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http://mobile.nytimes.com/2016/07/16/business/dealbook/the-carried-interest-loophole-what-loophole.html http://mobile.nytimes.com/2016/07/16/business/dealbook/t

http://mobile.nytimes.com/2016/07/16/business/dealbook/the-carried-interest-loophole-what-loophole.html http://mobile.nytimes.com/2016/07/16/business/dealbook/the-c... is a reasonable explanation of why this isn't really a loophole.

rlucas 10y ago
The Klinsky explanation you linked to is borderline disingenuous. Nah, it's just disingenuous. It's exhausting and daunting to list all the ways that Klinsky's ELI5 example is meaningfully different from what really happens in PE-land. What it comes down to is this: PE managers get a success fee for managing other people's money without putting up their own, which is very very normal, and usually counts as earned income (normal tax rate). However, when certain very specific circumstances apply, a bit of the tax code lets you legally pretend that instead of a success fee, the amount you get paid is a return on invested capital. Very plainly, the pension funds, sovereign wealth funds, HNWIs, etc. who put up the actual risk capital into the PE funds are putting dollars at risk and earning a return on invested capital. If one simply does the exercise of asking, "where are the dollars that the PE manager put at risk?" the lie is exposed. My personal pet peeve on this is that, back in the 1970s, it was actually the case that the general partners would have had unlimited liability and therefore really were, after a fashion, putting the entirety of their capital at risk to earn the carry. But since the 1990s at least and probably earlier, everyone in this game has used a pass-through LLC blocker entity to limit the personal liability of the managers. So they keep all the tax benefit but give up that pesky "risk" part. (Partnership structures and carried interest actually do have other things to recommend them as ways of aligning interests and making deals work. But pretending that the contingent, earned, success-based portion of income accruing to the manager is a return on risk capital invested for tax purposes is just a total fiction.)
- amluto 10y ago
  > However, when certain very specific circumstances apply, a bit of the tax code lets you legally pretend that instead of a success fee, the amount you get paid is a return on invested capital. I'd love to see an explanation of why it makes any sense to continue treating capital gains income (i.e. "return on invested capital") any differently than ordinary income. If we fixed that, then the carried interest "loophole" would cease to be relevant because it wouldn't change the tax rates paid. I don't see why the tax code should incentivize passive investment over actual work.
  - WalterBright 10y ago
    Inflation is one reason, as the capital "gains" resulting from inflation are taxed. Another reason is businesses need investment capital. Do you want to incentivize people providing that, or discourage it?
  - briandear 10y ago
    Carried interest, in my opinion isn't a capital gain unless the investor's own capital is at risk. However, let's talk about 'normal' capital gains. When you risk your own capital, you are obviously going after a reward, however the downside is that you can lose your capital. So a lower tax rate makes sense in order to incentivize the risk. Look at the property market in France for instance: the housing market is far less liquid than the US and that results in much higher housing prices because fewer people are going to sell their property if they lose 50% of the gain to taxes. That constricts supply and increases prices. There is definitely more to French housing than that, but the point is that high taxation reduces the benefit of selling something which disincentivizes selling, resulting in higher prices which doesn't harm the property owner as much as people trying to buy houses. In other words, high capital gains taxes reduces market liquidity. That means that capital that could be invested in something else is 'locked up' in an asset that isn't profitable to sell. That means some startup or some small business can't get access to capital they need to grow and expand -- or even get started in the first place. Look at VC activity in France vs. San Francisco. The difference isn't entirely cultural but a result of more expensive capital. Many European investors are far more conservative than US investors not because they want to be but because the incentives are stacked against aggressive or innovative investing, the types of which are responsible for many of the companies at which many people reading this work. So why incentivize risking own's capital? $1 million could seed a company that grows to dozens of employees, while if that $1 million were taxed at 50% that means that the government has to use the resulting $500k to provide utility for society. $500k could mathematically provide 10 jobs at $50k per year for one year. However, that million dollar seeded startup could create dozens of jobs as well as tax revenue from the resulting profit as well as tax income from all of the employees. A highly highly simplified example but the point is that a million in the marketplace has the potential to become multi-millions in future tax revenue. While that money in government doesn't have the same force multiplier potential unless you profess that we are on the far left of the Rahn Curve and government isn't yet big enough to support maximal economic output. My long drawn out point: incentivizing capital gains incebtivizes economic growth. Carried interest (on other people's capital) however is another issue altogether: essentially that's a commission when it's being treated like a capital gain.

