even if you don't agree. But I'm sure all the people who lost their jobs at newspapers because they weren't productive enough in the face of waning demand, and the fact that technology outstripped it, will agree with you.
If you think that companies should only get a certain amount of profit, then you certainly aren't conservative at all. Same goes for if you think a certain level of productivity only begets a arbitrary amount of pay for the person who makes the decisions that not many can make successfully. But If you think that it's simply wrong that these people pay a lower tax rate, while ignoring that they still pay more in taxes than most pay in their entire lives, then you aren't seeing the problem. If the government could learn how to control their spending, reform our structure for the future (i.e. entitlements), and stop focusing on belittling productive people (who don't need that money, but who certainly earned it) for which changing their situation will do nothing to change the situation we are in then maybe we could get somewhere constructive on the actual problem. The more we focus on arbitrary topics like this, while ignoring that making them pay 35% isn't going to solve the long term problem, the more likely we are going to fall off the cliff again. If you are a true conservative, you would realize that this topic won't solve our problems and that there are reasons why these are in tact and they don't have much to do with trying to make the rich richer at the poor's expense. Though some certainly take advantage of it in the wrong way, the alternative doesn't create a system where people won't take advantage of the way it's set up. That's reality.
Honest Question, if YOU were a large private investor and you could safely make one million on an established business or potentially four million for a troubled one, are you HONESTLY going to tell me that an extra 15% taxes would make a difference, which you would also pay for the 'safe' investment?
Btw: No one is getting taxed TWICE, Companies aren't individuals( Sorry Mitt) If you happen to OWN a Company it's a cost of doing business, besides I thought that tax money was to go to pay workers salaries and hurting them, isn't that the line in Congress now?
Great comment. If only the Romney campaign would make such a defense. Even if it were to fall on the dear ears of the masses, it needs to be articulated for the bright but relatively uninformed.
While of course I see the logic of incentivising (sp?) the middle class to invest a portion of the EARNINGS into "investments" as opposed to simple savings, why must we view this logic as an absolute all or nothing?
Leaving aside the argument on whether income taxes should exist (as opposed to other forms of taxation) and if so whether rates should be progressive, let's simple deal with the fact that income taxes DO exist and they ARE progressively scaled.
Why shouldn't this same "scaling" be extended to capital gains?
For the sake of argument (and to make the math simple) let's assume median individual income is $50,000.
For an individual earning $50,000 allow that individual to realize capital gains and dividends at a rate HALF that of what the individual is paying upon "earned" income.
For an individual earning $100,000 allow that individual to realize capital gains and dividends at a rate 60% that of what the individual is paying upon "earned" income BEYOND $50,000.
And so on and so forth.
Do you see where I'm going here? At a certain point... perhaps $200,000... perhaps $250,000... perhaps $500,000... capital gains and dividends should be taxed at the same rate as ordinary income because when you've reached this level... where your INVESTMENTS are bringing in four, five, ten times or more income than your fellow citizens' median "ordinary" income... well... how in God's name can you defend taxing that income at a lower rate than "sweat of the brow" income via salary?
In my view... you CAN'T defend it.
Now I know some of you will continue to defend it, but I'm telling you... purely on pragmatic grounds... not only are the dems and the libs never gonna buy it, but huge segments of "moderates" and "independents" upon who we need if we're gonna stop the continuing socialization of America aren't gonna buy it and they're gonna punish us (and yes, ultimately themselves) by voting against "Wall Street Republicanism."
Argue if you must... but at least CONSIDER what I'm saying here.
Carried interest sounds mighty like commission to me. Know of any commissions that are given a tax break? Used car salesmen of the world would like to know.
I've always understood it that capital gains gets taxed at lower rates because the owner of the capital is risking it in a venture. Partners or members in these companies who do not get paid anything but contribute their labor to the enterprises are engaging in the same behavior. They are investing with substantial risk of making nothing. I'm sure there are bunches of companies who would love to get their worker's labor for free and that these companies would love to pay them for their labor via any returns on investments the workers generated w/ their labor. I don't think you would find a tremendous number of workers who would do that because they wouldn't necessarily make any money and said workers couldn't afford it. It seems to me that the whole argument about taxing carried interest rests on the fact that it 'isn't fair' that some people are able to get paid in this manner while others are not.
That's not even counting the fact that it makes deals more possible - as I can assure you that losing 15% of your profit in a deal will affect whether or not it gets done.
Maybe I really don't understand this concept or something....
Jeff- You forget, as do most folks, that the calculation of a capital "gain" on which the tax rate is lower than on earned income, is not indexed. Therefore, the supposed gain that is taxed may represent less purchasing power than the original invested basis. Thus, if I invested $100 20 years ago in an equity that I now sell for $1000, I pay tax on $900 of supposed gain, despite the fact that my $1000 may actually buy less stuff now than the original $100 did than. Where is the real gain on which I am being taxed at any rate?
Federal tax law is written by Congress. Romney has never been a member of either house of Congress. Paul, Gingrich, Santorum, Obama, Biden and H. Clinton have all spent time (Paul and Biden essentially a whole career) in Congress. All six of these sitting or ex- reps and Senators have had more influence on how Romney's earning are taxed then he has.
