Tax reform should ensure that carried interest remains treated as a capital gain, 22 Members of Congress led by Congressman Richard Hudson (R-N.C.) wrote in a letter released earlier this week.
As the lawmakers note, carried interest meets all the criteria of a capital gain. It is not a loophole as some suggest and there is little justification for taxing carried interest capital gains as ordinary income.
Those who derive income from carried interest capital gains don’t have some special deal – they pay the same capital gains rates as everyone else. Carried interest is simply the share of an investment partnership allocated to the investor. These partnerships occur when individuals with capital and individuals with expertise pool their resources together. All income from this partnership is derived from a long-term investment in a business or real estate and so all income is treated as a capital gain.
While some have called for increasing taxes on carried interest by increasing the rate from 23.8 percent to 43.4 percent, this would be a mistake. Increasing taxes on carried interest raises little revenue and hurts the economy. Pro-growth reform should instead look to reduce taxes on capital.
As noted by the Joint Committee on Taxation, taxing carried interest as ordinary income would raise just $19.6 billion over the next decade, a drop in the bucket compared to the projected $41.7 trillion that the Congressional Budget Office estimates will be raised over that time frame.
However, after accounting for effects on the economy, the Tax Foundation estimates revenue from taxing carried interest as ordinary income would fall to just $13 billion due to negative macroeconomic effects.
This negative impact would be felt by pension funds, charities, and colleges that depend on investment partnerships as part of their savings goals. In addition, small businesses would find themselves increasingly shut out from investment money available to them from these partnerships.
Ideally, none of the income derived from a capital gain should be taxed as it is one of several layers of taxation in the existing tax code. This tax is levied on income that has already been taxed at the individual level and is then reinvested into the economy. This extra layer of taxation creates a bias against savings and suppresses productivity and new investment. In turn, this hinders the creation of new jobs, higher wages, and increased economic growth.
In fact, capital gains taxes are already high. Over the past eight years, the top rate increased from 15 percent to 23.8 percent. A study by Ernst and Young placed the top U.S. integrated rate at 56.3 percent after accounting for the corporate tax, federal and state capital gains taxes, and the Obamacare net investment income tax. In contrast, the average integrated rate amongst nations in the Organisation for Economic Co-operation and Development and the five member BRICS countries sits at just 40.3 percent.
Rather than push for a tax increase on capital gains, lawmakers should look to reduce the tax to promote economic growth and end the distortions in the tax code.