The US Capitol by R Boed is licensed under CC BY 2.0 DEED

A partisan cabal of lawmakers is wrongly calling to raise the tax rate on carried interest. Democratic senators have introduced legislation that taxes carried interest as ordinary income, which could put taxpayers on the hook to bail out public pensions, limit retirement options for American workers, and harm small business investment. 

“Carried interest” is a fraction of profits general partners of private equity, venture capital, and real estate funds, earn after they pay back their “limited partner” investors (e.g., pension funds). The Democrats’ bill would arbitrarily tax carried interest as high as the top ordinary income rate of 37 percent.  

The bill would negatively impact large swaths of the American economy. Carried interest is used in partnerships spanning many sectors. Applying a higher tax rate could potentially harm industries such as “oil and gas, real estate, and small businesses.” Another paper that analyzed venture capital funds found that changing the tax treatment “to ordinary income rates would significantly reduce the attractiveness of forming a new fund.” A higher tax rate limits the availability of affordable investment options for American workers and retirees. 

Pension funds often invest in private equity to receive higher returns. Grossly underfunded pensions need private fund investment exposure to make necessary payments when workers retire. If a public pension is underfunded, the only backstop is raising taxes on Americans to shore up the funds, which is a clear nonstarter. Increasing the tax rate on carried interest weakens the incentive to offer private fund investment options for pension funds and increases the likelihood of taxpayer bailouts. The additional benefit of a lower tax rate on carried interest is that it incentivizes general partners to operate funds so they perform well. This aligns incentives with pension fund investors and ultimately benefits American workers with a pension. 

Applying the ordinary income rate to carried interest could also weaken investment in small businesses. After all, in 2022, 85% of all private equity-backed businesses were small businesses. That same year, private equity was estimated to have contributed $1.7 trillion to U.S. GDP. Raising the tax rate on carried interest will make certain small business investments less feasible. 

Lawmakers should quit chasing carried interest and instead pursue legislative initiatives that balance the budget by reducing government spending. Spending is out of control, so much so that “debt held by the public in 1981 amounted to about 25 percent of GDP; today’s debt amounts to more than 100 percent of GDP.”

It is time to quit vilifying carried interest. Lawmakers should focus on reining in spending and making investment and retirement options affordable for all Americans.