Streetwise Professor

August 30, 2015

Don’t Get Carried Away By Political Rhetoric on Carried Interest Taxation

Filed under: Economics,Politics — The Professor @ 7:12 pm

The tax treatment of “carried interest” for private equity and hedge fund general partners is something pretty much everyone loves to hate. Politicians particularly. Several major candidates, including Hillary, Sanders, and Trump, have said that they will scrap it.

Their argument is simple. Carried interest is taxed at the lower long run capital gains rate  (20 pct), instead of the rate for earned income (39.6 pct). Obviously unfair!  Private equity and hedge fund managers are greedy bastards who do nothing to earn their money! (Trump says they just push paper around.) They don’t deserve a break! Restore fairness to the tax code!

Tax professionals are largely against the treatment too, though their reasoning is a little more sophisticated. Carried interest is income properly attributable to labor or service provision, and is not a return on capital. It therefore should be taxed as labor income.

A little reflection shows that both arguments are simplistic. I can’t say 20 percent is the right rate, but I am highly confident that 39.6 percent is too high. And that’s because carried interest treatment does affect returns on capital, and this should be taken into consideration when figuring out the proper tax treatment. Capital taxes are a bad idea generally, and the effects of carried interest on returns to capital should be taken into consideration when deciding how heavily to tax it.

First, what is carried interest? Private equity and hedge funds typically have limited partners as investors, and general partners who manage. These entities employ incentive mechanisms. The general partners get a percentage (overwhelmingly 20 percent) of all gains over a benchmark, and get zero incentive comp if they fail to reach the benchmark. This is incentive compensation is carried interest, and is taxed as a long term capital gain.

So what would be the effect of increasing taxation on carried interest? Basic tax incidence analysis applies here. Tax incidence analysis basically shows that the costs of a tax are paid not just on whom it is levied (PE and hedge fund GPs in this instance), but are also paid in part by those who buy from or sell to the taxed entity.

There is a supply and demand for the services of PE and HF managers. Investors are willing to pay for managers because the managers can earn a higher return than the investors could earn by investing themselves. Like the demand for anything, the demand for management services is downward sloping: the lower the cost of managers, the more capital will be invested with them because at a lower cost PE and HF outperform more competing investments.

Since these industries are likely highly competitive, the supply curve of services reflects the marginal costs of managerial services. The supply is upward sloping, mainly because some managers are more efficient than others. To expand the industry requires some managers to expand beyond their efficient scale, and also requires the entry of new, less efficient (i.e., higher cost) managers.

Taxes imposed on managers increases their costs, and shifts up the supply curve of managerial services. As the supply curve moves up and to the left, its intersection with the demand curve moves up and to the left. At the new, post-tax equilibrium, less funds are under management (which is crucial), and the cost paid by investors is higher. Thus, some of the burden of the tax is borne by the investors. The rise in the price of managerial services is typically small rather than increase in the tax, however, meaning that managers’ after tax income declines. Thus, the burden of the tax is shared between investors and managers.

How the burden is split depends on how steep the supply and demand curves are. Only if the supply of managerial services is vertical (“perfectly inelastic”) will all of the burden of the tax fall on the PE and HF bastards. This occurs only if all managers are equally efficient, and all are willing to supply the same amount of services at any price. If the supply of their services is very flat (i.e., a small decline in the price of their services leads to a large decline in the quantity supplied), virtually all the burden of the tax is paid by investors.

Thus, like all taxes, the tax on carried interest drives a wedge between the price paid by consumers (investors in PE and HF, in this instance) and suppliers (PE and HF managers).

The fact that investors pay some of the tax means that the carried interest tax is in part a tax on capital, except in the edge case (perfectly flat supply of PE and HF management). This is true because investor returns are depressed by the higher pre-tax compensation that must be paid to managers. Further, note that except in the edge case, investment in PE and HFs will decline, and thus they have less capital to invest. Although things are complicated by the fact that capital may be diverted to other investments, it is likely that total investment goes down. This means that even if the services managers are providing are deemed “labor” or “services”,  taxing carried interest reduces returns on some capital, and likely leads to a reduction in overall investment.

Since there are strong economic arguments that capital should not be taxed, and certainly not taxed as high as labor income if it is taxed, this in turn implies that taxing carried interest exactly the same as earned income is not likely to be optimal. I don’t know what the tax rate should be, but is plain wrong to analyze carried interest as pure labor income. It impacts returns on capital and this needs to be considered when deciding the right tax rate.

