Tax policy received scant attention in the presidential debates, but when it did both candidates displayed a serious lack of understanding regarding at least one critical component of the tax code: carried interest. Although arcane in nature and unheard of by most, carried interest is a tax rule that fosters capital formation, encourages investment and ultimately leads to job creation.
Simply put, carried interest is a type of capital gain. Homeowners are familiar with the term ‘capital gain’ which in that circumstance refers to the increase in value of your home over time as you make improvements or rising market prices increase its sale price. If you sell your principle residence and make more than $500,000 in profit as a married couple, you must pay a capital gains tax. You pay the capital gains tax rate, not the ordinary income tax rate, on the transaction because you have already paid taxes on the income used to purchase the house.
Likewise carried interest is a long-term capital gain that is earned by an investment partnership. In this case the asset is not a house, but an investment portfolio that the partnership established and grew over time. When sold, the portfolio manager pays a lower capital gains tax rate on the fund’s profit, not the higher ordinary income tax rate.
The presidential candidates have, unfortunately, decided to portray carried interest capital gains as a loophole granted to special interests. Both candidates want to raise this capital gains rate claiming it gives investment fund managers an unfair tax break. Fairness, however, is not what such an increase would achieve. Rather it would amount to double taxation.
The negative effects would be much worse than over-taxing a sub-set of taxpayers. The partnerships that are formed when an investor joins with a fund manager results in a structure that fosters informed investments that grow over time. This growth generates profits. When the profits are re-invested that is called capital. Such capital is invested in businesses so that they can grow, expand and create jobs.
Carried interest capital gain rules play a critical role in allowing capital to form. If you raise the carried interest capital gain tax rate, the government will take more in taxes–dramatically decreasing the amount of capital available for investment in the economy.
A significant portion of that capital available for investment is invested right here in Pennsylvania. According to the American Investment Council, private equity firms invested an estimated $24.49 billion in Pennsylvania-based companies in 2015. There are 143 private equity firms headquartered in Pennsylvania. These companies support more than 185,103 workers at facilities both in Pennsylvania and in other states.
In other words, carried interest capital gains is not a tax device aimed at making Wall Street fund managers richer. Rather, it is appropriate taxation that makes more capital available for investment in the companies that are creating much needed new jobs for Pennsylvanians and elsewhere.
It is common in an election year for candidates to propose new government spending programs in an effort to win votes. They then go looking for ways to pay for that higher spending. “Reforming” the nation’s complex tax structure is often an effective target.
But, changes can have unintended consequences. Raising the current 23.8% carried interest rate to 33% as proposed by Donald Trump or almost 50% as suggested by Hillary Clinton would result in only a modest increase in tax revenue flowing into the federal treasury. And we all know that any move to raise this rate would likely be coupled with other tax hikes on working families and small businesses.
Even if you set aside the unfairness of double taxing investors, raising the carried interest tax rate or eliminating that category of capital gain entirely would have the detrimental effect of reducing capital formation. That means dramatically fewer dollars available for companies to grow and create new jobs. Carried interest is not a tax break for the wealthy; rather it is a way for investors to put their earnings to work creating the new jobs needed as the nation struggles to recover from the Great Recession.
Lowman S. Henry is Chairman and CEO of the Lincoln Institute of Public Opinion Research, Inc. and host of the weekly Lincoln Radio Journal. His e-mail address is firstname.lastname@example.org
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