Tuesday, March 6, 2012
What is carried interest? And why does it get the tax treatment it does?
These arcane questions are usually reserved for the green-eyeshade crowd. And for good reason: they can be so bewildering that they seem to be taken from an I.Q. test written just for accountants. But because they concern a few very high-income individuals, including the presidential candidate Mitt Romney, for whom I am an adviser, they have been getting broader attention lately. So let’s examine the issue. ...
Critics of current law think it is unfair that these private equity partners are taxed at capital gains rates, whereas other high-income individuals like doctors and lawyers pay the much higher tax rates for ordinary income. It is a reasonable point, and some reform may well be appropriate. But ... it is not obvious what the best approach would be. Not all problems have easy answers.
Greg Mankiw's Blog, Taxing Carried Interest:
The piece is an attempt to explain the taxation of carried interest and is more pedagogical than opinionated. For the truly wonky who want to learn more about this topic, I recommend this article by Alan Viard [The Taxation of Carried Interest: Understanding the Issues:
Congress has recently considered taxing the carried interest of private equity fund managers at ordinary rates rather than at the 15 percent rate that currently applies to a portion of this income. The proposed change is intended to promote neutrality between the labor compensation of fund managers and other types of labor income. The case for reform, though, is less compelling than initial appearances suggest. The proper treatment of carried interest raises difficult second–best questions.]
ataxingmatter, Greg Mankiw Attempting to Justify Carried Interest, by Linda Beale (Wayne State):
Mankiw notes the historical trend in the US to differentiate between capital gains and ordinary income regarding tax rates (though we have had notable experiements, both in the regular tax and in the AMT, to the contrary). He asserts that there are "good reasons" for the preference for capital gains income--offering only the standard idea of lack of indexation for inflation/deflation as an example.
The purpose of the piece is to justify the carried interest treatment of money managers' gains from dealing with other people's money as equivalent to a carpenter who fixes up a dilapidated house and gets capital gains on the sale of the home, though the gains are really paying off the carpenter's sweat equity. Since the carpenter gets capital gains under our system, he says, why shouldn't the money manager who does an analogous activity (assuming--which may be a rather big jump-- that hedge fund, private equity and other money managers are doing "sweat equity" that adds to the value of the assets under management, and should be viewed analogously to the carpenter).
The problem with making these analogies, especially in the area of capital gains, is that the idea of capital gains is problematic to start with. We'd be much better off with a code that made no such distinction, since there are certainly instances where the distinction is an arbitrary one. Since the line drawing isn't easy (and it isn't), then the distinction shouldn't exist at all in the tax code. That would be the right solution overall.