With the “fiscal cliff” fast approaching and the federal budget taking center stage in national politics, legislators are under intense pressure to find politically feasible changes to the tax code that can be used to raise revenue. One feature of the tax code in particular – its treatment of the “carried interest” income earned by most private equity and hedge fund managers – has fallen squarely within these legislators’ crosshairs. It seems likely that this “loophole” will soon be eliminated, but current proposals for doing so miss the mark.
Most private equity firms’ fees are structured on the “2 and 20” model. The “2” refers to a baseline fee fixed at 2% of assets under management, which is taxed as ordinary income. The “20,” on the other hand, is the famous “carried interest:” fund managers also keep 20% of all gains realized by the fund. Because private equity funds typically enter relatively long-term investments, private equity fund managers can characterize their carried-interest income as long-term capital gains, which are taxed at 15%. Thus, successful private equity fund managers – whose incomes routinely exceed seven figures – often have the bulk of their income taxed at the low rate of 15%.
Not surprisingly, this practice has drawn scrutiny from legislators in Washington. Congressman Sandler Levin has introduced a “Carried Interest Fairness Act” in the House of Representatives, and President Obama’s 2013 budget specifically targets the loophole. Both simply propose that carried interest be taxed as ordinary income. This is an enticing solution: it singles out these wealthy fund managers, a group many people find unsympathetic, and it raises much-needed revenue.
However, resolving this issue may not be quite so simple. Whatever justifications exist for taxing other kinds of capital gains at rates lower than ordinary income may apply for carried interest income as well. For example, some argue that lowering capital gains taxes incentivizes risk-taking and investment; these incentives are certainly in play in the private equity world. The same is true of the “lock-in” rationale: some say lowering capital gains taxes prevents people from holding on to subpar investments simply for tax purposes, and the same considerations could affect the decision-making process of private equity fund managers deciding when to realize their gains.
A simpler solution would be to eliminate the distinction between capital gains and ordinary income altogether. Economic research has found little, if any, empirical evidence supporting the rationales described above. More direct and effective methods can be used to achieve the purported benefits of low capital gains tax. Worst of all, this distinction encourages people to engage in inefficient rent-seeking. The time spent by accountants and tax lawyers thinking of ways to re-characterize income, and indeed the hours spent writing this very article, could be used for other pursuits. The most sensible solution, then, is to do away with this distinction and tax income of all types at one simple rate.
 I.e., the large number of scheduled tax increases and spending cuts set to go into effect in early 2013. See Jonathan Weisman, Q&A: Understanding the Fiscal Cliff, N.Y. Times Economix Blog (Oct. 9, 2012, 6:28 PM), http://economix.blogs.nytimes.com/2012/10/09/qa-understanding-the-fiscal-cliff/.