Robert Murphy

One of the latest gripes against “evil” corporations and big business concerns the tax rate applied to general partners of private equity and hedge funds. In a campaign statement, Hillary Clinton opined:

It offends our values as a nation when an investment manager making $50 million can pay a lower tax rate on her earned income than a teacher making $50,000 pays on her income…As president I will reform our tax code to ensure that the carried interest earned by some multimillionaire Wall Street managers is recognized for what it is: ordinary income that should be taxed at ordinary income tax rates. Clinton’s statement raises both an interesting philosophical question, and a far more important economic one. First the philosophical question: Is the “carried interest” on a private equity (or hedge fund) deal a capital gain or regular income? It turns out that this question (like many deep philosophical ones) may not have a good answer. So-called carried interest refers to the percentage (generally around 20-25%) of net profit that the general partners retain from a fund’s earnings. For example, if a hedge fund’s investment in a project yields a net $100 million, the general partners might retain $20 million in carried interest and distribute the other $80 million to the limited partners.

So, the general partners are definitely $20 million richer, at least before taxes. Now the question is whether this increase in wealth is a capital gain or income for services. If the former, it will be taxed at 15%. If the latter, it will be taxed at the highest bracket, currently 35%. Obviously this apparently philosophical issue has serious ramifications, and provides a great opportunity for Democratic class warfare rhetoric.

As I hinted above, there really isn’t a crisp answer to this question, for the simple reason that in a market economy, successful speculators buy low and sell high (i.e. earn a capital gain), and in so doing provide a real service. Consequently, we can’t say whether the income of hedge fund or private equity partners is “really” a capital gain or “really” normal income. It’s both, and the tax code’s arbitrary attempt to distinguish between the two doesn’t mesh with economic reality. For an analogy, the classical economists of the early 1800s used to think that rent was a special type of income earned by landowners, whereas modern economics understands that rent is a much broader concept, as any tuxedo shop owner can attest.

Robert Murphy

Robert Murphy has a Ph.D. in economics and is the author of The Politically Incorrect Guide to Capitalism (Regnery 2007).

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