I believe that capital gains should be taxed at a lower rate than ordinary income for no other reason than the money paid out as capital gains has almost always already been taxed once at the corporate level. (The major exceptions being capital gains from the sale of stock or real estate.) But there are other reasons as well. Unlike employees who earn wages and salaries, investors get paid based on profits. If the company makes no profits investors get no income even though employees continue to receive their wages and salaries. When GM was hemorraging billions of dollars the UAW members and managers still got paid while the investors saw the value of their investment decrease precipitously. Investors also risk the money they invest which has already been taxed at least once before they had it to invest. With our current banana republic president, who is quite willing to set aside federal bankruptcy law to reward his political backers at the expense of investors who had priority under bankruptcy law (see GM and Chrysler bankruptcy), the risk has only increased. An investor takes the risk that their ALREADY EARNED AND TAXED investment in a company could potentially be wiped out either by the creative destruction of the marketplace or the capricious destruction of politicians. Standard of living increases are driven by productivity increases. Productivity increases are driven by capital formation. Capital formation results from investors taking risks. A lower tax rate on investment to encourage (or more accurately to not discourage) investors from taking risks is a necessary, though not sufficient, conditioin to increase the overall standard of living.
I am not a tax expert, but my understanding of the complaint about carried interest is that hedge fund managers, say, are in effect disguising their salary as capital gains because those managers aren't bearing a true economic risk, which ought to be a precondition for whether income qualifies as a capital gain. There is no true economic risk because of the nature of their fee guarantees (basically managers get their fees regardless of the performance of the fund).
(I don't know to what extent the Bain situation is like the hedge fund situation with no true economic risk involved and am just writing about the general situation).
The arithmetic of the partnership arrangement that allows hedge funds to do this, as described by Mr. Viard, is besides the point: the critics aren't saying that hedge funds are cheating (or of course the IRS would be investigating by now), rather they are saying that carried interest is in fact a gigantic loophole.
Contrary to Mr. Viard's assertion, the critics do explain why they think this is wrong: capital gains treatment, which is more favorable than ordinary income treatment, ought only to be allowed in situations where true economic risk is involved. That's a pretty simple proposition and very hard to refute from an equitable standpoint.
Now the question of what rates ought to be applied to ordinary income vs capital gains, or whether there should be a difference at all, which he does reference, is a valid but totally separate question.
All in all, a disappointing article.
When I get a bonus, its taxed at nearly 50%. When a hedge fund manager gets a bonus, its taxed at 15%. You can call it carried interest, you can call it Bob for all I car, but I call it a tax loophole. Tax it the same as wages, cause that's what it is.
Do you bother to read? Most hedge fund managers produce short-term capital gains because their funds have much higher turnover than private equity funds or venture capital funds. Therefore, the income allocated to most hedge fund managers will be short-term capital gains, which are taxed at ordinary income tax rates.
I think that's a simplistic characterization. I would venture to guess that these hedge fund managers are in a different position as you and your bonus. My guess is that they are partners or members in these companies - or the companies set up to take the fees or reap their share of the profits off their investments...and as such are at risk of losing their money they have invested in the company. I would also bet some portion of their income is taxed at ordinary income. I would also venture to guess that the younger guys working at these places are paying ordinary income on most of their pay.
What you should be bellyaching about is that your bonus is being taxed at nearly 50% to keep bureaucrats in jobs and politicians elected and making money when they retire.
Don't forget that changing this treatment will likely blow up a tons of companies and endeavors.
And they're not wages no matter how much you want to characterize them as such.
You're missing the point. The only reason you're in a position to get a bonus is because you have a job. And the only reason you have a job is because of "job creators".
If that hedge fund manager you're so jealous of didn't pay a lower tax rate than you, he'd quit doing whatever it is he does, and your job would disappear. You know it and I know it.
When you get a bonus and a hedge fund manager get a bonus, you get taxed at the same rate. You're confusing carried interest with a bonus, which is wrong. Besides, you can always lessen the impact of taxes on your bonus by adjusting your withholding. When you do this, the taxes taken out of your bonus is lessened.
What we have here is class envy. It is also surprising that people who engage in class envy never call for their taxes to be lowered, but for the other person's taxes to be raised higher.
What you're describing isn't entirely true. The portion of fees that hedge fund managers could account for in this fashion really are related to performance generated by the fund. Fixed fees typically flow to the management company, where they would be paid out largely as ordinary income, whether through dividends or standard salaries and bonuses. The incentive fees on which capital gains can sometimes be applied are usually some form of a percentage of fund profits. Private equity funds are a different beast altogether, though, given the inherent lockups and the easier "long term" argument that goes along with it.
That doesn't obviate the whole discussion of whether the structure is right, just making a very specific point.
"Critics don’t explain, though, why these tax savings are improper."
Isn't that akin to saying that critics cannot explain why receiving a W-2 form is a requirement to be elected president? And isn't the current POTUS about to spend six months campaigning on essentially that issue?
Isn't it interesting that the wealthiest people have access to special tax rates, special loan rates, special information...and yet they claim to desire a laissez-faire economic system. I find those claims to be ludicrous, because their wealth is created, mostly, by favourable laws that benefit the top 1%, and are generally out of reach for the 90%. It is a system of the rich, for the rich, and the lack of social mobility in the USA shows how it has been a hinderence to economic well-being for the majority. This system is not working, at least not for the vast majority of us. It is an inherently unfair system. It is time to level the playing field.
