The Taxation of Carried Interest

Several people have asked me my views on the taxation of carried interest. It is a complicated issue, and I don't pretend to be an expert on tax law, but here goes.

Deferred compensation, even risky compensation, is still compensation, and it should be taxed as such. Paul Krugman hit the nail on the head with this question:

why does Henry Kravis pay a lower tax rate on his management fees than I pay on my book royalties?

The analogy is a good one. In both cases, a person (investment manager, author) is putting in effort today for a risky return at some point in the future. The tax treatment should be the same in the two cases.

One hedge fund manager told me that the initial value of the carried interest should be taxed as ordinary income and then the subsequent returns should be taxed at the capital gains rate. Maybe so, but taxing the terminal value as ordinary income (as is being proposed) seems strictly better for the manager in present value. It is as if the manager put the initial value of the carried interest in a tax-deductible IRA, deferring tax on this compensation until the money is withdrawn at a later date. The proposed reform, therefore, does not seem excessive.

John Berry's recent article on carried interest suggests that the Bush administration is opposed to reform. If so, I fear the administration is on the wrong side of the issue.

Update: The FT reaches the same conclusion.

Update 2: A very smart tax economist, who prefers anonymity, writes me:

I don't disagree with anything in your blog, but I think you should have noted that this rule extends beyond the carried interest and reflects the general treatment of partnership profits interests received for services in all industries.

Carried Interest

If you want to understand the debate over taxing carried interest, this recent testimony by CBO director Peter Orszag is a good place to start.

Taxing Carried Interest

Click here to read my column in Sunday's NY Times.  The piece is an attempt to explain the taxation of carried interest and is more pedagogical than opinionated.  For the truly wonky who want to learn more about this topic, I recommend this article by Alan Viard.

Blinder on Taxing Carried Interest

Alan Blinder weighs in.

Realpolitik

Here's the latest on taxing carried interest: A prominent Democrat is trying to stop a prominent Republican from raising taxes on money managers.

Democratic Senator Charles Schumer of New York is fighting a plan to raise taxes on hedge funds and buyout firms with his own legislative poison pill: a demand that other powerful interests share any pain. Schumer is expressing concern about plans by lawmakers including Republican Senator Charles Grassley that would more than double taxes on private-equity and hedge-fund firms or their managers....

Schumer may be trying to shield both his Wall Street constituents and his party's electoral war chest, Grassley said. The Democratic Senatorial Campaign Committee, which Schumer heads, received $779,100 from employees of private-equity firms and hedge funds in June, six times their combined total in June 2005, federal filings show. That far exceeds the industry's contributions of about $60,000 to the Republican Senate committee.

If you read this blog, you know my views on this policy debate.