Why Taxing Carried Interest As Ordinary Income Is Good Policy

The House has passed a bill this past week that would change the taxation of carried interest from capital gains treatment to ordinary income treatment. The Senate has not weighed in on the debate but it is expected to do so soon. The New York Times has a story about it in today's business section. I've written about this issue in the past, roughly three years ago when it first surfaced as an issue. I am in favor of taxing carried interest as ordinary income and I'd like to explain why I think it is good policy.

I agree with Victor Fleischer's basic premise that carried interest is a fee for managing other people's money. It is a fee based on performance, but it is a fee nonetheless. It is not fair or equitable to other recipients of fee income to give a special tax break to certain kinds of fees and not to others. 

But even beyond the basic argument of equity and fairness, there are some other important factors to consider.

We have witnessed financial services (think asset management, hedge funds, buyout funds, private equity, and venture capital) grow as a percentage of GNP for the past thirty years. The best and brightest don't go into engineering, science, manufacturing, general management, or entrepreneurship, they go to wall street where they will get paid more. And on top of that, we have been giving these jobs a tax break. That seems like bad policy. If we force hedge funds and the like to compete for talent on a more level playing field, then maybe we'll see our best and brightest minds go to more productive activities than moving money around and taking a cut of the action.

Changing the taxation of the managers will not reduce the amount of capital going to productive areas. The sources of the capital; wealthy families, endowments, pension funds, and the like, will still put the capital in the places where they will get the highest after tax return. And these sources of capital, if they are tax payers, will still get capital gains treatment on their investments in hedge funds, buyouts, and venture capital. And the fund managers will still have to compete with each other to get access to that capital and their incentives will still be to produce the highest returns they can produce, regardless of whether they are paying capital gains or ordinary income on their fees.

We may see the best managers investing more of their own capital and less of other people's money with these changes to the tax law. When I invest my own capital in a company (either directly or through my funds) and that investment generates a capital gain, I will still get to pay a lower tax rate. So at the margin, I might prefer to invest my own capital over someone else's with the new tax rules. I believe that is good policy. I have seen a correlation between a manager having significant "skin in the game" and long term performance. So if these tax changes produce more "skin in the game" that will be a good thing.

Finally, we need to balance the federal budget and we need both revenue increases and expense reductions to do that. Think about the hedge fund manager who is investing a $10bn fund. Let's say that manager produces an annual return of 8%. That's not an amazing year, but the manager will make $160mm in carried interest anyway. Under current law, the manager will only pay roughly 25% of that as taxes between federal, state, and local taxes. Under the new law, the manager will pay double that. That's a difference of $40mm for one fund manager. And there are a lot of fund managers out there. 

It's time for asset managers to start paying their fair share of taxes. We are among the most highly compensated people in the world. And we've been getting a huge tax break for years. It's not right and I am happy to see our government finally do something about it.

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