There are some other considerations that bolster this conclusion. In particular, carried interest is like a call option on managerial performance: managers’ compensation increases with performance only once the “strike price” is exceeded. They underperform, they get no incentive comp.

Why choose this form of compensation? To align the incentives of managers and investors. High powered incentives expose managers to a lot of risk. They tend to be more risk averse than investors. In particular, investors shouldn’t care about idiosyncratic, diversifiable risk, but managers with incentive-based fees bear that idiosyncratic risk, and may be less well diversified. They will therefore tend to be more averse to that risk than investors: this creates a conflict of interest between investors and managers.

Option-like compensation mitigates this problem, because the value of options is increasing in risk (volatility). Thus option-like carried interests offsets managerial risk aversion, and tends to align the interests of managers and investors. It induces managers to invest in some higher risk projects that investors prefer because they offer higher average risk-adjusted returns.

Increasing taxes on carried interest reduces the after-tax payoff to the managerial option, but this effect is asymmetric: it only reduces payoffs when managers perform well, but doesn’t affect compensation when they perform badly. They have a weaker incentive to take risk because they get less of the upside, and have the same downside.

Put differently, the tax reduces the alignment of incentives between investors and managers. Managers will tend to make investments that are less risky than investors would like. Thus, increasing the tax on carried interest will tend to impact riskier investments disproportionately, and lead to underinvestment in them. In particular, investments with high idiosyncratic risks (which are likely to include many tech investments, for instance, whose performance depends on the success or failure of a technology, rather than the performance of the overall economy) are disproportionately punished.

(This can also be fit into the tax incidence analysis. With a higher tax rate, it is costlier to provide incentives to managers, and this drives down returns on capital, especially for high idiosyncratic risk investments.)

If the politicians and tax professionals are right about carried interest, raising the tax on it won’t reduce returns on capital and reduce investment, or divert investment away from risky but high average return projects. The foregoing analysis demonstrates that this is not correct. Tax incidence analysis, and a consideration of the effect of carried interest taxation on the incentive for managers to invest in high risk, high return projects that investors favor, show that raising this tax will reduce returns, reduce investment, and divert investment away from high risk projects.

And let’s remember why taxation on capital is harmful: it reduces wages. Less capital means lower productivity. Lower productivity means lower wages. So although the seen effect of higher capital taxation will be on the Gnomes of Greenwich, the unseen costs will be paid by those on whose behalf Hillary, Bernie, and Donald claim to be speaking. Funny how the middle class can get wet when the politicians try to soak the rich.

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  1. All very well, PE promoters shall have a success fee (hopefully with a challenging hurdle rate). But that does not mean that this part of their compensation should be receiving favorable tax treatment. There is no CAPITAL gain, Managing Partners may have invested in the fund with their own money, that should then be taxed at capital gains rates. But carried interest is a remuneration, ableit variable and success based. No one would suggest that a bonus paid to any employee should be taxed as anything but regular compensation. Making hair-splitting arguments about the incidence of taxation is not to be taken seriously. One could argue why anyone should be taxed at all! And does anyone think that the most notorious Private Equity freebooters would withdraw from the field because they earn a few million less? The mantra that capital should be taxed lightly vs wage income is also repeated ad nauseam, by the 1%! There is no reason why both sources of income should not be taxed at the same level, as should inherited wealth!

    Comment by Heinz Geyer — August 31, 2015 @ 10:54 am

  2. @Heinz-you are reasoning like a tax consultant, not an economist. You totally missed the point of the analysis.

    The ProfessorComment by The Professor — August 31, 2015 @ 2:54 pm

  3. Shouldn’t the option-like compensation require managers to pay a premium, rather than receive a tax rate discount? It isn’t the managers’ personal capital that is at risk.

    Comment by JF — August 31, 2015 @ 3:02 pm

  4. @Heinz-1. Tax incidence analysis is not “hair splitting.” Take off your green eyeshade and think outside of your little tax category boxes. 2. Re”does anyone think that the most notorious Private Equity freebooters would withdraw from the field”: I say that is an edge case in my analysis. As long as the supply curve of their services is somewhat sensitive to after tax compensation, my analysis goes through. 3. That capital should be taxed lightly is not a “mantra” limited to the “1%.” It is a result derived from basic economic principles. And if you paid attention to the final paragraph, rather than turn into some Pavlovian Occupy type, you will learn that this economic literature shows that working stiffs pay capital taxes, in the form of lower wages.

    Economics. Try it some time.

