5 Reasons to NOT Change Carried Interest Tax

There are several problems with raising the Carried Interest Tax:

1. Ultimately, this tax will be borne by many middle-class folks, as is usually the case with raising taxes. As long as there is a favorable capital gains treatment, financiers who are in the business of making capital gains will find a way to get that benefit. Perhaps it will by moving to a 2%/28% structure (instead of the 2%/20%) structure. Even if it is not 2%/28%, a market price has been set for private equity professionals (and don’t think Mega fund and the CEO’s of those funds – think the vast majority of people slugging it out in VC and PE in smaller funds) and they will find a way to get some of those economics back. And if it is shared (2%/25%, higher management fees, etc.), the brunt of the tax is effectively borne by LP’s and ultimately by the pension funds, the teachers and the unions, and the college endowments. So, you take from Peter to pay Paul who ends up paying an equal amount back to Peter, and Paul ends up in the same place or worse.

2. It isn’t just PE, all partnerships are this way. If a father and son start an ice-cream parlor and the father puts up 90% of the capital and they agree to split profits 50/50 because the son will do all the work, is now the son going to be taxed at ordinary income rates when they sell the business? Every partnership in the U.S. has been structured like this for decades. There has been a fundamental recognition that people contribute, and put at risk, more than just capital. They put know-how, relationships, career risk, etc. together and all of that is what builds the long-term capital gains. The free market is determining how those profits are being split and who is driving the capital gain – I am sure they (i.e. millions of individual negotiations over decades) have figured it out in a better way than a sub-segment of government that has looked at the issue over the past 2 months. Hubris.
 
3. GP’s have actual dollars at risk – their GP commitment. Do they need to have 20% at risk to get 20% of the profits as capital gains? Does that make sense when they are contributing more than just capital do make capital gains – know how, rolodex, relationships, careers etc. Maybe it should be a certain percentage, but if it were 20% then wouldn’t it seem like LP’s were getting too sweet of a deal? Maybe GP’s need to contribute 1% to have real skin in the game and contribute 19% in sweat, etc.
 
4. Really, all that is being done on a macro level is raising the capital gains tax on a certain sub-section of the population – PE firms and their LP’s. There is a reason that capital gains are taxed at a favorable rate – the argument is that because capital gains are good for everyone in society. Whether you believe that is a different debate. But given that is the argument that has won out over decades, let’s accept it. By taxing 20% of a capital gain at ordinary income rates (the GP’s share of the profits), effectively you are just raising the capital gains tax rate on the PE sector from 15% to ~20% (depending on the details of the deal) with LP’s paying 15% and GP’s paying 35%. But the end is the same as just raising the capital gains rate, some people who buy businesses will have to pay a higher tax then others (think individuals who buy businesses directly, etc vs. partnerships). A new tax is imposed and it will have effects. Wouldn’t it just be better and clearer to raise capital gains tax back up to 20%? More tax revenue would be generated and you would not be raising the tax to PE pros by 100%+ (15% to 35%) – the people who are effectively driving much of the capital gains – capital gains that are supposedly good for everyone in the economy. Do we really want to discourage that behavior (the creation of capital gains) by raising their tax by 100+%?

Again, people want to think of the Mega LBO fund billionaire instead of the small or middle market fund or VC fund slugging out to drive that marginal capital gain for society (and himself, but society benefits as much or more).

5. The market has been set for years. People have been made decisions on career choices (should I do that ice cream parlor with Dad or just get a job at the local dairy queen). The tax code should be consistent so that the market can make its decisions accordingly. To change now, upsets that balance. And not marginally by a few percentage points, but by increasing the tax rate by over 100%! Drastic decisions will be made and the effects are unknowable now as the market determines the “new market.” Think the real estate market in the 80’s as we cut taxes and then raised and changed them. It took years to recover.
 
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So basically, it won’t work, it isn’t feasible, and it is not desirable. But will we do it nonetheless? Probably. Why? Because the sound-bite will probably win out over intellectual thought — “These rich guys are only paying 15% — that isn’t fair.” Hopefully reasonable minds will prevail over the “mob rule.”