An Analysis of the "Carried Interest" Controversy

PDF of this report (15pp.)

By Aviva Aron-Dine

July 31, 2007

Key Findings

  • The current tax treatment of “carried interest” allows private equity firm managers to pay tax on a large portion of their compensation at the 15 percent capital gains rate, rather than at the 35 percent top income tax rate that would otherwise apply.
  • As financial industry billionaire Warren Buffett has noted, this means managers earning $500 million can easily end up paying a smaller share of their income in taxes than many middle-income Americans do.
  • Further, by treating carried interest differently than other comparable forms of compensation, the tax break creates economic distortions. Rather than helping the economy, taxing carried interest at low rates likely makes the market for financial services somewhat less efficient than it otherwise would be.
  • Some have claimed that eliminating the tax break for carried interest would greatly harm state employee pension plans and other investors. This argument does not withstand scrutiny and has been rejected by pension plans themselves.
  • The carried interest controversy also illustrates how taxing capital gains at much lower rates than other income creates powerful incentives for tax schemes designed to reclassify regular income as capital gains.

 

Related Areas of Research

This week, the Senate Finance Committee is scheduled to hold a second hearing on the tax treatment of “carried interest.”  A carried interest is a right to receive a specified share (often 20 percent) of the profits ultimately earned by an investment fund without contributing a corresponding share of the fund’s financial capital.  It is part of the standard compensation package for managers of private equity funds.

Current law allows these managers to pay tax on all or most of their carried interest income at the 15 percent capital gains rate, instead of at the individual income tax rate that would otherwise apply, typically 35 percent for these high-income individuals.  Rather than being taxed as managers receiving compensation for services rendered, recipients of a carried interest are taxed as though they were investors who had supplied 20 percent of the financial capital of the fund.

In addition, a small group of private equity firms are beginning to take advantage of a provision of current law that makes it possible for them to avoid paying corporate income taxes, even after issuing public stock.  Prior to the development of this new tax strategy, nearly all publicly-traded partnerships were subject to the corporate income tax. 

Both of these issues are attracting congressional scrutiny.  While part of the apparent impetus for the burst of congressional activity is the rapid growth of the private equity industry and the highly publicized tax machinations of the Blackstone Group, there are at least three additional justifications for giving these issues serious attention.

  • Economic efficiency.  If carried interest is largely or entirely compensation for management services, as appears to be the case, then it is being taxed more lightly than almost all other forms of compensation for similar services.[1]  Generally speaking, a tax system is more efficient when it treats like activities alike:  rather than having tax rates determine how people allocate their resources, it is better for the tax system to create a level playing field.[2]  Thus, Harvard economist Greg Mankiw, former Chair of the Council of Economic Advisers under President Bush, has written that from an economic perspective, carried interest should be taxed the same as other compensation for services.[3]  Similarly, Congressional Budget Office Director Peter Orszag testified to the Senate Finance Committee, “[The tax treatment of carried interest is] important [because]… anytime you have similar activities taxed in different ways, you create distortions…  So an executive in a financial services firm or a manager of a public mutual fund is taxed in a different way for those services than a general partner in a private equity or a hedge fund, and that should be of concern to tax policymakers because of the distortions it can create...”[4]
  • Revenue implications.  Given that private equity funds hold $1 trillion in assets, the revenue lost by taxing carried interest as capital gains could easily amount to several billion dollars a year.[5]  That amount is small relative to total federal revenues, but sizable relative to the cost of key initiatives many in Congress would like to fund, such as expansions in the State Children’s Health Insurance Program or increases in tax incentives for higher education or in the Earned Income Tax Credit.
  • Tax equity.  If a manager made $500 million from a carried interest (a high but far from unprecedented figure for managers of private equity funds), had no other income, and claimed no deductions or exemptions, his effective federal income and payroll tax rate this year would be 15 percent.  By comparison, the effective tax rate (taking into account individual income taxes and only the employee side of the payroll tax) for a single individual earning a $45,000 salary would be 20 percent.  As billionaire financier Warren Buffett has stressed, there is something questionable about a tax provision that makes it possible for individuals with multi-million dollar incomes to pay tax at lower rates than their secretaries[6] — particularly at a time when income concentration is rising rapidly, with financial industry compensation likely playing a meaningful role in this trend.[7]

After providing some background on the tax issues surrounding the private equity industry, this analysis focuses on the issue that has generated the most controversy — whether carried interest is compensation for services rendered.  The analysis concludes that carried interest does indeed constitute compensation for work performed; it then examines efficiency arguments for changing the tax treatment of carried interest, as well as claims that doing so would harm the economy.  Finally, the analysis discusses the ways in which this controversy illuminates the broader issue of capital gains taxation.  (In addition, the box on page 10 briefly discusses specific proposals to change the tax treatment of carried interest.)

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End Notes:

[1] University of Illinois Law Professor Victor Fleischer has described carried interest as “the single most tax-efficient form of compensation [i.e. the form of compensation that is taxed most lightly] that is available without limitation to highly-paid executives.”  Victor Fleischer, “Two and Twenty:  Taxing Partnership Profits in Private Equity Funds,” University of Colorado Law Legal Studies Research Paper No. 06-27, revised June 12, 2007, http://papers.ssrn.com/sol3/papers.cfm?abstract_id=892440.

[2] One important exception is when activities generate sizable social costs or benefits.  For example, many economists think it would be efficient for the federal government to impose a tax on carbon emissions.

[3] “The Taxation of Carried Interest,” http://gregmankiw.blogspot.com/2007/07/taxation-of-carried-interest.html.

[4] Transcript of Senate Finance Committee Hearing, “Carried Interest:  Part I,” July 11, 2007, obtained through Federal News Service.

[5] The $1 trillion figure is given in:  Peter Orszag, “The Taxation of Carried Interest,” Testimony Before the Committee on Finance of the U.S. Senate, July 11, 2007, http://cbo.gov/ftpdocs/83xx/doc8306/07-11-CarriedInterest_Testimony.pdf.  In addition, hedge funds hold another $1 trillion in assets, and hedge fund managers also typically receive a portion of their compensation in the form of carried interest.  However, hedge funds frequently hold investments for periods of less than one year, a period too short to qualify for the reduced tax rate for long-term capital gains.  Thus, a much smaller share of the income of hedge fund managers — as compared to the income of private equity fund managers — is currently taxed at the 15 percent long-term capital gains rate; a larger share is already taxed as ordinary income.

[6] Tom Bawden, “Warren Buffett Says Rich Should Pay More Taxes,” London Times, June 27, 2007, http://business.timesonline.co.uk/tol/business/industry_sectors/banking_and_finance/article1995931.ece.

[7] Steven N. Kaplan and Joshua Rauh, “Wall Street and Main Street:  What Contributes to the Rise in the Highest Incomes?” National Bureau of Economic Research Working Paper No. 13270, July 2007, http://www.nber.org/papers/w13270.

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