Bad Medicine on ‘Carried Interest’

By Kevin D. Williamson
Thursday, March 30, 2017

President Donald Trump, the great negotiator who couldn’t persuade Republicans to vote for a Republican health-care plan, has suggested that he’ll be teaming up with the Democrats to develop an alternative. On the matter of entitlement reform, he has promised to out-Schumer Chuck Schumer. One is interesting, two is coincidence, and three is a trend, which brings us to the very large tax increase President Trump is proposing — one that many Democrats, notably Hillary Rodham Clinton, have long supported.

The “carried-interest loophole” is a misunderstood and often misrepresented feature of U.S. tax law. To begin with, it isn’t a loophole at all: It is an intentionally designed feature of the tax code functioning as intended — it may be good or it may be bad, but it is the way it is for a reason, and it did not get that way by accident. Further, it does not have much to do with Wall Street hedge funds, despite the constant insistence from President Trump that it does.

Here are the basics: In our tax system, the term “long-term capital gains” generally means income from an investment held for at least one year and one day. The day-traders and algorithm-based high-frequency traders do not enjoy the tax advantage conferred upon those realizing long-term capital gains, which are taxed at a lower rate (maxing out at 23.8 percent) than are other forms of income (top tax rate 43.4 percent). This is of interest to investors on various timelines: If you are saving for your retirement, then a 20 percent tax discount on the accumulated gains of a 35-year investment plan is very important. If you are an entrepreneur who has put 40 years of his life into building a business, then the question of whether you are going to pay 23.8 percent in taxes when you sell it or 43.4 percent means a great deal. It is also very important if you are in the private-equity business, which is mostly what the current fuss is all about.

Unlike hedge funds, private-equity firms typically make long-term investments. Private-equity firms are not typically engaged in the business of trading and betting on the markets, but are genuine investors: They are private in that they help companies raise money without accessing the public financial markets, and they take equity in firms or in projects as their main form of payment. Sometimes they work with troubled companies that need to restructure and require financing to get that done; sometimes they work with very successful small companies to help them become large ones. That is what Mitt Romney did at Bain Capital, helping to launch nationwide chains such as Staples.

David’s Bridal is a pretty good example of how this works: It started as a single boutique, was built into a small and successful chain of local stores, and then was rolled out as a national chain with the assistance of private investors who had been involved in similar projects. The company changed owners a few times and had its ups and downs, and it was later acquired by the private-equity firm Clayton, Dubilier & Rice. That’s how a little shop in Fort Lauderdale ends up becoming a billion-dollar company that employs 12,500 people and makes a lot of investors — large and small — a lot of money. None of the key players in that story took a salary to get the work done. They invested their labor, their expertise, and their capital.

Typically, a private-equity firm is organized as a partnership in which the general partner (the firm itself) is compensated with a share (typically 20 percent) of any profits that might — the key word here is “might” — be generated by an investment. In addition to the general partner, there are limited partners, who put up the money.

And that leads us to one of the criticisms of the “carried interest” tax treatment of private-equity income: Often, the firms themselves do not have any real money at risk, the immediate financial risk being borne by the limited partners who put up the money. But that is not an argument for raising the tax rate on private-equity income — it is an argument against “sweat equity,” which is the lifeblood of entrepreneurship large and small. If you open a dry-cleaner business and your rich uncle invests $20,000 in the project to get you started, the profit you realize 20 years later when you sell your successful chain of cleaners is treated as a long-term capital gain for tax purposes, in spite of the fact that you didn’t have any of your own money at risk. You didn’t invest money: You invested time, work, knowledge, and innovation, and you bore the opportunity costs for all the other things you might have done with your time and labor. You are every bit as much of an investor as is a guy who buys 20 shares of GM and parks them in his retirement account for 20 years. More of one, some might say.

Private equity does not work on the underpants-gnomes business plan. The steps between making an investment and realizing a profit are many and complex and difficult. And not every deal works out in the end. Sometimes, they — this may shock you — lose money. Often, the private-equity industry as a whole does not perform as well as the S&P 500. It is a risky business.

And that is one of the reasons that it enjoys tax advantages. You might make a perfectly good argument that this is a poor rationale, that politicians in Washington are not competent authorities to say whether there is too little risk-taking and entrepreneurship in our economy, too much, or (even more implausible) that we’re at the Goldilocks just-right level. You might make an excellent argument — a persuasive one — that having government use the tax code to encourage people and institutions to pursue one kind of income (capital gains) instead of another kind of income (salaries, bonuses, health-insurance benefits) is poor policy. But that isn’t really an argument against the carried-interest treatment for private-equity income, either: It’s an argument for a flat tax, or at least an argument for taxing all sources of income the same way. Though I am sympathetic to the case for giving the guy who worked his ass off building a new business a break on his taxes vs. the rate paid by the middle manager who always just took a salary and never took any risk, that may be entirely sentimental.

But we are not talking about that. Nobody in Washington wants to face that particular angry mob of IRA investors with torches and pitchforks. What we are talking about is singling out a particular class of businessmen for punitive tax treatment because we resent how much money some of them make, and because what they do seems like voodoo to people who do not understand it.

As a matter of policy, changing the tax treatment of private-equity income would not raise a great deal of tax revenue relative to federal spending and liabilities, and it probably would not have as much of a flattening effect as our class warriors hope. For one thing, if we convert those investment managers’ income to salaries and bonuses, then the firms that employ them are going to deduct those salaries and bonuses as ordinary business expenses, which they would be entitled to do. For another, investors will respond to economic incentives. The people who run these kinds of businesses are pretty clever about moving money around. The gentlemen in Congress are not going to outsmart them.

The broader discussion about taxes and fairness and — odious phrase — “social justice” is a waste of time. Taxes are not an instrument of justice: They are an instrument of revenue. The federal government requires x dollars to do the things we demand of it, and the only end of tax policy should be raising those dollars in a way that causes as little economic disruption as possible and invades our privacy as little as possible. At the moment, our model is lots of disruption and maximal invasion of privacy — and all of it handled by the incompetent, corrupt, politicized agents of the Internal Revenue Service.

Those are the tax-code problems we should be addressing. Instead, we are addressing some unhappy Americans’ envy and resentment. That isn’t tax policy — it’s psychotherapy.

And it’s bad medicine.