Originally published by the Washington Examiner on September 5, 2017.
Republican leadership is sending mixed messages about the treatment of carried interest in their coming overhaul of the tax code. Senate Majority Leader Mitch McConnell says all “preferences” should be looked at, including carried interest, while Treasury Secretary Steven Mnuchin said that the administration might now seek only to “close the loophole for hedge funds,” but would exempt “funds that do create jobs.” Mnuchin’s statement is a step in the right direction, and it hopefully means that the administration is abandoning its misguided attacks on carried interest.
For reference, the carried interest is the portion of an investment partnership’s return that is earned by a fund’s manager. It is treated the same as the portion earned by the other investors — as a capital gain. Contrary to popular claims, that’s no “loophole.” If the return is a long-term gain it is taxed at the long-term capital gains rate, but if it’s a short-term gain it’s taxed as ordinary income. The rules are already the same for everyone.
Carried interest also only applies if there is a positive return. Investors and managers alike risk earning nothing at all if they fail to make smart investments. And where the manager is guaranteed a flat fee, it’s treated already as ordinary income.
It’s important to note that capital gains are taxed at a lower rate to encourage investment in the economy. Since savings and investments are already double and even triple taxed compared to consumption, it would be better if capital gains weren’t taxed at all. After all, we need risk-takers to make new investments or start businesses to help grow the economy.
Despite then-candidate Trump’s campaign rhetoric railing against hedge funds “getting away with murder,” as well as the administration’s current position as expressed by Secretary Mnuchin, carried interest doesn’t actually have much to do with hedge funds. They rarely hold positions for more than a year, which means their returns are not often classified as long-term gains.
Carried interest matters much more for partnerships found in private equity and venture capital, both of which are crucial for getting new businesses off the ground. Making an exception for carried interest to treat it differently than other capital gains would mean billions taken out of the commercial real estate sector where partnerships are common.
Democrats have tried for years to raise taxes on carried interest and other types of capital gains as part of their tax and spend agenda. They recently introduced legislation that would force carried interest to be treated differently and taxed higher than other capital gains, which they call “fairness.” Democrats seem willing to do serious damage to the economy just to squeeze more revenue from the private sector to fund big government.
Unfortunately, President Trump agreed with Hillary Clinton during the campaign that taxes should be raised on carried interest. He even repeated the misconception that doing so would impact politically unpopular hedge funds. However, since carried interest doesn’t often apply to hedge funds, Mnuchin’s statement might be taken as an attempt for the administration to “retreat with honor.” The president gets to keep his campaign promise against hedge funds, while the more damaging aspects of a tax hike on carried interest are avoided. In the grand scheme of things that wouldn’t be bad, but it still represents an unnecessary gift to the left by chipping away at the rationale for taxing capital gains at a lower rate.
There are a lot of myths regarding carried interest, and it’s an easy issue to demagogue. But the fact of the matter is that the current tax treatment of carried interest is already fair. A destructive tax hike would not only create new distortions in the tax code, the opposite of what Republicans aim to achieve with comprehensive tax reform, but would do significant damage to the economy and add unnecessary barriers to job growth.