    The ProfessorComment by The Professor — August 31, 2015 @ 3:57 pm

  5. @JF-No. The compensation is in the form of an option. In essence, they receive option like payoffs in exchange for their management services. In effect, the limited partners grant the managers a free call in return for their services.

    The purpose of the option-like payoff has nothing to do with whether the general partners’ (financial) capital is at risk. The purpose is to create a mechanism that rewards risk-taking because otherwise, the managers would invest more conservatively than the limited partners would prefer. The value of the option increases in the risk of the portfolio, which counteracts the fact that managers are likely to be averse to risks that investors are not, or are excessively averse to risk (due to their lack of diversification). Idiosyncratic, diversifiable risks (which limited partners should not care about) is costly for managers. Option-based compensation mitigates that cost.

    The ProfessorComment by The Professor — August 31, 2015 @ 5:12 pm

  6. It should be noted that this “carried interest” is taxed at the LT cap gains rate ONLY if the investment receives LT cap gains treatment. If most of the fund’s trading is taxed at the ST cap gains rate, then the carried interest is also taxed at the ST rate (which is equivalent to the labour income rate).

    Also, from a legal perspective, it’s going to be difficult to so split “VC”, “PE” and “Hedge Funds” from any other type of LLCs. Structurally, they are the same as any other LLC. The other group that receives carried interest treatment is entrepreneurs, where it’s called “sweat equity”. If they mess with carried interest, then sweat equity will also be taxed at the labour income rate.

    The government appears to have been trying to kill entrepreneurship in this country for a long time (how else do we interpret the aggressive impulses of the evil empire toward every attempt to erect so much as a lemonade stand?) and eliminating sweat equity and carried interest will deal a huge blow. Thus, it is reasonable to assume that there will not only be fewer managers willing to take a risk on a tech start-up, there will also be fewer entrepreneurs willing to take huge risks and for the same reasons. This will be a huge shame because real breakthroughs happen at the margin, on the sharp and scary edge.

    Professor, thank you for yet another fantastic analysis. It is completely, and very typically for you, on point. One minor quibble with your most recent post in the comments, however:

    “In effect, the limited partners grant the managers a free call in return for their services.”

    If it is in return for their services, then it is by no legitimate definition a “free” call. I think perhaps you meant that the call is part of the compensation package offered by limited partners to managing partners.

    Comment by Methinks — August 31, 2015 @ 8:06 pm

  7. @Methinks-Thanks. Always appreciated. To be honest, I am surprised to see that no one (not that I could find anyways) just works through the standard tax incidence analysis on this. But come to think of it that analysis is seldom applied even to relatively simple tax issues. I do think the option analysis is somewhat novel.

    I agree with the quibble. What I was responding to was @JF’s question of shouldn’t the managers pay a premium for the option. I guess a better way to put it is to say that they exchange their services for the option, so they do in effect pay for it.

    The ProfessorComment by The Professor — August 31, 2015 @ 8:46 pm

  8. Professor,

    Though it is a novel analysis, it is spot on and you’re speaking my language.

    I can’t believe a thinking individual would call a tax incidence analysis “hair splitting”. All taxes are distortionary and it is (put politely) irresponsible to refuse to analyze the probable effects of changes in taxes in favour of clinging to some completely manufactured categories such as “labour income” and “investment income”.

    Interestingly, nobody is in favour of changing the tax treatment of entrepreneurs’ “sweat equity” or on the stock options or stock granted to employees as part of their compensation (all are dictated by the tax treatment of the asset at the time of the sale, not by the reason the person received the asset). Those are all fine people we approve of! The people we hire to find the next Google to invest in? Undeserving pigs! paper pushers at best.

    I’m not surprised that if tax incidence analysis has been performed it is impossible to find because this is a largely emotional issue for people. It won’t make a difference. Get out the pitchforks and kill the market intermediaries, the speculators, the this and the that because?….FINANCE, that’s why!t This irrational crap has been with us for time immemorial.

    Heinz:”And does anyone think that the most notorious Private Equity freebooters would withdraw from the field because they earn a few million less?”

    All of a sudden we can’t think at the margins and we completely ignore opportunity cost? We also ignore how these “freebooters” might adapt?

    Comment by Methinks — September 1, 2015 @ 9:01 am

  9. I agree with your analysis: as always cut to the bone. There is one aspect of the whole capital vs income taxation issue that I have never really seen addressed: the costs associated with having a two tiered structure. What is the cost of the lobbying, accounting and other efforts made to turn one type of income into the lower taxed type of income? Going back to the 1970’s the efforts made and energy and effort spent through the tax shelter industry, the need for constant “innovation” to deal with changes in tax law always astounded me.

