Bridging the Gap: the Carry Tax

In August 14, 2011, in an unusual move that made some of America’s richest and most powerful people wince, Berkshire Hathaway’s Chairman and CEO Warren Buffett called on Congress and the super-rich in America to support a reform in the tax code to treat capital gains as ordinary income.

This is by no means a novel idea, but the weight of Buffett’s opinion piece in the New York Times spurred immediate discussion. It is not only a question of how much impact such a policy move will have on resolving the budget crisis, but also who will rise to the challenge.

Capital gain or loss refers to the positive or negative returns realized on buying and selling assets, ranging from houses and cars to stocks and bonds. Capital gains are taxed depending on a taxpayer’s ordinary income tax bracket and the time period of gains.

For a long-term investor who generates his/her income from investments on the financial market, all of that earning is taxed under the current rate of 15%. This is the case for most hedge fund and private equity fund managers. They invest money garnered from various institutional investors and wealthy individuals, and make a living by keeping a portion of the returns, called carried interest, in addition to charging management fees.

It is exactly these alternative asset managers that the “Buffett Rule” targets. On September 12, the White House published a proposal on how to treat the carry. “Today, fund managers pay the capital gains rate of 15% but, under Obama’s proposal, it would be increased to an ordinary income rate that, for most fund managers, would be around 35%. This would apply to those managing funds in asset classes like private equity, hedge fund, venture capital, real estate, timber and oil and gas.” By taxing carried interest as ordinary income, the Congressional Budget Office projects an additional $21 billion in revenue over the next decade, $18 billion of which will go toward paying for the recently proposed American Jobs Act.

If such a reform has the potential of bridging the federal budget gap, why has there been such strong push back? The main argument from private equity managers is that taxing carry as income will disincentivize them to grow or acquire portfolio companies, therefore hurting job creation and innovation.

In response to Obama’s proposal, Steve Judge, president of the Private Equity Growth Capital Council said, “Proposals to raise taxes on carried interest have consistently been rejected for over four years because raising taxes on investments would only sideline employers and investors and create further uncertainty in an already struggling economy.”A 2010 study by the Council estimates that higher taxes on carry will decrease investments by $7 billion to $27 billion annually.

Political ideology also plays a major role in promoting the fight against changing the treatment of carried interest. “We do not have time to waste on political games and pushing big tax increases that will only make our economy weaker for all Americans,” said Sen. Patrick J. Toomey, a member of the deficit reduction special committee, in response to Obama’s proposal. Five republican presidential candidates have already declared their pledge to eliminate capital gains tax.

However, frontrunner Mitt Romney, cofounder of private equity firm Bain Capital, has not made reducing capital gains tax a part of his campaign platform. Even support from the Democrats has been mixed.  Timothy M. Kaine, former Democratic National Committee Chairman and former Virginia governor, has publicly opposed capital gains tax hikes.

Even if both sides can agree to heed the call of Buffett, the logistics of carrying out such a reform can be challenging. The IRS will first need to define middle-income family’s earnings and tax rate, which leads to complicated calculations for higher earners when taking itemized and state deductions into consideration. It will also require a more inclusive definition of income. “Writing a Buffett rule into law would require defining income and setting a minimum rate for it,” said Roberton Williams of the Tax Policy Center, “Every time you set up something like this, you’re opening the door for the tax lawyers to come in and get around the attempt to raise revenues.”

Carried interest taxation is, and likely will continue to be, a thorny issue. Warren Buffett’s public stance may have been a nice surprise to some Americans concerned about the deficit, but it has also renewed debate. For readers interested in alternative asset management or Dartmouth seniors heading to the industry after graduation, tax hikes on carried interest will not be the end of private equity or hedge fund investing. But in a fragile economy, it may be wise to keep in mind the worst case scenarios spelled out by fund managers.