Carried Interest: The Scam of All Scams

[Guest post by Matt O'Brien]

I’m not sure this qualifies as a quiet room, but let’s talk about inequality anyway. More specifically, let’s discuss the taxes that some of the super-rich pay. The much-anticipated release of Mitt Romney’s tax returns confirmed what was widely assumed: He pays less of his income in taxes—13.9 percent to be exact—than do many middle-class households. Romney manages this sweetheart rate thanks to the so-called carried interest loophole that rather absurdly lets him classify the vast majority of his income as capital gains—which are taxed far lower than ordinary income. It’s an outrage. And one that is demonstrably without any justification.

First, a quick primer on how carried interest works. Capital gains generally only apply to profits investors earn from risking their own capital. This is not so with carried interest. Indeed, the magic of carried interest is that some financiers book capital gains far in excess of any capital they ante up—or, put differently, they get to count performance fees as capital gains. This is an enormous boon due to the low taxation of capital gains. After equaling the top marginal rate of 28 percent at the end of the Reagan years, the capital gains rate has fallen to 15 percent over the past two decades (versus a top marginal rate now of 35 percent). This is why the über-wealthy—the top 0.1% earn half of all capital gains—have had their effective tax rate plummet over this period. This lower rate is usually justified due to the double taxation of capital from corporate income taxes, but this isn’t necessarily true. It’s well-known that many corporations pay little or no income tax, and there are certain corporate structures called “pass-throughs” that avoid all tax as well. Private equity funds like Romney’s Bain Capital are, of course, organized as pass-throughs.

Leave aside for now the debate over whether it makes sense, to begin with, to tax capital gains at a lower rate than other income. What can’t be denied is that the carried interest loophole allows Romney (and many other wealthy Americans) to apply the capital gains rate to something different altogether: ordinary income, specifically the profits owed to the members of private partnerships—think venture capitalists, along with private equity, hedge fund, and real estate trust managers. These financiers are customarily compensated along a two-and-20 model: they earn a management fee equal to two percent of the size of their fund, and a performance fee of 20 percent of any profits. The two percent management fee is taxed as ordinary income—i.e., 35 percent—but, due to carried interest, the 20 percent performance fee is taxed at the long-term capital gains rate of 15 percent, despite the fact that fund managers typically only contribute a small fraction of the capital at risk.

In Romney’s case, he’s earning the vast majority of his money from a retirement package that entitles him to a continued share of Bain Capital’s profits. Courtesy of this cushy pension, Romney received $27 million in 2010 alone. The good news, though, didn’t stop there for Romney. Because Bain Capital is a private equity fund, Romney was eligible for carried interest. So while any other pensioner would be stuck paying a 35 percent tax rate on such a generous package, Romney was able to knock his tax bill down to 15 percent. Even his own economic advisor Greg Mankiw, a professor of economics at Harvard University, doesn’t think this makes any sense. As Mankiw points out, plenty of other professions involve working hard for an uncertain, but potentially lucrative return—such as textbook writers, like Mankiw himself. It’s difficult to dream up a rationale for why the tax code should so privilege financiers.

Apologists for carried interest—they do exist!—insist that eliminating this loophole would cripple investment. Much hand-waving ensues. So too do invocations of “job creators” and admonitions against disincentivizing risk-taking. These free market bromides are, to put it politely, little more than fairy tales. Indeed, it’s hard to figure how ending carried interest would harm investment when doing so wouldn’t increase investors’ tax bills. Only fund managers would owe more to Uncle Sam. Of course, financiers might jack up their fees to try to recoup their lost income, but the threat of investors parking their money elsewhere should hold this in check.

