It's well known by now that a minority of Americans controls the majority of wealth in the U.S. For example, a 2010 study by Levy Economics Institute found that 0.3% of wealth was held by the bottom 40% of the American population, and 84% of wealth was held by the top 20%. In terms of income, the U.S. now has the greatest income inequality than any other democratic nation in the developed world. Indeed, income inequality has been one of the primary themes of the Democratic campaigns for president and has provided reason for renewed debates over the appropriate taxation of carried interest. Tax policies on carried interest have essentially given a tax break to some of the wealthiest U.S. citizens—exacerbating the growing income inequality—for years.

Key Takeaways

  • Carried interest is a share of a private equity or fund's profits that serve as compensation for fund managers.
  • Because carried interest is considered a return on investment, it is taxed at a capital gains rate, and not an income rate. 
  • Critics argue that this is a tax loophole since portfolio managers get paid from that money, which is not taxed as income.
  • Advocates of carried interest argue that it incentivizes the management of companies and funds to profitability. 

Fund Management Compensation and Taxation

General partners of private equity or hedge funds are typically compensated for their fund management services in two ways. The first way is a management fee of about 2% of the total assets being managed. This fee is charged regardless of the funds performance and is taxed as ordinary income, the top rate being 37%.

The other way that the general partners are compensated is through what is known as "carried interest," which is usually around 20% of profits accrued above a specified hurdle rate. Often the hurdle rate is about 8%, and thus any returns the fund achieves above that rate means the fund's general partners receive a 20% commission in addition to any profit on assets the partners have personally invested in the fund. Both the profits on personal assets and carried interest are taxed at a capital gains rate, which for high-income earners is 20%.

Capital Gains or Ordinary Income?

Arguments in favor of taxing carried interest at the ordinary income rate are based on the view that carried interest should be treated as "performance-based compensation for management services." Taxing carried interest at the ordinary income rate would make it consistent with similar performance-based compensation like bonuses. Furthermore, the type of services provided by a fund's general partners is similar to that provided by corporate executives, as well as managers of publicly traded mutual funds.

Those who argue against the taxation of carried interest at the ordinary income rate believe that general partners should be treated like entrepreneurs. If so, carried interest would be viewed as similar to profits realized when an entrepreneur sells their business, which are generally taxed at the capital gains rate.

Some argue that the carried interest compensation is a reward for successfully earning profits while undertaking significant risks. If such compensation were taxed at the ordinary income rate, then this would create a disincentive to take such risks leading to less investment, less innovation, less growth and less jobs. Yet, it is not clear that a higher tax rate on carried interest would actually deter investment or that the promotion of more risky investments is actually advantageous for the economy.

Carried Interest and Income Inequality

Risk and reward aside, few argue that the carried interest loophole is innocent in the inequality blame-game. 

Perhaps the lax taxation policy on carried interest is forgivable, considering the recent donations by large hedge fund managers to university endowment funds. Two hedge-fund managers, John Paulson and Kenneth Griffin, recently donated $400 million and $150 million, respectively, to Harvard University. Stephen Schwarzman, chair and co-founder of the private equity fund Blackstone, recently donated $150 million to Yale University. Such charitable donations that are eligible for tax credits are pledged with the stated intention of fostering higher education.

Yet, Victor Fleischer, a law professor at the University of San Diego, found that private equity fund managers of university endowment funds, including Yale's, Harvard's, the University of Texas', Stanford's, and Princeton's, received more in compensation for their services than students received in tuition assistance, fellowships and other academic awards. He claims that Yale paid out $343 million to private equity managers in carried interest alone while only $170 million of the university's operating budget was aimed at assisting students.

With university endowment funds acting as vehicles to further enrich the wealthy at the cost of increasing student indebtedness it is hard to see how a tax break on carried interest is good economic policy. If a higher proportion of people's income is increasingly being used to service debt rather than purchase goods and services, it doesn't matter how much investment businesses receive. They're not going to grow if people can't purchase what they're offering. 

The Bottom Line

If those who perform similar services, and even take on similar risks, are required to pay the ordinary income tax rate, then general partners of private equity and hedge fund managers should pay the same rate. Considering that those on the lower end of the income and wealth spectrum tend to have higher marginal propensities to consume than their much wealthier counterparts, taxing carried interest at the ordinary income rate and using it to redistribute wealth is not just about fairness, it is good economic and social policy.