There is No Carried Interest Loophole

Abstract

Carried interest is a special, or disproportionate-to-ownership, allocation of profits to the general partner of a private equity or hedge fund partnership. Some commentators deride carried interest as a “loophole” that allows high-income taxpayers to reduce their taxes by improperly obtaining preferential, instead of ordinary, tax rates. In this paper, I provide three analyses that suggest these common concerns are misplaced. First, and contrary to concerns of impropriety, I show that the current tax treatment of carried interest is consistent with the basic principles of the tax system, including principles of equity and fairness. Relatedly, the taxation of carried interest in partnerships is identical to similar arrangements in corporations. Second, and contrary to concerns of reduced tax payments, I demonstrate that the current taxation of carried interest generally results in the U.S. government receiving more revenue than it would in absence of this special allocation. Third, I evaluate proposals to tax carried interest as ordinary income. Taxing carried interest as ordinary income may increase the tax rate on carried interest, but would also generate new deductions for the payment of carried interest that may partially or fully offset revenue raised by any tax rate increase, a fact often overlooked by commentators. In sum, the current taxation of carried interest is in line with the principles of the tax code and generates minimal, if any, revenue losses to the U.S. government and potentially increases revenue. Changes to the current tax treatment may induce economic distortions and reduce equity in the tax code. As such, commentators and politicians should refocus on more pressing and significant issues in the tax code.

Keywords: Venture Capital, Private Equity, Hedge Funds, Investor Taxes, Pass-Throughs, Partnerships, Carried Interest

JEL Classification: G23, G24, H24