The Reality of Taxing Carried Interest

06/15/2015 09:52 am ET | Updated Jun 15, 2016

Former Secretary of State Hillary Clinton launched her presidential bid saying, "While many of you are working multiple jobs to make ends meet, you see the top 25 hedge fund managers making more than all of America's kindergarten teachers combined. And, often paying a lower tax rate." Bashing the affluent is not a one-off; expect more transparent populism in the months ahead.

And expect a call to tax carried interest as ordinary income. Recall that carried interest is a share of profits more than proportional to the general partners' capital contribution if they meet investment goals. Carried interest is currently taxed upon the sale of the partnership's real assets as a long-term capital gain at a maximum rate of 23.8 percent. Recent proposals are to tax it at the ordinary income-tax rate (currently a maximum of 39.6 percent).

Candidate Clinton and other advocates will claim taxing carried interest improves the economy. Unfortunately, it won't. A key principle of taxation is efficiency. Taxing capital differently (e.g., ordinary income versus capital gains) across sectors and business forms means that taxes are driving business decisions and leading to sub-par allocation of national wealth. The desire to reduce those inefficiencies has been at the heart of proposals to shift toward a pro-growth policy that taxes consumption and eliminates taxes on the return to saving, investment, and entrepreneurial innovation.

Under a consumption tax, one could tax the full principal and earnings on an investment, including carried interest, but only if there is a full deduction of the original investment (the traditional Individual Retirement Account is the clearest example of this approach). However, the tax proposal for carried interest has no deduction, doesn't comport with principled consumption taxation and will not move toward an efficient, pro-growth tax policy.

Worse, it also doesn't match the principles of income taxation either. Under an income tax, the base is the potential to consume during the tax year -- i.e., the actual consumption plus any net savings. Under an income tax, the partner should be taxed on the expected value of the grant of the profit share in the year it is granted. When the investment is sold, any additional increase in value is a capital gain and should be taxed as such. Put bluntly, taxing carried interests as ordinary income is inconsistent with any principled tax policy. It should not be part of any revenue discussion that purports to move the U.S. toward a better tax code.

Candidate Clinton claims, and other advocates will assert, that taxing carried interest is "fair;" that it is unfair to accord a particular form of compensation preferential tax treatment. However, it seems a greater unfairness to tax similar investors differently depending upon whether they invest as an individual, corporation, or via the limited partnership structure. Even worse, changing tax treatment in midstream imposes retroactive tax increases on investments originally undertaken assuming that carried interests would be characterized as capital gains. That is not fair.

As a last ditch effort, candidate Clinton and advocates will claim that it will improve the nation's finances. There are outlandish estimates ranging up to nearly $200 billion dollars over the next decade. That's a drop in the bucket compared to the $7.2 trillion in deficits projected over the same period. Unfortunately, even that is too optimistic. The Joint Committee on Taxation pegs the revenue at only $15.6 billion over 10 years. Even the Obama Administration puts the figure at merely $17.7 billion.

Taxing carried interest as ordinary income is unprincipled tax policy, unfair, and hardly a budgetary pot of gold. It has provided President Obama and, now, candidate Clinton with a convenient instrument for a cheap political lashing. But it should not be confused with something that the United States should do.