The Carried Interest Tax Debate

The NY Times came out today on the side of taxing carried interest as ordinary income instead of capital gains. I'll be the first one to admit that the preferential treatment of carried interest as capital gains is a great boon to the general partners who run private equity and venture capital firms. And being a progressive who is in favor of more equity in our tax code, I would gladly pay more taxes. But I am not sure this is the best way for the federal government to get more money from me.

First, I think there are a couple things the NY Times got wrong.

Here's a quote from the Times' opinion piece:

The deeper question in all this is whether capital gains — which are currently taxed at less than half the top rate of ordinary income — should continue to be so lavishly advantaged. The answer there is no.

I think the Times is dead wrong on this one. Entrepreneurs and investors who risk their capital in an attempt to create new businesses that employ people, make our lives better, our businesses more efficient, etc should be rewarded for doing so. I don't think a long term risky investment that pays off should be taxed the same way that interest on a corporate bond is. We need a tax code that creates some incentives to take risk or wealthy people will be less inclined to do so. This is a competitiveness issue and the Times clearly doesn't get that.

Second, private equity and venture capital are different animals. An early stage venture firm that is making $1mm investments in hopes of a 10x gain over five to seven years is just a different animal than a buyout firm that invests $5bn in equity to make a $5bn gain in two to four years. The amounts are different, the risks are different, the incentives are different, and the gains are different (all by orders of magnitude).

But to my mind the biggest issue with changing the way VC carried interest is taxed is the unintended consequences. If angel investors who put up their own dollars at risk continue to get capital gains treatment (as they should) and venture capitalists who are investing institutional money lose capital gains treatment, the best venture investors will simply choose to invest their own capital instead of others. It's already happening. The capital bases of the very best venture capital firms are increasingly made of of the general partners' own capital. They continue to invest third party capital as well. If the economics of managing third party capital gets much worse, I bet we'll see the best firms move to investing only their own capital.

Comments

[Rick]

Of course the NY times got it wrong - they are always in favor taxing as much as possible and letting the government give the money back.

When I read this post, I heard Ben Stein's voice... "something D-O-O economics...".

[martin]

Being a positive kind of guy, you're concentrating on what happens to the profits / returns on a successful investment. While no one intentionally invests to loose money, I understand that the VC business is, in part, based on 1 in 5 or 1 in 10 deals working (i.e. 8 or 9 out of 10 failing).

How does US tax law treat capital losses ?

Here (Australia), not only can capital losses be offset against capital gains, they can be accumulated. For example, if I invest $100 each in two different years, and the year one deal goes sour and I loose $100, while the second deal returns me the original $100 plus an extra $100, at the end of year two, i pay tax on the NETT - i.e. year one nett is -$100, year two nett is +$100, nett capital gains is zero.

[Andy Swan]

"We need a tax code that creates some incentives to take risk or wealthy people will be less inclined to do so."

Wow, talk about summing up the conservative point of view on taxation in one sentence.

Some stats regarding the "equity" of taxation in the United States (from IRS):

Top 1% of Wage Earners pay more than 35% of taxes

Top 25% of Wage Earners pay more than 84% of taxes

On a side note, individuals who "would gladly do so" ARE allowed to pay more taxes than are legally owed and can do so quite easliy.

However, I would hate to see the effect on innovation, employment and investment that rich people giving their money to an inefficient, incompetent organization would have.

I would go into the unemployment rate, stock market and GDP growth since the "tax cuts for the rich", but alas, 95% of readers stopped reading this comment 432 characters ago :)

[Adam Stein]

Reasonable argument that pe and vc are over-taxed.

Assume that consulting and pe/vc investment both increase value of company.

Consulting:
Consultant: earns fee, pays ordinary income taxes
Company: pays fee, gets deduction
Gov't: no increase in taxes (assuming corporate tax rate ~= consultant tax rate) + higher taxes when company earns higher income

PE/VC:
PE/VC general partner: earns carry on disposition, pays cap gains taxes
Company: no tax effect as a result of pe/vc disposition
Govt: earns cap gains taxes plus higher taxes when company earns higher income

By taxing both sides of the equation (value of investment = pv of all cash flows), the gov’t is double-dipping and discouraging value-adding transactions.

[Landon Swan]

Agreed, Fred & Andy, and I love Australia's carry-over system. I wonder how much we could cut the gov budget if we just went to the national flat sales tax. Last I checked it would be around 23% with a prebate varying on family size. $2300 for singles, $6000 for family of 4.

(fairtax.org)

Talk about K.I.S.S.

[JayR]

I agree with you that the Times is wrong on the "deeper issue" for the reasons you stated. I also agree that PE and VC are different animals and a case could be made that profits in each industry should be treated differently, although it could be hard to draw up that legislation (e.g., is a later-stage VC more like a PE fund or an early-stage VC?).