    Worst of all were the transaction costs of these types of activities: has anyone tried to calculate the cost of a two tiered income tax?

    Comment by Sotos — September 1, 2015 @ 12:42 pm

  10. Sotos,

    All taxes create distortions. Full stop. Even if there were a single tax rate resources would be expended in pursuit of avoiding paying the tax and also in receiving that which is taxed away from someone else.

    The problem with taxing capital gains at all is that it amounts to a tax on delayed consumption and discourages the capital accumulation necessary for economic growth. In a 2012 article for Slate, Mathew Yglesias illustrates the problem with capital gains taxation:

    You imagine two prosperous but not outrageously so working people living somewhere—two doctors, say, living in nearby small towns. They’re both pulling in incomes in the low six figures. One doctor chooses to spend basically 100 percent of his income on expensive non-durables. He goes on annual vacations to expensive cities and eats in a lot of fancy restaurants. The other doctor is much more frugal, not traveling much and eating modestly. Instead, he spends a lot of his money on hiring people to build buildings around town. Those buildings become houses, offices, retail stores, factories, etc. In other words, they’re capital. And capital earns a return, so over time the second doctor comes to have a much higher income than the first doctor.

    So then there are too different scenarios:

    — In the world where investment income isn’t taxed, the second doctor says to the first doctor “all those fancy vacations may be fun, but I’m being much more prudent. By saving for the future, I’ll be comfortable when it comes time to retire and will have plenty left over to give to my kids.”

    — In the world where investment income is taxed like labor income, the first doctor says to the second “man you’re a sucker—not only are you deferring enjoyment of the fruits of your labor (boring) but when the money you’ve saved comes back to you, it gets taxed all over again. Live in the now.”

    And the thinking is that world number one where people with valuable skills take a large share of their labor income and transform it into capital goods is ultimately a richer world than the world in which such people just go out to a lot of fancy dinners.

    Comment by Methinks — September 1, 2015 @ 1:40 pm

  11. @Sotos. This is why a consumption tax has many advantages over income taxes. Like @Methinks says, all taxes have deadweight costs, but a consumption tax is far less distortionary than our monstrosity of an income tax system.

    The ProfessorComment by The Professor — September 1, 2015 @ 6:11 pm

  12. Not related to this topic but I saw this quote and thought of past SWP posts.

    “After more than a decade of talks, Putin announced a landmark $400 million gas supply deal to China last May — the first time Russia will sell pipeline gas to a non-European country. The accord followed a deterioration of relations with Europe and the U.S. as the Ukraine crisis deepened.

    But Gazprom recently confirmed that the price China pays for the gas is tied to the oil price, which has more than halved over the last year. “This may end up being one of Gazprom’s most misjudged investment decisions to date,” analysts at Sberbank CIB said last month.

    Gazprom said last week that supplies of the fuel to China under the 2014 agreement might not start until 2021, two years after the launch date originally announced.”


    I thought of your scepticism at the time and laughed and laughed. You called it!

    Comment by Pat — September 2, 2015 @ 1:08 pm

  13. @Pat-Thanks! It is pretty funny. And by pointing that out . . . thanks for allowing me not to have to say “I told you so.”

    The ProfessorComment by The Professor — September 2, 2015 @ 8:42 pm

  14. So you are arguing the carried interest deduction is a tax on capital? That doesn’t make sense and would be likely unconstitutional if true.

    Ok, so fundamentally your argument is true for all incentive based pay structures as far as incidence. Functionally the argument comes down to Capital is special and tax incidence on the creation of capital or specifically the incentive of capital creation is a fundamental drag on the economy. Yet, this is true for almost ANY job imaginable. What is special about the incentive pay compared to other jobs that directly influence capital formation. Should the incentive payments given to a bridge builder be considered less distortive because it is a physical asset which is more expensive because of the tax incidence.

    Also, the economic arguments for reduced capital gains are nice and rational but the evidence is non-existant despite 20 years of intense research. The problem is that the argument imagines that the more efficient allocation of capital has a benefit that exceeds the actual creation of capital. The problem is that since all savings are invested in some manner and the stock of savings far exceeds worthwhile investments there is little true benefit (much because of distortive trade policy by foreigners). I think it likely that the Capital Gains Tax cuts were likely enacted at just the exact time in history it became ineffective as a tool to promote growth.

    Comment by EOrr — September 3, 2015 @ 3:11 pm

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