Who really deserves the carried-interest tax break?

Carried interest is what venture capitalists, hedge fund managers and private-equity investors earn. But the 3 groups shouldn't all be treated the same.

By The Fiscal Times Jun 6, 2012 11:30AM

By Suzanne McGee

It's only a matter of weeks now before the election campaign heats up even further and the debate over income that comes from "carried interest" moves back into the spotlight once more. It's a topic that may sound arcane, but given that Republican presidential candidate Mitt Romney pays an effective rate of only about 15 percent on the bulk of his earnings – less than half the rate that most potential voters pay on their conventionally earned income – it's going to be contentious. With the job market apparently on the verge of swooning once more, Romney can attack President Barack Obama on his handling of the economy. One of the ways Obama may retaliate is by pointing out Romney's wealth – his earnings, combined with that low tax rate, have put him not just in the 1 percent, but in the top 0.1 percent – and the tax advantages he has had.

Carried interest is what managers of different kinds of investment pools – venture capital funds, hedge funds and private equity funds like Romney's former business, Bain Capital – earn by managing the money they raise on behalf of their limited partners. Those partners – mostly pension funds, endowments and other institutions, or affluent individuals – typically pay the managing partners of a portfolio somewhere in the neighborhood of 2 percent of the fund as a fee each year, plus 20 percent of any profits. The more successful the fund, the higher the fees and the managers' cut of the profits; some hedge fund managers pocket 40 percent of the returns, as long as their clients are happy with the outsize gains they are generating.

When a portfolio does well, the manager can do very well indeed. Let's say a company like Bain buys a business for $100 million and sells it three years later for $300 million, and that its agreement with its investors means it keeps 20 percent of the $200 million profit. That's $40 million to be divided among the Bain partners – all of which is taxed not at the 35 percent rate imposed on ordinary income but on the 15 percent levied on carried interest.

Supporters of this system argue that the investment funds are essentially behaving like entrepreneurs – taking the same kind of business risk and market risk – and they shouldn't pay a higher tax rate than an entrepreneur might take after selling his business. This is investment income, they point out. Remove the right to be taxed at this low rate, they contend, and you're removing the incentive to invest in businesses. Some – like Tom Price, a Republican Congressman from Georgia, for example – have argued that boosting the tax on carried interest would hamper job creation.

That assumes that all the funds that now benefit from this tax break are actively creating jobs – and that doesn't seem to be the case. Even a cursory glimpse shows that this group – although united in their opposition to any proposals in the White House or among Democrats in Congress to change the tax code in any way that would raise that tax rate – are really very different kinds of players in the economy. Not all can claim to be generating the same kind of economic growth, business growth or job growth. For instance, hedge funds create a handful of jobs for traders and analysts on Wall Street or in the hedge fund Mecca of Greenwich, Conn., but that's about it. (Unless you want to count the jobs at Manhattan's tony restaurants, Chelsea art dealers and the artists they represent, or the Hamptons real estate market and other beneficiaries of the spending of successful hedgies, that is.)

Some hedge fund managers would argue that they create liquidity in the financial markets – something that, if true, would offer a different kind of value. Other traders might quibble with that, however, pointing out that when liquidity shrinks in times of tremendous volatility, hedge funds tend to scuttle to the sidelines just as rapidly as their peers on other kinds of trading desks. Even hedge fund veteran Leon Cooperman – no fan of Obama's rhetoric – has called the tax treatment of his own earnings "ridiculous." Like Romney, Cooperman earns the bulk of his wealth from carried interest on his funds; unlike Romney, the blunt and outspoken Cooperman sees no rationale for the special treatment he gets.

At the other end of the spectrum lie the venture capital funds. Their managers really do have a vested interest in creating jobs, by deploying the capital in their funds in startup companies that they believe have the best chances of outperforming. When they do that well, and the companies in their portfolios thrive, jobs are created: Just look at the new jobs created by Facebook with the help of investments from venture funds like Accel Partners. The partners at Benchmark capital have created – indirectly – jobs at companies like eBay, Red Hat and Twitter, as well as wealth for their partners and their investors. And they are taking the same kind of business risk as are entrepreneurs, because they arrive on the scene at a time when companies have yet to prove the validity of their business models. More of their investments turn out to be DOA than turn into home runs like eBay. If any group deserves the "carried interest" preferential tax treatment, I'd put my bet on the VCs, whose business model revolves around spotting the best entrepreneurs with the most "scalable" business models, and giving them the capital to succeed.

