The silly season of tax policy is apparently once again upon us. Lawmakers are threatening to increase taxes on hedge funds, private equity funds, and venture capital funds by changing the tax treatment of so-called “carried interest.”
Right now, all profits from the various types of alternative investments are treated similarly by the tax code. Fund managers and fund investors can defer the gains and have them treated as “capital gains” rather than ordinary income. The carried interest tax proposal would treat the share kept by the fund managers differently from that of the investors, declaring the fund managers portion ordinary income.
Whether something is taxed as ordinary income or capital gains makes a huge difference. Capital gains taxes rates are capped at 15%. The highest marginal rate is currently 35%, although it is expected to climb to 38% when the Bush tax cuts expire.
The Old Tax Hike Shakedown
I have always regarded the talk of changing the tax treatment of carried interest as a political shakedown. Back in 2007, we had a wide-ranging debate about carried interest that stretched from the ivory towers—where law professor Victor Fleischer formulated the most intellectually coherent case for the higher taxes—to Capitol Hill. But, despite a Democrat controlled House and Senate, all we really got was bigger political contribution checks from hedge fund managers and more money for the lobbyists who were once staffers on Capitol Hill.
All evidence seems to indicate that this was the entire point of the exercise. This is why I call the regular revival of the carried interest tax issue “the silly season of tax policy.”
But that doesn’t tell us anything about the merits of taxing carried interest. If we were to close our eyes to the political shakedown and look directly at the issue, what should we conclude?
At one point, I thought that the argument offered by Fleischer appeared to be very strong. The taxation of carried interest as capital gains did look like something of a loophole. It really did seem like fund managers had found a way to have their paychecks treated better by the government than the paychecks of the rest of us. It was at least a bit annoying to have incredibly rich folks get taxed less for their compensation than, say, hard-working bloggers.
But I was wrong. Carried interest is correctly taxed as capital gains. There’s no good reason to change it to ordinary income.
The Tax System Is So Crazy It Wants To Tax Housework
Let’s start with the basics. There’s good reason to be suspicious of almost any argument that says the tax system would be more rationale, more in keeping with its basic principles, if we raised someone’s taxes. Why shouldn’t it work the other way? Why shouldn’t we instead look for other activities that closely resemble the activities subject to lower tax rates and try to get the lower rate for them too?
What’s more, the arguments for tax rationalization quickly become absurd. A very typical law school discussion of income taxes centres around how to tax housework. That’s right: there’s a somewhat serious issue about whether or not a stay at home spouse who performs housework should be taxable.
Here’s how that argument works. If your employer provided you with house-cleaning services as part of your pay, you would be taxed on that. If some stranger came buy and donated house cleaning services, that would be subject to a gift tax. So why do you get to escape the tax just because your wife does the cleaning?
We can go even further down this road. The refusal to tax spousal services deprives the U.S. Treasury of revenues. If you had to hire a house cleaner, the house cleaner would be subject to income taxes. By employing your spouse, you inflict a loss equal to the amount of those taxes on the Treasury. If your spouse was working instead of being a homemaker, his or her income would be subject to taxes. By employing him or her as a homemaker, you are depriving the Treasury of that revenue.
Your spouse is receiving lots of benefits as a homemaker that escape taxation. He or she basically has an income that totally escapes the tax system. Since this revenue must be made up by other taxpayers, it is fair to say that other taxpayers are subsidizing the homemaker.
The correct reply to this entire line of argument is to guffaw. It shows that there’s something wrong with the fundamental principles of the tax system rather than indicating that we should tax homemakers. Or, perhaps, that we shouldn’t try to conform our crazy system of taxes around some body of fundamental principles at all. In reality, isn’t just a collection of special interest takings and giveaways?
Still, that doesn’t get to the merits of Fleischer’s argument for taxing carried interest as ordinary income, which he presented in a paper called “Two and 20.” It only shows that maybe trying to get to the merits of such argument is a silly exercise.
Misunderstanding Carried Interest
Fleischer’s basic argument is that carried interest is basically the compensation received by a fund manager for performing the service of managing the fund, so it should be treated as we treat any other fee-for-service. That is, as ordinary income subject to the high marginal income tax rates.
Where Fleischer goes wrong is by supposing that carried interest is ordinary income. Let’s start with the basics. Suppose Joe Weisenthal starts a hedge fund called Stalwart Investments and suppose I invest in the fund. At first, Joe decides he’s only going to charge a 2% management fee—taking none of the upside at all.
Three years go by, and the fund is up 100%. My original $1 million investment is now worth $2million. Joe takes 2% a year of the total, and that gets taxed as ordinary income. My entire upside is a capital gain—a gain on my investment.—and only subject to the 15% capital gains tax.
Now suppose that Joe decides he’s missed out on a huge fortune, so he decides he’s going to claim a 20% share of future profits in a new fund he’s starting. I grumble a bit but give him $1 million for the new fund. Once again, after 3 years we’re up 100%. The fund’s gain is identical—$1 million.
Should the taxation of the $1 million the fund made be different just because Joe and I have changed the way we divide up the profit? That’s what Fleischer’s proposal amounts to. It takes any investment gain and taxes it differently depending on whether it is kept by the fund manager or the fund investor. That’s hardly a rational or fair tax policy.
Another way of looking at it is to say that my $1 million investment bought me an 80% share in the hedge fund. Joe’s “sweat equity” bought him a 20% share in the hedge fund. If the fund makes money on its investment, we divide up the profits according to the shares we have. Why should one partner’s shares be taxed higher than the others?
The answer is that it shouldn’t. Carried interest taxation as capital gains is not a loophole. It’s a straight-forward application of basic tax rules to the partnership structure of hedge funds. It even has an egalitarian feature—allowing the manager with who must seek capital for his fund the same advantage as the wealthy investor who wants to provide capital to the fund.
Leave the carry alone. It’s fine.
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