rlucas 10y ago

The Klinsky explanation you linked to is borderline disingenuous. Nah, it's just disingenuous. It's exhausting and daunting to list all the ways that Klinsky's ELI5 example is meaningfully different from what really happens in PE-land. What it comes down to is this: PE managers get a success fee for managing other people's money without putting up their own, which is very very normal, and usually counts as earned income (normal tax rate). However, when certain very specific circumstances apply, a bit of the tax code lets you legally pretend that instead of a success fee, the amount you get paid is a return on invested capital. Very plainly, the pension funds, sovereign wealth funds, HNWIs, etc. who put up the actual risk capital into the PE funds are putting dollars at risk and earning a return on invested capital. If one simply does the exercise of asking, "where are the dollars that the PE manager put at risk?" the lie is exposed. My personal pet peeve on this is that, back in the 1970s, it was actually the case that the general partners would have had unlimited liability and therefore really were, after a fashion, putting the entirety of their capital at risk to earn the carry. But since the 1990s at least and probably earlier, everyone in this game has used a pass-through LLC blocker entity to limit the personal liability of the managers. So they keep all the tax benefit but give up that pesky "risk" part. (Partnership structures and carried interest actually do have other things to recommend them as ways of aligning interests and making deals work. But pretending that the contingent, earned, success-based portion of income accruing to the manager is a return on risk capital invested for tax purposes is just a total fiction.)

amluto 10y ago
> However, when certain very specific circumstances apply, a bit of the tax code lets you legally pretend that instead of a success fee, the amount you get paid is a return on invested capital. I'd love to see an explanation of why it makes any sense to continue treating capital gains income (i.e. "return on invested capital") any differently than ordinary income. If we fixed that, then the carried interest "loophole" would cease to be relevant because it wouldn't change the tax rates paid. I don't see why the tax code should incentivize passive investment over actual work.
- WalterBright 10y ago
  Inflation is one reason, as the capital "gains" resulting from inflation are taxed. Another reason is businesses need investment capital. Do you want to incentivize people providing that, or discourage it?
- briandear 10y ago
  Carried interest, in my opinion isn't a capital gain unless the investor's own capital is at risk. However, let's talk about 'normal' capital gains. When you risk your own capital, you are obviously going after a reward, however the downside is that you can lose your capital. So a lower tax rate makes sense in order to incentivize the risk. Look at the property market in France for instance: the housing market is far less liquid than the US and that results in much higher housing prices because fewer people are going to sell their property if they lose 50% of the gain to taxes. That constricts supply and increases prices. There is definitely more to French housing than that, but the point is that high taxation reduces the benefit of selling something which disincentivizes selling, resulting in higher prices which doesn't harm the property owner as much as people trying to buy houses. In other words, high capital gains taxes reduces market liquidity. That means that capital that could be invested in something else is 'locked up' in an asset that isn't profitable to sell. That means some startup or some small business can't get access to capital they need to grow and expand -- or even get started in the first place. Look at VC activity in France vs. San Francisco. The difference isn't entirely cultural but a result of more expensive capital. Many European investors are far more conservative than US investors not because they want to be but because the incentives are stacked against aggressive or innovative investing, the types of which are responsible for many of the companies at which many people reading this work. So why incentivize risking own's capital? $1 million could seed a company that grows to dozens of employees, while if that $1 million were taxed at 50% that means that the government has to use the resulting $500k to provide utility for society. $500k could mathematically provide 10 jobs at $50k per year for one year. However, that million dollar seeded startup could create dozens of jobs as well as tax revenue from the resulting profit as well as tax income from all of the employees. A highly highly simplified example but the point is that a million in the marketplace has the potential to become multi-millions in future tax revenue. While that money in government doesn't have the same force multiplier potential unless you profess that we are on the far left of the Rahn Curve and government isn't yet big enough to support maximal economic output. My long drawn out point: incentivizing capital gains incebtivizes economic growth. Carried interest (on other people's capital) however is another issue altogether: essentially that's a commission when it's being treated like a capital gain.