Carried Interest Debate (Blog Post)
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Abstract
To many, the concept of carried interest is confusing or meaningless, and the question as to why anyone would debate something so arcane is even more so. In all likelihood, the concept of the exorbitantly wealthy Wall Street bankers or hedge-fund managers is much more familiar, so we will start from there. The objective of this blog post is to shed some light on the obscure world of "hedge funds," explain why the managers are perceived to pay so little tax, and explore recent political developments that may or may not affect that perception in the future.
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First, let's clear one thing up. When Donald Trump and Hillary Clinton rally against "hedge-funds" for paying so little tax [1], they are actually referring to private investment funds in general. In short, a private investment fund invests capital in order to achieve returns for investors. It is that simple; although, the types of funds, means through which capital is raised for the funds, how the capital is invested, where the profits are distributed, etc... can complicate the situation.
Before considering the aforementioned complications, one must understand the basic structure of a private investment fund. These funds, set up as limited partnerships or limited liability companies, are organized under general partners and limited partners. The general partners are the funds' managers or managing firms, while the limited partners are the funds' investors. These investors are typically made up of financial institutions, pension funds, and wealthy individuals. Types of private investment funds include private equity funds, venture capital funds, and, of course, hedge-funds. What are the differences between all of these funds? See the McNair Center's wiki page on carried interest for an in-depth explanation.
Now to discuss the elephant in the room, carried interest. General partners of the funds are compensated through management fees, carried interest, and profit from whatever stake (typically no more than 5 percent) they might have in the fund. Management fees are consistently around 2 percent of a fund's assets under management and are paid regardless of the fund's performance. Carried interest, alternatively, is a contractual right for the general partner to receive about 20 percent of the fund's profits[2]. The controversy stems from carried interest's tax treatment as it faces a maximum capital gains rate tax of 20 percent[3], compared to the maximum ordinary income tax rate of 39.6 percent[4]. Those in favor of a low capital gains tax believe that a higher rate would reduce incentive for general partners to take risks and this lack of incentive would then discourage innovation and efficiency in markets. Those opposed frequently argue that carried interest is performance-based compensation, much like a bonus, and therefore should be subject to the same rate, i.e. the ordinary income rate[5].
While the controversy surrounding carried interest has existed for some time, it has faced increasing media scrutiny since the last presidential election when it surfaced that Mitt Romney paid taxes of $1.9 million on $13.69 million in income in 2011, an effective 14.1 percent rate[6]. Perhaps in response to the media and public uproar, the American Taxpayer Relief Act of 2012 raised what was then a capital gains tax of 15 percent to 20 percent and was signed into law by President Obama on January 2, 2013[7]. In the aftermath of the Great Recession, being akin to those "hedge-fund guys" is politically precarious. It wouldn't be surprising if the current election's focus on increasing the capital gains tax had something to do with Romney's blunders.
Curious about the future of the capital gains tax after the 2016 elections? See our 2016 Candidates' Proposed Tax Reforms Post!
References
- ↑ [1] R. Rubin, 'Trump, Clinton Lines on Hedge Fund Tax Payments Puzzle Experts', Bloomberg, (New York City: September 2015)
- ↑ [2] V. Fleischer, 'Two and Twenty: Taxing Partnership Profits in Private Equity Funds',New York University Law Review, (New York City: April 2008)
- ↑ [3] K. Bell, 'A look at long-term capital gains tax rates', Bankrate.com, (New York City: April 2016)
- ↑ [4] K.Pomerleau, '2016 Tax Brackets', Tax Foundation, (Washington D.C.: October 2015)
- ↑ [5] 'Tax Carried Interest as Ordinary Income', Congressional Budget Office, (Washington D.C.: November 2013)
- ↑ [6] P. Rucker, J. Yang, S. Mufson, 'Mitt Romney releases tax return for 2011, showing he paid 14.1 percent tax rate', Washington Post, (Washington D.C.: September 2012) <ref name = "wiki">[7]'American Taxpayer Relief Act of 2012', Wikipedia, (San Francisco)
- ↑ Cite error: Invalid
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