Monday, February 25, 2013

Carried Interest: An Argument Falls Short

Carried Interest: An Argument Falls Short


I’ve argued repeatedly that the capital gains treatment on carried interest ought to be repealed.  The New York Times Op Ed page features a contribution from Lynn Forester de Rothschild, entitled “A Costly and Unjust Perk for Financiers[1].” Ms. Forester de Rothschild is the CEO of E.L. Rothschild, a family-owned investment firm founded by her third husband, Sir Evelyn Robert de Rothschild.  By the way, it’s his third marriage as well.

The central thesis of Ms. Forster de Rothschild’s argument is sound.  Since general partners don’t put any capital into a partnership, they should not receive capital gains treatment.  This principle has been at the center of the attack on carried interest for a long time.

Stealth (2009)

There are a couple of errors in her piece that the industry, especially the Private Equity Growth Council, is going to jump on.  First, she tries to broaden the debate by pointing out that real estate partnerships and hedge funds also enjoy carried interest treatment.  However, she fails to mention that the capital gains tax rate of 20% only applies if the asset has been held for one year.  As a result, most hedge funds generate short-term gains, which are taxed at the ordinary rate (now 39.6%).  Real estate partnerships, for the part, enjoy the 20% rate on carried interest profits.  As a result of her error, she grossly overstates the loss of income to the US Treasury from the carried interest exception.

Second, she points out that brain surgeons, stockbrokers, corporate lawyers, and actors don’t receive favorable tax treatment on their large incomes.  Perhaps she should apologize to brain surgeons and actors for dragging them into a debate about financiers.  Alternative managers, whether they manage private equity, real estate, or hedge funds, also pay ordinary income on their salaries[2], and those salaries are none too shabby.  What’s at issue is the treatment of their performance bonus.

Private equity managers argue that they are entrepreneurs.  Much like the folks who start up companies or invent new products and services, they should be able to convert their “sweat equity” into favorable tax treatment.  This is the argument that Ms. Forest de Rothschild fails to address at all.   The only thing inventive about private equity, real estate, or hedge fund managers is their ability to con us into thinking that they add huge amounts of value to our economy and well being, and therefore deserve tax privileges.

Ms. Forest de Rothschild is right about one thing.  The industry has the money and political power to protect its carried interest benefit, even while the top income tax bracket rises and sequester threatens public servants, public services, and the poor.




[2] There’s another tax issue worth fixing.  Some alternative managers invest part of their management fee in the fund, thereby converting ordinary income into capital gains.  Frankly, investors should be ashamed of themselves for paying such high management fees that there’s a windfall left over.

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