Tax Change: Fair but Unfair

The proposal to change the tax rules for carried interest is unfair not per se, but it is unfair because it singles out fund managers for tax discrimination.

Proponents of treating carried interest as “compensation,” taxable at high ordinary income rates, do have a good argument to a point. The carried interest is obviously compensation to fund managers for their work in creating superior investment returns; and it is coupled with relatively little risk of lost direct investment.

However, there are many other actors in our economy who receive forms of compensation taxed at capital gains rates in exchange for contributions comprised primarily of personal services. Entrepreneurs often start companies with very little capital, but receive large amounts of stock. Investors put up the cash and risk the direct financial loss – while the entrepreneur works in the business (and is usually paid a salary) but the gains (if any) to both entrepreneur and investor are taxed as capital gains. Executives often receive stock options or restricted shares in addition to their salaries. Not only are gains on these securities taxed as capital gains, there are other provisions in the tax code that can make these plans even more tax-favorable.

Fund managers are no differently situated (except being fewer in number and less politically sympathetic) than executives and entrepreneurs – if the favorable treatment of carried interest is unjustified, so is the capital gains treatment of founders’ stock and stock options.

All of these economic players are rewarded for economically desirable behaviors. Founders’ stock motivates entrepreneurs take the risky step of starting companies (which creates employment) instead of sitting in steady jobs.  Stock options align the interests of owners and managers. Carried interest encourages fund managers to allocate capital to its best use (i.e., to the most economically efficient use).

The question should not be taxing these incentives at higher rates, but whether, like many other countries (e.g., Belgium, Germany, Hong Kong, India, Netherlands, South Korea, Switzerland), they should not be taxed at all.