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Taxing Carried Interest Discourages Investment

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Taxing Carried Interest Discourages Investment

WSJ's MarketWatch March 7, 2014

President Obama’s proposal to tax certain returns on investments, known as "carried interest," as ordinary income would raise taxes on some investment partnerships. It would bring in $14 billion over 10 years to Uncle Sam, but its disincentive effects on investment could be far greater.

That is because firms would make fewer investments, especially in the businesses or projects that most need capital. That, in turn, would further reduce economic activity, especially financing for private companies, innovators, and small firms getting off the ground.

Because taxing carried interest would put U.S. investment partnerships in real estate, venture capital, private equity, and others at a disadvantage relative to their international counterparts, some of this investment capital over time is likely to move offshore. Private equity assets under management now total $3.3 trillion, of which $2.3 trillion is invested capital and $1 trillion is callable capital reserves. Over 60% of these assets are owned by pension funds, which provide retirement income to millions of Americans.

Why take that risk? We want to encourage investment, and we want a simpler tax code.

Carried interest, also known as profits interest, is a net profit share — often in the range of 20% — received by general partners upon sale of a capital asset, whether it is a shopping center or a company. The remainder of net profit is distributed among limited partners, generally public and corporate pension funds, charitable foundations, endowments, individuals, and other equity funds.

Carried interest resulting from long-term capital gains in a partnership has always been taxed at long-term capital gains rates, the same rate paid by any investor who buys a capital asset, grows its value, and sells it at a profit. Now the top rate is 23.8%, up from 15% in 2012. Under the president’s proposal, all carried interest would be taxed as ordinary income beginning in 2015, at the top rate of 43%, including the Medicare and tax and phaseouts of itemized deductions and personal exemptions.

One result of the president’s proposal is that two investment partnerships, one of which had carried interest income and the other which did not, would face different tax rates when their assets were sold. This disparate treatment is poor tax policy.

Accountants and politicians could debate the pros and cons of these tax provisions for years. But they would all agree that the proposed change raises taxes, $14 billion over 10 years, according to budget documents released by the White House on Tuesday. With the economy and employment growing slowly, America needs more investment, not less investment. Congress and the president should lower taxes on capital and risky investments, not raise them, to encourage such investment.

The current tax treatment of carried interest has been in place for decades. Carried interest on real estate, private equity, or venture capital investments is treated as a capital gain because it represents the profit earned from a capital asset whose acquisition and sale involves risk. It is not guaranteed income, like paychecks from an employer. Investors in the stock market face a lower tax rate because they could see their assets rise, or fall, just as do partners in private equity funds or real estate ventures.

Capital gains have generally been taxed at lower rates than earned income to encourage investment. Policymakers know that investors supply the financial capital essential for investments that spur innovation, improve productivity, and expand capacity. Also, capital gains contain an element of inflationary gain, and giving a tax break for capital gains used to be simpler than removing the inflation element from the gain. Now, with computers, it would not be so difficult.

Politicians such as Obama say that carried interest bears greater resemblance to wage and salary income than to capital gains, so it should be taxed at ordinary rates. But they miss the point: capital gains treatment is afforded to owners to encourage investment. If you own the asset and make a profit from its sale, that qualifies your profit for capital gains treatment.

General partners establish their ownership interest in these investment partnerships by contributing some capital, along with a significant amount of time, energy, and expertise. That is why limited partners seek them out. Managing partners generally contribute personally between 1% and 4% of a partnership’s investment in a struggling business to be turned around, or in a start-up venture in a new technology. If the investment is unsuccessful, they receive no carried interest and lose their investment.

Even when they receive carried interest, partners cannot always keep it. "Clawback" provisions can require them to give up some early profits if later profit targets are not met.

Raising taxes on hedge funds and private equity partnerships does have a nice populist ring to it. But proposals to tax carried interest inconsistently target one sector of the economy. It makes no sense to tax investment partnerships differently from partnerships that own auto dealerships, ice cream shops, or family farms.

Obama’s budget states that "The recent explosion of activity among large private equity firms and hedge funds has increased the breadth and cost of this tax preference, with some of the highest-income Americans benefiting from the preferential treatment." But retirees of all incomes benefit, too. According to the Private Equity Growth Capital Council, in 2012 64% of investors in private equity were pension funds, foundations, and endowments. The president’s proposal would mean less efficient capital markets, and therefore smaller pensions for millions of retired Americans and fewer foundation grants for charity and research.

We want a system where partnerships encourage innovation. We want to enable those with capital and management experience to team with entrepreneurs, supporting small businesses that create many of America’s jobs. Raising taxes would discourage this synergy.

President Obama wants to pass out the goodies — increasing the Earned Income Tax Credit — as well as look fiscally responsible. Hence the increase in tax on carried interest. Better to cut some green jobs programs, merge the 47 job training programs into one, or sell some assets than to raise taxes on one of America’s most competitive sectors.

This piece originally appeared in WSJ's Marketwatch