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Friday, July 12, 2024

Weekly SSRN Tax Article Review And Roundup: Narotzki Reviews Utke's There Is No Carried Interest Loophole

This week, Doron Narotzki (Akron; Google Scholar) reviews Steve Utke (Connecticut; Google Scholar), There is No Carried Interest Loophole.

Doron narotskiSteven Utke's paper presents a unique argument against the widespread criticism of the tax treatment of carried interest. Commonly referred to by many (including myself) as a "loophole," carried interest essentially allows private equity (“PE”) and hedge fund managers to lower their tax liability and pay taxes at long-term capital gains rates rather than higher ordinary income rates. Utke challenges this criticism, providing a comprehensive analysis that supports the current tax treatment mainly as both consistent with tax principles and beneficial for federal revenue.

Utke's paper makes three core arguments to support his claim: consistency with tax principles, revenue implications, and the consequences of changing the current tax treatment.

First, he argues the current tax treatment of carried interest aligns with the fundamental principles of the tax system. Utke explains that carried interest, which represents a disproportionate allocation of profits to PE fund managers, is actually consistent with how similar arrangements are treated in other business contexts. Specifically, the taxation of carried interest in partnerships echoes the treatment of analogous arrangements in corporations. This suggests that carried interest is in fact not a deviation from standard tax principles but rather a legitimate application of them.

To prove his point, Utke uses hypothetical examples involving property and partnerships. These examples demonstrate that income derived from capital assets should retain its character, regardless of the ownership structure or the involvement of effort in generating the income. This reinforces the idea that carried interest, being a form of capital gain, should rightly be taxed at preferential rates.

Second, Utke argues that contrary to popular belief, the existing taxation of carried interest often results in higher federal tax revenue than would be collected if it were taxed as ordinary income. Utke highlights that carried interest is sometimes already taxed at ordinary income rates, depending on the nature of the underlying income. Moreover, treating carried interest as ordinary income could lead to offsetting deductions, thereby reducing the net increase in revenue that proponents of change expect.

Utke's analysis includes a detailed examination of the potential revenue effects of reclassifying carried interest. He concludes that the anticipated revenue gains are likely overestimated and that any such gains could be negated by the economic distortions and new tax avoidance strategies that might arise from changing the tax treatment.

The third main point in Utke's paper is the unintended consequences of altering the tax treatment of carried interest. He argues that singling out carried interest for different tax treatment could create economic distortions and open new avenues for tax avoidance, a result we have seen before after Congress allegedly closed certain "loopholes." Furthermore, a comprehensive revision of the tax code to treat all similar income as ordinary income would be administratively burdensome and could disrupt established economic practices.

Utke also addresses the broader implications of focusing on carried interest as a tax policy issue. He contends that the emphasis on carried interest is misplaced, given its limited impact on overall tax revenue and fairness. Instead, policymakers should direct their attention to more significant and pressing issues within the tax code.

However, Utke’s conclusion is somewhat distinctive and there are opposing viewpoints to his position. The main one focuses on the equity and fairness of the tax system. Critics argue that taxing carried interest as capital gains instead of ordinary income disproportionately benefits wealthy fund managers and exacerbates income inequality. The beneficiaries of carried interest tax treatment are typically high-income individuals who already have significant wealth, and taxing their income at lower capital gains rates provides them with an undue tax advantage. Many believe it is inherently unfair for fund managers to pay lower tax rates on their earnings compared to other professionals who earn income through labor and pay higher ordinary income tax rates. Moreover, the preferential treatment of carried interest can erode public trust in the tax system. If the public perceives that the wealthy are benefiting from loopholes, it undermines the perceived fairness and integrity of the tax system. I believe this argument gains further weight considering the current state of the economic gap between taxpayers, where income inequality continues to widen, and the wealthiest individuals accumulate a disproportionate share of wealth.

Another opposing viewpoint focuses on the potential for increased revenue and economic efficiency by changing the tax treatment of carried interest. Critics may argue that reclassifying carried interest as ordinary income could in fact lead to a fairer distribution of tax burdens and potentially increase federal revenue. While Utke suggests that taxing carried interest as ordinary income might not generate significant additional revenue, others argue that even modest revenue gains could be beneficial, especially in addressing budget deficits or funding public services. Additionally, reclassifying carried interest as ordinary income could simplify the tax code by reducing the need for complex distinctions between different types of income, enhancing compliance, and reducing administrative costs. Changing the tax treatment of carried interest might also close a perceived loophole and reduce the incentive for fund managers to engage in tax planning strategies that exploit preferential capital gains rates.

Overall, Utke makes a significant contribution to this issue and provides a unique but thorough and persuasive defense of the current tax treatment of carried interest by demonstrating its consistency with tax principles, highlighting its surprisingly positive revenue implications, and warning against the consequences of changing its tax treatment. He makes a strong case for maintaining the status quo. His analysis suggests that the debate over carried interest is largely a distraction from more important tax policy issues. Policymakers would do well to heed his advice and focus on areas where meaningful improvements can be made.

Here’s the rest of this week’s SSRN Tax Roundup:

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