The Carried Interest Debate

In the 2016 election, carried interest and its taxation was a hot topic. Often explained as a “loophole” that allows the rich to exploit tax codes, carried interest is not a political issue that clearly fits within party lines. Lobbying by the financial sector occurs on both sides of the political aisle, and there are opponents and supporters within both parties. What are the dynamics of this debate, and what are the arguments for whether carried interest should be taxed differently?

Private Investment Funds

In the 2016 election, both Donald Trump and Hillary Clinton rallied against “hedge-funds” for paying so little tax. However, these comments were misleading. Clinton and Trump were actually talking about a tax rule that applies to a range of private investment funds.

A private investment fund invests capital with the goal of making returns for its investors. But within this description there is a lot of variety in the types of funds. Funds vary in their sources of capital, the targets of their investments and the roles they play in the economy.

https://commons.wikimedia.org/wiki/File:Fund_Structure.pngPrivate investment funds are typically set up as limited partnerships, rather than limited liability companies (LLCs). They organize themselves as general partners and limited partners. The general partners are the funds’ managers, which may be structured as a managing firm. Managing firms are often incorporated as an LLC. The limited partners are the funds’ investors. They are called limited partners because they are required to have limited involvement in the funds day-to-day activities. These investors are usually financial institutions, pension funds, insurance companies and wealthy individuals.

Rewarding General Partners

General partners invest in their own funds (typically contributing less than 5 percent of the capital) to make money. However, their compensation comes through management fees and carried interest. Usually around 2 percent of a fund’s raised capital goes to management fees.  Management fees are paid regardless of the fund’s performance and are there to cover operating costs and base salaries.

When a firm is set up it negotiates how excess returns – those paid after invested capital has been repaid – are shared. An 80/20 split between investors and managers is typical. Managers with strong track records can and do negotiate for more, sometime even offering to forgo management fees.  This 20 or so percent that goes to the managers is called “the carry” or, formally, the carried interest.

Types of Private Investment Funds

Common types of private investment funds include private equity funds, venture capital funds, hedge-funds and mutual funds.

Private equity funds generally invest in large companies with the intent to restructure and sell the firms for a gain. These investments usually mean acquiring controlling interests in public companies through stock purchases. The fund will then take the company private. Private companies can then be sold to another buyer or back to the public with a new initial public offering. However, private equity firms do also sometimes acquire private companies.

Venture capital funds invest in high-tech startup companies with high-growth potential. Once the fund purchases a stake in the company, it also provides coaching and other services to the company in order to increase its chances of success. Venture capital funds sell their positions at initial public offerings or when their portfolio companies get sold to incumbents or private equity firms.

Hedge funds focus on achieving high returns through risky investments. They differ from mutual funds in the diversity of their strategies and their underlying assets. Mutual funds typically only take long positions in stocks and bonds. Hedge funds can invest in anything. Their underlying assets include stocks, bonds, commodities, derivatives, warrants, futures, options, currencies, land, real-estate and much else besides. Hedge funds will often simultaneously take both long and short leveraged positions.

Tax Treatment

The carried interest controversy stems from its tax treatment. Carried interest is subject to a maximum capital gains tax rate of 20 percent (the long-term capital gains rate). This is compared to the maximum ordinary income tax rate of 39.6 percent, which is also the maximum short-term capital gains rate.

Those in favor of the current system believe that a higher rate would reduce the incentive for general partners to take risks. They sometimes specifically claim that greater taxes on carried interest could discourage innovation and efficiency in markets.

Those opposed to a reduced tax rate for carried interest frequently argue that carried interest is performance-based compensation.  Comparing it to a bonus, they say that it should be subject to the ordinary income rate.

The controversy surrounding carried interest has faced increasing media scrutiny since the 2012 election. Former Presidential Candidate Mitt Romney paid taxes of just $1.9 million on $13.69 million in income in 2011, an effective rate of 14.1 percent  Perhaps in response to the media and public uproar, the American Taxpayer Relief Act of 2012 raised what was then the long-term capital gains tax rate of 15 percent to 20 percent. President Obama signed this change into law on January 2, 2013.

The Economics

To economists the key question is one of efficiency: Would free markets achieve the efficient outcome without the additional incentive that carried interest provides? The answer probably depends on the type of private investment firm.

Venture capitalists face enormous information problems when trying to assess their potential investments. And many of their portfolio firms create value for outsiders who aren’t investors and who don’t use the firm’s products themselves. Each of these reasons leads to inefficient under-investment, which carried interest could help address.

Hedge-funds may make markets more complete by allowing investors to place capital into a wider range of underlying assets. Private equity firms may provide a “market for management” that disciplines publicly-traded firms. It is possible that without these types of investment vehicle there would be market failure, but it is unclear that they need additional incentives to address it.

Because mutual funds just aggregate and manage stock and bond portfolios – a job done by brokers and investors themselves – it is hard to see why they need subsidizing.

Looking to the Future

The House Republicans’ 2016 Tax Reform Proposal includes no explicit mention of carried interest. However, it does advocate for “reduced but progressive” capital gains taxes. If the administration chooses to adopt this plan, carried interest tax breaks could become even larger.

However, it is difficult to predict the fate of carried interest tax breaks, especially given President Trump’s past statements. During his campaign, Trump was highly critical of these tax breaks. He claimed that fund managers were “getting away with murder” by taking advantage of the rule. However, since taking office, Trump Administration has made no mention of its plans to address this tax code provision. The administration plans to reform U.S. tax law in the coming year, so carried interest is definitely a topic to look out for.

See the McNair Center’s wiki page on Carried Interest for further explanation of the dynamics of carried interest.

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