Even less convincing, though, are the claims that taxing fund managers like everybody else is taxed would curb their activities or make it harder for them to recruit talent. This is just empirically untrue. Consider the case of high-frequency trading (HFT) hedge funds. These automated traders aren’t eligible for the long-term capital gains rate (and hence the carried interest loophole) due to their gains not being, well, long-term. A position has to be held for a year to count as a long-term capital gain, otherwise it is taxed as ordinary income. There is, of course, an exception: gains from certain futures and options are taxed 60 percent as a long-term capital gain and 40 percent as ordinary income, regardless of their duration. None of this is an issue for venture capitalists and private equity managers who make multi-year investments, but it does impact the HFT crowd who make lightning-quick trades. Consequently, HFT hedge funds are taxed between 23 and 35 percent, depending on their portfolios. If there have been stories about HFT hedge funds having trouble hiring due to prospective employees worrying about their tax statuses, I have certainly missed them.

This type of favoritism in the tax code is precisely what Republicans say they despise. Indeed, imagine the outcry from the Wall Street Journal editorial pages if President Obama proposed halving the taxes of teachers, lawyers or—gasp!— manufacturing workers. There would be shrieks about crony capitalism. And yet, when it comes to implicitly subsidizing financiers, the Republican establishment suddenly sees things differently. They shouldn’t. The proliferation of HFT hedge funds, despite being taxed higher, shows that the warnings of economic calamity if carried interest is eliminated are ill-founded. It’s well past due to close this loophole and make the game a little less rigged.

Matt O’Brien is an intern at The New Republic.

Sadly, a great deal of people pine for a return to feudalism, apparently.

Sadly, a great deal of people pine for a return to feudalism, apparently.

Jesus. Then they have the nerve to complain that the rest of us aren't rich because we don't have a work ethic, and accuse of envy and class warfare for discussing these things.

No wonder Romney, et.al., want this stuff kept inside quiet rooms.

Jesus. Then they have the nerve to complain that the rest of us aren't rich because we don't have a work ethic, and accuse of envy and class warfare for discussing these things.

No wonder Romney, et.al., want this stuff kept inside quiet rooms.

"Carried interest" is a red herring. Here's the issue by way of an example, an example that is repeated hundreds, thousands of times every year around America.

My brother in law, a rich and busy doctor, and I form a partnerhip to invest in appreciating assets (what other kind do investors invest in). He puts up all the money and I find the appreciating assets, acquire them with his money, and manage them until we sell them at an enormous profit. For my efforts, my brother in law agrees that I can take 20% of those enormous profits as my share of the partnership. So I find those appreciating assets and buy them, using my brother in law's money, manage them for a year and a day, them sell t ... view full comment

"Carried interest" is a red herring. Here's the issue by way of an example, an example that is repeated hundreds, thousands of times every year around America.

My brother in law, a rich and busy doctor, and I form a partnerhip to invest in appreciating assets (what other kind do investors invest in). He puts up all the money and I find the appreciating assets, acquire them with his money, and manage them until we sell them at an enormous profit. For my efforts, my brother in law agrees that I can take 20% of those enormous profits as my share of the partnership. So I find those appreciating assets and buy them, using my brother in law's money, manage them for a year and a day, them sell them at an enormous profit. I report my 20% share of the profit as capital gain and pay a 15% tax. My brother in law reports his 80% share of the profits as capital gain and pays a 15% tax. I really like my brother in law. And he likes me. He's thinking about running for mayor. I intend to vote for him. I might even make a campaign contribution.

Separate example about "carried interest" so not to confuse.

My brother in law and I decide not to sell the appreciating assets after a year and a day becasue we believe there's even more enormous profit to be realized. Six months later I decide I want to run for mayor, so I offer sell my interest in the partnership to my brother in law based on the value of my 20% interest in those appreciating assets. My brother in law agrees to pay the price over a period of years in anticipation of selling the appreciating assets after I have retired from the partnership. I report the payments I receive from my brother in law as I receive them as capital gain and pay a 15% tax. The extra money comes ... view full comment

Separate example about "carried interest" so not to confuse.

