Included in the new Inflation Reduction Act (IRA) – reconciliation legislation negotiated by Senate Majority Leader Chuck Schumer (D-NY) and Sen. Joe Manchin (D-WV) – is a $14 billion tax hike, falsely billed by the IRA’s supporters as closing a “loophole,” that will stifle long-term investments. While NTU supports simplifying the tax code for taxpayers and addressing provisions subject to fraud or abuse, the IRA’s proposal to increase taxes on carried interest neither simplifies the tax code nor closes any loopholes.
As has been the established federal policy for five decades, carried interest on investments is treated as capital gains rather than wage income for tax purposes. In fact, the Tax Cuts and Jobs Act of 2017 already extended the holding period to qualify for this treatment from one year to three years. Under current tax rules, carried interest – a form of compensation for investment fund managers that is directly tied to the performance of the long-term investments managed – is taxed at around 20 percent (the long-term capital gains rate), rather than at marginal individual income tax rates, which can top out at 37 percent for some fund managers.
Again, Sen. Manchin has billed this provision in the IRA as closing a “loophole.” This is not the case. Instead, this provision would discriminatorily raise taxes on long-term investments.
The current tax structure for carried interest has freed up capital that partnerships of alternative investment vehicles (such as hedge funds and private equity firms), institutional investors, and individual investors, have funneled into long-term opportunities, including business startups and construction. In fact, according to the most recent Internal Revenue Service report, in tax year 2018 there were over four million partnerships of all kinds in the U.S., with the number of partnerships growing from previous years.
Raising the tax rate on carried interest will only take away that capital, causing reductions in long-term investments. Specifically, this tax increase will arbitrarily target investors in real estate, private equity, and venture capital, all of whom invest in areas critical to boosting American innovation and creating jobs. As a consequence of this tax hike, small businesses and startups – who are extremely reliant on investments during their early stage – may see decreased availability of resources to mature in the market. Middle class Americans will bear some of the burden of this tax increase through diminished innovation in the economy and less job creation.
Policymakers shouldn’t overlook taxpayers’ long-term stake in this debate. For example, state and local government pension systems frequently maintain private equity positions in their portfolios. Properly utilized, these investment tools help to balance return against risk, and in so doing maintain the health of multi-billion-dollar programs that often carry taxpayer guarantees. It is important to weigh the impact of higher costs on private equity to pension funds, which already face sustainability challenges ahead due to highly generous benefit formulas.
At a time of historic inflation and an economic decline, lawmakers should be trying to boost American investment and job creation. Unfortunately, the carried interest tax hike included in the IRA will only do the opposite.