Earlier this year, President Donald Trump made a proposal to double the tax rate on an important financing structure: carried interest. This idea has historically been a mainstay proposal of left-wing Democrats, as they tend to dislike “fat cat Wall Street financiers”. But underneath the class warfare argument, this structure is an important one in the financial world, allowing for risky, longer term projects with the potential for game-changing returns to be made.
Financing risky projects with longer term timelines is not easy. Banks and other traditional sources of funding tend to steer clear of investments without a clear payment schedule, or with a lower likelihood of positive returns. These issues help explain why the term “carried interest” even exists.
Carried interest is a performance or incentive fee paid to the general partner of a venture capital, private equity, or real estate investment partnership. This share helps align the manager’s compensation with the fund’s long term success. This fee (generally around 20%) is paid after investors receive their initial investments and a preferred return (typically called a hurdle rate). This is generally the main income that a general partner would earn for the active management of the long term investment, along with a small annual management fee of around 1% of assets each year.
The term dates back hundreds of years to maritime commerce, where ships would “carry” cargo to distant ports, braving weather, rudimentary navigation, and pirates along the way. In return for being willing to take the significant risks in effort and resources consumed along the way, ship captains and owners would take a 20% commission of the profit from the goods they carried.
In a sense, this was an early form of venture capital, where investors would loan funds to a risky venture in return for an opportunity for oversize gains down the road. The investors would take this risk partially due to the reputation and quality of the ship captain and primary ship owners, but if not for the potential for outsized gains (gold, sugar, spices, etc.) it would be unlikely that even investors with the deepest pockets would take this level of risk.
While investment recipients may be different today, the same concept still applies. For every successful investment in Google, Amazon, or Facebook, there are at least three other losing investments in companies like Geocities, Pets.com, or Myspace. The vast majority of America’s most innovative companies, who conduct the lion’s share of U.S. corporate R&D, were grown out of venture capital and private equity investments. However, over 75% of corporate start-ups fail. Like the ships of the exploration era, many investors today take reasoned risks in projects that end up deep in a proverbial ocean of failure. But it is still worth doing, thanks to investment structures like carried interest, and thanks to supportive tax structures that have been built up by forward thinking governments.
Ever since the U.S. federal income tax system was introduced in 1913, carried interest returns have been taxed as capital gains. While the rate itself has changed somewhat over time, the concept has been considered as a settled policy that long term investors can rely on. Combined with other federal programs and tax policies put in place after World War II, taxing carried interest as capital gains has helped America build the strongest and most innovative economy in the world.
But carried interest is now under threat from populist politicians who are proposing measures that would treat carried interest gains like normal income, doubling taxation on these gains. The Congressional Budget Office estimates that this measure would reduce the deficit by $13 billion over the next decade. These proponents claim that the carried interest “loophole” encourages and rewards risky behavior that may lead firms who receive investments from private equity into financial difficulties. They also claim that other workers, like waiters or car salesmen, also receive income based on performance and have no guarantees on how much they will make, and that investors in these private equity and venture capital partnerships lose out from the returns received by the fund managers. These claims, including the CBO estimate, are either based on faulty information or are outright wrong.
To begin with, the CBO estimate does not fully consider clear dynamic effects that would occur if increased taxes on carried interest were to take effect. Recent research suggests that tax collections would actually decline by almost $13 billion over 10 years. Investors would stop taking these risks, leading to fewer long-term investments and decreased VC funding. Firms that normally receive these investments would start to downsize or fail at higher rates. These declines would likely occur in industries critical to making America great again, like manufacturing, infrastructure, and technology. The change would also likely lead to declines in the real estate industry, exacerbating the housing affordability crisis facing America today. Overall, estimated job losses because of this ill-informed move could top 1.2 million over 10 years.
The progressive proponents of taxing innovation are also wrong in comparing venture capital, private equity, and real estate general partners to car salesmen and waiters. Yes, car salesmen and waiters have no guarantees on how much money they will make at the end of the day and will not know the size of their paycheck until the last day of the pay period. But the time horizon and the scale of risk is entirely different here. The car salesman may either sell a lot of cars or leave the job after a few months of not making the cut. His opportunity cost of time investment may be counted in the low thousands, and his work product may affect the livelihood of a few others at the car dealership. And there will always be someone else there to sell a customer a car. But if a venture fund faces a potential doubling in taxation of potential gains received on investment with less than a 25% chance of success on time horizons spanning several years, it would likely choose to take significantly less risk on future investments. Firms will not be created, and others will close because they could not find supportive funding.
Of all the claims made by these populist politicians, the claim that long term funds that finance the retirements of millions of Americans are worse off thanks to carried interest is the most off base. Carried interest correctly rewards risk taking. Pension funds look for long-term investments that have the potential for higher returns as part of their overall investment strategy. Including these in their investment mix allows these funds to post higher rates of return and provide seniors across the country with better standards of living in retirement. Data on public pension fund returns show that private equity and venture investments provided returns over 4% higher over the last 25 years than typical stock investments. Risk taking yields rewards over time, and retired Americans benefit from this.
With academic research showing such clear benefits to maintaining the current carried interest tax structure, and high risk and low benefits to taxpayers for making any changes, one can wonder why these populist politicians are considering this change in the first place. The districts where many of these politicians are from suffer from higher housing shortages than other areas and would lose out on new investments in low income and multifamily housing if this tax increase went through. Many also have higher unemployment rates in their districts, and this change would cause job losses and reduce investments in labor intensive industries. This suggests the effort to raise taxes on carried interest is more of an ideological pursuit than a well-reasoned policy option.
Treating carried interest returns as ordinary income would stifle innovation, make housing more expensive, cause the loss of millions of jobs, and reduce income to the federal government. Politicians should wake up and realize the potential costs to their own districts if this wrong-headed proposal passes.