Last week, Rep. Sander Levin (D-MI) and Sen. Tammy Baldwin (D-WI) held a press conference to promote legislation that will hike taxes on so called “carried interest.” Sen. Baldwin attacked President Trump’s historic tax plan and accused him of a “bait-and-switch,” because his plan cut taxes on job creators. Although, both candidate Donald Trump and Hillary Clinton said during the campaign that taxes should be reformed on “carried interest,” nobody believes that President Trump’s tax plan, including historic proposed cuts to the corporate income tax and simplification of the individual tax brackets, is going to be written by liberal Democrats.
Carried interest is widely misunderstood. Democrats and the media have long labeled it a "loophole," but the truth is that it is appropriately considered a form of capital gain. Like other forms of capital, taxing carried interest at a higher rate would have negative economic repercussions.
Investment funds are typically organized as partnerships between the investors and the fund manager. The investors bring the money, while the manager puts up the "sweat equity" and seeks to leverage his or her knowledge and experience to produce a positive return. The share of the return which is given to the manager is called the carried interest.
Partnerships are not taxed on their income, but instead are considered "pass through" entities. That simply means that profits and losses are passed onto the partners, who then pay the relevant tax. Logically, the nature of the income shouldn't change according to which partner receives the distribution.
Carried interest receives no favorable treatment in this regard, but is taxed according to the nature of the income. Short-term gains earned by the fund and distributed as a carried interest are taxed as ordinary income like any other short-term gain, and long-term gains are taxed at the lower statutory rate for long-term capital gains. Again, just like any other long-term gain.
What Democrats like Rep. Levin and Sen. Baldwin, authors of the legislation to hike taxes on carried interest, want to do is treat the fund manager differently than the other partners. But this is not justified. If there is no gain, then there is no corresponding carried interest. The fund manager is taking a risk that there will be a gain as with any other type of investment and just as the investors in the fund. Taxing the carried interest as a capital gain is thus fair and consistent with other forms of taxation.
More importantly, the current tax treatment is better for the economy.
Both during and after the campaign, Trump did discuss this tax break as unfair for hedge fund managers, but he did not put it into his tax plan released to Congress for a reason. Hedge fund managers represent only a fraction of those who are compensated through carried interest. Private equity and venture capital funds also typically compensate their managers with carried interest. According to a 2015 study by Stanford University, 43 percent of public U.S. companies founded after 1979 raised some amount of venture cash. Amazon, Microsoft, and Apple all were helped getting started by investments from venture capitalists.
The fund manager plays a crucial role in this equation. A system that sees them rewarded for making smarter investments that produce higher returns not only benefits the fund and its investors—which is not just the wealthy but also millions of ordinary Americans through pension funds—but the economy as a whole. When funds invest wisely it means that economic activity is increasing. Decoupling the manager from the performance of the fund would at least somewhat reduce their personal incentive to perform to their peak ability.
Perhaps the biggest danger from altering the tax treatment of carried interest is the precedent it would set for capital gains taxes more broadly. Democrats have long sought to increase taxes on capital to fund ever more government spending. But capital taxes are the most economically destructive and already represent a form of double-taxation which ought to be eliminated.
One odd development is seeing Sen. Joe Manchin (D-WV), a perceived moderate, join this liberal fight to hike taxes. When one looks at the class warfare politics behind the push to hike taxes on carried interest, one would not expect Manchin to join a fight that may hurt some of his constituents. Taxing carried interest at a higher rate will constrict investments that create jobs in states like West Virginia and may impact pension funds managed by hedge funds.
When added to the black-eye that Republicans took on healthcare, it is time for President Trump to turn the corner and pass a pure tax reform bill that cuts taxes and does not hike taxes on carried interest as a means to implement some class warfare against hedge fund managers.