by Mitch Kokai
Senior Political Analyst, John Locke Foundation
Kevin Williamson of National Review Online ponders prospects for one piece of President Trump’s tax plan.
The “carried-interest loophole” is a misunderstood and often misrepresented feature of U.S. tax law. To begin with, it isn’t a loophole at all: It is an intentionally designed feature of the tax code functioning as intended — it may be good or it may be bad, but it is the way it is for a reason, and it did not get that way by accident. Further, it does not have much to do with Wall Street hedge funds, despite the constant insistence from President Trump that it does.
Here are the basics: In our tax system, the term “long-term capital gains” generally means income from an investment held for at least one year and one day. The day-traders and algorithm-based high-frequency traders do not enjoy the tax advantage conferred upon those realizing long-term capital gains, which are taxed at a lower rate (maxing out at 23.8 percent) than are other forms of income (top tax rate 43.4 percent). This is of interest to investors on various timelines: If you are saving for your retirement, then a 20 percent tax discount on the accumulated gains of a 35-year investment plan is very important. If you are an entrepreneur who has put 40 years of his life into building a business, then the question of whether you are going to pay 23.8 percent in taxes when you sell it or 43.4 percent means a great deal. It is also very important if you are in the private-equity business, which is mostly what the current fuss is all about.
Unlike hedge funds, private-equity firms typically make long-term investments. Private-equity firms are not typically engaged in the business of trading and betting on the markets, but are genuine investors: They are private in that they help companies raise money without accessing the public financial markets, and they take equity in firms or in projects as their main form of payment. Sometimes they work with troubled companies that need to restructure and require financing to get that done; sometimes they work with very successful small companies to help them become large ones. That is what Mitt Romney did at Bain Capital, helping to launch nationwide chains such as Staples. …
… And that leads us to one of the criticisms of the “carried interest” tax treatment of private-equity income: Often, the firms themselves do not have any real money at risk, the immediate financial risk being borne by the limited partners who put up the money. But that is not an argument for raising the tax rate on private-equity income — it is an argument against “sweat equity,” which is the lifeblood of entrepreneurship large and small. If you open a dry-cleaner business and your rich uncle invests $20,000 in the project to get you started, the profit you realize 20 years later when you sell your successful chain of cleaners is treated as a long-term capital gain for tax purposes, in spite of the fact that you didn’t have any of your own money at risk. You didn’t invest money: You invested time, work, knowledge, and innovation, and you bore the opportunity costs for all the other things you might have done with your time and labor. You are every bit as much of an investor as is a guy who buys 20 shares of GM and parks them in his retirement account for 20 years. More of one, some might say.