Why the Carried Interest “Loophole” is a Fallacy 

For years pundits, academics, and legislators have wrongly accused carried interest of being a “tax loophole.” Calls to raise the tax rate on fees derived from profits made on private equity investments are imbedded in the myopic view that private equity managers make too much money, and that tax revenue is needed to balance the federal government’s budget.  

These slapdash conclusions are reflective of a socialist mindset on income distribution and the assumption that government spending must always increase year-after-year instead of considering the better alternative—reducing expenditures.  

Carried interest is a share of profits earned by general partners of private equity, venture capital, and hedge funds. General partners in a firm are paid as if it were a return on their investment rather than ordinary income and are taxed as a capital gain as such. Usually partners only receive carried interest when their fund produces a predetermined minimum return, called the hurdle rate, and this serves to make it operate like a performance fee, aligning the partners’ compensation with the funds’ success. If the general partner holds the compensation generated by the fund for over three years, the carried interest is taxed as a long-term capital gain (23.8%), rather than as ordinary income (40.8%).  

The tax treatment for carried interest is not a loophole as the Left has long mischaracterized. In fact, carried interest “is an intentionally designed feature of the tax code functioning as intended.” The word “loophole” implies that it was a legislative oversight providing certain individuals with a benefit unintended by the tax code–that does not apply here.  

Carried interest is designed to incentivize reasonable risk-taking by private equity and venture capital managers that is aligned with the fund’s success. It is a recognition that, in a high-tax economy, it is often difficult to encourage the risk-taking necessary for growth without financial incentives. The compensation is the cost for taking risks, but also includes higher returns for investors and retirees.  

Lower tax rates augment economic growth and benefit retirees. Pension funds often invest in private equity to receive higher returns. If legislators increased the tax rate on carried interest, retirement plans for millions of hard-working Americans would suffer. ATR has already outlined how attacking carried interest will harm state pension funds.  

Private equity firms invest hundreds of billions of dollars in the economy each year. In one specific example, the private equity industry employs 1.1 million people in California alone, and the California Public Employees Retirement System (CalPERS) has enjoyed a 10.4% return from private equity over a ten-year period. At the same time, CalPERS’s environmental, social, and governance (ESG) policies have cost retirees billions of dollars over the past couple of decades.  

According to the Wall Street Journal, about one quarter of state and local pension fund assets ($1.25 trillion) are invested in private equity, real estate, hedge funds, and private debt funds. There is “$480 billion in public-worker retirement money” invested in private equity—a 60 percent increase since 2018.  

Private equity has also elevated teachers’ retirement funds. In the first quarter of this year, the Pennsylvania Public School Employees’ Retirement System “significantly outperformed the average of large public pension funds” because of “its use of alternative investments such as private equity.”  

Increasing the tax rate on carried interest could pass more costs onto investment returns and reduce ordinary Americans’ lifesavings. 

The concept of “fairness” in the tax code is predicated on the constant assumption that government expenditures must always increase. To wit, government regulators continue to explore avenues to amend the tax code or issue regulations that squeeze taxpayers regardless of the detrimental effects on economic growth and American retirees’ nest eggs. 

It is time to quit chasing the carried interest “loophole” fallacy and instead pursue legislative initiatives that balance the budget by reducing government spending.