My brother in law and I decide not to sell the appreciating assets after a year and a day becasue we believe there's even more enormous profit to be realized. Six months later I decide I want to run for mayor, so I offer sell my interest in the partnership to my brother in law based on the value of my 20% interest in those appreciating assets. My brother in law agrees to pay the price over a period of years in anticipation of selling the appreciating assets after I have retired from the partnership. I report the payments I receive from my brother in law as I receive them as capital gain and pay a 15% tax. The extra money comes in handy during the election, but I lose anyway. Too many voters don't like my brother in law because he's a rich doctor and take it out on me. I think I may go to law school. Or maybe seminary. I'll have those payments coming in from my brother in law and I only have to pay a 15% tax on the payments. I like my brother in law even if nobody else does.

It's difficult to dream up a rationale for why the tax code should so privilege financiers.

Nobody deserves any privileges for anything under the tax law.

The tax laws should collect the most revenue with the least damage to the economy. High top rates do not hurt the economy. Low capital gains rates do not help the economy. The estate tax does not hurt the economy. The Republicans ran up $5 trillion in debt and, when it comes time to pay for it, the Republicans say somebody else should pay for it, other than the people who benefitted when Republicans pumped that $5 trillion into the economy.

It's difficult to dream up a rationale for why the tax code should so privilege financiers.

Nobody deserves any privileges for anything under the tax law.

The tax laws should collect the most revenue with the least damage to the economy. High top rates do not hurt the economy. Low capital gains rates do not help the economy. The estate tax does not hurt the economy. The Republicans ran up $5 trillion in debt and, when it comes time to pay for it, the Republicans say somebody else should pay for it, other than the people who benefitted when Republicans pumped that $5 trillion into the economy.

These are excellent comments. As an appropriate reward for the insight and perception provided, I invite each person who commented to invest in the bridge I am building in Brooklyn. It will be named the Nitt bridge

Today is an exciting day. I just saved a hen's life (although she is now missing quite a few feathers and is unhappily cooped up in the hen house until we figure out how the hawk got into the chicken yard). I just shot at a squirrel, but missed. My wife tells me not to shoot the red squirrels because they are native to our island, but orders me to shoot the gray squirrels because they are interlopers. So amidst all my other crimes and flaws, I am also a bad shot, a squirrel racist, ... view full comment

These are excellent comments. As an appropriate reward for the insight and perception provided, I invite each person who commented to invest in the bridge I am building in Brooklyn. It will be named the Nitt bridge

Today is an exciting day. I just saved a hen's life (although she is now missing quite a few feathers and is unhappily cooped up in the hen house until we figure out how the hawk got into the chicken yard). I just shot at a squirrel, but missed. My wife tells me not to shoot the red squirrels because they are native to our island, but orders me to shoot the gray squirrels because they are interlopers. So amidst all my other crimes and flaws, I am also a bad shot, a squirrel racist, infinitely tedius, and a not very ethical nihilist who claims, "I was just following orders." It's a dumb squirrel. It's back. I will pst and then take another shot.

I have been stalking this squirrel for weeks. I just killed it. This is a triumph for my Second Amendment rights, though if a bad human comes to our house, the best use of my pellet rifle would be to club the intruder with it. In fact we keep a stick (called a "fish bonker" -- I kid you not -- by the door, so if you invade our peaceful home in the woods, you are most likely to be felled by a fish bonker. There's a reason we are at the top of the food chain.

I have been stalking this squirrel for weeks. I just killed it. This is a triumph for my Second Amendment rights, though if a bad human comes to our house, the best use of my pellet rifle would be to club the intruder with it. In fact we keep a stick (called a "fish bonker" -- I kid you not -- by the door, so if you invade our peaceful home in the woods, you are most likely to be felled by a fish bonker. There's a reason we are at the top of the food chain.

My brother-in-law and I take our money and invest it in starting a small business. We are successful and make an enormous profit. Our profit is not capital gains so we pay a 35% tax rate on the earnings (well, on part of them anyway). More fool us, we should have emulated rayward and his rich brother-in-law and shuffled investment money around so that we could have gotten the privileged tax rate.

