What’s The Right Tax Rate For Carried Interest?

There’s a debate going on over carried interest.  Both Trump and Clinton have said they are going after hedge funds. Clinton has even advocated for a transaction tax, which is one of the stupidest taxes of all time.  Taxing the rich has become fashionable in the Obama era.

Taxes are nothing more than economic incentives.  If you want less of something, tax it.  Taxes raise the marginal costs of producing.

Our tax code is built on the notion of “fairness”.  However, when politicos and bureaucrats decide what’s fair, it’s never fair.  Lobbyists and corporations get loopholes and the rest of the people are left holding the bag.

In hedge funds, venture funds(VC), private equity funds(PE), and real estate funds, the tax treatment on income is different than if you held a 9 to 5 job.  It was for commodity trading as well.  Here is how they are taxed.

  • Commodity traders pay a 60/40 tax.  It’s a blended rate of 60% capital gains and 40% of the highest tax bracket no matter what they are.  Commodity traders also get tagged with the alternative minimum tax.  This was negotiated back in 1986 by Republican Senator Bob Dole.  Many commodity traders were paying 0% tax by putting on a spread at the end of the year, artificially losing money and rolling it into the next year.
  • Stock traders pay a rate depending on their level of income.  It can be as high as 39.5%.  If they make a lot of money and it’s their primary business, a lot of time they have to pay the alternative minimum tax.
  • Fund managers pay ordinary income taxes on the management fees they get from their fund.  For example, if you have a $10M fund and draw a 2% management fee, your income is $200,000/yr and you pay tax on it.  Where fund managers tax treatment changes is in gains from investments they make.  They pay straight capital gains of 20%.  It used to be 15% until it was raised.  On the first $10M of gains for a lot of VC investments, investors pay 0% tax.
  • Angel investors often get tax credits from states that can be used to defer taxes

Is this fair? In my opinion, that is exactly the wrong question to ask. The right question to ask is, “What kind of economic activity do I want to incentivize, and reward?

If society values innovation and startups, they should tax investments in them less than other activities.  They should also open it up to every American so everyone can take advantage of it.  Currently, investing in alternative asset classes is only available to accredited investors.

I am strongly in favor of a flat tax of 15% on all income, with precious few write offs.  Charitable deductions and other taxes you pay being about the only ones.  The government will be able to sustain itself just fine.

Investing in early stage startups is incredibly risky.  It’s very difficult to find people that want to take that risk.  It’s pretty easy to find people that say, “Oh, I would have invested in Facebook when Peter Thiel did.  How could you pass on that?”  Except, people did pass on Facebook.  Usually at early stages the company looks so stupid and outlandish that most people cannot envision, or find the intestinal fortitude to write a check to assume the risk.  They would prefer to wait for the stock to go public and invest then.  Or, buy real estate.

Recently I read two opposing views on the carried interest question.  One is from Alan Patricof.  He is a seasoned venture capital investor.  He has had a highly successful and lucrative career investing in startups.  His point is that if the general partner isn’t putting money in the fund, they shouldn’t get the favorable tax treatment.  I disagree with him because paying taxes isn’t a sign or function of patriotism.

Personally, I would never ever put money into any fund where the person running the fund didn’t have a large stake of their own personal wealth in the fund.  I want them to have skin in the game.  But, that’s a different topic.

The other side of the argument was clearly articulated by another New York venture investor.  Steve Brotman wrote a blogpost back in December of 2007 and it’s ideas ring true today.  In it, he explains that if you change the tax treatment all funds will just reposition/restructure themselves to appear different and slip through.  They will still pay lower taxes, it’s just the legal structures they operate under and invest through that will change.

Do we want to incentivize economic activity?  Do we want to reward people that invent new stuff, and invest in new stuff?  Do we want inventions to raise our standards of living?  Do we want a better life for everyone?

Then tax things accordingly.