Somewhere in between these two extremes lie private equity funds and buyout managers like Mitt Romney. Some of them help create jobs – or at least help companies salvage jobs that might otherwise be lost to a corporate bankruptcy – by providing capital that is part of a restructuring. They buy a company, take it private if it is currently publicly traded, and overhaul it before selling it back to public market investors or to a new owner, at a higher price. That takes business skills, sure, but it comes closer to management or consulting than to entrepreneurship. And few of those companies emerge from the process with more employees and a larger payroll than when they entered.

It's not reasonable to expect any of these entities to subordinate their quest for profit to social goals such as job creation. Their job is to maximize returns for both their limited partners and themselves. But when they criticize proposals to raise the tax paid on their "performance fees" as potentially impeding job creation and entrepreneurial activity, it becomes reasonable to question how much of that actually is going on.

It's perhaps utopian and probably unworkable to suggest that entities that claim the right to a lower tax rate based on arguments that they generate a lot of job growth should be asked to prove that claim. But as the weather and the rhetoric heat up, it may be an interesting exercise to understand which parts of these industries truthfully can claim to have created jobs and wealth for others beyond the narrow circle of their own limited partners.

Suzanne McGee is a columnist at The Fiscal Times. Subscribe to The Fiscal Times'  free newsletter.

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6Comments
Jun 6, 2012 3:07PM
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It is a joke!  I use to think that voting was the American thing to do!  But given our choices in "everything" we can vote for I am no longer  feeling that way!  It's not just our Government it's our Businesses that want to make the big bucks and send things out of the US and have them produced and then send them back to the US for Packaging and PROFITS.  Doesn't that tell us that we are LAZY or just plain STUPID!!! 

 

Even Dave Letterman the other night was showing how we can purchase an item for $ 1.79 and it was made in CHINA and how it should be made in the USA for $ 1.49.   Aren't we getting sick of going to the RETAIL STORES and picking up Clothing and checking to see where they are made?  I have decided it's USA or nothing!  Why can't we SEE what's going on!

Jun 6, 2012 2:30PM
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Once again, these idiots in this administration are trying to punish the risk takers and take their focus away from what the real problem is -- creating policies that allow businesses to create jobs.  For the "smartest people in the world" they sure act stupidly!!!
Jul 31, 2012 1:55PM
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Taxing Hedge funds and Private equity income as carried-interest capital gains is inherently unfair. These" investors" don't contribute to economic growth. Their sole purpose is to create wealth for themselves and their investors. Besides, as Warren Buffet argues, often times they're simply moving around capital through paper assets such as stocks and bonds. If the "investment"  they provide is so valuable, then why doesn't the gov't calculate it in the calculation of GDP? Furthermore, there is a fundamental difference between economic investment and financial investment. Economic investment deals with the allocation of tangible assets such as property, plants and equipment that lead to economic growth. Financial investment on the other hand, simply trades paper assets such as stocks and bonds that only lead to wealth creation for investors.
 Often times, especially in the case of private equity, the capital gains they create are simply paying themselves fees and dividends by leveraging up the acquired company. How risky is that, and why should that qualify as a capital gain when no economic growth was created? The only thing created was wealth for themselves and their investors.
Jun 7, 2012 2:12PM
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Where is the analysis of what happens when things go south? Typical of this class envy they talk about how much others could make....well why aren't you risking your money ,time etc. ....its because you may lose it and you have not got the courage to do that...
Jun 11, 2012 4:44PM
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The people who deserve to have their carried interest taxed as cap gains are those that actually risked capital to get it, not those that  just provided labor. Half of partnerships with carried interest are in real estate and most of those are single property partnerships where it is not possible for the genreal partner to create a partnership without first risking a significant amount of capital on the front end costs. Not all carried interest is created in the same manner. 
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