Ray has posted a version of this example a few times, and I see that there can be complexity in keeping track of when income is realized, but I still don't see any good reason why the work of the investment manager should not be treated the same as ordinary income. Except for that fact that the very ... view full comment

My brother-in-law and I take our money and invest it in starting a small business. We are successful and make an enormous profit. Our profit is not capital gains so we pay a 35% tax rate on the earnings (well, on part of them anyway). More fool us, we should have emulated rayward and his rich brother-in-law and shuffled investment money around so that we could have gotten the privileged tax rate.

Ray has posted a version of this example a few times, and I see that there can be complexity in keeping track of when income is realized, but I still don't see any good reason why the work of the investment manager should not be treated the same as ordinary income. Except for that fact that the very rich guys who are affected by this can make very large campaign contributions.

Plus in the (fictitious) example above, my brother-in-law and I would also pay the equivalent of payroll taxes on our small business income (the self-employment tax). Capital gains are not subject to this, so even if the tax rates were the same capital gains would still be privileged relative to ordinary income as far as total taxation is concerned. This makes arguments against equalizing the rates seem even more like complete crap to me.

Plus in the (fictitious) example above, my brother-in-law and I would also pay the equivalent of payroll taxes on our small business income (the self-employment tax). Capital gains are not subject to this, so even if the tax rates were the same capital gains would still be privileged relative to ordinary income as far as total taxation is concerned. This makes arguments against equalizing the rates seem even more like complete crap to me.

I remember vividly the end of the first day of the bar exam, and talking outside the exam room to the other anxious future lawyers about the important essay question, half discussing the trust law essay question and the other half discussing the state constitutional law essay question. The first reaction was the unfairness of giving different essay questions. Then the realization: there was one essay question for everybody, as everybody's essay question had the same set of facts. Oh my God! Identifying the issue is the first and most difficult task of the lawyer. And of the doctor. And of the business owner.

I remember vividly the end of the first day of the bar exam, and talking outside the exam room to the other anxious future lawyers about the important essay question, half discussing the trust law essay question and the other half discussing the state constitutional law essay question. The first reaction was the unfairness of giving different essay questions. Then the realization: there was one essay question for everybody, as everybody's essay question had the same set of facts. Oh my God! Identifying the issue is the first and most difficult task of the lawyer. And of the doctor. And of the business owner.

The only good thing is that if Romney and the Republicans manage to take over again, they will so screw over the poor and middle class, while continuing to deficit spend, that when the economy collapses and the debt bill comes due they will find that the middle class (what is left of it) and the poor will have nothing left to pay and they themselves will either be the ones holding the bag or end up swinging from a rope.

This was one of Obama's big mistakes, when he got to 60 votes in the Senate he could have gotten rid of that loophole (and damn Schumer if he got in the way, in the end he would have backed down)

The only good thing is that if Romney and the Republicans manage to take over again, they will so screw over the poor and middle class, while continuing to deficit spend, that when the economy collapses and the debt bill comes due they will find that the middle class (what is left of it) and the poor will have nothing left to pay and they themselves will either be the ones holding the bag or end up swinging from a rope.

This was one of Obama's big mistakes, when he got to 60 votes in the Senate he could have gotten rid of that loophole (and damn Schumer if he got in the way, in the end he would have backed down)

blackton, you are far too optimistic about people's propensity to wise up.

blackton, you are far too optimistic about people's propensity to wise up.

I imagine that a very large number of people who work in the not-for-profit sector would love for their income to receive the same tax treatment as the proceeds that their employer takes in and pays them with. I can imagine someone making a reasonable case for such a policy too. But that is not the law. Doctors, nurses, social workers, clerks, IT folks and even investment managers who work for not-for-profits don't get to pay taxes at their employer's rate. Why should investment managers for the very wealthy?

For that manner, why aren't the gardeners and household help of the very wealthy, whose pay is also principally derived from capital gains, given similarly lenient tax treatment?

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