Not sure I agree with you, however, on the "unintended consequences". The VCs who invest their own capital generally do so because (a) they don't want to deal with LP issues, disclosure issues, etc., (b) they are supremely confident in their ability to do so and (b) they can afford to lose it. The taxing of carried interest may result in some shifting of economic terms in funds (i.e., higher carried interest percentages), but I don't foresee funds turning down investor money over this. If anything, the unintended consequence that I see if carried interest is taxed as ordinary income is that fund managers would try to raise larger funds to try to net out the same after-tax gains, resulting in either overfunding companies or taking in more money than they can effectively manage.

[Charlie Crystle]

Andy, I agree that we've had a highly "inefficient, incompetent organization" --the Republican-controlled government of the last 6 years. It will suck less under the more fiscally responsible and less overtly corrupt Democrats.

My view on taxes, as 1) an entrepreneur who did very well, 2) as an investor in both public and private companies who did not do very well and 3) as an entrepreneur making a second go of it:

Don't tax the personal income of founders in startups with revenue under $2 million and fewer than, say, 30 employees, for the first 3 years of operation. Give everyone full health coverage. Require an employee option pool. Drop capital gains after 7 years of business to 5%.

From a societal perspective, it seems wrong to me that we tax work more than we tax capital. And it's simply not accurate to suggest that taxation of capital gains of the private investment world slows or accelerates investment if the tax is anything less than personal income and equal to any other type of investment. Investment in startups in the US give investors a known and trusted legal framework, deep university resources, deep entreprenurial and management resources, and the opportunity for terrific returns, regardless if the gains are taxed at 10% or 30%.

And as far as who pays taxes, if you want to tax the working poor, that's fine, but at least stop paying them poverty wages--it's not just immoral, it's expensive for taxpayers. And keep in mind that 90% of this country's wealth is owned by less than 10% of the people. So when we talk about tax fairness, keep in mind these things, but especially this one: the buffer between you and the street and the guy making 10 bucks an hour, and then tell me that you should be taxed at the same rate, or that capital gains should be taxed less than that guy.

[druce]

Having a different tax rate for income from capital vs. labor is 1) complex and subject to being gamed and 2) politically divisive.

If you own and run a small business like a restaurant, how much of your income is derived from the capital & risk-taking vs. labor?

If you pay yourself a dividend vs. a salary, why should it be taxed differently?

How many ways are there to pay yourself, from the Aeron chair so you can work at home, to 'business' entertainment, that are disguised as 'investment' in the business?

A proper tax system would be 1) a low, progressive income tax never to exceed 25-33%, with income from capital gains indexed to inflation, and 2) a sales tax, with low rates on staples/essentials/investment and high rates on luxuries.

You can make this system as flat or as progressive as you want, including negative income tax (earned income tax credit), personally I would make it as progressive as you can and still finance necessary government activities.

The current system is an abomination, nothing but a full-employment act for lawyers and accountants. The corporate income tax is a special disgrace, it makes no sense except to discourage investment in activities that make profits, while making people believe someone else pays it, and providing employment for armies of obfuscators.

Profits are an illusion. Cash is a fact, at least until the lawyers and accountants got into the act, and Enron/derivatives came along.

[smartone]

"We need a tax code that creates some incentives to take risk or wealthy people will be less inclined to do so."

Isn't making money incentive enough? if in fact having to pay more in taxes means you made more money --

If you want to create incentives for people to risk how about getting rid off US debt and deficit -- currently tons of money is being siphoned out of free markets into Fed T Bills..

[KevinD]

Carried interest is a capital gain that LP's have agreed to share with the GP. Both GP and LPs pay tax on their share, and the government gets exactly the same amount of capital gains tax as if there had been no carried interest. (Actually, they get more, because of the incentive of carried interest) Why should the government get any more than that?

[Shripriya]

Fred, the example that you gave of an early stage VC and a large LBO shop are true, but they are the ends of the spectrum.

There are VCs that do much bigger deals and PE firms that do much smaller deals.

VC firms who put in $30-40mm and get a 10x return and PE firms who put in $40-50mm and get a 3x return. Both in a 4 year time frame. Should they be treated differently? I say no.

You can't cut things as cleanly as VC versus PE.

[Vicente C de Baca]

A progressive AND market-friendly compromise would be a progressive tax rate on obscene marginal capital gains (like your X billionth dollar begins to be taxed in the 30 %'s, instead of the teen %'s). Despite your Laffer/Reaganomics-esque claim that entrepreneurship will be stifled by a higher cap gains rate, internet entrepreneurship did not seem to be stifled much during the later Clinton years when the tax was higher, and the lower rate now doesn't seem to be a huge rationale for starting a business as opposed to previous yrs. Nonetheless, I like a lower cap gains rate for middle class people investing a few extra bucks and for small businesses, I just think gains in the billions can be taxed more progressively.

[Andy Swan]

Higher tax RATE does NOT mean more money in government coffers. Thinking that "taxing the rich" to "give to the poor" is a fallacy. The fact is that capitalism is NOT a closed system, and one man's gain is not another man's loss.

The entire pie growing benefits everyone to some degree, no matter how small or large of a percentage you have of it. Redistributing wealth "progressively" actually leads to REgression in GDP and employment rates.

