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.