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The Carried Interest Debate

Posted on June 3rd, 2010 by John Reeder

This may be an exercise in futility, but I thought I would give some time to the other side of the carried interest debate.  My read is that the real estate industry is about 99% against raising taxes on the general partner/profit participant members (let’s say fund managers for brevity) of real estate partnerships.  However, I increasingly find myself on the other side of this debate.  I just don’t see a compelling reason to keep the capital gains treatment there for someone who is earning a fee based on a service, rather than placement of their own money. 

To be clear, I would be in favor of lowering the tax rate applied to ordinary income across the board, which would be a fine way in my mind to address this issue (instead of raising the tax for fund managers, lower it for everybody else), so you can’t dismiss me as being on the “more taxes, all of the time” side of this debate.

I just happen to think all of the arguments for keeping the carried interest tax at the capital gains rate are really weak.  Real estate defenders of carried interest usually say that we should close the loophole for hedge funds, but not for real estate.  But that strikes me as silly.  Venture capitalist Fred Wilson has a better argument than I can formulate, so here it is:

I agree with Victor Fleischer‘s basic premise that carried interest is a fee for managing other people’s money. It is a fee based on performance, but it is a fee nonetheless. It is not fair or equitable to other recipients of fee income to give a special tax break to certain kinds of fees and not to others.

But even beyond the basic argument of equity and fairness, there are some other important factors to consider.

We have witnessed financial services (think asset management, hedge funds, buyout funds, private equity, and venture capital) grow as a percentage of GNP for the past thirty years. The best and brightest don’t go into engineering, science, manufacturing, general management, or entrepreneurship, they go to wall street where they will get paid more. And on top of that, we have been giving these jobs a tax break. That seems like bad policy. If we force hedge funds and the like to compete for talent on a more level playing field, then maybe we’ll see our best and brightest minds go to more productive activities than moving money around and taking a cut of the action.

Changing the taxation of the managers will not reduce the amount of capital going to productive areas. The sources of the capital; wealthy families, endowments, pension funds, and the like, will still put the capital in the places where they will get the highest after tax return. And these sources of capital, if they are tax payers, will still get capital gains treatment on their investments in hedge funds, buyouts, and venture capital. And the fund managers will still have to compete with each other to get access to that capital and their incentives will still be to produce the highest returns they can produce, regardless of whether they are paying capital gains or ordinary income on their fees.

We may see the best managers investing more of their own capital and less of other people’s money with these changes to the tax law. When I invest my own capital in a company (either directly or through my funds) and that investment generates a capital gain, I will still get to pay a lower tax rate. So at the margin, I might prefer to invest my own capital over someone else’s with the new tax rules. I believe that is good policy. I have seen a correlation between a manager having significant "skin in the game" and long term performance. So if these tax changes produce more "skin in the game" that will be a good thing.

June 3rd, 2010 | Category: Uncategorized

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