If you look at the last three major tax cuts to the top-brackets, each resulted in stunningly higher GDP growth rates, massive drops in unemployment, a record high Dow, and RECORD HIGH tax revenues for the government. This includes the Bush tax cuts that we are currently benefiting from (spending is a massive problem getting worse)

Grow the pie!!!!

[Mark]

Ironically, the real competitiveness issue is, in my opinion at least, that capital gains rates should be higher to subsidize making ordinary income rates lower. As long as the ordinary income earned by wage earners is taxed so much, they have less opportunity to accumulate capital to make risky investments themselves, and history has shown that good things happen when non-wealthy or even poor people make risky investments. Every major tech company that I can think of was started by non-wealthy or poor people (Microsoft, Apple, Google, Yahoo, YouTube, Netscape -- I believe the founders of all those companies qualify). Just maybe, this is because a non-wealthy person who’s willing to stake his or her life savings of a few hundred thousand dollars on his or her idea is going to really believe in that idea and/or work a lot harder to try to make that startup work than would the wealthy investor or founder. For this reason, wouldn’t our country be better off with tax rates that tend to enable non-wealthy people -- and not just wealthy people -- to start businesses?

By the way, I must admit, your post surprises me because it has shades of the same kind of thing that drives me crazy with the Bush administration. They are constantly trying to lower or even eliminate taxes on income that wealthy people can generate without doing any work at all. (Capital gains, dividends, inheritances.) Yet they do little to lower, in any meaningful way, ordinary income taxes. I can’t, for the life of me, understand why ordinary income rates should ever be higher than c/g rates. How can it be right that capable middle-class earners that must work to support their families pay dramatically higher tax rates than people who inherit money and then do nothing except live off returns on passive investments? Allowing Paris Hilton to live off of a huge pile of money that she didn’t even earn can’t be good policy.

[Charlie Crystle]

Andy, the GDP does not measure the drop in qualtiy of life, job opportunities, increase in cost of living, etc, over teh same period you describe. GDP is merely a measure of output, not what's happening on the ground. And the meager climb out of the Bush recession into the Bush stagflation, not to mention the overwhelming and irresponsible increases in the national debt and trade deficits, do not constitute record growth. Clinton used to say a rising tide lifts all boats; the problem is the tide isn't rising, it's swirling, and a whole lot of people don't have the benefit of a boat.

I'm just sayin.

[Grand Egress]

Fred, I generally agree with, but one small point: Yes, the VC investors in startups have their returns taxed as capital gains. But often the entrereneurs rewards are taxed as ordinary income. This is because the VCs often require the entreprenuers to convert their founders equity into stock options which vest -- and which the IRS tyopically views as compensation (ergo, taxed ordinary income) not invested capital (ergo, taxed as capital gains.)

[Charlie]

"Entrepreneurs and investors who risk their capital in an attempt to create new businesses that employ people, make our lives better, our businesses more efficient, etc should be rewarded for doing so."

Doesn't the normal risk/reward horizon take care of this?

[andy long]

"If angel investors who put up their own dollars at risk continue to get capital gains treatment (as they should) and venture capitalists who are investing institutional money lose capital gains treatment, the best venture investors will simply choose to invest their own capital instead of others. It's already happening"

Oh, please. VC general partners put up, at most, 5% of the capital and receive, at least, 20% of the profits. What VC in his/her right mind would turn down a 4:1 profit leverage (not even discussing management fees) because of a 2.5:1 tax disadvantage? I know that many VC's are math challenged but golly fellas, let's have a reality check.

Forgeting for a moment the "all tax is theft" proponents, there are two aspects of VC: a return on general partner capital, which should be taxed at the capital gain rate, and a management incentive, which should be taxed at ordinary income.

[Michael]

This kind of analysis only reveals the problems with social engineering via taxation. The government can and does use taxation to influence what people do with their money and that's a problem.

Even if the government was smarter than individuals and was more able to make decisions on what individuals should do with their money, how do they have this right? When did we the people ask the government to figure out how we should invest the money that we earn? When did we the people ask the government "please control my property" ?

Obviously we didn't. And the fact is that the government is not more able to do this anyways. The failures of collectivism shows that individuals making economic decisions easily outperform a central policy maker.

And don't be fooled. The government using taxation policy to favor one kind of investment over another is no more constitutional than the government taking control of the coal industry.

One last note on the NYT quote about investment being "lavishly advantaged." This is a ludicrous statement. It would seem to indicate that investors just found a pile of cash, invested it, and started reaping rewards because of the taxation policy. Any money invested was income originally and already taxed. It is then taxed again when any gains are realized from the investment. There is no advantage at all.

[druce]

A funny post on tax policy

http://gregmankiw.blogspot.com/2007/03/barstool-tax-policy.html

[Samthed]

Let's get to the point: "progressive" taxes = socialism. What place does "progressive" taxes and socialism have in this country?
The answer is "progressive taxes" and socialism have NO place in America. The founding fathers founded this country to get away from excessive taxes! The democrats are truly un-American,should be treated as such and should have no place in American politics.