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Standard Deduction

How a Carried Interest Tax Could Raise $180 Billion

Hillary Clinton addressed carried interest at a community college in Monticello, Iowa, in April.Credit...Doug Mills/The New York Times

When Hillary Rodham Clinton opened her campaign for the Democratic presidential nomination in Iowa, the first substantive issue she raised was a safe one: carried interest. “There’s something wrong when hedge fund managers pay lower tax rates than nurses or the truckers that I saw on I-80 as I was driving here,” she said.

President Obama also raised the issue at a recent forum on inequality, calling fund managers our society’s “lottery winners.” Taxing carried interest at a low rate is, for many of us, a simple issue of fairness. The richest among us should not pay tax at a low rate on labor income.

Private equity moguls and other defenders of the status quo object to the characterization of carried interest as labor income. But they also argue that there just isn’t that much money at stake.

Taxing carried interest at ordinary income rates would raise about $18 billion over 10 years, according to a Treasury estimate of President Obama’s recent budget proposal. The Joint Committee on Taxation, which scores congressional legislation, has made similar estimates in the past.

One or two billion dollars a year is more than most of us can find in between the seat cushions. It would roughly double what Congress gives the I.R.S. to spend on information technology. Still, the number is small enough that it makes raising the issue seem petty and vindictive. Referring to carried interest has become a badge of solidarity, a touchstone for measuring class allegiances.

We should not overlook the substance of the issue. By my calculations, the government’s estimate is low by an order of magnitude. Taxing carried interest at ordinary rates would generate about $180 billion in revenue over 10 years.

Here’s how I get to a different bottom line. “Carried interest” is the investment fund manager’s share of the profits of the fund. Managers of private equity funds, venture capital funds and many hedge funds pay tax at the long-term capital gains rate on much of their income. Because this return represents a return on labor efforts, not a financial return, I have argued in the past that carried interest should be taxed at higher ordinary income rates.

Figuring out how much money is at stake isn’t easy. As I argued a few weeks ago, we should require investment funds to report carried interest separately on tax returns.

In the meantime, I looked at the latest available data from the I.R.S. Statistics of Income division. There is no separate reporting of carried interest, but buried deep in the data there is a line that reports the income of “partnership general partners” – that is, when the partner earning income is itself not an individual, but a partnership or limited liability company.

This entry in the data turns out to be a pretty good proxy for carried interest, as the fund manager of an investment fund is typically itself organized as a partnership. (By contrast, it is not unusual for the general partner of a real estate partnership to be an individual.)

The I.R.S. data is broken down by industry. In 2012, finance partnerships earned just over one trillion in income, about half of which ($527 billion) was taxed at long-term capital gains rates or preferential dividend rates. Within this group, “partnership general partners” reported $78 billion in income. The same group reported $53 billion in 2011 and $56 billion in 2010. About $40 billion, or half of the $78 billion, was taxed at low rates; applying a 20 percent rate increase would raise $8 billion a year.

One could argue, I suppose, that 2012 was not a representative year. But recent years have been even better. For example, Kohlberg Kravis Roberts alone earned about $8 billion in carried interest in 2014. The Blackstone Group reported earning $4 billion in carried interest.

My starting point for carried interest — the data on “partnership general partners” — is underinclusive. Individuals and corporations organized under Subchapter S also receive carried interest. And then one must add back in other industries, like real estate, that also generate carried interest.

If you add the amount of carried interest earned by general partners, there is about $200 billion annually in carried interest income, of which about $100 billion is taxed at low rates. Applying a 20 percent tax rate increase yields $20 billion a year, or $200 billion over 10 years. Applying a 10 percent haircut for factors like the actual invested capital of managers and anticipated changes in behavior, and the bottom line is $180 billion over 10 years.

The vast difference between the government’s estimate and my own is attributable to the anticipated behavioral response to the tax change, which one can think of as dynamic scoring on a microeconomics level.

For example, imagine that we doubled the capital gains rate to 40 percent from 20 percent. We would not get twice as much revenue as we do now. Some owners of appreciated property would feel “locked in” and defer the sale of assets.

The government’s low revenue estimate results from this “X factor” of anticipated behavioral response. But, unlike holding on to appreciated stock, there is no easy way to avoid realizing the income from carried interest.

Simple workarounds, like borrowing money from limited partners to buy direct interests in the funds, have been closed off. More complex workarounds, like having managers invest directly in portfolio companies, change the fundamental economics of private equity investing, where performance is measured on a fund-wide basis. I first proposed taxing carried interest at ordinary rates in 2006, and I’ve had thousands of conversations about it with tax lawyers. If there were an easy workaround, someone I know would have heard something about it.

Cynics say that the rich always figure out a way to avoid paying tax. This is not true. The system has many flaws, but the fact remains that closing loopholes raises revenue.

And there’s this: If it were so easy to avoid paying tax on carried interest, why would the industry fight so hard?

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